Last week the EBA published its consultation paper on its expectations for the management and supervision of ESG risks by banks and investment firms.
This is important reading for Boards and those tasked with ensuring the adequacy of Board governance with respect to ESG risk, as well as those in the finance function responsible for managing and monitoring financial risks.
The outcome of the consultation will be finalised EBA guidelines and standards, published in 2021 or 2022, and may also lead to amendments to prudential legislation. But the consultation has consequences now. Its purpose is described as “firstly, to present the EBA’s understanding on the relevance of ESG risks for a sound functioning of the financial sector”. It describes current EBA understanding of existing rules, which understanding is evolving to incorporate the ESG perspective. So it is important that firms read this now to consider any adjustments to their current governance frameworks.
The desired change that drives the paper is that whilst firms have made good progress in handling ESG risk within their CSR programmes, there is much work to be done in treating it as a financial risk.
Identifying a three step process, the EBA discusses tools and metrics that can be used for each stage in the integration of ESG risk as a financial risk:
- Risk identification
- Risk evaluation and assessment
The final step, action, is where board governance plays a critical role. The EBA reflects on the good and bad practices it has observed and identifies good governance mechanisms including:
- Integration of climate change as a financial risk into business strategies and processes
- Incorporation of ESG risk-related considerations into setting business strategies in particular by extending the time horizon for strategic planning to reflect the nature of ESG risk
- Setting and disclosure of ESG risk-related objectives and limits
- Assessment of the need to develop sustainable products
- Adjustment of business processes to give effect to the strategy and objectives set e.g. by changing levels of engagement with certain types of borrow or investee companies
- Internal governance mechanisms
- Responsibility of the Board and Board committees to ensure adequate monitoring of ESG risk (covering both long and short term view) and to oversee progress against the firm’s ESG risk appetite and ESG risk-related objectives
- Clear understanding by the Board of the impact of ESG factors on the business model including changes in “market sentiment”
- Board responsibility to oversee the implementation of near and long term goals. Data gaps and uncertainties will not justify inaction in setting limits or objectives
- Consideration of whether specialised committees are appropriate given the scale and complexity of the business and the risks, and if so, steps to ensure their interaction with risk committees and the internal control functions
- Comprehensive and joined-up approach to incorporation of ESG factors and a clear allocation of duties and tasks
- Remuneration alignment with ESG objectives
- Risk management
- Mapping risk appetite framework so that risk indicators and limits are allocated across the banking/investment group, across different business lines and across branches to reflect reality
- Development of detailed risk monitoring metrics at exposure-, counterparty- and portfolio- level with ESG characteristics and risks categorised for each
- Quantitative management of ESG risk in the ICAAP and recovery plans
- Stress testing used to determine effectiveness of business strategies from an ESG risk perspective - EBA calls for testing across many more scenarios and along a much greater time horizon than typical in supervisory stress testing to reflect the uncertainty of climate change impacts.
The EBA sees the need for enhancing the incorporation of ESG risks into institutions’ business strategies and processes and proportionately incorporating them into their internal governance arrangements. This could be done by evaluating the long-term resilience of institutions’ business models, setting ESG risk-related objectives, engaging with customers and considering the development of sustainable products. Adjusting the business strategy of an institution to incorporate ESG risks as drivers of prudential risks should be considered as a progressive risk management tool to mitigate the potential impact of ESG risks.