Response to discussion paper on the role of environmental risk in the prudential framework
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Therefore, we are aligned with the EBA’s statement in paragraph 27 of the Discussion paper, according to which: ‘Liquidity ratios are based on short-term indicators which aim to measure the resilience of the liquidity position by setting, through standardized approaches, a proper buffer of securities. Given that environmental risks are expected to materialize over time horizons longer than the ones in scope for these ratios and that these ratios do not allow for banks’ risk-based assessments to capture environmental risk factors to derive liquidity requirements, liquidity ratios are expected to remain mostly unaffected by environmental risks and have a limited role in addressing such risks. Also, the leverage ratio, as a non-risk-based measure which functions as a backstop, does not specifically interact with environmental risks’.
Meteorological and hydrological institutions, for example, have collaborated to generate climate risk maps in specific locations that can be used as input for future climate risk materiality assessments and risk integration into the bank's risk management frameworks.
We welcome the review of the Energy Performance in Buildings Directive, which intends to expand the scope of energy performance certifications and increase data accessibility, among other things. This may enable the development of risk factor data for real estate exposures. Currently, the collection of this data is challenging in some Member States. This challenge was experienced also during the ECB climate stress test 2022 exercise.
We also welcome the European Union's initiative for a single access point.
Also, small horizon changes, on the other hand, would have a marginal impact on ESG risk capture. Instead, we would suggest considering a medium-term horizon for rating assignment . In practice, the counterparty rating as an outcome of the rating model can be overridden based on expert opinion as to the longer-term view on the sector and the specifics of a company (strategy, transition plan, risk, estimated financials, etc).
Apart from this, environmental risks are not the sole source of forward-looking/long-term uncertainty for financial institutions. Questioning whether prudential models should be based on historical data would create regulatory and supervisory uncertainty and might jeopardize the level playing field. In our opinion, if additional own fund requirements related to environmental risk were necessary, they should be addressed through the long term stress test under Pilar 2.
At this stage, given the well-known restrictions in terms of empirical evidence, data gaps, modeling development, and IT development procedures, it appears difficult to incorporate this forward-looking nature of environmental risks into Pillar 1 without jeopardizing the framework's advantages and qualities. The inclusion of forward-looking approaches would be more relevant for exercise already based on scenarios. In this regard, Pillar 2, stress testing and scenario analyses, would be more appropriate tools for these considerations.
• When collecting data from companies’ reports/financial statements, such as carbon emissions, both data quality/accuracy and completeness may be an issue.
• Distinguishing between approaches/models for assigning ESG scores to various industry sectors adds to the complexity of environmental risks assessments performed by credit rating agencies.
• A thorough assessment of a company's ESG risks can be time consuming, as it may involve activities such as tracking a company’s supply chain.
• In addition to the above, lack of alignment and comparability may occur until there is a common methodology for the measurement and quantification of these risks between the different credit agencies.
Generally, we also agree that the increased availability of quality ESG-related data on the market will allow CRAs to better challenge CRA credit risk analyses leading to enhanced due diligence.
• Scarcity of ESG disclosures in firms’ financial reports.
• Collecting additional information from firms/clients may require bilateral meetings/calls that can be costly and time consuming.
• Internal competency is required for ESG - related assessment/judgment.
• Lack of alignment and transparency of methodologies used by different CRAs could be an issue and as stated in Section 5.2.2 (a) may incentivize banks to “cherry-pick” CRAs that provide a more favourable rating.
• Additional challenge with regard to environmental risks treatment in credit risk is the double counting of risk. For instance, energy efficiency is taken into account via collateral valuation and, hence, accounted for in LGD. When evaluating a client's rating/probability of default, energy efficiency of a property he or she owns can be taken into account as well. This could result in double counting of financial risks associated with environmental factors as long as the PD/LGD models are not mature.
Also, a more granular treatment of energy-efficient mortgages should be considered in the valuation of property rather than in introducing new risk weights/new risk classes.
Therefore, we think that it would be unnecessary to add environmental criteria for the eligibility to the sub-asset classes HQ Object and HQ Project finance since environmental factors are sufficiently taken into account due to the very nature of these activities.
In ESBG’s view, questioning whether prudential models should be based on historical data would create regulatory and supervisory uncertainty and might jeopardize the level playing field. In our opinion, if additional own fund requirements related to environmental risk were necessary, they should be addressed through the long term stress test under Pillar 2.
In our view, it is difficult to estimate environmental risk using IRB models for a number of reasons:
• Due to a lack of sufficient high-quality data, including environmental risk factors into the IRB framework is extremely difficult.
• The behaviour of environmental risks does not necessarily correlate with credit cycles or risk characteristics used to estimate credit risk. Environmental risk behaviour does not always correspond to credit cycles or risk characteristics used to calculate credit risk. Prior experience with identifying and monitoring ESG risk in the credit process demonstrates that the prevalence of ESG risk can alter over time owing to both endogenous and external factors. This means that the fact that the bank is managing ESG can also have an impact on the significance of environmental risk factors, making them less significant to IRB modelling.
As indicated in the discussion paper, the Pillar 1 capital framework is not designed to consider risks that develop over long periods of time. Due to these issues, it is debatable whether it is currently appropriate and/or possible to expand or revise the IRB framework to account for environmental risks in a satisfactory manner without qualitative assessments. Moreover, as data pertaining to environmental risk is currently scarce it will take time to collect enough data of sufficient quality to be used for the purpose of IRB modelling. Therefore, any revisions to the Pillar 2 framework in this respect must be done with a substantial time lag until implementation, so that good data quality regarding ESG may be achieved.
Before the common data foundation has significantly matured, there should be ample flexibility for banks to integrate environmental risks into IRB models. Banks have the best understanding of their customers’ risks and since modelling approaches are not yet mature for environmental drivers, regulators should recognize and allow for diverging approaches. For example, the introduction of override on rating classes could be the easiest solution to adopt until quality data are available.
Not related to IRB models, ESBG Members are aware of at least one bank that is actively developing an ESG score, which will assist in the identification of customers that are especially sensitive to ESG factors. In the future, the instrument could be used to investigate the relationship between ESG sensitivity and financial consequences for clients. The tool will be used as part of the credit application process and can serve as a starting point for data collection.
Both approaches raise our concerns. To establish a reasonable treatment of green versus brown assets, it appears that more data collection and research is required. Furthermore, uncertainty about potential regulatory changes affecting green/brown companies makes it difficult to estimate/predict their profitability and future behaviour.
Overall, we support the EBA view expressed in Sections 5.2.2 and 5.2.3 that environmental risk may already be accounted for in collateral valuation and going forward will be captured more properly via external credit assessments. Therefore, we believe that policy and regulatory actions outside of the Pillar 1 framework would be more suitable at that time.
In addition, all of the above listed approaches may be challenging due to the complexity and uncertain magnitude of environmental risks and their impact. The scarcity of historical data, time series, and research, particularly for certain industries and exposure types, makes it difficult to include environmental risks into pricing models and the calibration of new regulatory risk weights via new risk factors.
In particular:
• introducing an ESG component in the identi¬fication of the appropriate bucket makes CSR and EQ bucket mapping process more complicated and will require publicly available ESG scores or classification logic with a broad coverage. Moreover, variations in methodology employed by providers of ESG scores/assessment could lead to unequal treatment of exposures across institutions
• regarding an increase of the risk, it concerns us how granular one should be when introducing this approach. Environmental risk associated with issuers within one (current) bucket can vary significantly.
• Even though a relative simplicity of the RRAO framework can provide for more aligned treatment of ESG risks across the industry, modification of the RRAO framework to include ESG risks can lead to excessive capital requirements.
This process poses some challenges:
- Definition of climate risk events, which have always happened but are becoming more common and severe as a result of climate change.
- Determination of the best method for identifying these losses, such as through a mark in the company's systems.
- Training and awareness for the centers that are responsible for operating losses, which should be independent to identify and register these losses as soon as they materialize, allowing for easier analysis and reporting.
- Historical identification of losses related to extreme climate events.
Taking the former into consideration, Pillar 1 may not be very sensitive to these types of long-term impacts, and its requirements may necessitate changes for considering forward-looking issues that could lead to unnecessary regulatory and supervisory uncertainty.
Nonetheless, we understand the benefits of transparency in Pillar 3 through the recently published EBA ITS for Pillar 3 ESG risk disclosures.
Q1: In your view, how could exposures associated with social objectives and/or subject to social impacts, which are outside the scope of this DP, be considered in the prudential framework? Please provide available evidence and methodologies which could inform further assessment in that regard.
In ESBG’s view, although environmental, social, and governance risks face some of the same obstacles and constraints when it comes to identifying and measuring issues, their nature is very different, thus, they should be evaluated and analysed under separate and distinct processes.Q2: Do you agree with the EBA’s assessment that liquidity and leverage ratios will not be significantly affected by environmental risks? If not, how should these parts of the framework be included in the analysis?
In our view, environmental risks have no meaningful impact on liquidity and leverage ratios. Liquidity indicators focus on short-term horizons that are much shorter than the time horizons that environmental risks might potentially materialize. Because the leverage ratio is a safety net requirement rather than a risk indicator, it does not merit consideration in an ESG risk assessment.Therefore, we are aligned with the EBA’s statement in paragraph 27 of the Discussion paper, according to which: ‘Liquidity ratios are based on short-term indicators which aim to measure the resilience of the liquidity position by setting, through standardized approaches, a proper buffer of securities. Given that environmental risks are expected to materialize over time horizons longer than the ones in scope for these ratios and that these ratios do not allow for banks’ risk-based assessments to capture environmental risk factors to derive liquidity requirements, liquidity ratios are expected to remain mostly unaffected by environmental risks and have a limited role in addressing such risks. Also, the leverage ratio, as a non-risk-based measure which functions as a backstop, does not specifically interact with environmental risks’.
Q3: In your view, are environmental risks likely to be predominantly about reallocation of risk between sectors, or does it imply an increase in overall risk to the system as a whole? What are the implications for optimum levels of bank capital?
We believe that, in the long term, new systemic risks may occur; however, such risks are beyond conventional risk management horizons. In the short and medium term, it's largely about asset reallocation, with banks gradually changing their portfolios toward a decarbonized economy, and businesses attempting to adopt new technology, among other things. This will be largely determined by the specific strategies of banks and their clients, as well as the pace with which they adapt to a decarbonized economy. It's important to emphasize that these efforts will vary greatly even within industries, not simply across them. Companies that have difficulty obtaining bank financing may be forced to abandon the market or turn to alternative investment sources. While the economy's general transition is unpredictable, there is no need to introduce higher overall capital requirements, and risk sensitivity must be maintained and improved in order to include ESG concerns into existing risk management frameworks.Q5: How can availability of meaningful and comparable data be improved? What specific actions are you planning or would you suggest to achieve this improvement?
When it comes to collecting and accessing reliable and granular environmental data, we believe that collaboration between credit rating agencies, financial institutions, and corporations is critical. Banks will be reliant on collaboration if they are obliged to include ESG risks in their models. Creating meaningful time series for use in scenario calibration, as well as IRB models, is of particular importance.Meteorological and hydrological institutions, for example, have collaborated to generate climate risk maps in specific locations that can be used as input for future climate risk materiality assessments and risk integration into the bank's risk management frameworks.
We welcome the review of the Energy Performance in Buildings Directive, which intends to expand the scope of energy performance certifications and increase data accessibility, among other things. This may enable the development of risk factor data for real estate exposures. Currently, the collection of this data is challenging in some Member States. This challenge was experienced also during the ECB climate stress test 2022 exercise.
We also welcome the European Union's initiative for a single access point.
Q6: Do you agree with the risk-based approach adopted by the EBA for assessing the prudential treatment of exposures associated with environmental objectives / subject to environmental impacts? Please provide a rationale for your view.
We consider that a risk-based approach that is supported by sound evidence is the preferred prudential approach. The Pillar 1 framework should not be used as an incentive to allocate assets to climate-related initiatives. Improving the framework's sensitivity to ESG risks, on the other hand, is a critical and difficult endeavour.Q7: What is your view on the appropriate time horizon (s) to be reflected in the Pillar 1 own funds requirements?
Climate risks are generally long-term risks that extend well beyond the capital planning horizon or the maturity of the majority of bank assets. The issue of time horizon(s) for the quantification of the Pillar I risk is sensitively complex because if the horizon is stretched by 20-30 years, the quantification turns out to be much less precise and it can also be a source of potential errors and unintended consequences. On the other hand, the quantification estimated on a very long-time horizon, but applied in a shorter term scenario seems to be too conservative and more related to a stress-test exercise. In our view, it would be unreasonable to prolong the time horizon in Pillar 1 over such extended horizons. Also, it does not seem feasible to adjust the current time horizon of the prudential framework, because it would entail a recalculation of PDs, LGDs, EADs, and ultimately capital requirements, which could significantly reduce their comparability.Also, small horizon changes, on the other hand, would have a marginal impact on ESG risk capture. Instead, we would suggest considering a medium-term horizon for rating assignment . In practice, the counterparty rating as an outcome of the rating model can be overridden based on expert opinion as to the longer-term view on the sector and the specifics of a company (strategy, transition plan, risk, estimated financials, etc).
Apart from this, environmental risks are not the sole source of forward-looking/long-term uncertainty for financial institutions. Questioning whether prudential models should be based on historical data would create regulatory and supervisory uncertainty and might jeopardize the level playing field. In our opinion, if additional own fund requirements related to environmental risk were necessary, they should be addressed through the long term stress test under Pilar 2.
Q8: Do you have concrete suggestions on how the forwardlooking nature of environmental risks could be reflected across the risk categories in the Pillar 1 framework?
In ESBG’s view, the forward-looking nature of environmental risks may already be reflected in the Pillar 1 framework via the inclusion of environmental risks in collateral/property valuation; market and appraisal values might already reflect the market view on environmental risk. We consider it difficult to ensure that a supporting or penalising factor applied to green and environmentally harmful exposures respectively can adequately reflect ESG risk. Also, we believe that the time horizons used in the estimation of Pillar 1 own funds should be maintained, given that environmental risks are not the sole source of forward-looking/long-term uncertainty for financial institutions. Questioning whether prudential models should be based on historical data would create regulatory and supervisory uncertainty and might jeopardize the level playing field. In our opinion, if additional own fund requirements related to environmental risk were necessary, they should be addressed through the long term stress test under Pilar 2.At this stage, given the well-known restrictions in terms of empirical evidence, data gaps, modeling development, and IT development procedures, it appears difficult to incorporate this forward-looking nature of environmental risks into Pillar 1 without jeopardizing the framework's advantages and qualities. The inclusion of forward-looking approaches would be more relevant for exercise already based on scenarios. In this regard, Pillar 2, stress testing and scenario analyses, would be more appropriate tools for these considerations.
Q9: Have you performed any further studies or are you already using any specific ESG dimensions to differentiate within credit risk? If so, would you be willing to share your results?
Some members of ESBG are now working on the climate stress test under Pillar 2, and an initial phase is underway to examine climate risks from a management perspective, allowing them to determine sensitivity in terms of Economic Capital requirements (this is planned for 2023).Q10: What are the main challenges that credit rating agencies face in incorporating environmental considerations into credit risk assessments? Do you make use of external ratings when performing an assessment of environmental risks?
We believe that credit rating agencies face the following challenges when incorporating environmental considerations into credit risk assessments:• When collecting data from companies’ reports/financial statements, such as carbon emissions, both data quality/accuracy and completeness may be an issue.
• Distinguishing between approaches/models for assigning ESG scores to various industry sectors adds to the complexity of environmental risks assessments performed by credit rating agencies.
• A thorough assessment of a company's ESG risks can be time consuming, as it may involve activities such as tracking a company’s supply chain.
• In addition to the above, lack of alignment and comparability may occur until there is a common methodology for the measurement and quantification of these risks between the different credit agencies.
Generally, we also agree that the increased availability of quality ESG-related data on the market will allow CRAs to better challenge CRA credit risk analyses leading to enhanced due diligence.
Q11: Do you see any challenge in broadening due diligence requirements to explicitly integrate environmental risks?
A bank may face the following challenges when attempting to broaden due diligence requirements:• Scarcity of ESG disclosures in firms’ financial reports.
• Collecting additional information from firms/clients may require bilateral meetings/calls that can be costly and time consuming.
• Internal competency is required for ESG - related assessment/judgment.
• Lack of alignment and transparency of methodologies used by different CRAs could be an issue and as stated in Section 5.2.2 (a) may incentivize banks to “cherry-pick” CRAs that provide a more favourable rating.
• Additional challenge with regard to environmental risks treatment in credit risk is the double counting of risk. For instance, energy efficiency is taken into account via collateral valuation and, hence, accounted for in LGD. When evaluating a client's rating/probability of default, energy efficiency of a property he or she owns can be taken into account as well. This could result in double counting of financial risks associated with environmental factors as long as the PD/LGD models are not mature.
Q12: Do you see any specific aspects of the CRM framework that may warrant a revision to further account for environmental risks?
We consider that the CRM framework used in the estimation of Pillar 1 should be maintained, and if there is a need for a particular treatment in this regard, the stress test exercises under Pillar 2 should be considered.Q13: Does the CRR3 proposal’s clarification on energy efficiency improvements bring enough risk sensitiveness to the framework for exposures secured by immovable properties? Should further granularity of risk weights be introduced, considering energy-efficient mortgages? Please substantiate your view.
To our opinion, the definition of energy efficiency in the CRR3 could potentially be improved; energy efficiency could also concern water, for example.Also, a more granular treatment of energy-efficient mortgages should be considered in the valuation of property rather than in introducing new risk weights/new risk classes.
Q14: Do you consider that high-quality project finance and high-quality object finance exposures introduced in the CRR3 proposal should potentially consider environmental criteria? If so, please provide the rationale for this and potential implementation issues.
It should be noted that HQ Object Finance and HQ Project Finance exposures benefit from an enhanced due diligence to ensure that financial risks are adequately covered. This includes the analysis of environmental factors. A risk-based approach should be followed and double-counting should be avoided. Environmental topics, with the transition and physical risks, would be best considered within the cash flows projections of the borrower when possible, and within the risk assessment of the transaction. There should not be an adjustment factor on top of other factors of selection of High-Quality transactions.Therefore, we think that it would be unnecessary to add environmental criteria for the eligibility to the sub-asset classes HQ Object and HQ Project finance since environmental factors are sufficiently taken into account due to the very nature of these activities.
Q15: Do you consider that further risk differentiation in the corporate, retail and/or other exposure classes would be justified? Which criteria could be used for that purpose? In particular, would you support risk differentiation based on forward-looking analytical tools?
If environmental risks are captured in instrument valuation then further risk differentiation could already be taken into consideration, without a need of additional exposure classes/subclasses introduction. Moreover, banks can have a limited access to data necessary to perform such classification. Alternatively, this could be captured in policy. The objective to integrate environmental risks cannot be achieved at the level of an asset class but should be assessed at the level of the counterparty as it has been done in climate stress tests.In ESBG’s view, questioning whether prudential models should be based on historical data would create regulatory and supervisory uncertainty and might jeopardize the level playing field. In our opinion, if additional own fund requirements related to environmental risk were necessary, they should be addressed through the long term stress test under Pillar 2.
Q16: Do you have any other proposals on integrating environmental risks within the SA framework?
We have not identified risk-based considerations that would allow changes to the SA framework.Q17: What are your views on the need for revisions to the IRB framework or additional guidance to better capture environmental risks? Which part of the IRB framework is, in your view, the most appropriate to reflect environmental risk drivers?
In ESBG’s view, questioning whether prudential models should be based on historical data would create regulatory and supervisory uncertainty and might jeopardize the level playing field. In our opinion, if additional own fund requirements related to environmental risk were necessary, they should be addressed through the long term stress test under Pilar 2.In our view, it is difficult to estimate environmental risk using IRB models for a number of reasons:
• Due to a lack of sufficient high-quality data, including environmental risk factors into the IRB framework is extremely difficult.
• The behaviour of environmental risks does not necessarily correlate with credit cycles or risk characteristics used to estimate credit risk. Environmental risk behaviour does not always correspond to credit cycles or risk characteristics used to calculate credit risk. Prior experience with identifying and monitoring ESG risk in the credit process demonstrates that the prevalence of ESG risk can alter over time owing to both endogenous and external factors. This means that the fact that the bank is managing ESG can also have an impact on the significance of environmental risk factors, making them less significant to IRB modelling.
As indicated in the discussion paper, the Pillar 1 capital framework is not designed to consider risks that develop over long periods of time. Due to these issues, it is debatable whether it is currently appropriate and/or possible to expand or revise the IRB framework to account for environmental risks in a satisfactory manner without qualitative assessments. Moreover, as data pertaining to environmental risk is currently scarce it will take time to collect enough data of sufficient quality to be used for the purpose of IRB modelling. Therefore, any revisions to the Pillar 2 framework in this respect must be done with a substantial time lag until implementation, so that good data quality regarding ESG may be achieved.
Before the common data foundation has significantly matured, there should be ample flexibility for banks to integrate environmental risks into IRB models. Banks have the best understanding of their customers’ risks and since modelling approaches are not yet mature for environmental drivers, regulators should recognize and allow for diverging approaches. For example, the introduction of override on rating classes could be the easiest solution to adopt until quality data are available.
Q18: Have you incorporated the environmental risks or broader ESG risk factors in your IRB models? If so, can you share your insight on the risk drivers and modelling techniques that you are using?
ESBG Members do not currently include environmental risks or broader ESG risk factors in their IRB models. However, ESBG Members are aware of at least one significant corporate Probability of Default Model (PD model), which includes policies, management, and the long-term impact of a counterparty, that is now under supervisory review. ESG risk drivers have the ability to move the final risk grade to an adjacent grade with a lower or higher final PD estimate, depending on the counterparty profile.Not related to IRB models, ESBG Members are aware of at least one bank that is actively developing an ESG score, which will assist in the identification of customers that are especially sensitive to ESG factors. In the future, the instrument could be used to investigate the relationship between ESG sensitivity and financial consequences for clients. The tool will be used as part of the credit application process and can serve as a starting point for data collection.
Q19: Do you have any other proposals on integrating environmental risks within the IRB framework?
We believe that environmental risks could not be easily integrated into the IRB framework because we consider that the quantification of these risks should be included in the Pillar 2 long term stress testing exercises. At this stage, the introduction of override on rating classes could be the easiest solution to adopt until quality data are available.Q21: What would in your view be the most appropriate from a prudential perspective: aiming at integrating environmental risks into existing Pillar 1 instruments, or a dedicated adjustment factor for one, several or across exposure classes? Please elaborate.
In our view, introducing an adjustment factor could result in double counting of ESG risks that are already accounted for in collateral value or ratings. As a result, it's critical to be transparent about why an adjustment factor was used on a particular exposure. At the same time, it is challenging to estimate to what extent ESG risks are already priced in. To put it another way, it's difficult to separate the impact of environmental factors on property value.Both approaches raise our concerns. To establish a reasonable treatment of green versus brown assets, it appears that more data collection and research is required. Furthermore, uncertainty about potential regulatory changes affecting green/brown companies makes it difficult to estimate/predict their profitability and future behaviour.
Overall, we support the EBA view expressed in Sections 5.2.2 and 5.2.3 that environmental risk may already be accounted for in collateral valuation and going forward will be captured more properly via external credit assessments. Therefore, we believe that policy and regulatory actions outside of the Pillar 1 framework would be more suitable at that time.
Q23: What are your views on possible approaches to incorporating environmental risks into the FRTB Standardised Approach? In particular, what are your views with respect to the various options presented: increase of the risk-weight, inclusion of an ESG component in the identification of the appropriate bucket, a new risk factor, and usage of the RRAO framework?
In ESBG’s view, there is not yet any evidence about the impact of ESG risks on market factors to justify the modification of the current proposed FRTB framework. Furthermore, ESG risks are expected to materialize over long time horizons, while the time horizon for the management of market risk is quite shorter. Thus, in our view, at the current stage, a Pillar 2 or 3 approach suits better for the impact of ESG risks on market risk.In addition, all of the above listed approaches may be challenging due to the complexity and uncertain magnitude of environmental risks and their impact. The scarcity of historical data, time series, and research, particularly for certain industries and exposure types, makes it difficult to include environmental risks into pricing models and the calibration of new regulatory risk weights via new risk factors.
In particular:
• introducing an ESG component in the identi¬fication of the appropriate bucket makes CSR and EQ bucket mapping process more complicated and will require publicly available ESG scores or classification logic with a broad coverage. Moreover, variations in methodology employed by providers of ESG scores/assessment could lead to unequal treatment of exposures across institutions
• regarding an increase of the risk, it concerns us how granular one should be when introducing this approach. Environmental risk associated with issuers within one (current) bucket can vary significantly.
• Even though a relative simplicity of the RRAO framework can provide for more aligned treatment of ESG risks across the industry, modification of the RRAO framework to include ESG risks can lead to excessive capital requirements.
Q24: For the Internal Model Approach, do you think that environmental risks could be better captured outside of the model or within it? What would be the challenges of modelling environmental risks directly in the model as compared to modelling it outside of the internal model? Please describe modelling techniques that you think could be used to model ESG risk either within or outside of the model.
In ESBG’s view, there is not yet any evidence about the impact of ESG risks on market factors to justify the modification of the current proposed FRTB framework. Furthermore, ESG risks are expected to materialize over long time horizons, while the time horizon for the management of market risk is quite shorter. Thus, in our view, at the current stage, a Pillar 2 or 3 approach suits better for the impact of ESG risks on market risk.Q25: Do you have any other proposals on integrating environmental risks within the market risk framework?
We propose the inclusion of the ESG risks in the stress scenarios or potentially addressing ESG risks initially through additional Pillar 3 disclosures.Q26: What additional information would need to be collected in order to understand how environmental risks impact banks’ operational risk? What are the practical challenges to identifying environmental risk losses on top of the existing loss event type classification?
When it comes to identifying operational losses linked to climate and other environmental risks, we believe that it is important to quantify and properly assess their quantitative materiality and to be able to manage them effectively.This process poses some challenges:
- Definition of climate risk events, which have always happened but are becoming more common and severe as a result of climate change.
- Determination of the best method for identifying these losses, such as through a mark in the company's systems.
- Training and awareness for the centers that are responsible for operating losses, which should be independent to identify and register these losses as soon as they materialize, allowing for easier analysis and reporting.
- Historical identification of losses related to extreme climate events.
Q27: What is your view on potential integration of a forward-looking perspective into the operational risk framework to account for the increasing severity and frequency of physical environmental events? What are the theoretical and practical challenges of introducing such a perspective in the Standardised Approach?
In our view, environmental risks have distinct characteristics: they assess non-financial risk factors, there is considerable uncertainty about when they will materialize and historical data is not particularly useful in predicting the severity of future impacts. Furthermore, risk measurement methodologies are still being developed, and there is a notable lack of consistent and accurate data.Taking the former into consideration, Pillar 1 may not be very sensitive to these types of long-term impacts, and its requirements may necessitate changes for considering forward-looking issues that could lead to unnecessary regulatory and supervisory uncertainty.
Nonetheless, we understand the benefits of transparency in Pillar 3 through the recently published EBA ITS for Pillar 3 ESG risk disclosures.