The ECB’s recent review looks at banks' climate and environmental risk disclosures, and assesses compliance with its 2020 Guide on climate-related and environmental risks. Covering 103 significant financial institutions, 28 less-significant institutions, and 12 globally systemically important banks (G-SIBs), the review benchmarks progress in ESG risk management, and identifies areas of good practice.
Improvement required: ECB notes where more work is needed
While the ECB notes progress since the 2022 review, there's still further improvement needed across the board. Over the last year, basic information in public disclosures on climate-related and environmental risks have increased, but the overall quality of disclosures and adequacy versus minimum ECB expectations are generally low. This suggests further progress is needed.
Overall, only 34% of institutions disclosed across all recommended categories (below) and only 6% disclosed adequate information.
In its findings the ECB made notes across multiple key areas.
Materiality
Most banks (86%) disclosed climate-related and environmental risks as material and only 24% disclosed adequate information. This category showed significant need for progress.
Business model
60% of firms described the potential strategic impact of transition risks in the short and/or long term on their business models, with only 37% disclosing adequate information.
Governance
Almost all banks (97%) made disclosures that described the board’s oversight of climate-related and environmental risks, with only 50% disclosing adequate information.
Risk management
Almost all banks (92%) made disclosures that described the processes for identifying, assessing, and managing fundamental climate related and environmental risks, with only 41% being adequate.
Metrics and targets
75% of institutions disclosed KPIs or KRIs associated with strategy-setting, while 46% disclosed adequate information. This category showed the largest need for progress.
Scope 3 financed emissions
Over half the banks assessed disclose information on the amount of carbon emissions they finance, this information was incomplete in the majority of cases. Only 16% disclosed adequate information. This category showed the largest need for improvement.
Other environmental risks
35% of institutions disclosed key information on environmental risks other than climate-related risk. Only 17% disclosed adequate information. This category showed significant need for improvement.
The ECB has sent banks individual feedback letters, with the expectation that they improve their climate and environmental risk disclosures, to reflect material risks and comprehensively demonstrate their risk profile. Improving the quality of ESG risk disclosures will help reduce greenwashing and give all stakeholders greater confidence in climate-related and environmental risk management.
Materiality
Banks must disclose material climate-related or environmental risks. But these will be different for each firm, depending on their individual business model and risk profile.
86% of banks believed their risk exposure to climate-related and environmental risks was material (up from 80% last year). However, the disclosed information was often poor, and the ECB felt that around one third of banks weren't adequately assessing materiality. While around a third of banks did undertake an internal assessment for materiality of their exposures, the assessment process itself wasn’t fully disclosed or clear. Of those that didn’t identify material ESG risks, banks often didn’t provide clear justification or didn’t undertake a materiality assessment.
Business model
Around 60% of firms didn't adequately describe the strategic impact of climate-related and environmental risks on their business models. Only 32% appropriately considered the impact of physical and transition risks. Firms often described and assessed risks too broadly, demonstrating how they relate to the wider financial sector, but not explicitly linking them to the organisation’s unique business model. On the flipside, just 29% considered how their business models affect the climate in turn. A total of 14 banks disclosed both for a double materiality assessment showing the impact on the business model and the firm’s impact on the wider environment.
Many firms didn’t look at how ESG transition risks may affect their business environment, sector or counterparties. This makes it tricky for stakeholders to fully understand the risks the organisation faces.
While firms are expected to disclose the KPIs and KRIs used for risk management and setting the strategy, just 40 banks did. Of these, just 12 adequately demonstrated their methodology, and 27 did so partially.
Governance
Firms have made particularly good progress around disclosures of climate-related and environmental risk governance, with the majority making a disclosure in this area (up from 71%). Around 50% of firms had adequate climate-related governance arrangements in place, with effective oversight and senior management involvement. However, there's room for improvement around key areas of focus, including greater Board involvement when reporting, monitoring, and mitigating climate risk and updating assessment thresholds. More granular information can help increase frequency of reporting and further insight over how respective committees interact and how information flows across them.
Risk management
The majority of firms disclose information about their processes for identifying, assessing, and managing ESG climate-related and environmental risks. But only few firms disclose these in a way that's fully accessible to stakeholders and allows them to understand how climate-related and environmental risks have been integrated across the wider risk management framework. This includes consistency, time horizons, and proportionality. This is a consistent pattern over the last few years, with the volume of firms disclosing their risk management processes increasing, but the volume of good quality, comprehensive disclosures has stayed roughly the same.
Often, risk identification processes aren't developed enough and firms haven’t made the connections between climate-related risks, and financial and non-financial risks. While some give details of how the sectors they operate in are affected, few firms give quantitative information to support this or outline their exposures.
Around 56% of banks didn’t disclose which key risk indicators are used to monitor climate-related and environmental risks. Where tools to manage these risks were discussed, including stress-testing or ongoing assessments, there was limited information on underlying assumptions, risk factors, transmission channels, scenarios, or which business-areas have developed the tools. Most banks linked climate-related and environmental risks to typical risk types, such as credit, operational or market risk, but didn't disclose if those risks material, or how climate-related and environmental risks were embedded in those risk frameworks.
Metrics and targets
Firms need clear ESG KRIs and KPIs to set meaningful targets and track progress against them. This includes scope 3 financed emissions, however, half of firms didn't disclose them, and the remainder only partially disclosed them. More than 80% used proxies for the estimation of Scope 3 emissions. Where firms provided methodology to support these calculations, it was too broad and didn’t include essential formulae, procedures used, or key assumptions. It was also sometimes unclear what was a scope 3 financed emission, versus the firm’s own activity. They also lacked detail over whether their financed emissions included any removed or avoided emissions. Banks also tended to lack clarity around the quality of ESG data used, the date of collection, or the depth of the value chain considered. Consequently, the ECB had doubts over the soundness and reliability of these metrics, which was compounded by the lack of comparability across different banks.
Banks also use alignment metrics to assess how their portfolios align to their Paris Agreement objectives. The ECB expects firms to consider how this will impact their ESG and broader strategy in the short, medium, and long term. NACE sector classification can be used to identify credit portfolios in key risk sectors, but only six firms used it. Similarly, just 19 institutions disclosed information on EPC in their real estate portfolios, making it difficult to set meaningful targets and leading to greater use of proxies.
On the other hand, 32% of firms have undertaken a PACTA analysis, which uses different scenarios to assess Paris alignment across portfolios in key risk sectors. However, these need more detail to add value and just 14% of firms using PACTA looked at more than one portfolio in a key risk sector.
Other environmental risks
Consistent with previous reviews, few firms looked beyond climate-related issues to disclose other environmental risks. Of those, 20% of banks included just one environmental risk (typically biodiversity risk), while the remainder looked at risks including water pollution and deforestation. Where banks disclosed material exposures to environmental risks through physical or transition transmission channels, few had described how the controls are embedded in their risk management frameworks to mitigate.
Improving the quality of disclosures
To improve the quality of disclosures, firms need to look at their underlying climate-related and environmental risk data, sources, processes and methodology, and ensure it's properly documented for all stakeholders and aligns with best practices. This includes good use of existing frameworks and metrics for setting effective ESG targets, clearly-defined KPIs, and KRIs with monitoring and more granular reporting.
Firms need greater consideration of other environmental risks, with a clear understanding of how risks can crystallise over varying timescales, and how they're integrated into the wider risk framework This is becoming increasingly important due to public commitments to net-zero, and increasingly regulatory scrutiny in this space to ensure a safe and sound financial system. In-scope banks must inform the ECB of their remediation plans, and improve the quality of their disclosures.
For more insight and guidance, get in touch with Rashim Arora.
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