Quantitative risk

Regulatory guidance on climate and environmental risks for the financial services sector

By:

Andreas Spyrides

04 Oct 20214 min read

The European Central Bank (ECB) has provided guidance to financial institutions in order to disclose and manage climate change-related and environmental risks within an organisation.

Contents

As of November 2020, ECB published the final guide on climate-related and environmental risk with supervisory expectations relating to risk management and disclosure. The expectations set out in the guide are to be read in conjunction with, and are not intended to substitute or supersede, any applicable law. ECB highlights the essential need for a risk management framework which accounts for the specific impact on credit, operational, market, and liquidity risks.

The guidance is applicable to Significant Institutions (SIs) directly supervised by the ECB. Less significant institutions (LSIs) are invited to consider these as well as other relevant publications by their National Competent Authorities (NCAs). The guide is applicable as of the date of publication, November 27th, 2020.

Identification of climate-related and environmental risks

Climate change is a source of systemic risk which is expected to cause physical and transition risks that will impact the way that the financial system operates. Physical and transition risks are drivers of existing risk. The projected trajectories of climate-related risks will have an impact on the economic and financial variables that will vary depending on the level and timing of mitigation measures and whether the transition occurs in an orderly or disorderly fashion. Potential financial losses arising from climate-related and environmental risks depend on the adoption of new policies, technological developments, and consumption.

Physical Risk: the economic impact arising from the expected increase in the frequency and magnitude of natural hazards. These can either be acute impacts from extreme weather events or chronic impacts from increased temperatures, sea level rise, and precipitation.
Transition Risk: includes any institution's financial loss that can result, directly or indirectly, from the process of adjustment towards a lower-carbon and more environmentally sustainable economy. Delayed and abrupt introduction of climate policies will result in transition risks to affect the profitability of businesses and wealth households, creating financial risks for lenders and investors.

How should financial institutions address them?

ECB expects financial institutions to prudently manage and transparently disclose climate-related and environmental risks, conduct self-assessment based on currently applicable guide on climate-related and environmental risks, present action plans, and support their disclosure statements with relevant quantitative and qualitative information affected by climate change.

Business Model and Strategy

Assessment and monitoring of the current and forward-looking impact of climate-related and environmental risks on the business environment in which they operate, in the short, medium, and long term, in order to be able to make informed strategic and business decisions.

Governance and Risk Appetite

Institutions are expected to embed these risks in their governance and risk appetite frameworks, while adequately considering all relevant functions. In addition, appropriate and regular reporting on climate-related and environmental risks to the management body is expected to ensure proper management of these risks.

Risk Management

Requirement for a risk management framework which accounts for the specific impact on credit, operational, market, and liquidity risks as well the ICAAP overall, including risk quantification by means of scenario analysis and stress testing.

Risk Type	Risk Management Expectations
Credit	Consideration of climate-related and environmental risks at all relevant stages of the credit-granting process and to monitor the risks in their portfolios. Institutions are expected to consider climate-related and environmental risks in their collateral valuations and loan pricing frameworks.
Market	Monitor on an on-going basis the current market risk positions and future investments, and development of stress tests that incorporate climate-related and environmental risks.
Liquidity	Assessment of causation of net cash outflows or depletion of liquidity buffers, incorporating these factors into the liquidity risk management and liquidity buffer calibration.
Operational	Consideration of the impact on business continuity and the extent to which the nature of these activities could increase reputational and/or liability risks.

Disclosures

The EU institutions have reached a political agreement to develop a taxonomy, for sustainable investments. Institutions subject to the Non-Financial Reporting Directive (NFRD) will be asked to provide further transparency on the extent to which their activities can be regarded as environmentally sustainable. The European Commission plans to conduct a review of the NFRD as part of the strategy to strengthen the foundations for sustainable investment.

Institutions are expected to publish key metrics on climate-related and environmental risks deemed to be material, with due regard to the European Commission’s Guidelines on non-financial reporting: Supplement on reporting climate-related information.

Why Grant Thornton Cyprus?

Our Prudential Risk, ESG experts, and Consulting team understands that regulation continues to drive the strategic agenda for banks and investment firms. ESG and other sustainability related areas are likely to be high on the regulatory agenda for years to come. We specialise in assisting clients across the financial services sector in navigating through the maze of regulation and support clients to identify regulatory obligations and work towards full compliance balanced with your business needs.