Response to discussion Paper on management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03)
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We agree with the definitions of ESG risks. The double materiality perspective is an important part of the definition of ESG risks. The report provides a definition in terms of financial materiality and environmental and social materiality and clarifies that the report concerns only financial materiality.
But institutions rarely apply a double materiality perspective. ESG risks should be approached from a double materiality perspective over long-term horizons.
Physical and transition risks could bring cascading and indirect losses which are not included in financial decision-making. Climate impacts can be exacerbated by second and third order effects such as socio-economic, ecological, transnational, and political changes. Increased regional inequalities could present a systemic financial risk and national and international level. See E3G (2020) A Vision for Sustainable Finance in Europe: Chapter 5 – Resilience.
Secondly, physical risks can result in capital flight from the most vulnerable regions. A focus on risks by credit institutions, combined with a lack of structured opportunities, can result in the withdrawal of credit from activities, sectors and communities which are most exposed to climate risk. This could exacerbate geographical disparities and social inequalities within Europe. See E3G (2020) A Vision for Sustainable Finance in Europe: Chapter 5 – Resilience.
As a think tank working on climate change, E3G has received funding in light of the COVID-19 crisis to ramp up its programmes on sustainable finance, macroeconomic governance and green recovery, all of which integrate climate, socio-economic and governance factors across the board.
Indicators: Due to its relative rigour, the EU taxonomy should be considered an important instrument in delivering the Paris Agreement and contributing to harmonised processes for sustainable global finance flows. It should be used as the point of reference for future ESG risk-related work in the EU. The report should also note that the NGFS has asked policymakers to develop an unsustainable taxonomy, which is also supported by the ECB. In the ECB’s consultation to the EU Sustainable Finance Strategy, it noted that a brown taxonomy would contribute to assisting supervisors in their assessment of institutions’ unsustainable exposures.
Regarding setting and disclosing ESG risk-related strategic objectives and limits, there is a need for these to be long-term and science-based targets aligned with relevant public policies, such as net-zero emissions by 2050. The EU taxonomy would provide an adequate basis for this.
Regarding engaging with customers and relevant stakeholders, there is a need to enhance long-term engagement between investors and their investee companies. At the EU level, the Shareholder Rights Directive should be reviewed to strengthen shareholder engagement and stewardship, while Stewardship Codes should be strengthened to integrate sustainability issues.
We agree about the need to incorporate ESG risk-related considerations in directives and regulations applicable to the banking sector, such as CRD and CRR. The provisions on governance and risk management should introduce requirements to set and disclose a long-term sustainability strategy and a plan to meet science-based targets including net-zero emissions by 2050.
The EBA should recommend institutions – as well as advise the European Commission to implement legislation to require institutions' boards of directors to:
- Take responsibility for ensuring the alignment of the institution’s strategy with relevant public policies such as the Paris Agreement and the Convention on Biological Diversity
- Ensure that the institution sets and discloses a long-term sustainability strategy and a plan to meet science-based targets including net-zero emissions by 2050
- Implement the right board and committee structures to ensure that sustainability risks and opportunities are managed and reported based on informed decisions
- Ensure that management identifies material sustainability risks and takes appropriate action according to the materiality of the risks
- Align remuneration and promotion with the achievement of sustainability targets
- Ensure that the institution discloses in line with the TCFD recommendations
Risk differentials should be established through science-based and forward-looking scenario analysis, as advocated by the TCFD and the TEG, as opposed to market approaches that may not be science-based or transparently constructed. The EU should consider a brown supporting factor but not a green supporting factor, which has been rejected by many experts and organisations such as Bruegel and the Grantham Institute.
Climate stress-testing for organisations for credit providers should also become mandatory. To this end the EBA should bring forward the timeline of the EBA report planned for June 2025 on ‘Prudential treatment of exposures related to environmental and/or social objectives’.
The forthcoming implementation of Basel III should also be used for sustainability integration across bank supervision.
1. Please provide details of other relevant frameworks for ESG factors you use.
n/a2. Please provide your views on the proposed definition of ESG factors and ESG risks.
With regards to negative economic externalities, there is a growing literature on the economic value of ESG factors. For example, Dasgupta, P (2021) The Economics of Biodiversity: The Dasgupta Review.We agree with the definitions of ESG risks. The double materiality perspective is an important part of the definition of ESG risks. The report provides a definition in terms of financial materiality and environmental and social materiality and clarifies that the report concerns only financial materiality.
3. Do you agree that, for the purpose of assessing their inclusion in institutions’ and supervisors’ practices from a prudential perspective, ESG risks should be approached primarily from the angle of the negative impacts of ESG factors on institutions’ counterparties? Please explain why.
ESG risks will materialize through the investment value chain and therefore should be approached through negative impacts on institutions’ counterparties.But institutions rarely apply a double materiality perspective. ESG risks should be approached from a double materiality perspective over long-term horizons.
4. Please provide your views on the proposed definitions of transition risks and physical risks included in section 4.3.
We agree with the definitions of physical and transition risks. It is important that not only climate change is considered but also other environmental risks. A larger set of evidence is being developed on these risks, for example, the Task Force on Nature-related Financial Disclosures.Physical and transition risks could bring cascading and indirect losses which are not included in financial decision-making. Climate impacts can be exacerbated by second and third order effects such as socio-economic, ecological, transnational, and political changes. Increased regional inequalities could present a systemic financial risk and national and international level. See E3G (2020) A Vision for Sustainable Finance in Europe: Chapter 5 – Resilience.
5. Please provide you views on the proposed definition of social risks and governance risks. As an institution, to which extent is the on-going COVID-19 crisis having an impact on your approach to ESG factors and ESG risks?
We agree with the definition of social risks but note two noteworthy additions. Firstly, although the social implications of transition risks are fairly understood for the energy sector, in particular the coal sector, other sectors such as transport, industry, and agriculture lack a similarly granular understanding. This creates multiple financial risks. See E3G (2020), The Just Transition Fund: 4 Benchmarks for Success.Secondly, physical risks can result in capital flight from the most vulnerable regions. A focus on risks by credit institutions, combined with a lack of structured opportunities, can result in the withdrawal of credit from activities, sectors and communities which are most exposed to climate risk. This could exacerbate geographical disparities and social inequalities within Europe. See E3G (2020) A Vision for Sustainable Finance in Europe: Chapter 5 – Resilience.
As a think tank working on climate change, E3G has received funding in light of the COVID-19 crisis to ramp up its programmes on sustainable finance, macroeconomic governance and green recovery, all of which integrate climate, socio-economic and governance factors across the board.
6. Do you agree with the description of liability transmission channels/liability risks, including the consideration that liability risks may also arise from social and governance factors? If not, please explain why.
We agree with the description provided and the consideration that liability risks may also arise from social and governance factors. There is already a substantial pipeline of climate litigation, and as physical and transition impacts increase it is likely that the legal system will become more widely used as a mechanism to address disputes over regulation or use of scarce resources.7. Do the specificities of investment firms compared to credit institutions justify the elaboration of different definitions, or are the proposed definitions included in chapter 4 also applicable to them (in particular the perspective of counterparties)? Please elaborate on the potential specificities of investment firms in relation to ESG risks and on how these specificities, if any, could be reflected in this paper.
The definition of ESG factors and risks should be harmonized across the financial system and not specific to different types of institutions.8. Please provide your views on the relevance and use of qualitative and quantitative indicators related to the identification of ESG risks.
Challenges: With regards to time-horizon mismatch, this is indeed an issue and it will be essential to integrate long-term risk horizon into ESG risk assessments. With regards to non-linearity, we recommend adding further information on the cascading second and third order effects of climate and environmental impacts.Indicators: Due to its relative rigour, the EU taxonomy should be considered an important instrument in delivering the Paris Agreement and contributing to harmonised processes for sustainable global finance flows. It should be used as the point of reference for future ESG risk-related work in the EU. The report should also note that the NGFS has asked policymakers to develop an unsustainable taxonomy, which is also supported by the ECB. In the ECB’s consultation to the EU Sustainable Finance Strategy, it noted that a brown taxonomy would contribute to assisting supervisors in their assessment of institutions’ unsustainable exposures.
9. As an institution, do you use or plan to use some of the ESG indicators (including taxonomies, standards, labels and benchmarks) described in section 5.1 or any other indicators, inter alia for the purpose of risks management? If yes, please explain which ones.
n/a10. As an institution, do you use or plan to use a portfolio alignment method in your approach to measuring and managing ESG risks? Please explain why and provide details on the methodology used.
n/a11. As an institution, do you use or plan to use a risk framework method (including climate stress testing and climate sensitivity analysis) in your approach to measuring and managing ESG risks? Please explain why and provide details on the methodology used.
n/a12. .As an institution, do you use or plan to use an exposure method in your approach to measuring and managing ESG risks? Please explain why and provide details on the methodology used.
n/a13. As an institution, do you use or plan to use any different approaches in relation to ESG risk management than the ones included in chapter 5? If yes, please provide details.
n/a14. Specifically for investment firms, do you apply other methodological approaches, or are the approaches described in this chapter applicable also for investment firms?
n/a15. Please provide your views on the extent to which smaller institutions can be vulnerable to ESG risks and on the criteria that should be used to design and implement a proportionate ESG risks management approach.
We agree that smaller institutions can be vulnerable to ESG risks to a greater extent than larger institutions.16. Through which measures could the adoption of strategic ESG risk-related objectives and/or limits be further supported?
We believe further action is needed to require the boards of directors to integrate ESG risks, as well as through prudential requirements. We have provided more detail in the following questions.17. Please provide your views on the proposed ways how to integrate ESG risks into the business strategies and processes of institutions.
We agree that there is a need to integrate ESG risks in the business strategies and processes of institutions. Regarding setting business strategies, the report could better define what mid- and long-term time horizons refer to, which in our view should be 2030 and 2050.Regarding setting and disclosing ESG risk-related strategic objectives and limits, there is a need for these to be long-term and science-based targets aligned with relevant public policies, such as net-zero emissions by 2050. The EU taxonomy would provide an adequate basis for this.
Regarding engaging with customers and relevant stakeholders, there is a need to enhance long-term engagement between investors and their investee companies. At the EU level, the Shareholder Rights Directive should be reviewed to strengthen shareholder engagement and stewardship, while Stewardship Codes should be strengthened to integrate sustainability issues.
We agree about the need to incorporate ESG risk-related considerations in directives and regulations applicable to the banking sector, such as CRD and CRR. The provisions on governance and risk management should introduce requirements to set and disclose a long-term sustainability strategy and a plan to meet science-based targets including net-zero emissions by 2050.
18. Please provide your views on the proposed ways how to integrate ESG risks into the internal governance of institutions.
We agree that there is a need for institutions to proportionately incorporate ESG risks in their internal governance arrangements.The EBA should recommend institutions – as well as advise the European Commission to implement legislation to require institutions' boards of directors to:
- Take responsibility for ensuring the alignment of the institution’s strategy with relevant public policies such as the Paris Agreement and the Convention on Biological Diversity
- Ensure that the institution sets and discloses a long-term sustainability strategy and a plan to meet science-based targets including net-zero emissions by 2050
- Implement the right board and committee structures to ensure that sustainability risks and opportunities are managed and reported based on informed decisions
- Ensure that management identifies material sustainability risks and takes appropriate action according to the materiality of the risks
- Align remuneration and promotion with the achievement of sustainability targets
- Ensure that the institution discloses in line with the TCFD recommendations
19. Please provide your views on the proposed ways how to integrate ESG risks into the risk management framework of institutions.
The EBA should advise the European Commission to revisit the mandate of the ESAs and explore the Joint Committee and the European Systemic Risk Board to develop a common EU methodology for scenario analyses and climate/environment stress testing. This should be done by coordinating with the NGFS to ensure harmonisation of approaches. Stress testing should then be made mandatory for all institutions in the financial sector.20. The EBA acknowledges that institutions’ approaches to environmental, and particularly climate-related, risks might be more advanced compared to social and governance risks, and gives particular prominence in this report to the former type of risks. To what extent do you support this approach? Please also provide your views on any specificities associated with the management of social and governance risks.
Social and governance risk scenarios are at earlier stages of development than environmental scenarios, and therefore more work is needed in this area. The EBA should coordinate with the Joint Committee and the European Systemic Risk Board to develop a common EU methodology for social scenario analyses and stress testing. It is important that social risks are managed to prevent future social and political tensions between and within member states.21. Specifically for investment firms, what are the most relevant characteristics or particularities of business strategies, internal governance and risk management that should be taken into account for the management of the ESG risks? Please provide specific suggestions how could these be reflected.
We are of the view that all characteristics noted in the document and our consultation response will need to be implemented in order to meet the Paris Agreement and remain within Planetary Boundaries. Meeting these goals requires a complete shift in ESG risk management practices. In particular, ensuring alignment with science and relevant public policies such as the Paris Agreement and the Convention on Biological Diversity will be critical. This will require legislation across a number of areas as noted above.22. Please provide your views on the incorporation of ESG factors and ESG risks considerations in the business model analysis of credit institutions.
We agree that the business model analysis of credit institutions should consider ESG factors and ESG risks considerations in order to ensure the long-term resilience of the credit institutions themselves. This should be also applied to supervisory assessments. Both a rigorous assessment of the current business models and the proposed forward-looking assessment of future business environment the institutions face should be performed.23. Do you agree with the need to extend the time horizon of the supervisory assessment of the business model and introduce as a new area of analysis the assessment of the long term resilience of credit institutions in accordance with relevant public policies? Please explain why.
Long-term resilience assessment should be carried out, while also considering a longer time horizon in the supervisory assessments of the business models in order to tackle issues related to short-termism, taking into account the long-term climate mitigation targets of 2030 and 2050. This would also make the notion of sustainability in the business model essential for the long-term resilience thinking.24. Please provide your views on the incorporation of ESG risks considerations into the assessment of the credit institution’s internal governance and wide controls.
Incorporating ESG risks into the supervisory assessment of credit institutions’ internal governance and wide control is important not only from risk management and resilient business model perspectives but also to ensure alignment of ESG consideration and material impact with the internal practices and remuneration policies of institutions.25. Please provide your views on the incorporation of ESG risks considerations in the assessment of risks to capital, liquidity and funding.
We agree with the proposed incorporation of ESG risks considerations in the assessment of risks to capital, liquidity and funding, because ESG risks directly affect prudential risks and should be included in the supervisory review practices. Institutions should thus be incentivized to manage climate risk, including through a risk-based differentiated capital requirement framework in CRD and CRR based on a long-term risk horizon and a higher capital requirement for carbon-intensive assets.Risk differentials should be established through science-based and forward-looking scenario analysis, as advocated by the TCFD and the TEG, as opposed to market approaches that may not be science-based or transparently constructed. The EU should consider a brown supporting factor but not a green supporting factor, which has been rejected by many experts and organisations such as Bruegel and the Grantham Institute.
Climate stress-testing for organisations for credit providers should also become mandatory. To this end the EBA should bring forward the timeline of the EBA report planned for June 2025 on ‘Prudential treatment of exposures related to environmental and/or social objectives’.
The forthcoming implementation of Basel III should also be used for sustainability integration across bank supervision.