Response to discussion paper on the role of environmental risk in the prudential framework

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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.

We recognise the importance of social issues, and we believe that social risks could be a potentially important driver of prudential risks for banks. We would also highlight that there are potentially material interactions between climate-related risks and social risks, with actions taken to mitigate climate risk creating the risk of an ‘unjust transition’ that excludes or disadvantages certain sections of society.
However, we believe that the data and methodological issues that create challenges in the management of climate risks are, at present, even more acute for social risks. For that reason, and given the urgency with which climate risk needs to be addressed, we do not think that it is the right time to be opening up a debate on the prudential treatment of social risks. The EBA, and banks, should for the time being prioritise the management of climate-related financial risks.

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?

We agree that leverage ratios are unlikely to be significantly affected by climate or environmental risks.
However, we believe that liquidity risks could potentially be influenced by climate-related factors. For example, the crystallisation of physical risks could lead to increases in net outflows, and both physical and transition risks could have an impact on the value of assets that comprise liquidity buffers. Borrowers affected by physical risk events are likely to draw on credit lines to cover short-term basic necessities in the days after the event – especially given that insurance payments and relief funds often take weeks or months to arrive at the affected businesses and individuals. Acting as the first source of funds could create an acute liquidity risk for banks – especially for those whose customers are concentrated in regions that are particularly susceptible to physical risk.
On the funding side, climate-related risks could be relevant to the stability of a bank’s funding profile or market access (through reputational issues driven by environmental risks).
Although banks are well accustomed to considering the impact of increases in net outflows or other risks to funding (and in our experience some banks already consider the risk of severe physical risk events causing liquidity shocks), in our view it is important that banks consider the incremental impact of climate factors in their liquidity risk management.
However, our view is that the calibration of the Liquidity Coverage Ratio and Net Stable Funding Ratio does not necessarily need to change.
Instead, the risks to the liquidity resulting from environmental risk factors should be identified and assessed in the Internal Liquidity Adequacy Assessment Process (ILAAP), considering their forward-looking nature and the various transmission channels for climate change liquidity risks, including second round effects. As a minimum, banks would be expected to identify and assess their risks to liquidity as part of their ILAAP and to consider the potential impacts on their liquidity situation of acute physical risk events, as well as potential concentrations to environmental risk factors in their funding structure and in liquidity buffers.

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?

The impact of physical and transition risks will likely be uneven, depending on the sectors and geographies in which the corporates operate – in some cases, it is highly likely that there will be increased opportunities and decreased risks.
That said, we believe that overall climate and environmental risks will cause an overall increase in the level of risk in the system, rather than simply a re-allocation of risk – particularly in the event of a disorderly transition or hot house world, as described in the Network for Greening the Financial System (NGFS) scenarios.

It is too early to say whether the current level of capital in the banking system is sufficient to enable banks to withstand any overall increase in risk. The results of supervisory scenario analysis exercises undertaken to date (such as the Bank of England’s Climate Biennial Exploratory Scenario and the ECB’s Climate Stress Test) suggest that banks’ current level of capital may be sufficient. However, limitations in the scope and coverage of those exercises mean that the results should be interpreted with caution.
However, should empirical evidence suggest that the banking system is undercapitalised against system-wide climate risks, macroprudential tools may be most appropriate to ensure the resilience of the banking system. Moreover, the potential effects of a sudden global or regional environmental crisis should continue to be assessed through supervisory and/or internal climate stress scenarios and addressed through the Pillar 2 supervisory toolbox where appropriate.

Q4: Should the ‘double materiality’ concept be incorporated within the prudential framework? If so, how could it be addressed?

We agree with the way the ‘double materiality’ concept (financial and environmental/social materiality) is articulated in this consultation. Financial materiality is clearly directly relevant to prudential policy. Environmental/social materiality is relevant to the extent that it has an impact on financial materiality. In order to assess the exposure of their counterparties to physical or transition risks in the round, banks should assess the extent to which a counterparty’s ‘inside-out’ environmental impact affects its vulnerability to transition risk (through, for example, changes in policy, development of less environmentally harmful viable alternatives, or changes in consumer sentiment). As such we believe that the prudential framework should reflect this.

This approach to materiality is consistent with the definition of materiality in the International Sustainability Standard Board’s (ISSB) draft sustainability standards which focus on matters that would affect ‘enterprise value’. IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information states that “disclosures relevant to an assessment of enterprise value could relate to the entity’s reputation, performance and prospects as a consequence of the actions it has undertaken, such as its relationships with people, the planet and the economy, and its impacts and dependencies on them” [IFRS S1 1 6(c)]. Please note that we see a need for further clarity on the meaning and application of ‘double materiality’ in the broader EU Regulatory Framework, in particular the connection between financial materiality and impact materiality.

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?

We believe that the most important avenue through which climate-related data will become more readily available is corporate disclosure in line with TCFD, NFRD/CSRD, and in due course the ISSB standards. We recognise the important work being done by EFRAG in setting out detailed and extensive technical standards, and Deloitte is responding separately to that consultation. We strongly support the development of global baseline reporting standards through the ISSB, and encourage close collaboration between the EU (including the EBA) and the ISSB to achieve the greatest possible international convergence.

Climate scenario analysis exercises have also, thus far, proved useful in identifying where data gaps exist. Supervisory follow-up and bank remediation of identified gaps should help to address some issues.

We are also supportive of initiatives such as the development of a European Single Access Point (ESAP). Where possible, centralisation of climate-relevant data will ease the data collection burden for banks, which is especially important to smaller banks with fewer resources. This also applies to climate risk-relevant data such as EPC certificates.

We believe that industry collaboration, with support from the EBA, could be a very helpful step in addressing issues with data availability and quality. The EBA could promote industry-wide efforts to agree standardised templates for data collection from banks’ counterparties. We would also highlight the benefits of data pooling among banks, where banks share data on low volume events such as climate risk triggered defaults in corporate, object finance and project finance exposures.

In our experience, some banks (particularly those with fewer resources) struggle to gain a good overview of the data that are available (either open-access or otherwise). The NGFS’ efforts to collate a repository of available data providers and vendors is a welcome development in this respect.

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 agree that the prudential approach to managing climate-related risks should be risk-based, rather than pursuing any particular policy objectives related to the green transition (e.g. incentivising lending to green industries or disincentivising lending to high emitting industries). Although we recognise the importance of those policy objectives, we believe that using the prudential regime to pursue them could have important unintended consequences. A green supporting factor could arguably lead to misallocation of capital and the potential creation of ‘green bubbles’, while a brown penalising factor could potentially exacerbate transition risks and reduce the availability of transition finance for companies that most need to make the transition.
Climate-related disclosures, including the Green Asset Ratio, appear better placed to encourage lending to sustainable activities. Any Pillar 1 measure that sought to encourage green or discourage brown lending would also, in our view, likely be too rigid – perceptions of what constitutes ‘green’ or ‘brown’ are liable to change over the course of the climate transition, potentially creating a need for continuous revision of the Pillar 1 approach. This could lead to increased complexity and/or volatility in bank capital requirements.

Q7: What is your view on the appropriate time horizon (s) to be reflected in the Pillar 1 own funds requirements?

We do not think that the time horizon principles for Pillar 1 own fund requirements should be changed to accommodate specifically the incremental impact of climate risks on the specific risk types. This could introduce unnecessary complexity and cost, whilst reducing comparability with historic Pillar 1 disclosures.

It would be appropriate for regulatory authorities to provide guidance on the application and interpretation of the current time horizon principles used in Pillar 1 own funds requirements, for the purpose of capturing climate change and environmental risk factors (e.g. methods to incorporate in PD and LGD the impact of physical risks, which can increase the uncertainty in future collateral values beyond the next 12 months). This will be necessary to ensure consistency and comparability in the implementation across the banking industry.

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?

We note that ESMA published a report in February 2022 on the integration of ESG factors into credit ratings, and according to the Commission’s June 2021 Sustainable Finance Strategy the Commission is due to take action by Q1 2023 on the integration of ESG factors into credit ratings. We believe that the ESAs should encourage external credit rating agencies to consider the relevant climate change and environmental risk factors in their credit risk methodologies – as long as this is done in a consistent, transparent and forward-looking manner.
Guidance from the EBA on the expected features of sound external credit rating methodologies with respect to climate change and environmental risk factors could be helpful in reducing variability of outcomes and transparency among credit ratings agencies. The guidance would set out the EBAs’ conditions under which such external credit rating methodologies could be eligible for use under the Pillar 1 standardised approach.
Similarly, banks under the IRB approach would benefit from EBA guidance setting out the regulatory view on the following aspects of IRB models:
- how the performance of internal credit risk methodologies should be tested against climate change and environmental risk factors;
- how the credit rating methodologies and related credit risk estimates (PD, LGD, EAD) should be treated if the above tests show that the performance of a credit risk model has decreased or would benefit from improved integration of climate change and environmental risk factors; and
- how to assess the materiality of change for such IRB models when consideration for climate change and environment risk factors is improved in the rating process, or in the PD, LGD and CCF estimates.

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?

Deloitte Netherlands has undertaken research assessing the impact of climate-related risk on probability of default (PD) in a Dutch corporate shipping portfolio. PD was estimated using both generalised linear models and survival analysis. The risk drivers considered in PD analysis were shocked for six forward looking climate scenarios using a carbon elasticity model.
The results suggested an increase in the average PD of shipping exposures when transition risk is taken into account. The impact of transition risk on PD differed depending on the scenario, and is considerably larger in disorderly transition scenarios.
A second piece of analysis assessed the relationship between climate-related risk drivers and the PD of a Dutch mortgage portfolio, comparing six PD models. The results indicated that there is no clear evidence based on historical data that climate-related risk drivers have an impact on PDs. However, a spatial Mundalk pooled logistic regression model showed some significance in climate-related risk drivers.
Thirdly, a macro-econometric model was deployed to measure climate-related credit risk for a portfolio of residential mortgages in the United States. For physical risk, conventional financial risk drivers were supplemented with flood risk indicators in a logit model. Transition risk was quantified using scenario analysis, with scenarios simulated using an Energy-Environment-Economy macro-econometric model. The results showed that mortgage defaults are particularly susceptible to unemployment. Drops in consumer expenditure and increases in energy prices increase unemployment and subsequently mortgage defaults.
Finally, Deloitte Netherlands undertook some analysis of the impact of climate change on wildfires in the United States. A logit model was used to calculate the probability of wildfires exceeding a particular threshold per month over a period spanning 1992-2017. The explanatory variables in the logistic regression were climate variables including precipitation, maximum temperature and drought indices. Overall, the analysis showed that wildfire risk probability was increasing due to the increase in temperature and droughts, especially in future scenarios with higher Greenhouse gas emissions.
Further information is available on request.

Q11: Do you see any challenge in broadening due diligence requirements to explicitly integrate environmental risks?

Due diligence is a potentially sensible route to capture climate change and environmental risk factors in the SA-CR framework, but is not a substitute for credit rating agencies designing robust methodologies to capture those factors. Therefore, this measure should complement a requirement for credit rating agencies to design their methodologies to capture climate change and environment risk factors in their credit rating methodologies in a transparent and consistent manner. In the due diligence process set out in the Commission’s proposal for CRR3, only penalising factors can be considered, while enhancements in the credit risk profile of a counterparty resulting from its climate change and environmental policies would be disregarded. This could lead to excessively conservative risk weights for certain counterparties, and should be carefully monitored.
The phasing in of any due diligence requirements should be coordinated to the greatest possible extent with the enhancements in the methodologies of external credit rating agencies and with the improvements in the availability of climate-related corporate disclosures. In this context, it would be necessary to clarify the extent to which due diligence requirements would apply to banks’ exposures to small and medium sized enterprises (SMEs) and to non-EU companies, considering that these companies have an obligation to disclose information under the Taxonomy Regulation and the proposed EU Corporate Sustainability Reporting Directive only if they exceed certain turnover thresholds.
Regarding the potential application of a proportionality principle in the context of due diligence, we have the following comments:
- size may not be the only relevant criterion for that purpose, considering that small and medium sized entities may still be particularly exposed to climate change and environmental risk factors, depending on sectors, products, regions and customer types in their portfolio; and
- it would be worth clarifying which asset classes, portfolios or any other relevant classifications are likely to be most relevant for the purpose of due diligence of environmental risk factors, including for the largest banks.
It would be appropriate for regulatory authorities to provide guidance on the application of the due diligence requirements for the purpose of capturing climate change and environmental risk factors to ensure consistency and comparability in their implementation across the banking industry, considering that this is still an emerging practice for banks.

Q12: Do you see any specific aspects of the CRM framework that may warrant a revision to further account for environmental risks?

Climate-related risk factors are, at least to some extent, already captured in house pricing dynamics. Energy efficiency, and specifically the EPC labels for properties, already have some impact on property prices, particularly for properties with either the best or worst EPC labels. Even if the current impact of energy efficiency on property values is relatively minor, it is reasonable to expect that the value that the market places on energy efficiency is likely to increase over time.

Art. 208 has been amended under the European Commission’s CRR3 proposal. In the Commission’s proposal, the existing requirement in CRR2 for frequent monitoring of property values is retained, allowing for upwards adjustment beyond the value at loan origination, but only up to the average value over the last three years in case of commercial immovable property and over the last six years in case of residential immovable property. Modifications made to the property that improve its energy efficiency are however considered as unequivocally increasing its value. Upward adjustments to the property value are therefore permitted under certain conditions. Art. 229 of the proposed CRR3 on the valuation principles for immovable properties has been also amended to require “prudently conservative valuation criteria” under both the IRB and CR-SA approaches, which means that banks are expected to consider any potential downward trends in the value of immovable properties, including due to poor energy efficiency.

Consequently, our view is that the rules proposed by the European Commission in the draft CRR3 published on 27 Oct. 2021, if maintained in the final CRR3, are flexible enough to enable environmental risk factors in market prices to be factored into the risk weights through the collateral valuations and the LTV (Loan-to-Value) ratios. If less flexible rules were to be adopted in the final CRR3 (e.g., if there were to be a cap on the collateral value set at the property value measured when the institution originated the exposure), it is possible that the value that the market places on energy efficiency in the future will not necessarily be reflected to the same extent in the future prudential rules applicable to banks.

We also think that it would be a sensible step to ensure that the periodic reviews of the value of collateral consider climate change and environmental risk factors. To this end, the following requirements could be revised to refer more explicitly to climate and environmental factors:
- In Art. 208 (3a), that banks are expected to consider efficiency labels and any other relevant environmental factors in the valuation and revaluation models of immovable properties;
- In Art. 229 (1), that banks are expected to consider efficiency labels and any other relevant environmental risk factors in the valuation principles for immovable properties.

Banks should be able to disregard those labels and factors if they can provide evidence that they have no influence on the valuation of all or part of the immovable properties they take as collateral.

We consider that further guidance on how climate change and environmental risk factors should be considered in periodic reviews of the collateral value would be helpful in ensuring consistency of approaches. This could also include guidance around the internal processes and controls that banks need to put in place.

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.

Please refer to our response to Q12. We do not believe that further granularity of risk weights is necessary under the CR-SA, provided that the valuation and revaluation provisions in the final CRR3 are flexible enough to factor in the value that the market will likely increasingly place on energy efficiency in the future.

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.

The criteria provided in the CRR3 proposal (Art. 122a (3a) for high quality object finance and Art.122a (3c) for high quality project finance) consider a broad range of risk-sensitive factors, that the EBA is expected to specify further in regulatory technical standards.
In the case of high quality project finance, banks have the option to apply the infrastructure supporting factor if all the conditions defined in Art. 501a are met (“infrastructure supporting factor”). One of those conditions is that the asset being financed contributes to environmental objectives: (i) climate change mitigation; (ii) climate change adaptation; (iii) sustainable use and protection of water and marine resources; (iv) transition to a circular economy, waste prevention and recycling; (v) pollution prevention and control; (vi) protection of healthy ecosystems.

None of the risk factors listed in Art. 122a (3c) (high quality project finance) explicitly refer to any environmental risk factors. The related criteria exclusively refer to legal, contractual or financial conditions. If the infrastructure supporting factor is retained in the final CRR3, the benefit of adding climate and environmental risk objectives to Art. 122a (3c) would be more limited.

We think however that it would be relevant to add due diligence requirements (in the same manner as those prescribed in Art. 113(1) of the draft CRR3) for banks to exclude project finance exposures that are subject to high climate and environmental risks from the lower risk weight associated with high quality project finance.

Similarly, none of the risk factors listed in Art. 122a (3a) (high quality object finance) explicitly refer to environmental risk factors. However, climate and environmental factors (such as energy inefficiency, non-compliance with environmental regulations and laws) could be reflected in some of the proposed criteria (e.g. adequate contractual protections around the value of the asset; testing of technology and design of the asset; all necessary permits and authorisations for the operation of the assets have been obtained).

If no specific reference to environmental risk objectives is included in Article 122a (3a), due diligence requirements could be added to explicitly exclude object finance exposures that are subject to climate and environmental risks from the lower risk weight associated with high quality object finance.
Please refer to our answer to Q11 regarding the potential implementation issues of the due diligence requirements to capture climate change and environmental risk factors.

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?

Any differentiated treatment would need to be based on empirical evidence on risk differentials between different exposure classes. Although risk differentiation based on forward looking tools (such as scenario analysis) could be helpful, our view is that Pillar 2 would be a more suitable place to use those tools than Pillar 1.

Q16: Do you have any other proposals on integrating environmental risks within the SA framework?

As pointed out in our answers to Q8 and Q11, some further EU initiatives to ensure the transparency and consistency of the integration of climate change and environmental risk factors into external credit rating methodologies would be welcome, given the implications for the SA-CR risk weights and for the calculation of the output floor for IRB banks in the future CRR3 regime.

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?

As the EBA pointed out in the DP, the way and extent to which climate change and environmental risk factors will translate into financial risk over time, particularly credit risk, re¬mains an area of significant uncertainty.
The overall impact of those risk factors on the aggregate capital needs of the EU banking sector, particularly for credit risk (which makes up the bulk of Pillar 1 capital requirements) is uncertain – especially given that given uncertainties in the interaction of different risk factors, and given that different risk factors will materialise over different time horizons.
Moreover, there is a great deal of uncertainty as to whether the current IRB models can fully capture climate change and environmental risk factors, considering that the calibration of risk parameters (PD, LGD, CCF) is based on historical data, which do not fully reflect the risks associated with the transition to a carbon neutral economy and, and the potential increasing frequency and severity of the crystallisation of physical risks.
This being the case, we believe that the Pillar 2 framework is more suitable to capture the evolving and forward-looking nature of climate change and environmental risk factors than Pillar 1.
We do not believe either that it would be necessary to include an IRB requirement to complement the rating assignment (i.e. risk differ¬entiation step) with ad¬ditional climate change and environmental risk drivers. Our view is that, prior to including such drivers in IRB models, there should be evidence of their relevance (as is the case for all other model inputs). We do not see the need for an exception here.
We fully agree with the EBA’s opinion that the aim of any adjustments to the IRB framework should be to increase the accuracy of credit risk measurement and therefore that such adjustments should not lead to an undue decrease in model performance. As such, any further incorporation of forward-looking elements in the Pillar 1 framework should be anchored in available empirical evidence on the impact of climate change and environmental degradation.
Solutions such as the use of margins of conservatism, adjustments to reflect ‘environmental downturn’ conditions, or calibration segments could potentially be relevant to address weaknesses of IRB models.
However, we suggest that as a first step CRR should require banks to monitor and test the effects of climate and environmental risk factors on the performance of their models for counterparties, facilities and CRM instruments deemed to be sensitive, or likely to be sensitive, to climate change and environmental risk factors.
Where there is evidence that IRB models (internal ratings, PD, LGD estimations) do not appropriately capture climate change and environmental risk factors, banks then should be required to remediate weaknesses using the most relevant means depending on the particular issue that needs to be addressed. This is consistent with the approach to any other relevant risk factors that may affect model performance - e.g. through incorporation of climate change and environmental inputs into the model for certain segments, enhancements to the override policy, calibration segments or use of margin of conservatisms where weaknesses cannot be addressed more appropriately.
Such enhancements would need to be supported by appropriate governance and controls, and would be subject to the model change requirements as set out in the Commission Delegated Regulation EU N°529/2014 on assessing the materiality of extensions and changes of the Internal Ratings Based Approach and the Advanced Measurement Approach.
Given that limitations in data will hinder banks’ ability to identify segments of counterparties, facilities and CRM instruments that are particularly sensitive to some climate change and environmental risk factors, the phase-in of any new requirements should be coordinated to the greatest possible extent with the improvements in the availability of climate related corporate disclosures.
The counterparties, facilities and CRM instruments with limited sensitivity to climate change and environmental risk factors could be excluded from this regular monitoring and testing requirement.
It would also be necessary to clarify the extent to which these requirements apply to banks’ exposures to SMEs and to non-EU companies, considering that those counterparties only have an obligation to disclose information under the Taxonomy Regulation and the proposed EU Corporate Sustainability Reporting Directive if they exceed certain thresholds. In principle, we believe that those types of companies should be treated with the same rigour as non-SME and EU counterparties, although the phase-in of any new requirements should allow sufficient time for the availability of data from those counterparties to improve – which is likely to take longer than for non-SME EU non-financial corporate counterparties.
If this approach is taken forward, it would be useful for the EBA to provide additional guidance to banks in order to ensure comparability and consistency of approach on:
- the monitoring and testing of IRB models with regard to climate change and environmental risk factors;
- which asset classes, portfolios or any other relevant classifications are likely to be most relevant for the purpose of those regular monitoring and testing exercises;
- the expected frequency of those exercises; and
- the reporting to supervisors on the outcome of those regular monitoring and testing exercises.

Q19: Do you have any other proposals on integrating environmental risks within the IRB framework?

As suggested in the DP, we support the addition of specific references to climate change and environmental risk factors in the slotting approach with a view to excluding from categories 1 and 2 specialised lending exposures sensitive to climate change and environmental risk factors or having harmful environmental impacts that may be detrimental to their sustainability and therefore to the borrower’s ability to repay the loan. In any case, the measures taken with regard to the slotting approach should be consistent with those taken with respect to “high quality project finance” and “high quality object finance” under the standardised approach (please refer to our response to Q14).

Q20: What are your views on potential strengthening of the environmental criterion for the infrastructure supporting factor? How could this criterion be strengthened?

We support the proposal made by the EBA to clarify Art. 501a (1) (paragraph o) in order to require the lender to verify the assessment performed by the obligor that the project in question contributes to environmental objectives. We are also of the view that the criterion in Art. 501a (1) paragraph (o) should be aligned with the concept of EU taxonomy-aligned activities. Therefore, the application of the supporting factor should be allowed if, in addition to meeting the other criteria set out in Article 501a, the project is able to be classified as being Taxonomy-aligned - significantly contributing to one or more of the environmental objectives, while not inflicting significant harm on any of the remaining environmental objectives and meeting the relevant minimum safeguards and technical screening criteria.

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.

We favour the integration of climate change and environmental risk factors into the existing Pillar 1 instruments as explained in our previous answers. As set out in our response to question 6, we consider that the drawbacks of dedicated adjustment factors would exceed their potential benefits and we do not recommend this method for integrating climate change and environmental risk factors into Pillar 1. We agree with the EBA that the Pillar 1 prudential framework should remain risk sensitive.
The potential introduction of dedicated adjustment factors to some segments of exposures would pose several risks in our opinion.
Firstly, we consider that IRB models will need to be adequately adjusted to reflect environmental drivers of credit risk, as would be the case for any other emerging or new driver of credit risk. If specific adjustment factors are applied, the risk of double-counting effects (upward or downward) would be particularly high.
Secondly, the most significant climate change and environmental drivers of credit risk, and the magnitude of their influence on credit losses, may vary from one bank to another depending on the specifics of the bank’s portfolio profile and its underwriting standards. There may also be variation from one country to another, due to local legal provisions. In our view, it is impossible for dedicated adjustment factors to reflect these differences accurately.
Thirdly, in consideration of the current data limitations, it is unlikely that adjustment factors can be appropriately calibrated to reflect the impact that climate and environmental risk factors may have on credit risk losses.
Finally, in consideration of the magnitude of the current uncertainties around the potential effects of climate change and environmental risk factors on financial risks, we favour a more flexible framework for incorporating those factors into the Pillar 1 framework. To achieve this, as set out in responses to previous questions we advise that banks be required to perform due diligence of those factors (under the SA-CR) and to test and monitor the performance of their IRB models against those factors when there is a risk that those models may underperform. We also advocate enhancing the integration of climate change and environmental risk factors into external credit ratings.

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 general, we do not believe that including environmental risks in Pillar 1 for market risk is the best approach to address banks’ and investment firms’ trading exposure to climate and environmental risks at this juncture. In our opinion the Pillar 2 framework allows for more appropriate risk identification, measurement and management of climate and environmental risks for the banks by recognizing the different business models and specific environmental risks for each bank. Any Pillar 1 approach that integrated environmental risk factors would need to be calibrated with caution, taking into account the ripple effects in relation to interest rate risks, volatility and pricing.

We believe the option to incorporate environmental risks when defining the buckets into which a risk factor falls would be the easiest approach to implement for banks. We also believe this approach would be the least sensitive to any model assumptions and data modelling, and would provide a level playing field between banks for measuring and managing environmental risks. However, as set out in our answer to question 15, any differentiated risk weight treatment would need to be based on strong empirical evidence of a risk differential.

In our opinion, the Residual Risk Add-on (RRAO) approach (with some adjustments) is most compatible with the current FRTB framework and more importantly with the current liquidity and market structure of climate-related financial products. This will allow the banks to evaluate and measure the environmental risks in their trading books without any changes to the current SbM and JTD models. The add-on approach seems more appropriate than other approaches in recognising the hard to hedge and illiquid nature of many climate-related financial products. We agree with the DP’s suggestion that the RRAO approach would need to broaden and move to a risk-based approach rather than its current notional-based approach.

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.

Currently we do not believe that environmental risks can satisfy the model requirements for the internal model approach within the FRTB regulation. In particular, the approach in paragraph 167 (adjusting historical data) is not consistent with current FRTB framework.

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?

We agree with the EBA’s views that the identification of climate change and en¬vironmental risk factors as triggers of operational risk losses on top of the existing risk taxonomy is a sensible step to take, in order to monitor the materiality of operational risks associated with environ¬mental factors and the trend in this risk. Amendments to the existing framework to ensure that banks enhance their monitoring of external environmental factors could be useful, even though at present there are more material operational risks to banks than those posed by climate and environmental risks.
Identifying losses driven by climate change and environmental risk factors would be relatively straightforward. Banks already describe loss events and the causal factors that drove the loss event (particularly for larger losses). Including climate change and environmental risk factors as new causal factors would not necessarily create any new challenges for banks. However, designation of causal factors for loss events is a highly subjective piece of analysis, and there could be some inconsistency in approaches and terminology used among banks. Should the EBA proceed with this approach, the publication of additional guidance would be helpful.

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, integrating a forward-looking approach into the operational risk framework would create excessive variability between banks in their Pillar 1 capital requirements for operational risks.

Q28: Do you agree that the impact of environmental risk factors on strategic and reputational risk should remain under the scope of the Pillar 2 framework?

Reputational and strategic risks are important risks for banks to capture in their risk management, and it is vital that banks continue to have adequate risk management processes in place to consider those risks. However, we agree that reputational and strategic risk continue to be best captured under the Pillar 2 framework. The time horizon for Pillar 2 should explicitly span the timeframe in which a bank can reasonably change its strategic direction and/or repair its reputation.
The calibration of the Pillar 1 approach to operational risk, anchored on income and considering additional loss factors, is not well suited to capturing strategic and reputational risks, including those caused by climate change and environmental risk drivers. We do believe, however, that it would be useful for the EBA to provide additional guidance on capturing reputational and strategic risks driven by environmental factors, in order to ensure consistency of outcomes among banks.

Q29: Do you have any other proposals on integrating environmental risks within the operational risk framework?

The EBA could consider issuing guidance on how to avoid (or account for) double counting of the effects of environmental risk drivers. For example, environmental risk drivers’ impact could already be captured to some extent in banks’ assessment of strategic or reputational risks.

Q30: What, in your view, are the best ways to address concentration risks stemming from environmental risk drivers?

Of the options considered, we believe that additional reporting requirements related to sectoral or geographical concentration risks would be the most appropriate, potentially taking a similar approach to that taken for shadow banking entities under Article 394 (2) CRR. Banks could be required to publish information on their largest 10 exposures that are exposed to transition risks, and separately their largest 10 exposures subject to physical risk. The EBA should also consider whether any new reporting requirements would duplicate existing disclosure requirements, such as under Template 4 of the EBA Pillar 3 disclosure requirements for ESG risks. Naturally, this would need to be supplemented by clear guidance on the how banks should define high exposure to physical or transition risks.

More generally, banks’ exposure to concentration risks as a result of climate change is likely to be highly specific to their business model. For this reason, Pillar 2 may be a more appropriate avenue through which climate-related concentration risks should be managed. Banks are already required to conduct materiality assessments as part of their ongoing risk management (including through the ICAAP), which should in principle help them identify where concentrations of physical or transition risks arise in their book. It could be useful, however, for supervisors to clarify that they expect banks to consider climate and environmental risk-driven concentrations in their ICAAP.

Q31: What is your view on the potential new concentration limit? Do you identify other considerations related to such a limit? How should such a limit be designed to avoid the risk of disincentivising the transition?

Although imposing a new quantitative concentration limit would likely have a more significant impact on bank behaviour, the unintended consequences (including those outlined in the DP, such as potentially heightened transition risks caused by a widespread reduction in the availability of transition finance for certain sectors or geographies, and the outsized impact on banks with exposures concentrated in certain regions or sectors) would make the imposition of a hard concentration limit counterproductive. Since physical risks are expected to have a greater impact on less economically developed regions, quantitative limits which restricted the access to finance of people in those regions could exacerbate climate-driven inequalities. We would also highlight that it could create perverse incentive for banks – banks with more information on the physical or transition risk profile of their counterparties could be penalised more than those which had taken a less proactive approach to gathering counterparty data.

We would also highlight that gathering information on the physical or transition risk characteristics of banks’ counterparties would be hampered in the near term by current challenges around the availability of data – for example, on EPC labels, CO2 emissions, or on the location of a counterparty’s material physical assets. Imposing a hard limit would also not take into account that the nature of banks’ exposures to particular sectors could differ. For example, one bank could be funding the normal business of counterparties in a particular sector, while another could be exclusively or predominantly funding the execution of counterparties’ transition plans in the same sector.

Q32: With reference to the three risk categories the IFR is based on (Risk-to-Client, Risk-to-Market and Risk-to- Firm), which of these could be related to environmental risks, and to what extent?

In general, we believe that the most relevant climate-related transmission channel for investment firms is operational risk – but most notably reputational and strategic risk, which are currently captured under the Pillar 2 framework. We would support the continued management of those risk types through Pillar 2 rather than Pillar 1. As for banks, we would support additional disclosure of where climate and environmental risks have caused operational losses.

Q33: Should any of the existing K-factors incorporate explicitly risks related to environmental factors?

Climate and environmental risks could be relevant to the TCD (Trading counterparty default) and CON (Concentration) Risk to Firm K-factors. On TCD, we would support treatment of any climate-driven credit risk exposure that may arise from ancillary credit granting services provided by investment firms under Pillar 2 and the SREP. For concentration risk, we would advocate taking an approach that is consistent with the approach applied to banks. We refer to our answer for question 26 on this point.

We agree that any amendment to the Risk to Market NPR K-factor (Net position risk) should ensure continued consistency with the approach taken for market risk.

Any other comments?

Comments also submitted by email to Jacob Gyntelberg on 02/08/2022.

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