Banking regulations in the age of environmental risks (Note)

DISCLAIMER: The opinions expressed by the author are personal and do not reflect those of the institution that employs him.

Article written in June 2021

Purpose of the article: This article aims to analyze the introduction of environmental criteria and risks into banking regulations. It highlights the decisive role of banks in steering the economy towards sustainable activities and provides an overview of the regulatory texts currently being drafted.

Summary:

• Banking regulators are placing increasing importance on environmental issues, and the banking sector can play a decisive role in steering the economy towards sustainable activities.
• Banks should take environmental indicators into account when assessing the credit risk of their customers/counterparties. This requires changes to the current models used to assess this risk.
• Banks need clear and well-defined indicators, sufficient data, and harmonized methodologies in order to be able to include environmental risks in their risk management framework.
• A distinction should be made between companies with a significant negative impact on the environment and those with less impact across all sub-categories of environmental risk, particularly physical risk.
• The introduction of environmental risks into capital requirements should be clarified and harmonized with the requirements for disclosure of information to the public and the supervisor.

Global warming, significant biodiversity loss, and pollution linked to human activities are increasingly threatening the future of our planet and our society. As a result, European governments and regulators are increasingly taking environmental issues into account, although the measures taken to date remain limited.

Indeed, our traditional economic model, largely based on the use of natural resources, will reach its limits when these resources are depleted or no longer sufficient. The depletion of these resources risks not only disrupting living conditions in several geographical areas, but also causing social and economic crises (including in developed countries) when resources become scarce and climatic conditions become hostile.

Since 2020, environmental and climate criteria have begun to be integrated by European banking supervisory and regulatory authorities, notably the European Banking Authority (EBA), the French Prudential Supervision and Resolution Authority (ACPR) and the European Central Bank (ECB). Environmental risks will potentially be included in the capital requirements for banking institutions in the coming years. In addition, from 2022, banks and investment companies will be required to be transparent with investors about the sustainability of their investments.

The inclusion of environmental risks in banking regulations is a major development and will bring about significant changes in risk management as well as in the organization and business strategy of banks. Although the introduction of these risks may be perceived by banking institutions as restrictive, due to the difficulty of implementation and a possible increase in capital requirements, it may also represent an opportunity. Banks that finance innovative and environmentally friendly projects, as well as less polluting and more sustainable activities and products, will have a comparative advantage in terms of sustainable profitability, environmental risks, and resilience. In addition, they will be able to become drivers of a more environmentally friendly and responsible economy.

1. Financing policies: directing financing towards sustainable sectors and activities

The EBA guidelines on lending and monitoring loans[2] impose a number of criteria that banks must take into account before granting credit. Borrowers’ exposure to environmental factors is one of these criteria[3]. For loans or borrowers associated with a higher environmental risk (identified using heat maps, for example), institutions must require a more in-depth analysis of the business model, including a review of current and projected greenhouse gas emissions, the market environment, applicable environmental regulatory requirements, and the likely impacts of these requirements on the borrower’s financial situation.

The purpose of this section is to analyze the environmental criteria that institutions could consider when granting a loan, providing a few examples.

First, banks could consider the sustainability of a company’s business in their financing policy, in particular by taking into account a longer time horizon than the current ones: for example, 20 or 30 years. This longer horizon would take into account the negative effects that many industrial, commercial, and service activities can have on the environment and local populations. For example, although an activity may prove to be successful and profitable in the short and medium term (up to 5 years), it may be unsustainable because of its environmental impact and the fact that its profitability may decline over longer time horizons (decline in consumer demand, technology used becoming obsolete, etc.). The Taxonomy Regulation[4] defines environmental sustainability criteria for all sectors of the economy (with the exception of solid fossil fuels in electricity production) and sets out requirements for companies in terms of transparency on the sustainability of their investments. Banks could use these criteria as a basis for assessing the sustainability of a company’s activities.

In a context where climate and environmental issues are becoming increasingly important, banks have the opportunity to play a central role in guiding the companies they finance towards greater sustainability. For example, they can promote the development of certain sectors or types of activity such as waste recycling, organic farming, education, renewable energies, short supply chains, etc. Companies or sectors that are less environmentally friendly will thus tend to convert to more sustainable activities.

In addition, banks could require estimates of greenhouse gas emissions, environmental degradation that the activity may cause (deforestation/reduction of green spaces, water and soil pollution, animal abuse, etc.), and energy consumption for the projects they intend to finance. These estimates could be prepared by experts or companies specializing in environmental engineering.

Finally, banks could take environmental criteria into account in addition to financial criteria when setting interest rates. In particular, they could apply a higher interest rate to less sustainable companies. This differential would correspond to an environmental risk premium. Calculating this risk premium would require calculating an expected loss (and therefore a probability of default (PD) and a loss given default (LGD) in internal model-based approaches) that would take environmental factors into account. This would require the development of new models for estimating PD and LGD credit risk parameters so that they take into account not only traditional macroeconomic and financial variables but also environmental and climate variables from fields other than finance (engineering, physics, chemistry, etc.). Drawing inspiration from Article 8 of the Taxonomy Regulation[5], banks could, for example, include in their scoring/rating models the share of their corporate clients’ revenue or profits derived from sustainable activities and the share of these companies’ operating and investment expenditures related to sustainable assets or economic activities.

2. Taking environmental risks into account in capital requirements

In its discussion paper « On management and supervision of ESG risks for credit institutions and investment firms, » the EBA defines environmental risks as financial risks resulting from institutions’ exposures to counterparties that may contribute to or be adversely affected by environmental factors such as climate change and other environmental degradation. It classifies environmental risks into three subcategories:

Ø Physical risk: the risk incurred by the institution when it is exposed to counterparties that may be affected by the physical effects of climate change and other environmental factors. This includes acute physical risks (resulting from meteorological events) and chronic physical risks (resulting from long-term changes in the climate).

Ø Transition risk: the risk incurred by the institution when it exposes itself to counterparties that may be negatively affected by the transition to a low-carbon, climate-resilient, or environmentally sustainable economy. This includes policy and regulatory changes related to climate and the environment (e.g., carbon pricing), technological changes (new, less harmful technologies rendering older ones obsolete), and behavioral changes (consumer/investor choices shifting toward greener and more sustainable products).

Ø Liability risk: the risk incurred by the institution when it exposes itself to counterparties that may be held liable for the negative impact of their activities on the environment.

Environmental risks are not included in the risk categories specified in prudential regulations[6]. They could therefore be treated as a new risk category, which would imply specific capital requirements for these risks, as is the case for traditional banking risks (credit, market, and operational risk).[7]

Nevertheless, the EBA’s definitions of environmental risks suggest that these risks have a direct or indirect impact on the future financial health of banks’ counterparties. Consequently, they could be included in existing prudential risk categories. Indeed, climate and environmental degradation, increased taxation on certain raw materials or types of activities, the possibility of legal action or reputational damage, or technologies that may soon become obsolete all have an impact on a company’s financial health and the sustainability of its business. As a result, its value and solvency may be affected.

The challenge for banks, particularly those that use internal models to estimate risk weights (RW), is therefore to include in their credit risk estimation models PD ( probability of default) and LGD ( loss given default) parameters, as well as environmental and climate variables that may originate from fields other than finance.

Ø Physical risk can be taken into account by introducing variables related to climate change and other environmental factors into a counterparty’s PD and LGD. These variables can be constructed from projections of global warming, water and soil pollution levels, and the state of natural resources (including biodiversity) for the geographical area in which the counterparty or its subsidiaries operate. Although the effects of an individual company’s environmental impact are not directly taken into account in its physical risk, and therefore in its credit risk parameters, the degradation of its physical environment would have a direct impact on these parameters.

Ø Transition risk can be taken into account by introducing variables relating to the transition to a more environmentally neutral and sustainable economy into a counterparty’s PD and LGD. These could include the estimated time it will take for a company to transition to a more sustainable and environmentally neutral activity, the estimated level of demand for its products over the next 5 to 10 years, the taxation of harmful raw materials it may use (such as coal or oil), etc. The advantage of transition risk is that it results from the individual activity of a company (unlike physical risk, which results from the impact of several companies), and is therefore able to directly reflect the ecological impact of an individual counterparty on its credit risk.

Ø Liability risk can be taken into account by introducing variables relating to potential damages that a counterparty may have to pay (to local populations, the government or local authorities of a country, or other companies operating in the same geographical area) as a result of harm/damage to the environment and local populations into the PD and LGD of a counterparty.

For banks using the Standardized Approach[8], if external ratings do not include environmental risks, these risks can only be taken into account by adding an « environmental risk level » category to the risk weighting (RW) tables provided by the regulator. In all cases, banks using this approach should take environmental risks into account when calibrating their provisions[9].

3. A critical analysis of publications by European banking regulation and supervision authorities on environmental risks

On November 3, 2020, the European Banking Authority (EBA) published a consultation paper on the management and supervision of environmental, social, and governance risks (known as « ESG risks »)[10]. This document defines these risks and provides an initial framework for how they could be included in the regulation and supervision of credit institutions and investment firms (hereinafter referred to as « institutions »). In this document, the EBA proposes criteria and methods for understanding the impact of ESG risks on institutions, as well as the mechanisms and strategies to be implemented by institutions to assess and manage ESG risks.

To support institutions in their discussions with the EBA, on November 27, 2020, the ECB published a guide explaining the supervisor’s expectations regarding environmental and climate risks. According to this guide, institutions must have a strategic and forward-looking approach to taking these risks into account. The ECB expects institutions to take these risks into account as drivers of existing risk categories when developing their business strategy, risk appetite, and governance and risk management framework. The guide also explains how institutions should become more transparent by improving their climate- and environment-related disclosures.

One of the methods for assessing environmental and climate risks proposed in these publications is to carry out stress tests. An initial pilot exercise on climate risks had already been developed in May 2020 by the French Prudential Supervision and Resolution Authority (ACPR) in collaboration with the Banque de France. This exercise considered three scenarios with an impact on macroeconomic variables: GDP, inflation, and unemployment. In the first scenario (the baseline scenario), the risk of transitioning to climate targets is manageable, with the transition taking place gradually and without any major macroeconomic shocks. In the second scenario, the transition does not begin until 2030. As a result, restrictive measures must be put in place from 2030 onwards to make up for lost time and achieve climate targets, resulting in a sharp revision of the price of carbon, which leads to significant macroeconomic and sectoral disruptions. Finally, in the third scenario, governments do not introduce transition measures and economic actors do not change their behavior. GHG emissions continue and climate targets are not met. This scenario results in significant physical risk in the medium and long term, with an increase in the frequency and severity of extreme weather events, leading to a significant deterioration in macroeconomic variables (GDP, inflation, unemployment) from 2040 onwards. The transition risk, on the other hand, remains limited.

On March¹, 2021, the EBA also published a consultation with a view to publishing ITS (implementing technical standards)[13] on disclosure requirements relating to ESG risks. Institutions will be required to publish a number of ESG-related items in Pillar III, including exposures to sectors or geographical areas exposed to climate change and the ratio of sustainable assets (as defined by the European Taxonomy). These requirements will come into force in June 2022 and will be fully implemented in June 2024.

The publications on environmental risks by European banking regulators and supervisors lay a solid regulatory foundation for the prudential treatment of these risks. They introduce major changes in the risk management and governance of institutions. First, banks will have to assess new risks that they were not previously accustomed to measuring. In addition, they will have to review and significantly modify their current models, particularly those used to assess credit risk parameters (rating, probability of default PD, loss given default LGD). Second, banks will have to consider new risk factors and indicators when granting and monitoring loans. These new indicators will influence their lending decisions and their assessment of existing customers (potential changes in their ratings). Third, institutions will have to change the way they perceive and govern their risks and review their risk appetite.

However, these publications have certain limitations. Four challenges can be highlighted:

a) The introduction of environmental risks requires clear and well-defined indicators and harmonized methodologies that would enable banks to integrate these risks into existing risk categories, particularly credit risk. Furthermore, banks do not have sufficient data on these risks, as highlighted by the EBA’s 2020 pilot exercise[16]. The application of the regulation on environmental risks requires not only a list of indicators clearly defined by the regulator, but also the use by counterparties of firms specializing in the measurement of these risks, and the development of new banking models that take these indicators into account in financial or risk variables (PD and LGD in the case of credit risk). For the Standardized Approach, environmental risks should be taken into account either in external ratings (i.e., by external rating agencies/organizations) or by adding a category reflecting the level of these risks in the RW weighting tables provided by the regulator.

b) Based on the definition of physical risk, a company that has an unsustainable business and causes significant damage to the environment would be assessed in the same way as a company that has a much more sustainable business and a limited impact on the environment, as long as both companies are located in the same geographical area. This indifference in terms of physical risk assessment does not encourage companies to individually reduce their negative impact on the environment. Individual indicators on the sustainability of the activity and on the environmental impact (greenhouse gas emissions, water and soil pollution, product recycling and/or sustainability index, level of natural resource use, respect for animal welfare, etc.) should be established and made very clear, in the same way as the financial indicators that currently determine a company’s solvency.

c) The climate stress test proposed by the ACPR only allows banks to « translate » climate risks into changes in credit risk parameters based on the deterioration of traditional macroeconomic variables (GDP, inflation, unemployment). This can be problematic insofar as traditional macroeconomic variables do not take sufficient account of the sustainability of investments and their environmental impact. Indeed, an economy can be growing and at full employment without companies’ activities being sustainable, low-carbon, and environmentally friendly. The impact of environmental and climate risks can only be felt on macroeconomic variables if governments are determined to impose measures to transition towards climate targets (e.g., a significant increase in the price of carbon) or if there is a significant increase in physical risk (which is what the^third scenario of this stress test exercise predicts from 2050 onwards if the transition does not take place). Furthermore, this stress test focuses on climate issues and does not take into account other environmental aspects, such as biodiversity loss, water and soil pollution, etc.

d) Finally, the EBA and ECB publications do not clearly explain when environmental risks will be taken into account in banks’ capital requirements and whether this will be done solely through existing risk categories (particularly credit risk) or by (also) considering environmental risks as separate risks. Furthermore, requiring banks to publish data on these risks in Pillar III before their inclusion in Pillar I or II[17] has been clearly defined could create confusion for banks and investors, as well as customers/depositors, justifying a necessary harmonization of the consideration of these risks in the various pillars of banking regulation.

Conclusion

The introduction of environmental risks into banking regulations is a major challenge for climate change mitigation and environmental preservation, as well as for banks’ risk management. On the one hand, taking these risks into account would encourage institutions to finance sustainable projects and activities with a reduced impact on the environment. On the other hand, it would significantly change banks’ business strategies and their perception, management, and governance of risks.

However, the framework provided by the regulator has its limitations. Banks lack high-quality data, clear and well-defined indicators, and harmonized methodologies for assessing these risks and reflecting them in existing categories of prudential risks.

Furthermore, in order to encourage companies to operate in a more sustainable manner, the individual impact of each company on the environment should be taken into account in the assessment of each sub-category of its risks, particularly physical risks. By promoting more sustainable activities, banks will contribute to reducing their risks and to a more sustainable, environmentally friendly, and resilient economic and banking system.

Finally, the inclusion of environmental risks in banks’ capital requirements is not yet very clear or well explained, yet banks are required to publish prudential information related to these risks from June 2022 onwards. Harmonized consideration of these risks across the various pillars of banking regulation would make them clearer for all stakeholders (including banks, investors, and customers/depositors).

References

• ACPR, (2020), Scenarios and main assumptions of the climate pilot exercise;

• CRD IV Directive (DIRECTIVE 2013/36/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of June 26, 2013);

• CRD V Directive (DIRECTIVE (EU) 2019/878 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of May 20, 2019);

• NFRD Directive (Directive 2014/95/EU of the European Parliament and of the Council of October 22, 2014);

• EBA Consultation paper on draft ITS on Pillar 3 disclosures on ESG risks (EBA/CP/2021/06);

• EBA Discussion Paper on management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03);

• EBA Action Plan on Sustainable Finance, December 6, 2019;

• EBA Guidelines on loan origination and monitoring (EBA/GL/2020/06);

• EBA Guidelines on institutions’ stress testing (EBA/GL/2018/04);

• EBA (2020), Mapping climate risk: Main findings from the EU-wide pilot exercise;

• ECB Guide on climate-related and environmental risks, Supervisory expectations relating to risk management and disclosure;

• EBA Opinion on disclosure requirements in relation to environmentally sustainable activities in accordance with Article 8 of the Taxonomy Regulation;

• CRR Regulation (REGULATION (EU) No 575/2013 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of June 26, 2013);

• CRR II Regulation (REGULATION (EU) 2019/876 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of May 20, 2019);

• European Taxonomy Regulation (Regulation (EU) 2020/852 of June 18, 2020 on promoting sustainable investments and amending Regulation (EU) 2019/2088);

• SFDR Regulation (Regulation (EU) 2019/2088).