The impacts of environmental (ESG) risks on Pillar I

The EBA has released a new discussion paper about the potential impacts of ESG on Pillar I.

The analysis shows that it is already possible to include new categories of risk drivers in the Pillar I framework such as ESG risks. Internal models, external credit ratings and valuations of collateral and financial instruments are a few of them. Clarifications within the framework are also explored to address those ESG risks and the paper also puts up forward-looking methodologies for discussion to consider those environmental risks.

At the same time, environmental and particularly climate-related risk drivers have been identified as sources of financial risks that can materialise through traditional categories of prudential risk.

The EBA is mandated under Article 501c of Regulation (EU) No 575/2013, i.e. the Capital Requirements Regulation (CRR), and Article 34 of Regulation (EU) 2019/2033, i.e. the Investment Firms Regulation (IFR), to assess whether a dedicated prudential treatment of exposures related to assets, including securitisations, or activities (CRR), and of assets exposed to activities (IFR) associated substantially with environmental and/or social objectives would be justified.

This DP builds on previous EBA publications including in particular the EBA Action Plan on sustainable finance. In line with that plan, the first phase of the EBA work in this area focused on ensuring sound governance, strategy and risk management of ESG risks and putting in place disclosures of key metrics.

Prudential requirements were identified as an important element in the European Commission’s 2018 action plan ‘Financing sustainable growth’ under action 8 (‘Incorporating sustainability in prudential requirements’).

Due to the complementary nature of and close interrelations between the prudential and accounting frameworks, it is important to consider to what extent environmental risks are reflected in accounting exposure values.

It appears that targeted amendments to the existing prudential requirements would address these risks more accurately than dedicated treatments such as supporting or penalising factors, given the various challenges associated with the design and implementation of such factors.

Credit Risk

Overall, it is key to ensure that the calculation of RWAs is not distorted and to maintain risk-based capital requirements which fulfil their function as safeguards against unexpected losses, hence contributing to safeguarding financial stability. At the same time, acknowledging that fully embedding environmental risk drivers in the existing credit risk framework also raises challenges, alternative approaches should continue to be assessed. In any case, any policy approach should avoid overlapping and double counting effects e.g. between amendments within the framework and adjustment factors, as this could result in an underestimation of risks. It should as well be ensured that the overall level of capital requirements remains adequate from a prudential perspective.

Operational Risk

A key challenge in analysing the potential need to adapt the operational risk framework is the lack of  data to identify how environmental factors have an adverse impact on the operational risk inherent in banks. There may be a presumption that operational risk events due to physical risks and business disruptions, such as power outages, or to legal or compliance risk, may become more prevalent. However, it is currently not possible to properly monitor such developments. Therefore, it appears natural that, as a first step, institutions are required to identify environmental factors as triggers of operational risk losses on top of the existing risk taxonomy. This would also allow identification of whether the part of operational risk that is associated with environmental factors is material, and whether there is an increasing trend in this risk.

Investment firms

Although it seems difficult to directly associate the Risk-to-Client K-factors with the risks arising from environmental risk drivers, investment firms may face reputational risk and business model risk if the composition of assets under management in terms of their environmental profile is not taken into account. Finally, commodity and emission allowance dealers may need further analysis and special consideration, because of the specificities of their business models and the markets they operate in.

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