How to manage environmental risks: the case of the banking sector

The banking sector plays a crucial role in the economy by providing financing and investment opportunities to businesses and individuals. However, it is also exposed to various environmental risks that can impact its operations, profitability, and reputation.

Environmental risks arising from climate change, natural disasters, and other environmental factors can affect the economic performance of borrowers, the value of assets, and the sustainability of operations. 

Therefore, managing environmental risks is essential for the long-term success of the banking sector.

Environmental Risk Management: good practices and tips

The European Central Bank (ECB) has recognized climate-related and environmental risks as major drivers of risk for the banking sector. 

These risks, which include credit, market, and operational risks, are expected to have a significant impact across different sectors and geographic regions. 

The ECB believes that it is crucial for all institutions to take decisive and timely action to ensure the sound management, effective disclosure, and comprehensive handling of these risks. 

The recognition of the importance of climate and environmental risks highlights the need for institutions to incorporate sustainability considerations into their risk management frameworks, in order to protect both themselves and the wider economy from the potential negative effects of climate change.

In its report on the state of climate and environmental risk management in the banking sector, the ECB outlines good practices pertaining to different aspects of the operation and governance of the sector’s institutions.

Business Model and risk identification

Double materiality and strategic planning

In order to integrate and manage environmental risks, an institution must apply the double materiality concept from the European Commission's Guidelines on Non-financial Reporting. This involves assessing both the impact of environmental and social risks on the institution's business environment (financial materiality) and the impact of the group's activities on the environment (environmental materiality). 

Financial materiality

In order to identify and manage environmental risks, an institution must conduct a continuous assessment of its impact on the business environment. 

This involves several steps, including the systematic integration of risk types and group exposures to ensure complete coverage, the development of a group risk management framework for environmental risks, the establishment of an organizational structure that facilitates discussion between risk experts and senior management on emerging risks, improved risk monitoring, and comprehensive risk identification. 

The vulnerabilities within the group's exposures must then be analyzed by the business sector to provide a clear understanding of the risks, which can be integrated into the strategy-setting process.

Environmental materiality

To evaluate the significance of climate and environmental factors related to the group's operations and their impact on the overall strategy, an Environmental Materiality assessment must be conducted through the development of a materiality matrix. This matrix is constructed using a bottom-up approach after extensive consultation with internal and external stakeholders.

The focus is on the analysis of environmental topics that are linked to the business activities of their customers and their potential impact on the group's operations. 

The results of this assessment are used in strategic planning and management of reputational risks.

Alignment with the objectives of the Paris Agreement

When an institution establishes climate-related risks as a critical component of its overarching strategy, it employs a three-step process that merges physical and transition risks with its climate risk appetite framework. 

The approach includes the following steps:

  1. Carrying put a policies and processes assessment in order to understand which one requires a revision to incorporate climate risk considerations. 

Additionally, the institution identifies how environmental risks impact its operations and commits to enhancing specific focus areas.

  1. Conducting a qualitative assessment of the institution to identify the impact of climate risks in order to inform the strategy and risk appetite for the different portfolios.
  2. Adopting a quantitative approach based on scientific scenarios to inform the institution’s strategy and climate risk appetite.

This process generates a well-defined strategy to transition from the current portfolio to one that aligns with the Paris Agreement goals for the most exposed sectors, including fossil fuels, energy production, automotive, steel, and aviation. 

The strategy is incorporated in the institution’s governance framework through the establishment of specific key performance indicators (KPIs) that are published in annual progress reports. 

These KPIs encompass the majority of the institution's exposures and establishes goals to be accomplished within a specified timeframe. 

The annual progress report clearly explains the methodology and metrics used to determine these indicators.

Governance and risk appetite

Involvement of the management body in the institution’s supervisory and executive functions

To establish comprehensive governance arrangements that involve executive and supervisory functions, an institution can create subcommittees and departments dedicated to specific tasks. For instance, the supervisory board's risk committee can review the institution's global risk strategy and appetite. The institution's Risk Department can then develop a climate risk management strategy, review sectoral policies, and provide an annual opinion on the institution's climate risk and sectoral strategies.

Moreover, the institution can set up a dedicated steering committee to ensure consistent implementation of environmental commitments across the institution, supported by relevant experts. This committee's work will drive sectoral policies and portfolio allocation. Additionally, a corporate sustainability committee can coordinate and monitor the institution's strategy deployment. The corporate sustainability department can develop group policies for sectoral corporate sustainability and collaborate with the risk department to design the institution's environmental risk strategy. 

The corporate sustainability committee can also issue opinions on environmental-relevant sectoral strategies, considering potential reputational risks and environmental impacts, and integrate these opinions into the relevant sectoral strategies.


Definition of qualitative statements and quantitative indicators

The incorporation of environmental risks into risk appetite statements by institutions involves the inclusion of both qualitative and quantitative risk indicators. 

Qualitative statements usually consist of guidelines or targets outlining the institution's willingness to assume specific risks. 

In contrast, quantitative risk indicators are created utilizing a partially or entirely quantitative methodology.

Integration of environmental risks into reporting practices: from gap analysis and data collection to reporting tools

The establishment of a reporting framework that considers environmental risks is based on three components: gap analysis, data collection and reporting tools.

Gap analysis

To evaluate data related to the environment, it is crucial to comprehend the demands based on the institution's distinct risk profile and business model, along with pertinent or forthcoming regulatory obligations. Afterward, the institution conducts an analysis of data gaps by scrutinizing its current data resources and capabilities. This examination helps identify domains where data is deficient or inadequate to fulfill the institution's necessities for managing environmental hazards.

Data collection

The next step is the development of a data collection strategy to identify, collect and aggregate the data needed to measure relevant environmental risks. 

To do so, institutions can develop a dedicated environmental risk questionnaire to be filled out at the time of credit origination and during annual reviews, to collect data from its clients. 

The environmental questionnaire must be completed by all counterparties at least once a year, and the collected data can be used to calculate scope 3 emissions according to the GHG Protocol and the CDP.

Reporting tool

To ensure effective management of data, it is crucial to establish a specialized platform dedicated to non-financial reporting. 

This platform would encompass a range of indicators applicable to all entities within the organization, aimed at managing environmental risks faced by the institution. 

Examples of these indicators include investments in energy sectors, the proportion of coal in the energy mix of the investment portfolio, and the level of financing directed towards energy efficiency, such as loans to enhance the energy efficiency of buildings.

The platform would operate as a comprehensive steering tool for the entire group, consolidating both internal and external data sources, such as rating agencies, and presenting risk indicators for specific portfolios and entities, as well as for the organization as a whole.

Risk Management

Asset allocation: integration of Environmental risks in asset allocation decision-making

In order to embed transition risks and physical risks in the decision-making process an approach to asset allocation that considers the associated environmental risks should be implemented.

In order to adopt such approach, it is necessary to implement the following steps:

  • Definition of a risk taxonomy
  • Analysis of the sector’s sensitivity to regulatory, technological, and market risk drivers.
  • Definition of Total exposure at default affected by the transition and physical risks
  • Establishment of key risk indicator aimed at monitoring and controlling exposure to sectors classified in the high and very high sensitivity categories.

Market risk: integration of environmental-related criteria in sector and investment policies

To include environmental risks in an institution's market risk management framework, one can use exclusion and phase-out criteria for sector policies that are highly vulnerable to such risks. 

This approach, which applies to market activities regardless of their accounting classification (e.g., banking book or trading book), involves establishing explicit limitations on investments in particular sectors and interactions with counterparties operating in those sectors. 

By implementing sectoral investment and exclusion policies, institutions can effectively manage environmental risks in their market activities.

Stress testing: definition of baseline and adverse stress scenarios for physical risks and transition risk

The definition of possible stress testing scenarios both for transition risk and for physical risks, along with assessing the potential impact of each scenario on the institution’s credit portfolio, is a strategic action to be implemented.

In the context of transition risk, there are two potential scenarios that can be outlined: an orderly scenario and a disruptive scenario. The former involves a smooth transition towards meeting the targets outlined in the Paris Agreement, while the latter requires a more rapid shift toward compliance

Each scenario has its own set of specific targets for various sectors such as energy production, Emissions Trading System (ETS), and non-ETS sectors.

In order to estimate the potential investment required by clients to transition from the current business-as-usual scenario to the Paris Agreement scenario, multiple factors need to be taken into consideration. 

One crucial factor to consider is the financial performance of the clients. By analysing the earnings before interest, taxes, depreciation, and amortization, it is possible to calculate the investment required for clients without incurring any financial distress.

This assessment enables clients to make informed decisions about their investment strategies, weighing the potential costs and benefits of transitioning to a more sustainable business model. It is a critical component of risk management, allowing businesses to mitigate the financial risks associated with climate change while also aligning with global efforts to address the issue.

Regarding physical risks, performing a thorough and precise assessment of the possible physical risks that may impact a client's portfolio is feasible. This assessment can involve assigning a physical risk score at both the client and collateral level for properties (by utilizing geospatial location data). Based on the estimated impact of various physical risk scenarios, it is possible to develop a synthetic client scoring system.

Liquidity risk: assessment of liquidity vulnerabilities arising from environmental risk events

In order to assess the liquidity vulnerabilities arising from environmental risk events it is necessary to incorporate the qualitative assessment of the potential vulnerabilities into the risk inventory.

In identifying such vulnerabilities, the institution employs a comprehensive approach to risk evaluation that evaluates both economic and normative perspectives. 

The portfolio is divided into two broad categories of physical and transition risks. 

Further segmentation into specific sub-categories helps pinpoint potential areas of liquidity vulnerability.


Policy framework for environmental risk disclosure

The disclosure policy of the institution outlines the process of creating environmental risk disclosures. This process includes defining the materiality of the information, referencing the institution's methodological standard, and describing the necessary steps for preparing the disclosures. 

Each step is assigned roles, responsibilities, and tasks to the relevant organizational units.

The policy provides a list of quantitative and qualitative indicators, such as metrics and data recommended by the Task Force on Climate-related Financial Disclosures, SASB, and PACTA, to assess the materiality of the information. The policy also establishes the process and frequency for conducting the materiality assessment, as well as a clause for reviewing the assessment in specific situations. The justification for the frequency decision is documented.

Moreover, the policy highlights that the materiality assessment is verified and approved by the management body in its executive function, and the risk committee is regularly informed about materiality assessment developments. The institution conducted a gap analysis to broaden the information provided in the C&E risk disclosures, following the European Commission's Guidelines on Non-Financial Reporting and the supplement on reporting climate-related information.

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