by David Ramos Muñoz
The European Central Bank (ECB) published on November 20 its long-awaited Final Guidelines on Climate-Related and Environmental Risks. Although an in-depth review is not possible in a brief post, we offer our preliminary assessment here. In our view, the document released by the top banking regulator is both a testimony of how much there is still to walk, but also a decisive step in the right direction.
First of all, the document is no mere declaration of intent. It includes 54 pages of seriously meditated ideas, it is relatively comprehensive, going from the more general to the more specific, and it sets clear expectations for financial institutions.
Second, the ECB announces that such expectations are no joke. In fact, the ECB also released in November its Report on institutions’ climate-related and environmental risk disclosures, and took the opportunity to state in no uncertain terms that “in general, institutions do not yet comprehensively disclose their risk profile and that significant efforts are needed to promote transparency in the financial markets on the climate-related and environmental risks institutions are exposed to. As of yet, virtually none of the institutions in the scope of the assessment would meet a minimum level of disclosures set out in the “ECB Guide on climate-related and environmental risks” . Thus, as of today, banks would get a “D” on their disclosures. And disclosures are only part (and arguably not the most crucial part) of the ECB’s assessment.
Third, the ECB chooses its Supervisory Review and Evaluation Process (SREP) methodology to frame how climate-related risks will be accounted for. Those unfamiliar with the SREP concept, more than a “process” it is a philosophy about how the ongoing, iterative relationship between regulator and regulated should take place. The ECB does not sit back to calculate ratios like a box-ticking exercise. It gathers data, and does an automated scoring, but then applies supervisory judgment to reach a final determination, taking into account quantitative, but also qualitative information; it evaluates the viability and sustainability of the business model, and the adequacy of governance and risk management. When the process is finished, it sets expectations for the next cycle, and starts again.
What does this mean for climate-related risks? A lot. The current guidelines expressly indicate that climate-related risks will shape the supervisor’s expectations not only for disclosures, but also for banks’ business model and strategy, governance and risk appetite, and crucially, risk management. Thus, the management of climate-related risks thus cannot be circumscribed to a specific area, but will be part of the lenses through which the ECB sees the bank as a whole. That has the potential to effect real change in the way banks themselves perceive climate change.
In fourth place, the ECB has shown openness to improve its own understanding of climate change as a financial phenomenon, including some improvements from its May 2020 “Draft” Guidelines, to its “Final” November Guidelines.
As rules and standards on sustainability may change over time, institutions may increasingly face compliance-related risks, such as liability, litigation and/or reputational risks, stemming from climate-related and environmental issues. To give just two examples:
1.- The ECB has modified expectation 5.2. which now states “To the extent needed, institutions are expected to strengthen the available capacity and resources, as well as to encourage appropriate training for all relevant functions. This also includes ensuring that the institution’s norms, attitudes and behaviours related to risk awareness take into account the uncertain, but potentially significant, impacts of climate-related and environmental risks.” This, i.e. the “perception” problem of remote-but-catastrophic risks, and how they impact the agents’ decision-making function under uncertainty was one of the points we highlighted in our comments (as, we imagined, other stakeholders did too) one that must be addressed by changing the bank’s culture.
2.- The paragraph on expectation 5.5. on the “compliance” function is completed with a final reference to the fact that “As rules and standards on sustainability may change over time, institutions may increasingly face compliance-related risks, such as liability, litigation and/or reputational risks, stemming from climate-related and environmental issues”. The need to specifically address the looming presence of litigation risk was another aspect that we highlighted in our comments to the Draft ECB Guidelines, which now make it more salient.
Finally, by way of constructive criticism, the ECB’s effort is a very good step to force banks to come to terms with climate-related risks on an individual basis. However, if recent history teach us something, is that not only the solvency of individual institutions, but also the (network) structure of the market matters to determine how large shocks will be absorbed by the financial system. This is a point that we also highlighted in our comments, i.e. that a microprudential approach is a good first step, but not enough. The ECB seems to acknowledge as much, because the Final November 2020 version of the Guidelines includes a new footnote 12, which states that: “While climate-related change and environmental degradation can give rise to microprudential and macroprudential risk, it should be noted that this guide is prepared by the ECB in the context of the task conferred to it under the relevant SSM regulation and is therefore limited to microprudential risk.”
Unfortunately, that happens to be true, and making sweeping, market-wide macro-prudential interventions is not up to the ECB, but to (national) macroprudential authorities (whether it is sensible to allocate to the ECB supervisory competences over the systemically important banks, while leaving macroprudential supervision to Member States is another matter). That, however, shows that this exercise is still a work-in-progress: once the banks’ performance is assessed under the yardstick of the new climate-related “expectations” in 2021-2022 the ECB will have more information on patterns and system-wide problems, which may prompt new system-wide policy changes. This will require a combination of relentlessness, and ability to learn. So far, the ECB has shown positive signs of both, which should be a cause for cautious optimism.