Although the methods for banks to assess risks at counterparties may be less advanced for the social pillar in relation to the environmental pillar of ESG, the social pillar remains important. MSCI ESG Ratings aim to measure a company’s management of financially relevant ESG risks and opportunities. We use a rules-based methodology to identify industry leaders and laggards according to their exposure to ESG risks and how well they manage those risks relative to peers. Our ESG Ratings model maps company operations to a proprietary database of ESG risk factors to determine the ESG key issues that are most financially relevant for companies in that industry. Our MSCI ESG Ratings model accordingly considers several key issues under the social pillar of ESG.
The MSCI ESG Ratings model has two components for each key issue - the risk exposure to the issue and management practices to mitigate risks. For banks, there are more key issues assessed under the social pillar (e.g., consumer financial protection, privacy & data security, access to finance) compared to the environmental pillar, meaning the social pillar is given a higher overall weight in our bank’s ratings model.
Recent MSCI ESG research has helped to assess the impact of incorporating ESG factors on the risk and performance of banks’ bond portfolios, for example. As per MSCI ESG research’s report on the impact of ESG ratings on corporate bond portfolios, the aggregate MSCI ESG Ratings score showed stronger results in terms of reducing risk than the individual E-, S-, and G-pillar scores and within the three pillars, the S pillar showed the strongest performance in returns, while the E pillar showed the strongest differentiation in terms of risk over the broader universe.
Given the importance of the social pillar for the banking sector, we welcome discussion from the EBA on the role of exposures associated with social objectives and/or social impacts in the prudential framework.
In the short-term, environmental risks may present more of a reallocation consideration as some sectors are particularly vulnerable to physical risks and/or transition risks, while others will develop necessary solutions to adjust to the impacts of environmental risks. Climate change, however, presents long-term impacts that affect society at large, and no sector will escape its negative impacts, be it from transition-related or physical (both chronic and acute) impacts, or both. It is a risk that cannot be fully hedged as it affects the entire economic system.
The requirements by prudential authorities for climate scenario analysis and, in some cases, stress tests are in line with this assessment. The MSCI Climate Value-at-Risk model, as such, is designed to provide forward-looking and return-based valuation assessments by company, including for banks, to measure climate related risks including company value decrease caused by transition or physical risk. In a recent study of impacts for transition risks and opportunities on MSCI ACWI Index constituents using climate-stabilization scenarios developed by the Network for Greening the Financial System (NGFS), in the Net-Zero 2050 scenario, carbon-intensive sectors and industry groups such as energy, utilities and materials carried the highest policy risk, with the average energy company losing around 31% of enterprise value. In contrast, the software and services industry group had the lowest amount of policy risk, losing only 0.27% of enterprise value on average. Notably, our research also showed that under a late-action scenario, the average bank and the average energy company doubles its loss to enterprise value, in comparison to the Net-Zero 2050 scenario.
Non-financial reporting in the EU is based on the principle of double materiality. Furthermore, under the EBA’s Pillar 3 ESG risk disclosure guidance, banks will need to collect and disclose e.g., carbon emissions from counterparties. Yet, carbon emissions per se are not financially material unless they are regulated and priced. If such policies are implemented progressively and with sufficient planning certainty, even carbon intensive companies can adjust their business model and will not necessarily default as a result of the transition to a low-carbon economy.
In a disorderly transition scenario, however, policy action is expected to come late and abruptly, e.g., as a result of legal action that forces governments’ (or corporates) to implement carbon mitigation activities. This would penalize companies with a high carbon exposure and could lead to higher default rates for carbon intensive business models. Given the high discrepancy between current action and Paris-aligned climate targets, the disorderly scenario is becoming more likely.
The MSCI Net Zero Tracker is published quarterly and measures progress by companies on a path to net zero – which is the pathway required to align with the Paris accord’s objective to keeping global warming ‘well below 2°C’ above pre-industrial temperatures. Only 11% of listed companies align with a 1.5°C warming pathway. To align with a 1.5°C rise in temperature, listed companies would need to cut their total carbon intensity by an average of 8%-10% each year between now and 2050. The amount of annual decarbonization aligns with the self-decarbonization embedded in MSCI’s Climate Paris Aligned Index, which exceeds the European Union’s requirement that climate benchmarks decarbonize at least 7% on average per year in line with the global goal of limiting future warming to 1.5°C.
MSCI supports the EU’s efforts to require non-financial disclosures as per the standards drafted by the European Financial Reporting Advisory Group (EFRAG).
We do note, however, that the main challenge for banks in the use of ESG data is related to scope. Specifically, data availability remains limited for private assets, as well as real estate. To compensate for missing data, banks will need to fully integrate their ESG data requirements into client onboarding and due diligence processes going forward.
MSCI has worked on a full portfolio solution for banks to measure their financed emissions across asset classes building on the methodology provided by the Partnership for Carbon Accounting Financials (PCAF).
In addition, banks have access to public open-source database from international authorities like the NGFS for climate-specific scenarios and data. MSCI is building its climate-related scenarios on the NGFS approach.
MSCI assigns its ESG ratings under established principles of conduct which ensure the consistent application of rating methodologies and the quality of our ESG ratings:
i. Transparency – MSCI has made ESG ratings and the key elements of our ratings process and underlying methodology publicly available at no cost on our website. Our clients and issuers have access to fully documented methodologies, extensive rating reports and underlying rating data.
ii. Conflicts of interest - MSCI operates under strict policies and procedures that (1) protect against conflicts of interest (arising from, for example, relationships with or pressures from issuers, investors or governments) impacting our ESG ratings and (2) ensure that our ratings are independent. All employees of our ESG ratings business are trained on, and certify to, our policies and procedures at least annually, with additional targeted training taking place throughout the year.
iii. Assignment of ratings – We have over 200 analysts globally who analyze data originating from corporate disclosures as well as from media, academic, non-governmental organizations (NGOs), and regulatory and government sources. MSCI has an established governance process to ensure that ratings are assigned consistently and in accordance with our rating methodology.
IOSCO (International Organization of Securities Commission) published “Final Report – Environmental, Social and Governance (ESG) Ratings and Data Products Providers in November 2021 which establishes a framework for the assignment of ESG ratings.
There is a risk of contamination of existing risk categories (credit, market, operational) through climate risk transmission channels. We considered transmission channels of transition-related climate risks to credit risks for a large sample of USD and EUR bond issuers and found that 16% of the investment-grade issuers could be downgraded to high yield in a ‘Net Zero 2050’ scenario. When considering the impacts of physical and transition risks on European equity (measured by loss of enterprise value): the average European energy company loses 18% in the aggressive physical-risk scenario, while it loses 49% in the 1.5°C scenario for transition risk.
We would agree that it is important for institutions to incorporate environmental risks into existing risk management frameworks. This will allow for continuous monitoring as institutions do with other forms of risk they are exposed to. Institutions may want to consider disclosing in their publicly available risk management frameworks how they are integrating environmental (and broader ‘S/G’) risks. This would allow institutional and individual investors to judge the risk management systems when comparing to peers.
We agree on the importance of adopting long-term approaches in assessment of risk to capital in the context of environmental risks and we believe that capital adequacy should be evaluated over the long-term period. Due to the nature of ESG risks, scenario analysis and stress tests should be considered and built into risk management frameworks. In relation to capturing ESG risks in credit risk, concentration analysis over different dimensions i.e., sectors, geographical regions and counterparties, can be detrimental to mid- and small-size financial institutions that tend to present business models focused on certain sectors, regions and companies.
We support the adoption of forward-looking, longer-term approaches to prudential risk management, as they best reflect this risk dimension. We recommend aligning on a single set of time horizons (short, medium, longer term) and specific time ranges for each to allow for comparability of results.
Please refer our response to Question 6.
Yes, MSCI has conducted studies focusing on climate-related impacts and credit risk. Please see the following:
As referenced in the EBA Discussion Paper, Section 5.1.2 Corporates:
No. A proactive approach to integrate environmental risks into due diligence requirements may require regulatory guidance. This could further detail the expectations set out in the EBA guidelines on loan origination and monitoring (see here):
Pt. 57: Institutions should take into account the risks associated with ESG factors on the financial conditions of borrowers, and in particular the potential impact of environmental factors and climate change, in their credit risk appetite, policies and procedures. (…)
We see advantages of both approaches. Inclusion of ESG aspects in various measures of risk is being broadly adopted which we expect to continue. Incorporation of ESG aspects directly in the existing Pillar 1 concept seems therefore to be a natural approach, which avoids double-counting . At the same time, adjustment factors appear to offer easier and more uniform implementation across credit institutions of various sophistication, leaving less room for individual judgement on what aspects are already incorporated and by what means.
The incorporation of environmental risk in the Standardized Approach (SA) should reflect the idiosyncrasies of this risk class through the usage of granular data and proper transmission channels modelling. A risk-based approach should be preferred allowing financial institutions to manage and hedge environmental risks, ensure stability of the financial system and facilitate the transition toward a low-carbon economy.
The proposed approaches present both advantages and disadvantages. In particular, increasing the risk weights and inclusion of an ESG component within buckets to include climate risks are easy-to-implement approaches to increase the capital charge and could be preferred by Tier 2 or Tier 3 financial institutions with lower trading book exposures. However, the two approaches cannot properly reflect the idiosyncratic nature for environmental risks, and they can lead to distortions and misrepresentation of the actual risks. Moreover, financial institutions might face difficulties in managing if environmental risks are reflected by assigning exposures to a new penalizing bucket or increased weights. These approaches can present difficulties with calibrating capital charges according to potential environmental related losses.
The inclusion of a new dedicated factor for environmental risk represents a transparent approach for measuring exposures and potential losses. The main drawbacks that we identify are related to 1) increasing complexity in managing risks as banks would need to explicitly model the price impact of this risk factor themselves, and 2) proper accounting for the correlation between environmental risks and other risk classes, avoiding both double- and undercounting.
The Residual Risk Add-on (RRAO) approach might be a good compromise for including environmental risks. It allows to preserve the current frameworks for Sensitivities-based Method (SBM) and Jump-to-Default (JTD) and it gives flexibility on the inclusion of environmental risks. RRAO components should be enhanced to include environmental risks ensuring the adoption of a risk-based approach through, for example, forward-looking stress tests on financial variables in correspondence of environmental scenarios.
Considering the nature of environmental risks and the well documented relation between physical and transition risk and credit worthiness of issuers, it could be worthwhile to enhance the JTD approach for accounting for different level of exposures to environmental risks of different issuers.
While defining an approach to reflect environmental risks we would stress the importance of ensuring coherence between SA and Internal Model Approach (IMA). The final decision should reflect the different extent of risk sensitiveness and representation of the two models without creating distortions between the two models. Different approaches between IMA and SA can prevent the use of the latter as floor for capital charge estimation.
The main challenges in relation to modelling environmental risks within the existing framework are related to missing historical data for calibration and longer-term horizons compared to existing risk classes.
External modelling (for example, as a new type of non-modellable risk factor) could allow the selection of an approach that can properly reflect the nature of environmental risks. Moreover, it could allow to maintain consistency with the SA model without amending the existing structure of the model.
Even for the IMA, it could be worthwhile to assess the possibility of enhancing the DRC module to reflect environmental exposures through the use of a dedicated set of stress tests in correspondence with environmental scenarios.
Among the challenges that drive physical exposure to climate-related risks is the increasing digital interconnection and reliance on infrastructure like data servers or IT services in locations that can be highly vulnerable to e.g., flood or heat-related risks but may not be captured or reported for the purpose of identifying operational risks. As such, MSCI supports Principle 11 of the Basel Committee on Banking Supervision’s Principles for the effective management and supervision of climate-related financial risk that banks should assess the impact of climate-related physical risk drivers on their operations and specifically their ability to continue providing critical operations.
Forward-looking climate scenario analysis is becoming established in financial markets with over 2,600 organizations (of which 1,069 are financial institutions) supporting the TCFD recommendations through disclosures and management. Climate scenarios incorporate rates of carbon emissions, policy changes, socioeconomic factors, population growth, and development to derive a probabilistic view of what our world will look like in the future depending on the climate actions we take or lack thereof. These models also project temperature increases until the end of the century and predict the climactic effects of that warming and the ensuing physical hazards.
To start integrating forward-looking metrics into operational risk frameworks, it is essential to develop site-level analysis focusing on the location of critical infrastructure and service hubs and understanding the underlying exposure of those sites to physical climate hazards and how the exposure will evolve over time with a changing climate. These hazards can be chronic (slowly evolving like extreme heat) or acute (extreme weather events like tropical cyclones) and can have different impacts on assets depending on the level of vulnerability of the facility and the revenue generated there.
Climate modeling of physical hazards is conducted on a global scale which limits the resolution of the modeling. One of the challenges is that the granularity of climate risk models does not always sufficiently capture site-specific risk elements. However, there have been great improvements in measuring the direct affects that climate change has on extreme weather events.
The biggest challenge of forward-looking scenario analysis is that it is theoretical by nature and therefore, climate models have large degrees of uncertainty. In practice, climate change is already materializing through an increase in intensity and frequency of tropical cyclones, flood events, wildfires, and extreme heat conditions. We are also seeing the economic impact these events can have on a number of sectors and industries. For example, recent MSCI ESG research analyzing how companies in the MSCI Europe Index could be impacted by climate change using the MSCI Climate Value-at-Risk model shows that capital-intensive industries are more vulnerable to extreme weather events, with the average European energy company losing 18% of its enterprise value under an aggressive scenario. Importantly, the main driver of physical risk exposure was found to the location of companies’ facilities. MSCI is of the view, therefore, that there is a need to integrate forward-looking scenario analysis as part of the operational risk framework.
Environmental risk factors specified in the paper are relevant for both investment firms and credit institutions. In addition to ESG risk that emanates from counterparties’ exposures of their funds, investment firms might need to consider risks stemming from investors that can be negatively affected by ESG factors, increasing redemption risk for investment firms.