BIS published the remarks of ECB President (Christine Lagarde) and the Bank of Italy Governor (Ignazio Visco) at the launch of the "COP26 Private Finance Agenda" for the 26th UN Climate Change in London. Additionally, in February 2020, the ESMA Chair Steven Maijoor delivered a keynote address on sustainable finance issues at the European Financial Forum in Dublin. Ms. Lagarde highlighted that the Eurosystem is reviewing the extent to which climate-related risks are understood and priced by the market and is paying close attention to how credit rating agencies incorporate such risks into their assessments of creditworthiness.
The ECB President Christine Lagarde added that the ECB Banking Supervision is assessing the approaches of banks to climate risks and is developing supervisory expectations on those risks. Preparatory work is also under way for a macro-prudential stress test to assess climate-related risks, with the first results expected by the end of the year. The stress test framework aims to assess how climate-related risks propagate through the real economy and the financial system. The stress test will draw on granular information, possibly including geographical location and carbon footprint, and focus on 90 significant institutions across the euro area. It will also, at some stage, model how dynamic interactions can amplify the effects. With respect to addressing these risks, she emphasized on the following:
- Banks need to consider the risks such events create for their credit exposures. Losses can arise from both direct damage and from the effects that potentially higher maintenance costs, disruption and lower labor productivity could have on profitability and hence default risk.
- Intervention by public authorities through regulation and taxation is certainly required to achieve the transition to a carbon-neutral world. Early and coordinated action can help deliver a smooth transition for the economy.
- It is vital for financial institutions to understand the risks on their balance sheets. Greater disclosure by companies on their climate exposure is a prerequisite, bolstering the ability of market participants and financial institutions to carry out appropriate risk assessment. Disclosures by financial institutions suggest that there is some way to go. Recent analysis of the 12 largest banks and 14 largest insurers in the euro area shows that a majority disclose the impact of their business travel, commuting, and other energy usage. Yet most of their exposure to climate-related risk is likely to stem from their financial activities. Only 5 out of the 26 partially disclose the impact of their financial assets, and none of them provide full disclosure.
The Governor of the Bank of Italy, while speaking at the launch event for COP26 in London, stated that the financial sector can be key in influencing the transition to a zero-emissions economy and central banks may play their part. Among other issues, he discussed the problems related to Environmental, Social, and Governance (ESG) scores, as currently there are neither globally accepted rules for ESG data disclosure by individual firms, nor agreed auditing standards to verify the reported data. Moreover, intrinsic difficulties exist in deciding which indicators are relevant in assigning an ESG score (how we should evaluate, for example, the “social” component of the score), especially when compared to financial aggregates, where the most important indicators, such as revenues, costs, earnings, and cash flows, are all widely available auditable items.
The Governor of Bank of Italy added that ESG scores of individual firms differ greatly across rating agencies if compared, for example, with credit ratings. The studies find that the correlation between the ESG scores assigned to the euro-area listed companies by three of the main providers ranges from 40% to 60%, compared with a correlation between credit ratings that is over 90%. There is also evidence of biases in ESG scores, which tend to overrate companies that are larger and belong to specific industrial sectors and geographic regions. The lack of disclosed data and the lack of disclosure standards prevent ESG-score providers from correctly assessing the sustainability of business practices. In Europe, a directive requires large companies to provide information on the way they operate and manage environmental and social challenges; this directive applies to approximately 6,000 companies with more than 500 employees. The importance of this issue, however, warrants further public action for small and medium enterprises and, especially, for enhancing the standardization of data for all firms.
Earlier, in February, the ESMA Chair spoke at the European Financial Forum 2020 in Dublin, about translating changing risks and investor preferences into regulatory action. Mr. Maijoor emphasized the importance of rigorous and standardized ESG information at a global level, in addition to discussing issues related to greenwashing risk and ESG ratings:
- He said that financial firms, need to be transparent on the ESG profile of the investments they make on behalf of their clients. ESMA is conducting regulatory efforts to codify—together with EIOPA and EBA—what is required when these firms market products claiming to have ESG characteristics and on how to account for the adverse impact of their investments. The introduction in European law of the requirement for financial firms to disclose principal adverse impact of their investment decisions on the environment is a ground-breaking transparency initiative. ESMA will launch a public consultation on this by the end of this quarter on the specific disclosure requirements and look forward to your feedback.
- He also mentioned that ESG ratings are becoming increasingly important but the level of public scrutiny and supervision of them is far from optimal. The lack of clarity on the methodologies underpinning those scoring mechanisms and their diversity does not contribute to enabling investors to effectively compare investments which are marketed as sustainable, thus contributing to the risk of greenwashing. He believes that, where ESG ratings are used for investment purposes, ESG rating agencies should be regulated and supervised appropriately by public-sector authorities.
- Furthermore, the co-existence of multiple disclosure standards and frameworks requires consolidation, to achieve, in the medium-term, a single set of standards which will also be the basis for digitalization of ESG information. Given the global reach of the challenges posed by the transition to sustainability, Europe can play a leading role in promoting this consolidation at international level. The European Commission’s international platform on sustainable finance can help launch such a consolidation process and create the basis for European standards that are truly international.
- ECB President on Climate Change
- Bank of Italy Governor on Transition to Net Zero
- ESMA Chair on Sustainable Finance
Keywords: Europe, EU, Italy, Banking, Insurance, Securities, ESG, Climate Change Risk, Sustainable Finance, ESG Scores, ESG Ratings, Disclosures, Credit Rating Agencies, Stress Testing, ECB, ESMA, Bank of Italy, COP26, BIS
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