Frank Elderson: Overcoming the tragedy of the horizon: requiring
banks to translate 2050 targets into milestones
Keynote speech by Mr Frank Elderson, Member of the Executive Board of the European Central
Bank, at the Financial Market Authority's Supervisory Conference, Vienna, 20 October 2021.
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Introduction
It is a great pleasure for me to speak here and I would like to thank the organisers for inviting me.
Today, I want to look ahead - to next year, to the next five years and to the three decades up to
2050, the year by which the EU has pledged to become carbon neutral under the Paris
Agreement. Thirty years is a hair's breadth of time: merely one-hundred-and-fifty-millionth of the
earth's 4.5 billion years of existence. A brief span indeed.
There is no doubt that time is running out for us to tackle the climate and environmental crises.
What does this mean for banks? This means that the time for preparations is over and the time
for action is now. Banks need to start thinking about the next important step in risk management
which will require them to look at the thirty years ahead and devise intermediate targets for their
risk exposures that can render them fit for a carbon-neutral economy by 2050.
Banks can no longer simply declare their intention to be Paris-compliant by 2050. They must
make structural changes to their way of doing business so as to make sure that they actually
reach that goal and avoid the build-up of risks for them and the entire financial system.
Let me first share some of the insights gained from our benchmark of the banks'
selfassessment against our supervisory expectations. I will then turn to what I've just referred to as
the next important step in risk management - transition planning - and what banks, as well as
supervisors and other competent authorities, need to do in order to make it work.
Banks' climate-related and environmental risk management capabilities
The ECB is committed to doing everything within its mandate to incorporate climate and
environmental considerations into our activities.
On the supervisory side, we have been taking steps to increase our understanding of the impact
of the climate crisis from a financial risk perspective and ensure that banks have a
comprehensive, strategic and forward-looking approach to disclosing and managing all
climaterelated and environmental risks, or C&E risks for short. We asked banks to self-assess their
position relative to these supervisory expectations and have been benchmarking their responses
over the past months. We will soon publish the results and the good practices we identified in the
process. I'll offer a sneak preview of them now.
On the bright side, banks have started reflecting C&E risks in their current structures; roughly
half of them are adapting their governance arrangements accordingly. Some banks have
developed comprehensive dashboards for assessing C&E risks when granting credit, some are
tightening their credit-granting criteria and others are measuring and disclosing the carbon
emissions linked to their loan books.
The gloomier side of things, though, is that the banks themselves deem 90% of their practices to
be only partially or not at all compliant with the ECB's supervisory expectations. Tellingly, the only
banks that did not identify as being exposed to medium and long-term C&E risks were those
which did not conduct a materiality assessment. This is all the more problematic when our
benchmarking shows that a majority of banks said they were exposed to medium and long-term
C&E risks. We expected them to analyse how these risks can, or will, affect their different
portfolios and products over the short, medium and long-term, considering various scenarios.
Given the nature of C&E risks, this forward-looking type of analysis should be elementary
practice.
But the vast majority have not done this analysis. Concrete and important management tools and
practices are lacking in this area. When looking for actions that go beyond a mere screening of
the business environment, we found that about half of the banks under our direct supervision
have few or no concrete actions planned to embed C&E risks in their business strategy.
Only a quarter of the institutions have set key indicators to monitor and steer the performance of
their different business lines, portfolios and products with regard to, for example, green loan
origination or their exposure to high-carbon sectors. And only a quarter of those extend these key
performance indicators to more than 25% of their portfolio. No more than a fifth of the banks
under our direct supervision have set a key risk indicator for C&E risks in their risk appetite
statement and only about a third of these have set a concrete limit on these indicators.
There are also encouraging examples: many banks have started to proactively manage their
transition risks and set goals for decarbonisation, net zero emissions or alignment. Notably, a
dozen banks have started measuring and monitoring the alignment of their portfolios, defining
indicators and considering how to align their strategy to the Paris Agreement while avoiding an
excessive build-up of transition risks. They are no doubt making progress. And if banks are not
closing the gap with our supervisory expectations, we will step up our supervisory efforts
correspondingly.
But my bottom line today is this: having processes and procedures in place, assigning
responsibilities, conducting risk analyses of various sorts - these are all means to an end.
Banks' plans to align their practices with our expectations will ensure that they have adequate
risk management capabilities to weather the storms - but these capabilities should be used
more broadly.
It is time for banks to start using their toolbox for short and medium-term planning to mitigate the
long-term impact of climate change on their strategies.
Transition plans
As the wider economy moves and changes on the path towards the Paris goals, economic
sectors will have to adjust how they operate and respond to both greener consumer preferences
and new public policies - such as the carbon tax just introduced by Austria.
Banks must incorporate these structural changes in their strategic considerations and
decisionmaking and steer their business towards a smooth transition to carbon neutrality. In its
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sustainable finance strategy , the European Commission acknowledges the need for financial
institutions to improve their disclosures of sustainability targets and transition planning. In
addition, the Commission's proposal for a Corporate Sustainability Reporting Directive (CSRD)
requires financial institutions to set out and disclose their transition plans - but it leaves their
content and timing to the discretion of each bank, without stipulating any clear metrics,
milestones or targets.
In parallel, there are moves within the financial industry itself to develop and implement credible
plans for the transition. In an initiative of the COP26 Private Finance Hub led by Mark Carney, the
Glasgow Financial Alliance for Net Zero brings together 53 banks from 27 countries, representing
almost a quarter of global banking assets. These banks are committed to aligning their business
practices to net zero by 2050 and have set intermediate targets for 2030 or sooner, committing
to subsequent five-year decarbonisation plans along with annual progress reports.
In my view, both the legislative initiatives currently under way and the industry's own
acknowledgement of the importance of moving to transition-robust business models, implies that
banks need transition plans compatible with EU policies implementing the Paris Agreement, with
concrete intermediate milestones, to enhance their long-term strategies and decision-making.
And I would call on the legislator to make this explicit by introducing a legally binding requirement
for banks to have such Paris-compatible transition plans as a capstone to the legislative and
private sector initiatives already being put in place.
These transition plans should highlight at any given point in time, from now until 2050, the bank's
alignment and potential divergences with the relevant policy objectives through which the EU
implements the Paris Agreement. Such a transition plan should be part of a bank's
strategysetting and be closely linked to its business model and business plan. It should contain concrete
intermediate milestones from now until 2050 and the associated key and performance indicators
so that the bank's management and the competent authorities can at all times understand the
risks arising from a possible misalignment with the transition path. If banks fail to meet these
milestones, competent authorities - including prudential supervisors - will have to take
appropriate measures to ensure that this failure does not result in financial risks.
For ECB Banking Supervision, the main concern is the level of banks' risks exposures. Have the
exposures been sufficiently mitigated and are they prudent? Have the banks sufficiently taken into
account the economy's adaptation to the climate crisis and the associated changes in consumer
preferences? As C&E risks become increasingly widespread and more material, banks will,
inevitably, be exposed to them. From a supervisory perspective, adequate mitigation therefore
needs to be in place. We see that more and more banks are realising this and are taking up
commitments to this end. This creates the space for us to act as supervisors. But in addition to
banks' exposures to an economy increasingly marred by climate change and banks' own stated
intentions, a legal obligation for banks to have a clear, detailed and prudent transition plan in
place would increase the consistency of the regulatory and supervisory framework and
contribute to maintaining a level playing field.
Having references for milestones and yearly targets for every economic sector will make our
oversight of banks' transition strategies more effective and thus help the European banking
sector achieve an orderly transition towards carbon neutrality, starting today.
Formulating transition plans with these characteristics must be one of the top guiding principles
for banks as they step up their risk management to address the effects of the climate crisis. It
was also in this context that the European Union raised its 2030 climate ambition in what is
called the Fit for 55 package.
In the same vein, the ECB's focus on these transition plans would be less on the year 2050, but
rather on the intermediate points in time: 2025, 2030, 2035, 2040. Why? First, because detailed
plans featuring milestones have been widely used by banks to manage other risks - a clear
example of this is the crucial role that disposal plans for non-performing loans played in reducing
the legacy asset burden in the European banking sector. And second, because our
benchmarking shows that banks systematically fail to establish a clear link between their stated
carbon emissions goals for 2050 and their concrete actions in the present and medium term.
Indeed, we see that some banks that declare carbon neutrality by 2050 have no strategy in place
to reduce their exposures to carbon-intensive industries by 2030, nor have they made any
progress in assessing their role in financing the transition of such companies. Even if banks
comply with our supervisory expectations for the management and disclosure of C&E risks, that
does not automatically mean that they have a Paris-compliant transition plan.
This is why I believe that having in place a formal, legally binding requirement to adopt such
transition plans will push banks to go beyond the mere point-in-time measurement of C&E risks
and to embark on a thorough assessment of the structural changes that are likely to occur within
the industries they derive their business from.
Long-term planning such as that involved in transition planning is a novelty as far as the risk
management practices of most European banks go. As such, some novel elements will need to
be in place to, on the one hand, support banks' efforts, and on the other, allow for a robust
challenging of these plans by competent authorities. There are two elements that I think are
particularly crucial for this next stage for banking supervision.
First, we will need to have in place science-based European transition scenarios. So far, we
have been advising banks to refer to the International Energy Agency's reference scenarios. But
these are global scenarios and they do not reflect the ongoing developments within the European
legal framework.
Instead, banks can rely on the work already developed in this realm by the Network for Greening
the Financial System (NGFS), which has been designing scenarios to assess the potential future
impacts of climate risks under different climate policy actions. These scenarios are already a de
facto international standard for central banks and supervisory authorities when performing
climate stress test and scenario analysis. As suggested by the European Commission's new
sustainable finance strategy, the NGFS scenarios should be considered a starting point for
testing the impact of Europe-specific transition plans, as well as guiding banks in setting their
own targets. The Commission encourages EU environmental and financial authorities to work
together to tailor the global NGFS scenarios to European policies in a science-based manner.
Such scenarios would also speed up the development of more advanced supervisory tools for
assessing the forward-looking alignment strategies contained in banks' transition plans. In
addition, EU-wide scenarios would serve as a benchmark for the financial industry as a whole
and thereby promote self-discipline among market participants.
We will also need transparency and appropriate disclosures around banks' transition plans. The
European Banking Authority (EBA) Pillar III disclosures and the CSRD are steps in the right
direction - but we need to be more ambitious. Currently, the EBA templates provide a snapshot
of the channels through which banks can be affected by C&E risks. These templates can be
supplemented with tools that give us information on banks' forward-looking alignment - or a lack
thereof - vis-à-vis the European intermediate targets for carbon emissions.
With these two elements in place, banks and we, the supervisors, would be able to assess and
mitigate the prudential risks caused by any gaps between banks' trajectories and the European
benchmark.
Transition plans and ECB Banking Supervision's climate strategy
Before I conclude, I would like to clarify how transition planning fits into the ECB's overall climate
strategy for banks.
Transition plans should become the next addition to banks' risk management practices. But they
in no way pre-empt the supervisory dialogue with banks on their risk management capabilities.
They are simply another, albeit crucial, element to ensure that banks manage all material risks,
one we have been insisting on specifically with regard to C&E risks since 2020.
Getting banks to develop action plans to comply with the expectations that the ECB set out in its
guide on C&E risks was the first step in getting them to assess and develop their risk
management capabilities. Transition planning is the second step, and one that will help banks to
effectively develop a mitigation strategy to soften long-term impacts. Transition planning still
concerns risk management capabilities insofar as we expect banks to build on their current ones
and apply them extensively. This is to ensure that banks' strategies are sustainable as the wider
economy transitions into greener production patterns and consumer preferences.
At the same time, we will continue to roll out other elements of our climate strategy. In the course
of next year, we will conduct a supervisory stress test with a focus on C&E risks. In addition, we
will carry out a full supervisory review of banks' practices for incorporating C&E risks into their
risk frameworks, and gradually roll out a dedicated Supervisory Review and Evaluation Process
methodology that will eventually influence banks' minimum capital requirements. But this is not
the end game. Gradually we will start treating climate-related risks like any other risk and include
them in all relevant supervisory requirements.
Conclusion
Let me conclude.
The final results of the ECB's benchmarking of banks' disclosure and risk management
practices for C&E risks suggest that, as things stand, European banks may be largely
misaligned with the economic transition path towards carbon neutrality by 2050. The probability
of them having to face sudden build-ups of prudential risks in the thirty years from now to the
Paris deadline is considerable.
The safest way to mitigate this risk is for banks to step up their risk management capabilities and
clearly map their transitioning strategy. Banks should develop transition plans compatible with EU
policies implementing the Paris Agreement that include concrete intermediate milestones from
now until 2050, and disclose progress towards these goals on an annual basis. To support this
effort, transition plans should become a legal requirement.
The realities of the climate crisis are everywhere. On a macroeconomic level, there is no doubt
that a combination of physical and transition risks has started to emerge. Only by introducing
mandatory transition plans can banks' lofty intentions for the next 30 years be turned into
concrete actions now. Such mandatory transition plans can help avert the tragedy of the horizon.
But this next step in risk management needs to be taken today. We don't have thirty years; we
don't even have ten years. In the earth's timescale, all we have between today and 2050 is a blink
of an eye.
1European Commission (2021) Strategy for financing the transition to a sustainable economy.