UniCredit - How should banks manage ESG risks? EBA sets down the new rules

The EU regulators are not waiting for the final legal text to be published in the Official Journal and are moving on to the next phase of their roadmap on Sustainable Finance by drafting guidelines on how banks should handle ESG risks, as the integration of these risks into the conventional risk management frameworks is still at an early stage and practices can vary a lot across financial institutions.

Against this backdrop, the European Banking Authority (EBA) launched a public consultation on its proposed guidelines which establishes a methodology for the identification, measurement, management, monitoring and integration of ESG risks by European banks in a consistent and harmonised way, as required by the Capital Requirements Directive (CRD). 

The draft guidelines focus on three key points: how to identify and measure ESG risks, how to manage and monitor ESG risks, and how to plan to address the financial risks associated with the EU objective to become carbon neutral by 2050. Let us consider them in turn.

First. The draft guidelines require big banks to perform a materiality assessment of ESG risks every year, or every two years for small institutions, using both qualitative and quantitative elements and data. This evaluation should consider the potential effects of ESG risks on all conventional financial risk categories and should give an overview of how relevant ESG risks are for the bank's way of doing business and risk profile. Banks should also use reliable data processes and a mix of methods, including exposure-based, portfolio-based and scenario-based methods, to identify and measure ESG risks across their lending and investment portfolios.

Second. The draft guidelines indicate that banks should incorporate ESG risks into their business and risk strategies, risk appetite, internal culture, capabilities and controls, internal capital adequacy assessment process (ICAAP) and internal liquidity adequacy assessment process (ILAAP), and credit risk policies and procedures. Institutions should consider ESG risks when setting and implementing their overall business strategies and risk appetite framework, which should include both ESG-related key risk indicators and limits, as well as forward-looking metrics such as historical losses, financed emissions, share of income from counterparties operating in carbon intensive sectors, portfolio alignment, physical risk exposure and ESG-related litigation claims. Furthermore, EBA proposes minimum standards for banks to include ESG factors into their credit risk policies and procedures, such as internal risk classification, credit scoring or rating models, and valuation of collateral. As expected, EBA asks banks to assign clear roles and responsibilities for ESG risks management across all the three lines of defence and to ensure that their management body and staff are well trained on ESG factors and risks. 

Third. EBA sets out the key principles and governance arrangements for the transition prudential plans that banks should prepare to address the financial risks associated with the EU objective of achieving carbon neutrality by 2050. Banks should base their plans on a robust materiality assessment of ESG risks, set targets over different time horizons, use climate and environmental scenarios and pathways, and document their transition planning process.  Moreover, banks are asked to clearly allocate the internal responsibilities for the development and ensure adequate capacity and resources for the implementation of prudential plans.

Going forward, EBA invites all stakeholder to share their views and suggestions on the draft guidelines until April. The final guidelines, which consider the principle of proportionality, are expected towards the end of 2024 and will apply from the end of 2025 to all European banks that follow the CRD, no matter their size, complexity and business model.