Banks�� managing the financial risks of climate and environmental change

April 2024

Regulatory expectations around climate-related financial risk continue to be a significant concern for banks. There are already challenging requirements which form part of 'business as usual' supervisory cycles for the PRA and ECB. Supervisors have made it clear that, where banks fall short, they can expect sanctions, and the ECB has begun to put this into practice. Regulatory policy in this area continues to be a topic for discussion and is expected to evolve as climate risk modelling approaches and banks' capabilities mature.

, the PRA’s Supervisory Statement on Enhancing banks�� and insurers�� approaches to managing the financial risks from climate change, is now five years old and the PRA has committed to updating it this year. Although the PRA was one of the first prudential regulators to set expectations on climate risk, it has arguably been overtaken by its European counterparts both in terms of granularity of expectations and approach to enforcement. The ECB's 2020��(PDF- 712KB) on climate and environment-related risks has already been updated in parts and recent speeches suggest that further enhancements are likely. The EBA is��(PDF - 608KB) on proposals that would deliver under its CRR3��and CRD6 climate and environment-related mandates. At a global level, the��continues to explore climate and broader sustainability impacts, and the FSB's 2024��continues its work on coordinating international efforts to address climate-related financial risk.

In this article, ��㣨Leyu�� in the UK looks at ten areas where banks are likely to see continued focus or new developments in 2024. For more detail on the expectations already issued by the��PRA, ECB and BCBS.

1) More prescriptive expectations on the quantification of ESG risks

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The EBA's��(PDF- 608KB) on draft guidelines on the minimum standards and reference methodology for the identification, measurement, management and monitoring of ESG risks offers insights into the likely direction of travel. The consultation is the start of the process to deliver the EBA's climate risk mandates under the amended Capital Requirements Regulation (CRR3).

The EBA notes that banks should consider the role of ESG risks as potential drivers of all traditional categories of financial risks, including credit, market, operational, reputational, liquidity, business model and concentration risks. It also sets out more granular expectations including:

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Time horizons for materiality assessments:

less than three years for short-term, three to five years for medium-term, and at least 10 years for long-term.

Specific data sets

that banks should obtain from their large corporate counterparties for climate and environmental risks: geographical location of key assets and exposure to environmental hazards, current and forecast scope 1, 2 and 3 GHG emissions, material impacts on the environment, dependency on fossil fuels, energy and water consumption, litigation risk, and transition plans.

Requirements for banks' internal procedures around principles for measurement and assessment

to provide for a combination of methodologies including exposure-based (for a short-term view on credit risk profile), portfolio-based (to support medium planning and definition of risk limits / risk appetite) and scenario-based (to assess sensitivities across different time horizons, including long-term), specifying key risk indicators that need to be considered in each methodology.

In the UK, the PRA has also��to publishing thematic findings on banks' processes to quantify the impact of climate risks on expected credit losses. Banks can expect these findings to highlight both good practice and areas for improvement.��

2) Continued integration of climate-related risk into existing risk management frameworks

Again, the EBA consultation is a helpful pointer. Banks will be expected to embed ESG risks within their standard risk management systems and processes, incorporate them into the ICAAP and ILAAP, and ensure consistency with overall business and risk strategies. This is not new per se, and echoes earlier messaging from the��, which noted that effective practice would include having a well-defined quantitative risk appetite statement (RAS) aligned to the overarching risk management framework (RMF).��Banks should expect updates to SS3/19 to reflect lower tolerance for challenges such as data limitations, and expectations that gaps in risk management frameworks have been addressed.

2) Continued integration of climate-related risk into existing risk management frameworks

Again, the EBA consultation is a helpful pointer. Banks will be expected to embed ESG risks within their standard risk management systems and processes, incorporate them into the ICAAP and ILAAP, and ensure consistency with overall business and risk strategies. This is not new per se, and echoes earlier messaging from the��, which noted that effective practice would include having a well-defined quantitative risk appetite statement (RAS) aligned to the overarching risk management framework (RMF).��Banks should expect updates to SS3/19 to reflect lower tolerance for challenges such as data limitations, and expectations that gaps in risk management frameworks have been addressed.

3) More��mature scenario analysis and stress testing capabilities

Supervisors have published many findings in this area, including a recent��from the BCBS on the role of climate scenario analysis in strengthening the management and supervision of climate-related financial risks��and a BoE��on using scenario analysis to measure climate-related financial risks. Banks should expect further focus on:

Decision-useful scenario analysis, e.g. running scenarios that can help in making credit decisions.

Use of scenario analysis to test the adequacy of their strategic response to climate change risks, e.g. by quantifying the impact of scenarios on profits and losses, risk-weighted assets and regulatory capital.

Extending macro scenarios provided by bodies such as the NGFS, and tailoring them to provide relevant asset-level analysis.

Ensuring that management actions resulting from scenario analysis are credible and can be executed in a stressed environment, even where other market participants are likely to be implementing similar actions.

Efforts to overcome data limitations when running scenarios, including using client and counterparty data held by the bank rather than relying on proxies.

Evidence of why selected data and assumptions are appropriate to a firms' specific business vulnerabilities.

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4) Climate capital to remain under Pillar 2 rather than be mandated under Pillar 1�� for now��.

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The Bank of England's 2023��report��on climate-related risks and capital concluded that further work was required to assess whether there was a regime gap in the macro prudential framework. If such a gap is identified, further consultation will be required on the best way to address it before mandating any capital requirements. In the meantime, the current approach, whereby climate-related risk is captured under Pillar 2 as part of the ICAAP, will continue.��

This is consistent with the EU approach, with the ECB setting Pillar 2 capital requirements as part of the Supervisory Review and Evaluation Process (SREP). In the current EBA consultation (see above) there is no mention of specific climate capital requirements�� instead the focus is on managing risk across traditional financial risk types and using the ICAAP to capture material risks.��

However, climate capital still forms part of the Basel Committee's workplan. In December 2022, it published��FAQs��on how banks could reflect climate risk in Pillar 1, and committed to publishing additional information as data availability and methodologies matured. The��showed continued focus on assessing climate-related gaps in the Basel framework, so the debate is far from over.

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5) Increased focus on the prudential impacts of greenwashing

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In the wider sphere of sustainability regulation, reporting and disclosures have been a key driver of regulatory pressure for firms across financial services�� as reflected in the latest edition of the��㣨Leyu�� Regulatory Barometer. However, the reputational risks involved in making misleading sustainability claims (greenwashing), whether deliberate or not, and the associated litigation risk, can all translate into prudential impacts. Banks in the EU will already be familiar with the ECB's��of deep dives on reputational and litigation risk. Given increasing focus on greenwashing by other regulators including�� the��(PDF-1.496MB) and the��FCA, it would seem logical for the PRA to also expect banks to assess, manage and mitigate the��potential impacts of greenwashing accusations e.g. litigation and reputational risks.

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6) Support for further disclosure requirements

The PRA has been consistently supportive of climate-related disclosures, recommending TCFD-aligned disclosures in��(PDF- 880KB). In 2024, there may be further support for the FCA's upcoming work to incorporate the Transition Plan Taskforce's (TPT's) disclosure framework and associated guidance, as well as the developing UK Sustainability Disclosures Standards (SDS) and UK Green Taxonomy, into in its disclosure requirements.��

On prudential disclosures, the PRA is yet to mandate granular climate-related requirements although it expects material risks to be disclosed. The EBA has done so, under its��, and the BCBS recently��on Pillar 3 templates for banks to disclose qualitative and quantitative data such as exposures by sector, financed emissions and exposures subject to physical risk by geographical area. The PRA is responding to the BCBS Pillar 3 consultation, as confirmed in its latest�� it would be likely to adopt any final BCBS recommendations but will be interesting to see how any decisions on this might be influenced by the secondary competitiveness and growth objective.

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7) Reflecting nature and wider ESG risks in prudential expectations

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The ECB already includes environmental-related risks in its prudential expectations. It has added a new��to its 2024/25 workplan to focus on the risks stemming from nature loss and degradation and how they interact with climate-related risks. The PRA does not currently set out any specific requirements on nature-related risk. However, the FCA's 2024-25��referred to a 'nature' regulatory principle coming into force, and a report is expected in April from the��, providing a 'first-of-its-kind UK Nature-Related Risk Inventory' that will estimate the dependency of UK banks and insurers on ecosystem services and present a methodology to translate these dependencies into financial risk. Additionally, the Global Association of Risk Professionals (GARP) published its first global��on nature-related financial risks, finding that there is increasing focus on nature but firms�� maturity levels on strategic engagement is relatively low.��Given increasing emphasis in this area, it is reasonable to expect that the PRA may move on this�� potentially as part of the review of SS3/19.

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8) More stringent penalties

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This has already begun. In a recent��Frank Elderson, ECB Board member, warned that banks failing to meet supervisory expectations on C&E risks would face a penalty for every day that shortcomings remained unresolved. Letters have been sent to individual banks and these penalties are now being applied. In its 2022 supervisory priorities letters for UK deposit takers and international banks, the PRA highlighted the ‘range of supervisory tools under review for use where we deem progress to be insufficient��. As the PRA reviews SS3/19, it may start to take a stronger stance. Banks should not underestimate how serious supervisors are.

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9) Novel approaches to climate risk modelling

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A key challenge for banks in climate risk modelling is the lack of a granular industry or regulatory standard on approaches and assumptions. This leads to variation in the level of sophistication of climate risk modelling approaches, making it difficult to compare risks across the industry, and a possibility that key��exposures are being under- or over-estimated across the sector. Banks are making their own decisions on how to develop their modelling, including on issues such as dynamic balance sheet models, factoring in second-order effects such as impacts on supply chains and developing bespoke climate risk scenarios. It will be interesting to see if prudential regulators introduce granular expectations on modelling approaches and assumptions beyond the high-level expectations already published.��

Supervisors too are looking at modelling capabilities that can assist in their analysis of climate-related risk. Project Gaia has been developed by the Bank of International Settlements (BIS) partnering with the Bank of Spain, the Deutsche Bundesbank and the ECB. Gaia is an artificial intelligence (AI) application that uses large language models, to search and extract data from corporate climate-related disclosures, enabling quick and efficient analysis of climate-related risks in the financial system�� the recent��(PDF- 6.7MB)on the project included analysis of 20 key performance indicators (KPIs) for 187 financial institutions over five years. One possible next phase of Project Gaia is to make the tool publicly available to analysts to support the growing demand for climate-related data. Banks should expect supervisors and analysts to make increasing use of such models to gauge the potential systemic financial risks of climate change.

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10) Enhanced governance expectations

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While not specific to financial services, the updated��(PDF-399KB) will require boards to not only monitor a company's risk management and internal control framework but also explain how they have measured its effectiveness through a declaration in the annual report. Banks will want to consider how these requirements will reflect their work on climate-related risks.��

In the EU, acceleration of the effective remediation of shortcomings in governance is one of the ECB's supervisory��for the next two years. This encompasses not only the functioning of banks' management bodies, but also their risk data aggregation and reporting capabilities. Given that ECB-supervised banks should have embedded climate and environment-related risks in their governance, strategy and risk management by the end of 2023 at the latest, they can expect these risks to be included as part of BAU governance reviews.

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Michelle Adcock

Director, FS Regulatory Insight Centre, Risk and Regulatory Advisory

��㣨Leyu�� in the UK

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Radhika Bains

ESG Specialist Manager, EMA Regulatory Insight Centre

��㣨Leyu�� in the UK

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