EBA discussion paper on the management and supervision of ESG risks

European sustainable finance regulations evolved considerably in 2020, and the European Banking Authority (EBA) is continuing this trend into 2021. It recently published a discussion paper assessing the potential inclusion of Environmental, Social and Governance (ESG) risks in the supervisory review and evaluation process (SREP) performed by national competent authorities (NCAs)[1].

What firms need to do now

EU-regulated credit institutions and investment firms should review their current policies and procedures for managing ESG risks against the measures proposed in this discussion paper, and formulate a plan to address the gaps as and when this is required.

Institutions should begin to identify suitable governance structures to be implemented around ESG risks, including any necessary updates to Board and senior management-level responsibilities and risk escalation procedures. Similarly, a comprehensive materiality assessment should be performed to determine the most material ESG risks facing the organisation. Institutions should monitor developments in tools and methodologies for ESG risk measurement, as these may facilitate compliance with future regulatory expectations in this area.

Finally, assessing ESG risks requires a steady stream of high-quality, up-to-date information from counterparties. At this stage, most institutions do not possess the necessary information to measure the ESG risks to which their counterparties are exposed. Most information is collected during the loan-granting process and is limited to financial data. However, ESG-related data will be needed to meet requirements under the EU Taxonomy, SFDR, and any regulation emerging from this EBA discussion paper. Given the complexities and costs of data gathering and verification from counterparties, institutions would be well-advised to begin this process now.

What are the recommendations?

There are four main themes:

1Common definitions of ESG factors, ESG risks and their transmission channelsThe EBA proposes definitions of ESG factors, ESG risks and transmission channels (physical, transition and liability risks) – the EBA views these risk categories as sufficiently material to be included within the CRD and IFD
2Quantitative and qualitative indicators, metrics and methods to assess ESG risksThe EBA presents a non-exhaustive list of ESG indicators and metrics, together with a description of several tools and methodologies that can support the identification, evaluation, and assessment of ESG risks
3Management of ESG risks by institutionsThe EBA offers recommendations regarding the way in which institutions can embed ESG risks in their internal governance and risk management frameworks
4ESG factors and ESG risks in supervisionThe EBA elaborates on effective ways to proportionately reflect ESG risks in the SREP and makes several policy recommendations in this respect

The discussion paper lays out far-reaching recommendations for local regulators, which would broaden their current scope of supervision. For example, NCAs would be required to assess:

  • the viability and sustainability of institutions’ business models, considering ESG risks –to determine whether the institution’s current strategy allows for acceptable returns over a three-year period;
  • management leadership and oversight of ESG risk management through internal governance frameworks, management responsibilities, control frameworks and information systems; and
  • ESG risks as drivers of prudential risks and the adequacy of risk-specific controls, potentially through scenario analysis and stress testing.

Findings from the consultation will be submitted to the European Parliament and Commission in June 2021. These will inform future regulatory requirements from the EBA, including:

  • the ongoing development of technical standards embedding ESG risks with Pillar 3 disclosure requirements, to be included within Capital Requirements Regulation 2 (CRR2); and
  • assessing whether Pillar 1 capital requirements should include a dedicated prudential treatment of exposures associated substantially with environmental and/or social objectives.

[1] https://www.eba.europa.eu/calendar/discussion-paper-management-and-supervision-esg-risks-credit-institutions-and-investment