The ECB’s Guide on climate-related and environmental risks, published in November 2020, provides an overview of 13 recommendations related to Strategy, Governance, Risk management and Disclosures, and banks are expected to fully comply with them. Moreover, with the effects of climate change and environmental risks being more visible than ever in our daily lives and the way business is conducted, financial institutions are more inclined to incorporate corresponding objectives and targets into their practices. However, the effective management and measurement of climate-related and environmental risks remain challenging.
Financial institutions can use their well-established risk management practices and frameworks as a starting point, but they need to enhance them to address the climate-related and environmental risks’ unique features such as the combination of short and medium to long-term impacts, nonlinearities, potential tipping points and interconnectedness among various risk sub-types.
Past experiences in scenario analysis and stress testing also provide the financial industry with the opportunity to get a quantitative view on their exposures to the transition to a more sustainable (Paris Agreement aligned or Net Zero) economy and society, as well as on their exposures to physical risks corresponding to climate-related and environmental issues. Moreover, the ECB and an increasing number of national regulators and supervisors request banks to conduct materiality assessments, various risk identification and monitoring exercises, as well as climate risk stress tests on their portfolios while taking into account various transition scenario pathways.
As climate-related and environmental risk measurements (most importantly stress testing and portfolio alignment calculations) entail a significantly longer time horizon and different methodologies compared to traditional practices, many financial institutions will have to redesign – or enhance at least – their existing toolkits in many aspects of their risk management and risk measurement.
Since the publication of the ECB’s Guide on climate-related and environmental risks in November 2020, the ECB has carried out various assessments and inspections on the banks’ preparedness and practices:
- ECB supervisory assessment of climate risks disclosures,
- ECB climate stress test 2022,
- ECB thematic review of climate-related and environmental risks
which led to the overarching conclusions that banks still have a lot to do to ensure full compliance with the ECB’s recommendations.
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