The European Central Bank's Approach to Climate Risk Management

The European Central Bank Guide on climate-related and environmental risks outlines how the ECB expects its supervised banks to manage and disclose C&E (climate-related and environmental) risks under current prudential rules.

The guide aims to enhance banks' awareness of and preparedness for managing climate-related and environmental risks.

It outlines 13 key supervisory expectations, covering:

• The impact of climate-related and environmental risks on the business environment (1) and its implementation into business strategy (2,3) and risk appetite framework (4).
• Governance (5) and internal reporting (6).
• Integration of C&E into existing risk management (7), including credit risk (8), business continuity, reputational and/or liability risks (9) and market risk (10).
• Stress Testing (11).
• Liquidity risk and buffer calibration (12).
• External Reporting and Regulatory Disclosure (13).

Each primary expectation is accompanied by detailed sub-expectations designed to delineate the requirements and assist supervised banks in fully understanding their responsibilities.

At present^(*), the capital requirements framework has no climate-specific provisions.

Nevertheless, with the mandate that climate and environmental (C&E) risks be fully incorporated into the Internal Capital Adequacy Assessment Process (ICAAP) by the end of 2024, and the inclusion of climate-related findings in the 2022 Supervisory Review and Evaluation Process (SREP), it can be argued that climate risks have an indirect influence on banks' capital requirements. 

In 2022, some banks saw their SREP score negatively affected by climate-related risks. In turn, this changed their Pillar 2 requirements.

^(*) As of February 2024.

Expectation 8 of the ECB Guide on climate-related and environmental risks relates to credit risk, stating that financial institutions must factor in climate and environmental risks when allocating credit, as well as supervise and manage these risks in their loan portfolios, credit process, risk classification and collateral valuations.

Additionally, banks should identify risk concentrations originating from climate-related considerations and price their loans appropriately related to the risk (including climate risk). 

Expectation 8 has 6 sub-expectations, summarised above.

To align with the ECB's guidelines and comply with regulations, financial institutions need to align with all 13 guidelines. 

A potential approach: 

1. Become familiar with the requirements as explained in the Guide on climate-related and environmental risks.
2. Collaborate with a data provider specialising in climate and/or environmental risks for your industry. For example, for physical risks in the financial services industry, you should aim for forward-looking, quantitative, up-to-date climate risk data that enables you to assess your portfolio, identify materiality exposures and report meaningful information and key metrics.
3. Liaise with internal stakeholders to establish the appropriate governance and organisational structure required to integrate climate-related risks into your existing framework. For example, you may need to establish a dedicated committee.

Climate X specialises in physical climate risk data for the banking industry, having built the first fully integrated climate risk platform. If you need help with your climate risk journey, speak to us.

The ECB has explicitly outlined 13 expectations of compliance.

In essence, financial institutions should assess the materiality of their climate risks, as well as consider climate-related and environmental risks when creating and executing their business strategy, governance, and risk management structure.

The ECB’s primary method for evaluating banks’ compliance is the supervisory review and evaluation process (SREP). 

SREP evaluates banks’ risk profiles, determining what supervisory measures are needed to promote banks' soundness. The SREP methodology has four pillars:

1. Business Model and Profitability Assessment
2. Internal Governance and Risk Management
3. Capital Risk Assessment
4. Liquidity and Funding Risk Assessment

The ECB assigns a final SREP score to each bank based on their risk assessment.

With the ECB making C&E risks one of its supervisory priorities for 2023-25, banks’ governance, management, and oversight of C&E risks are under the microscope. For example, a few banks' 2022 SREP scores were negatively affected by climate risk exposure, which affected their Pillar 2 capital requirements.

For more information about ECB policy, Climate Risks and SREP, download our full whitepaper below. It's free.

In 2023, it has been reported the ECB has started to impose penalties on banks that don't comply with risk management expectations.

These penalties would be applied daily and could amount to 5% of average daily revenue, suggesting daily penalties of up to €1.4m for a bank with an annual turnover of €10bn.

Plus, in 2022, some banks saw their Pillar 2 requirements modified due to a worse SREP score negatively affected by climate-related risks.

Finally, the ECB has announced that it has established deadlines for banks to fulfil all supervisory requirements by the end of 2024 gradually - the final deadline for banks to comply.

Institutions must establish and maintain internal governance systems to manage their operations responsibly, which includes recognising and addressing the effects of climate-related and environmental factors on their business and ensuring long-term sustainability and resilience.

ECB guidelines are primarily outlined in expectations 3 (management body responsibilities) and 5 (organisational structure).

These complement Article 74(1) CRD and EBA Guidelines on Internal Governance (EBA/GL/2017/11).

The ECB defines climate risk stress testing criteria outlining the key elements to stress test for: physical risk, transition risk, their evolution under different warming scenarios, and how these climate risks might realise in the short, medium and long term. 

In their climate stress testing, banks should define their risk assumptions, consider various scenarios, and assess their capital adequacy under different conditions with a focus on at least a three-year forward-looking perspective. For strategic planning, a longer time horizon should be adopted, considering that these risks are more likely to become apparent over the medium to long term.

ECB guidelines are primarily outlined in the expectation 11.

Yes, the ECB has specific time horizons for its climate risk assessment.

Banks must analyze short-, medium-, and long-term scenarios (expectation 1) and focus on at least a three-year forward-looking perspective for stress testing (expectation 11).

Additionally, the ECB suggests using a longer time horizon for strategic planning. This is because some climate risks are more likely to materialise in the medium to long term.

The ECB expects institutions to utilise detailed approaches when assessing the effects of climate-related and environmental impacts on their business environment.

This may involve considering differences within sectors, between assets, accounting for supply chain effects, or utilising specific geographic location data, depending on the nature of the climate-related impact.

This can be achieved with granular, asset-level climate risk data, such as Climate X's. If you need help with your climate risk journey, speak to us.