by David Ramos Muñoz

The European Central Bank (ECB) closed its public consultation on its draft ECB Guide on climate-related and environmental risks on September 25, 2020, a remarkable initiative, which nonetheless still leaves many uncertainties for the future.

The Draft Guidelines are an extremely meritorious initiative, which show the ECB’s international leadership on the XXI^st century’s defining issue. Yet, while signalling an encouraging turn by financial regulators, there are three main problems in the ECB’s approach to the issue: (1) it treats climate-related risk as a microprudential issue, by inserting it as part of the Supervisory Review and Evaluation Process (SREP), which is aimed at setting Pillar 2 requirements (and also disclosures) on a bank-by-bank basis. No attention is paid to issues such as (i) the patterns of interconnectedness in the banking system, which are crucial to understand how a large shock (like climate-related shocks promise to be) would spread across the system, and whether said system could withstand it; or (ii) how macroprudential tools could be used to supplement micro-prudential ones. (2) The Draft Guidelines treat climate-related risk like “just another” kind of risk, which can be addressed by merely expanding the time horizon of existing risk models. Economic research suggests instead that low-probability-catastrophic outcome scenarios are prone to “ambiguity” and “unawareness”, which may suggest a different framework for risk assessment. (3) The Draft Guidelines treat matters pertaining to bank culture in a traditional fashion (based on “risk appetite”). For climate-related risks the problem may not be one of “risk appetite”, which suggest that units consciously decide to take on more risk, but, again, ambiguity, and unawareness. Another problem, important to assess Transition risk, is the alignment between the perception of climate-change goals within the institution, when compared with social (or government) perceptions. It is not a matter of “monitoring opinions”, but of monitoring that a misalignment between the social norms inside the institution, and outside it does not lead the institution to underestimate the risk of sudden policy changes, reputational costs, and damage. Indeed, the treatment of liability risks, reputational risks, etc, (including their relationship to social norms) is another part where the treatment is unclear and/or ambiguous.