Key areas for consideration
The keynote speech given on June 16th 2021 by Frank Elderson, a member of the ECB Executive Board, at the ECB-EBRD joint conference on ‘Emerging climate-related risk supervision and implications for financial institutions’ highlighted the need for banks to take action to meet the ECB’s expectations. Although the ECB recognizes that banks have made progress, it stresses that banks are “still a long way off meeting the supervisory expectations we have laid out for them.”
In recent months, Deloitte supported several banks across Europe in drafting their roadmaps for integrating climate-related and environmental risks. From this experience and our market insights, we have identified several areas for banks to consider when integrating these risks.
Implementing a consistent strategy and aligning your ESG risk management activities with your business environment, overall purpose, goals, KRIs and KPIs are essential. However, combining the typically shorter-term banking horizon with the longer-term horizon for climate impact can be challenging. By taking a structured approach and preparing a detailed plan, you can reach short-term goals and progress in your long-term strategy.
Impact versus risk
Combining initiatives relating to the positive impact that a financial institution aims to make on the planet and society and the impact that the planet and society have on the institution can be challenging. These inside-out and outside-in effects often get confused or are considered separately from each other, while they may in fact be interconnected or share common grounds. Institutions therefore need to have a better understanding of their overall sustainability landscape and to speak a common language.
Ownership and accountability
ESG risks span organizational departments and existing risk categories. The challenge is to define ownership and accountability for these risks and to understand how they are linked to other risk types. Clearly understanding the definition, scope and interconnectedness of ESG risks in the risk taxonomy is a good starting point. Next you need to make sure your ESG risks are properly embedded in all three lines of defense: business, risk management and control, and internal and external audit. The ESG risk governance should align with the overall organizational risk appetite.
The data required for accurate risk identification and measurement (including data on greenhouse gas emissions) is often not readily available or of insufficient quality. We recommend you to consider a mix of quantitative and qualitative data from verified and reliable external sources. Adopting a transparent approach to data collection and use is crucial, given the uncertainties associated with external ESG-related information at counterparty level (AFM, 2020). Over time, you will develop a learning curve and be able to overcome these challenges.
Methodologies and stress testing
ESG risk management is a forward-looking exercise with a long-term horizon. This makes using conventional risk management methodologies to quantify ESG-related information challenging. Using a mix of hybrid qualitative and quantitative approaches – such as heatmaps, or sectoral or geographic concentration analysis – can help you to identify risks and to better understand their materiality. Econometric models can then be useful for quantifying the risks in your most material portfolios.
Understanding the meaning and interconnectedness of social and environmental risks
Investors, financial institutions, and businesses have tended to overlook social risks (i.e., risks relating to the rights, well-being, and interests of people and communities). Moreover, they don’t always understand that the environmental component of the ESG framework is much broader than CO2 emissions and also includes other interconnected and reinforcing factors such as how climate change impacts biodiversity loss, and vice versa. Therefore, it is essential to not only understand the full spectrum of risks, but to also recognize their interrelations.