Financial institutions ‘show a strikingly low appreciation of capacity and resource needs’ for good climate risk management

Banks are likely to have to move quickly to improve their climate risk assessment and mitigation as regulatory expectations rise. The ECB’s review of European banks’ progress shows how important it is to move quickly as climate risks are no longer distant and have rapidly become material risks in the short- to medium-term (3–5 years).

• The European Central Bank released a ‘thematic review’ of over 100 banks of varying sizes with €25 trillion of assets and found significant gaps in climate risk management
• Banks have rapidly increased their focus on climate risks, but it takes a concerted, multi-year effort to build the capacity that regulators are increasingly expecting
• Financial institutions in other markets that are just beginning to address climate risks are making a good strategic decision, but should expect to accelerate these efforts

The ECB has concluded its ‘thematic review’ of European banks’ progress on climate-related risk assessment and mitigation and says it has found some progress. However, much of the review is focused on how much work remains if banks are to meet the ECB’s supervisory expectations by 2024, backed up by the threat of enforcement actions. European regulators have been among the most proactive in this area, and because of their involvement in the Network for Greening the Financial System, they may be a bellwether for supervisory priorities on climate-related risk.

A major sign of their focus on climate-related financial risk is that in 2022 the ECB found that 80% of the 107 banks with €25 trillion or more in assets saw climate-related financial risks as being material to their risk strategies. More importantly, 70% of the banks determined that this materiality would be felt within 3–5 years.

The timeline during which the bank’s perception of the importance of climate-related risks has risen so much has been extremely compressed, with regulatory efforts being amplified in 2020 by the ECB’s release of a final guide on climate-related and environmental risks. The share of banks responding that climate-related and environmental risks were material rose by 17 percentage points between 2021 and 2022.

Notwithstanding the rapid increase in perceived importance of climate risks, implementation was found to have wide gaps, with the ECB commenting that “institutions show a strikingly low appreciation of capacity and resource needs” to fully integrate climate-related risks. Despite the rapid growth in their internal assessments of customers’ climate risk profiles, the ECB found that 96% of institutions had gaps for climate risks in key sectors, geographies or risk drivers, and 60% were classified as ‘major gaps’.

While taking the banking sector to task on the shortfalls identified in their climate risk mitigation, the ECB also highlighted a variety of incremental steps that banks have taken during their implementation process. The regulatory approach is not a type of ‘pass/fail’ review, but recognizes, in the words of ECB Vice-Chair of the Supervisory Board Frank Elderson, that “banks need to adjust before it’s too late [because] it takes time to fundamentally adapt and design concrete pathways to maintain a resilient business model”.

For banks at an earlier stage of setting priorities or targets relating to climate-related risks or impacts, the progress of many European banks can seem quite advanced, but they did not get to where they are overnight, and still have significant gaps between their ambition and actions (55% of European banks covered by the review were identified as having developed but not implemented their climate-related policies).

The incremental degrees of progress found among European banks where supervisory expectations have been the highest should provide some reassurance about the value of developing strategies for better climate risk management over time. Investors will likely compare all banks to the ‘best-in-class’ for climate risk management. Regulators are also working to bring similar expectations into their supervisory reviews through peer-learning platforms like the NGFS. And customers will benefit from the assistance and financing resources needed to make a rapid and more orderly transition.

• In the ECB’s review, they noted several indicators from the practices of leading banks, including that they:Use scientific pathways and recognize how the pathways themselves continue to evolve over time to meet Paris and Net Zero 2050 objectives
• Use climate strategy to adjust their product offerings
• Establish policies to phase out specific activities in certain timelines
• Engage with clients on client-specific actions to mitigate risk of alignment, and have policies for how they will respond where engagement fails, including abandoning the client relationships
• Establish integrated transition planning policies, processes and actions

That is a long list. Many financial institutions have progressed only to the point of assigning responsibility for climate-related impacts to senior management. Others have expanded the responsibility to a sustainability team. But the real challenge comes in taking the next steps forward, especially where data limitations are severe.

One of the common approaches to the data limitation has been to focus on a narrow list of sectors with customer engagement, so as to improve the data available and guide decision-making from the bank’s perspective. But even where companies operate in an environment where that type of reporting is either done for a subset of companies (such as listed companies) or where regulation is coming into effect soon for a wider array of companies, as with the Corporate Sustainability Reporting Directive (CSRD), it is not always easy to obtain the cooperation needed to collect the data.

The ECB’s Elderson noted that “the banks tend to favour actual client data, which they collect from a broad customer base via questionnaires. And these banks do not take no for an answer. Instead, they experiment with ways of encouraging customers to fill in the questionnaires.” The challenges of customer engagement don’t begin just with implementing the transition; they start with building customer awareness about the need for the data in the first place, and continue engaging until they have the data.

That approach is important for banks to take, but it cannot be the only one because there is a discontinuity between the time required for collecting good data and the time when comprehensive action is needed. This gap needs to be reconciled by financial institutions taking a both/and approach to their climate change response. It will not be enough to focus only on a few high-emitting sectors that are unlikely to cover more than a small share of their balance sheet.

Disclosure requirements like the PCAF standards recognize this by phasing in broader definitions of customer emissions data in terms of what must be disclosed. Banks should be thinking about the same thing in terms of how they use all of the data sources, from broad comprehensive data that may offer less precision as well as less comprehensive data that moves towards the leading practice.

Climate change is not just one of many risks; it is rapidly developing and expanding and interrelated with the other risks that banks are addressing or will need to address in coming years. And it will take more work than even a committed bank can accomplish in a few years’ time. It’s become near-term financially material and banks will need to increase the resources they put into responding either on an accelerated timetable if they don’t currently face supervisory requirements, or one that is even faster.

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