Frank Elderson: Making banks resilient to climate and environmental
risks - good practices to overcome the remaining stumbling blocks
Speech by Mr Frank Elderson, Member of the Executive Board of the European Central
Bank and Vice-Chair of the Supervisory Board of the European Central Bank, at the 331
st European Banking Federation Executive Committee meeting, Frankfurt am Main, 14
March 2024.
* * *
Introduction
Thank you for inviting me to this exchange on the current state of climate-related and
environmental (C&E) risks. We have come a long way since 2019, when we first started
discussing C&E risk management with you - the European banking associations and
the European banks you represent.
It is thanks to the hard work perfomed every day by thousands of dedicated climate risk
experts in banks all over Europe that notable expertise has been built up and vital
progress achieved.
And, thanks to the ongoing dialogue between supervisors and banks, the risks
stemming from the climate and nature crises are increasingly being integrated into
banks' risk management, strategies and governance.
It is in precisely that spirit that I am here today: to listen to you, to discuss the
challenges you face, but also to share the ever-growing set of good practices that we
have observed. To suceed in our common goal of making banks resilient to climate and
nature risks, it is vital that we maintain this dialogue and facilitate the exchange of good
practices.
Climate risks are increasingly materialising
Before we get into the nitty gritty of C&E risk management, I will start by saying a few
words on the risks themselves. The far-reaching impacts of climate change and nature
degradation are more apparent than ever: 2023 was the hottest year ever recorded,
while extreme weather events are becoming more frequent and increasingly these
events also leave their mark on the economy.
For instance, last year devastating floods in Slovenia showed that just a couple of days
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of heavy rain can lead to damages, equivalent to 16% of GDP .
Climate risk events are not just one of the many standalone risks that banks face. They
are instead a driver for each traditional type of risk reflected in the Basel framework,
from credit risk, liquidity risk and market risk to reputational and operational risk,
including legal risk.
For example, floods may impair a company's production facility, which then affects its
ability to repay a loan, in turn leading to higher credit risk for the bank.
Consider what happens if your house is built in an area vulnerable to wildfires. This
could reduce the value of your home, leaving the bank that granted you the mortgage
with higher risk on its balance sheet.
And take operational risk, for instance: we have already seen cases of floods that
materially damaged banks' IT infrastructure or even washed away the vault and safety
boxes of customers at local bank branches.
These are just some examples of recent climate risk events that we are experiencing,
now, in a world in which average annual global temperatures are on the verge of
exceeding the threshold of 1.5 degrees Celsius. However, the latest scientific evidence
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suggests that we are not on a path to 1.5 degrees, or even 2 degrees, but on a
baseline trajectory towards average temperatures of 2.9 degrees Celsius above
preindustrial levels.3
So, everything we have read about the devastating difference between the 1.5 degree
and the 2 degree scenario is nothing if you compare it with the hot house scenario we
are heading towards. This means that the physical risks we currently see unfolding are
just the tip of the iceberg of what we can reasonably expect in a world subject to 2.9
degrees of global heating.
Just this week the European Environmental Agency (EEA) published the results of a first
European Climate Risk Assessment concluding that "climate stress tests need to better
account for cascading, compounding and tail risks from climate change to the overall
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EU economy" .
Internal capacity-building is crucial to gauge C&E risks
Clearly, we cannot ignore that the ongoing climate emergency will render banks more
susceptible to risks. It is therefore more important than ever that banks identify,
measure and most importantly manage C&E risks. To do so, relevant expertise and
human capital is absolutely crucial. Banks' management bodies need to be well-versed
in C&E risks, and we expect banks to reflect these skills in a diverse board composition.
And we see more and more banks walking the talk, for instance by setting up a
dedicated committee composed mainly of independent directors with the appropriate
skills in C&E risks.
But this is not only a task for CEOs, committee members and the like. Employees
across the organisation should be aware of how the climate and nature crisis might
affect their everyday tasks. For instance, when granting a loan, a credit officer should
be skilled in understanding the C&E risk drivers affecting a mortgage so they do not
turn a blind eye to a material source of risk. And it is also critical for banks to have the
necessary resources to implement well-designed frameworks across the institution.5
Current state of C&E risk management in banks
Let me now turn to where banks under our supervision stand in incorporating climate
and environmental aspects into their risk management. In our continuous supervisory
dialogue, we have urged banks to ensure the sound management of C&E risk, using the
ECB's 2020 supervisory expectations as a starting point.
Failing to adequately manage C&E risks is no longer compatible with sound risk
management, just as it would not be acceptable to turn a blind eye to other relevant
drivers of standard risk categories.
The ECB has consistently reminded that this is not a call on banks to divest from
carbon-intensive industries. It is, instead, a call to actively manage the risks, for
instance, through client engagement and transition and resilience finance. In other
words, banks must be cognizant of the risks they take and manage them accordingly.
Imagine a bank that has a client operating in a high-emitting sector such as power
production from fossil fuels. Instead of abandoning the relationship with this client, the
bank can continue lending to it through transition finance, for example to fund
expansion of renewable power production. We see more and more banks doing exactly
that: managing risk through active client engagement and by offering transition finance
products, which also represent a business opportunity for banks.
Since we first started discussing C&E risks with banks back in 2019, progress has
undoubtedly been made. Banks have taken steps to integrate C&E risks into their
strategy, governance and risk management. For example, we see that banks'
materiality assessments and business environment scans are becoming more robust
compared with their initial submissions. However, it is also true that a number of banks
did not perform an adequate materiality assessment. As a result, they received binding
supervisory decisions, including the potential imposition of periodic penalty payments if
they fail on their requirements. In other words, we have told those banks to remedy the
relevant shortcomings by a certain date. If they do not comply, they will have to pay a
penalty for every day that the shortcomings remain unresolved. It is a step that we do
not take lightly: it is not about forcing banks to do something that is merely "nice to
have"; it is about compelling banks to manage material risks adequately and in a timely
manner.
Although at present none of the banks under our supervision fully meets all our
expectations, each and every of our expectations has already been fulfilled by at least
one bank. This shows that progress is possible, and that it is not just taking place
among a few banks, but across the board. This is good news, since we expect all banks
under our supervision to be fully aligned with our supervisory expectations by the end of
2024.
Implementation challenges and good practices
Now I understand that some SSM banks are facing implementation challenges.
Integrating C&E risks into standard risk management is not an easy task. But while
demanding, it is far from impossible. Let me illustrate this with a few concrete examples
of how banks can use good practices to overcome remaining stumbling blocks.
For instance, it is not straightforward to quantify transition risks in a forward-looking
manner given the continuous evolution of emission reduction policies. Think about
higher carbon prices for high-emitting steel and cement producers under the reformed
EU Emissions Trading System or the ban on the sale of new petrol and diesel cars from
2035. To show how this can be done, the ECB recently published a report quantifying
the most pronounced transition risks in banks' credit portfolios using "alignment
assessment". This methodology is already being developed by banks and supervisory
authorities, and I would encourage more banks to leverage it to get a better grip on
transition risks.
Another example is climate-related litigation, which has sky-rocketed in recent years.6
Around the world, some 560 new cases have been filed since 2021, and they
increasingly target corporates and banks. Admittedly, measuring and managing these
risks is challenging. Promisingly, however, some banks are already quantifying
reputational risks using scenario analysis or started allocating capital towards litigation
risks in the internal capital allocation.
Financial risks are not limited to climate change. We are currently witnessing an
unprecedented decline in natural ecosystems and the vital services they provide such
as pollination, clean water or healthy soil. This also matters for banks, given that 75% of
all bank loans in the euro area are to companies that are highly dependent on at least
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one ecosystem service. However, assessing nature-related risks is complex. Unlike for
climate risk, which can be measured in terms of carbon emissions, there is no single
indicator that would facilitate quantification of nature-related risks.
Encouragingly, several banks have already implemented risk management practices
focusing explicitly on nature-related risks. For instance, one bank has adopted a
classification system using a heatmap to identify and monitor which clients are most
exposed to nature risk drivers, such as biodiversity loss, water stress and pollution. The
approach is integrated in the institution's credit policy and loan origination framework.
For high-risk clients, the credit officer may decide to give a negative credit decision. In
other cases, a positive credit decision may be tied to specific conditions such as
increased monitoring. First and second lines of defence are trained specifically on how
to integrate the approach in credit decision-making. Other banks are already allocating
capital to environmental risks in their internal capital calculations.
These examples show that, while the task is admittedly challenging, good practices are
already out there and banks can leverage them to overcome the remaining stumbling
blocks.
It is crucial for supervisors and the industry to exchange good practices in order to
master the mammoth task of making banks resilient to climate and nature risk. That is
also why we published the good practices we observed in both the climate stress test
and the thematic review . We will continue to update the good practice reports going
forward.
And let me assure you that our supervisory teams are open to discuss how to best
handle data or methodology questions that come up along the path.
The path ahead
2024 is a crucial year for our supervisory priority to make banks resilient to climate and
nature risks. By the end of this year, we expect all banks under our supervision to be
aligned with our supervisory expectations. We will closely monitor banks' progress
towards meeting final deadlines. And, if necessary, we will use all the measures in our
toolkit to ensure the sound management of C&E risks. These include imposing periodic
penalty payments and setting Pillar 2 capital requirements as part of the annual
Supervisory Review and Evaluation Process.
2024 is also vitally important for disclosures. The ECB's latest assessment found that
although all eligible banks manage to disclose most of the data, more work is needed to
promote further consistency and improve the quality of disclosure. Moreover, banks that
fall within the scope of the European Banking Authority's implementing technical
standards on Pillar 3 disclosures on environmental, social and governance risks will
have to start disclosing the alignment of their credit portfolios with a net zero scenario
by the end of 2024 at the latest.
2024 is an important milestone but not the end of the journey. Just as any other
prudential risk, C&E risks demand continuous attention and adaptation. Good practices
will evolve, as will the regulatory environment. For instance, it is only a matter of time
before transition plans become mandatory. The revised Capital Requirements Directive
(CRD VI) endorsed by the co-legislators will include a new legal requirement for banks
to prepare prudential plans to address C&E risks arising from the adjustment towards
climate neutrality by 2050.
To prepare for these upcoming legal requirements, the best advice I can give to banks
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is to start putting in place their Paris-compatible transition plans. By that, I mean
realistic, credible, science-based and externally vetted transition plans that banks can
and actually do implement in a timely manner. They should include concrete
intermediate milestones between now and 2050. Banks should also develop key
performance indicators that allow their management bodies to monitor and address any
risks arising from possible misalignment with their transition path. Some banks under
our supervision are already actively using transition planning tools to assess the
alignment of their portfolios with the Paris Agreement. Now we expect all banks, not just
a few frontrunners, to do so in order to prepare for the upcoming requirements from
European legislators.
Conclusion
Let me conclude.
Since we started our dialogue on C&E risks with you back in 2019, some major
stumbling blocks have undoubtedly been overcome.
It is thanks to thousands of motivated experts - bankers and supervisors alike - that
vital progress has been made. But the job is not yet done: 2024 is a crucial year to clear
our path of the remaining stumbling blocks.
The ongoing climate and nature crises will inevitably render our economy more
susceptible to shocks. From a risk-based perspective, let me reassure you that ECB
Banking Supervision will continue to play our part in spurring on banks to prepare for
these risks, in a 1.5 degree, a 2 degree and even a 2.9 degree scenario. And let me
repeat: 2.9 degrees is the current baseline. So we need to make sure that banks are
resilient to climate and nature risks - a vitally important imperative if ever there was one.
1
See European Environment Agency (2024), European climate risk assessment , EEA
Report, No 01/2024; and Financial Times (2024), "EU warned of rising risk of systemic
financial shocks from continent warming", 11 March
2
United Nations Environment Programme (2023), Emissions Gap Report 2023: Broken
Record - Temperatures hit new highs, yet world fails to cut emissions (again) .
3
Intergovernmental Panel on Climate Change (2023), Climate Change 2023 Synthesis
Report - Summary for Policymakers
, March.
4
See European Environment Agency (2024), European climate risk assessment,
Executive Summary, p. 29.
5
For more details on resourcing as a key challenge, see Basel Committee on Banking
Supervision (2023), Newsletter on the implementation of the Principles for the effective
management and supervision of climate-related financial risks , 21 November.
6
See, for example, Elderson, F. (2023), "Come hell or high water: addressing the risks
of climate and environment-related litigation for the banking sector", speech at ECB
Legal Conference, 4 September; and Network for Greening the Financial System
(2023), Climate-related litigation: recent trends and developments , September.
7
Ceglar, A., Boldrini, S., Lelli, C., Parisi, L. and Heemskerk, I. (2023), "The impact of
the euro area economy and banks on biodiversity ", Occasional Paper Series, No 335,
ECB.
8
Elderson, F. (2024), ""Failing to plan is planning to fail'' - why transition planning is
The Supervision
essential for banks", Blog, ECB, 23 January.