EU: European banks could face higher legal and reputational risks for failures in transition planning

A study published by the European Central Bank (ECB) has found that many European banks could face higher legal and reputational risks by deviating from the wider transition away from carbon-intensive industries.

The study, which analysed 95 EU banks covering 75% of euro area loans, found that the credit portfolios of roughly 90% of banks were “substantially misaligned with the goals of the Paris Agreement”.

“The misalignment with the EU transition pathway can lead to material financial, legal and reputational risks for banks”, according to Frank Elderson, member of the Executive Board and Vice-Chair of the ECB Supervisory Board in a related blog post. “It is crucial for banks to identify, measure and – most importantly – manage transition risks, just as they do for any other material risk.”

Around 70% of the banks analysed are also subject to elevated reputational and litigation risks because despite publicly committing to the Paris Agreement, their credit portfolio is still “measurably misaligned with it,” Elderson said.

Misalignment stems from exposures to companies in the energy sector that are lagging behind in phasing out high-carbon production processes and are late in rolling out renewable energy production, he said. Banks generate over 60% of their interest income from counterparties in carbon-intensive sectors.  It is of course not for supervisors to tell banks who they should or should not lend to – however according to Elderson there is a need for banks to actively manage the risks as the economy decarbonises, and “do more work with their counterparties to ensure that the companies they finance do not prevent them from living up to their net-zero commitment."  This is particularly in light of the fact that climate litigation has skyrocketed in recent years, with some 560 new cases filed globally since 2021, and legal action increasingly targeting corporates and banks.

What do banks need to do?: Focus on Transition Plans

Banks should adopt Paris-aligned transition plans with realistic, transparent, and credible goals that can be implemented in a timely manner. These should incorporate concrete intermediate milestones from now until 2050, with key performance indicators that allow management bodies to monitor and act upon risks. 

Banks can leverage on the alignment assessment methodology outlined in the latest study to advance their transition planning capabilities, as well as the practices identified in both the ECB report on good practices for climate stress testing of December 2022 and the November 2022 ECB report setting out observations from the 2022 thematic review (see our blog post here).

"Transition planning must become a cornerstone of standard risk management, as it is only a matter of time before transition plans become mandatory," says Elderson, with the revised Capital Requirements Directive (CRD VI), imposing a new legal requirement for banks to prepare prudential plans to address climate-related and environmental risks. Additionally, supervisors are mandated to check these plans and assess banks' progress in addressing their climate and environmental risks. Supervisors can also require banks to reduce their exposure to these risks and to reinforce targets, measures, and actions included in their plans, Elderson said. Moreover, banks that fall under the scope of the EBA’s ITS on Pillar 3 disclosures on ESG risks will have to disclose the Paris alignment of their credit portfolios by the end of 2024, at the latest (and again, the methodology set out in the latest ECB report can provide “a concrete approach” for banks to follow in meeting this disclosure requirement).

The ECB study assessing the risks stemming from the (mis)alignment of banks’ financing with the EU climate objectives published on 23 January 2024 is available here.

The ECB Supervision blog post by Frank Elderson is available here.