A fresh take on risk and valuation
The climate change has an increasingly profound impact on society. Therefore, financial institutions are expected to play a major role in funding the transition to a zero-carbon economy.
In preparation, regulators are developing guidelines describing how financial institutions should incorporate climate risk into their existing strategy, governance, and risk management frameworks. This includes the assessment of both short-term and long-term impacts of physical and transition risk on the existing portfolios of the bank as well as the disclosure of new KPIs related to climate risk management.
Gap Analysis:
Assessment of your current situation against existing regulation and market practices.
Roadmap:
Development of a roadmap to align your governance and risk management framework with the expectations from the ECB.
Strategy:
Align the business strategy with the Paris Agreement and limit exposure to climate risk.
Scenario Analysis:
Assess your exposure to climate risk under different scenarios.
Stress Testing:
Assess the resilience of your portfolios under extreme climate scenarios.
Disclosure:
Reporting of mandatory KPIs such as GHG emissions, financed emissions, and Green Asset Ratio.
The ECB’s ‘Guide on Climate-related and environmental risks’ provides an overview of 13 recommendations related to the following four dimensions: Strategy, Governance, Risk Management and Disclosure.
The ECB recommendations provide a first regulatory outline for financial institutions to start incorporating climate risk into already existing frameworks.
By starting from a set of potential pathways (scenarios) to a zero-carbon economy, the related changes in macroeconomic drivers shall be assessed in these scenarios. Consequently, institutions will be able to utilize the resulting outputs in several aspects of their existing frameworks ranging from the risk appetite framework to risk modelling (credit risk, market risk, etc.).
The ECB has published the “Guide on climate-related and environmental risks” in November 2020 to encourage banks to facilitate investments in a more sustainable economy. This guide outlines the ECB’s take on the prudent management of climate risk and describes how the institutions are expected to integrate that dimension into their already existing risk management framework in the form of 13 recommendations. This article outlines our interpretation of the ECB guide and presents some key points to facilitate understanding and implementing those regulatory expectations from the point of view of banking institutions.
ReadThe article walks the reader through the different modules of the 2022 ECB Climate Stress Test. While we still find ourselves at the dawn of introducing climate risk into the existing risk management frameworks, the ECB continues to pave the way for financial institutions. In the methodology paper released in October 2021, the regulator has showcased their expectations for the upcoming bottom-up stress test. By elegantly side-stepping the intricacies of advanced climate modelling, financial institutions are enabled to start their climate stress testing journey while laying strong foundations for more advanced approaches in future exercises.
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