European Central Bank has urged banks to step up their climate risk assessments, after major benchmarking exercise reveals sector is poorly prepared for escalating impacts
Climate change presents a toxic cocktail of business model, credit, and operational risks to the banking sector over the short-to-medium term, yet not a single commercial bank in Europe is close to fully aligning their environmental and climate risk practices with expectations set out by supervisors.
That is the sobering conclusion of a major study published this week by the European Central Bank (ECB), which assessed 112 EU banks’ preparedness to deal with escalating climate and environmental risks, benchmarking the institutions’ progress against 13 expectations set out by the central bank last year.
The conclusions of the first-of-a-kind study are stark, with its warning that banks across the eurozone are largely failing to overhaul their risk strategies to prepare and adapt their business to the physical and transition risks posed by the climate and biodiversity crises and the accelerating net zero transition in line with the ECB’s expectations.
The report is published just one year after the central bank set out climate and environmental risk integration guidance for European banks designed to make Europe’s financial system more resilient to climate change and enable a smoother net zero transition.
Despite some progress from banks that have adopted new risk management practices since the publication of the guidance, the pace of progress remains far too slow, according to the ECB.
In a blog post published to coincide with the report, ECB executive board member Frank Elderson warned “almost all banks” were only partially, or not at all, aligned with the ECB’s supervisory expectations. While there is increased recognition from banks that climate and environment risks will have a material impact on their risk profile within the next three to five years, this is far from the case across the board, he said.
The findings reveal that few institutions have put in place climate and environment risk practices that have a discernible impact on their strategy and risk profile, with just a handful showing they had made “any effort at all” to take stock of the type of data they would need to identify and report internally on these risks.
The report notes that more than half of banks surveyed have “no concrete actions planned” to embed climate and environment risks in their business strategy, with Elderson noting that only a “handful of banks” are actively planning to steer their portfolios on a Paris-compatible trajectory.
Somewhat unsurprisingly, the report reveals the banks that claim to be anticipating the least potential disruption from climate and environmental risks are also those with the patchiest risks assessments in place. “Tellingly, of the institutions that report C&E risks as being immaterial to them, not a single one has an appropriate materiality assessment in place: they are either not comprehensive enough in their risk assessment or they haven’t even attempted to analyse the impacts of climate risk on their business at all,” Elderson wrote.
The ECB has also warned that most institutions have a “blind spot” for physical risks, which are largely less well understood than transition risk. And few institutions have started accounting for other drivers of environmental risk, such as biodiversity loss and pollution.
In his blog post, Elderson suggested banks had fallen prey to the “doctrine of unripe time”, a term first coined by academic F.M. Cornford to describe how organisations can delay taking actions that they nominally accept will inevitably have to be taken at some point. In other words, banks are delaying much-needed action to reduce their exposure to climate and environment risk not because they contest such action is needed, but because they believe the right moment for such reforms has not yet arrived.
“This is clearly not the best way to tackle climate-related and environmental risk,” Elderson argued. “Instead, paraphrasing F.M. Cornford, the argument for acting now is that it is the prudential thing to do. Inability to manage C&E [climate and environmental] risk poses a serious prudential risk to the stability of Euro area banks and the banking sector as whole.”
The European Central Bank’s position, reiterated in the report, is that climate-related and environmental risks are “key risk drivers” for the banking sector, predicting they will have a “widespread impact” across sectors and geographical areas.
The scale of the risk is considerable. The ECB has warned that many institutions are currently not on track to not have practices in place aligned with supervisory expectations in the near future. More than half of the banks are unlikely to have completed their plans by the end of 2022 and roughly a fifth have no short-term deliverables in place at all. “These institutions may not be able to soundly, effectively and comprehensively manage C&E risks that they are exposed to,” the study notes.
Writing on Twitter, energy analyst Assaad Razzouk branded the findings as “very grim and worrying”. “Banks don’t have a clue and don’t want to have a clue,” he said, warning that the findings suggested a “banking crash” was likely in Europe.
This chart from the ECB report basically says it all: Banks don’t have a clue, and don’t want to have a clue
— Assaad Razzouk (@AssaadRazzouk) November 22, 2021
The ECB’s one-year stocktake of banks’ progress on climate and environmental risk makes for hugely unsettling reading. It paints a picture of an industry armed with significant risk management resources seemingly opting to walk blindly into a well-documented scenario that could have a devastating impact on their future profitability and wider financial and economic stability. It comes in the same month that analysts laid bare the significant financial toll of an unmanaged net zero transition, with the Climate Stress-Testing and Scenarios Project calculating the financial system is set to suffer $150bn in losses annually from 2026 if polluting companies do not start to decarbonise rapidly. Commerical banks could play a significant role in minimising that shortfall, of course, but they will find it much harder to drive an effective net zero transition if their climate risk assessments are not up to scratch.
The good news is that the ECB’s findings do highlight progress is going in the right direction, with the risk guidance published last year revealed to be having some effect on the commercial banking system in Europe, albeit at a far slower pace that is needed. Moreover, the hope is that it is not yet too late to get a grip on these escalating risks. In the wake of its latest findings, the ECB has again called on banks to take “decisive action” to address the shortcomings set out in the report, noting that it has sent all institutions a personal feedback letter warning banks that they urgently need to set ambitious and concrete goals and timelines to mitigate their exposure to both existing and future environmental and climate risks.
But as always, the question is whether banks can and will rethink their approach before the risks begin to bite, and governments and the wider economy are forced to once again cope with the fallout.