ECB expectations on banks to step up management of climate and environmental risks in 2023

“We see the glass filling up slowly, but it is not yet even half full. This is both good and bad news: good news because there is progress compared with where banks were some years ago; bad news because banks are still a long way from where they need to be.”  

These were the words of Frank Elderson (Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB), in a keynote speech on 27th March 2023, on the topic of the management of climate and environmental risks by banks under ECB supervision. 2023 is seen as a crucial year for translating ambitions in this area into sound internal practices, and this serves as a timely reminder for banks that in order to meet supervisory expectations, “banks must considerably increase the pace of progress”.

You will recall that when publishing the results of its thematic review on climate related and environmental risks in November 2022 (see our blog post here), the ECB set key milestones for all supervised banks to meet, with the ultimate expectation that by the end of 2024 all banks will be fully aligned with all supervisory expectations on C&E risks outlined in the ECB’s 2020 Guide on climate-related and environmental risks.  After 2024, the ECB will no longer tolerate “a limbo of identifying a risk as material but not adequately addressing it”.

This speech comes against the backdrop of the, fast approaching, end of March 2023 deadline for the first general milestone (to adequately categorise C&E risks and conduct a full assessment of their impact on banks’ activities (for all business areas, in the short, medium and long term)). 

More still to be done to adequately address C&E risks from a prudential point of view

On the positive side, Elderson notes that banks have made meaningful progress in accounting for and addressing C&E risks.  It is recognised that there is broad consensus among banks that C&E risks are a material source of financial risk and that they are impossible to evade. As a result, banks have made progress in integrating C&E risks into their risk management processes. 

However, the ECB have concluded that there is still a material gap between where banks currently stand and its supervisory expectations.  For example:

• In the climate stress test it was found that three in five banks still do not have a climate stress testing framework in place. Among the banks that do, most do not ensure independence between the development and validation functions of the stress testing framework.
• The ECB’s thematic review showed that virtually all banks have blind spots in the identification of C&E risks. One such blind spot is the lack of consideration of the physical risks posed by the climate and environmental crises.
• There are broader environmental risks (e.g. the decline of natural ecosystems)  that go beyond purely climate-related risks that banks still do not adequately focus on. Elderson reminds banks that the ECB’s supervisory expectations explicitly apply to the management of both climate-related and environmental risks, both of which are a material source of financial risk. However, in his view many banks have so far come up with only a high-level description of the general impact on vulnerable sectors, like agriculture, mining and manufacturing, and have yet to perform adequate materiality assessments.

Next steps

The ECB is mindful of the challenges that banks will face in meeting its expectation that all banks under ECB supervision will be fully aligned with its supervisory expectations on C&E risks by the end of 2024 at the latest.  The intermediate deadlines are intended to smooth this transition and banks are expected to meet them.

Banks are reminded of the examples of good practice that the ECB published in November (good practice for C&E risk management) and December (good practice for climate stress testing) 2022 that banks can utilise to accelerate progress towards the upcoming milestones.   

Acknowledging that no “one-size-fits-all” approach exists, banks are encouraged to discuss specific implementation challenges as part of the ongoing supervisory dialogue.

Elderson reiterates that the ECB will closely monitor banks’ progress with respect to the deadlines, and, if necessary, will use all measures in its toolkit to ensure compliance with supervisory expectations. These include imposing periodic penalty payments and setting Pillar 2 capital requirements as part of the annual Supervisory Review and Evaluation Process.