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    EC Study Endorses Faster Integration of ESG into Bank Risk Management

    August 27, 2021

    The European Commission (EC) published a report on the study that explores the development of tools and mechanisms for integration of environmental, social, and governance (ESG) factors into the prudential framework as well as into the business strategies and investment policies of banks. Findings show that ESG integration is at an early stage and the pace of implementation needs to be accelerated to achieve effective ESG integration. To support this acceleration, enhancements are required on ESG definitions, measurement methodologies, and associated quantitative indicators. Data inadequacy and common standards remain key challenges to be overcome to drive ESG integration. Cross-stakeholder collaboration, along with the supervisory initiatives and guidance, is expected to be critical in addressing these challenges.

    This study serves as one of the multiple inputs that will inform the workstream for the implementation of the EC Action Plan on Sustainable Finance and considers other ongoing initiatives in the context of ESG. The Financial Markets Advisory Group within BlackRock prepared this report on the study, which was conducted on behalf of EC. The study is relevant for stakeholders such as banks, supervisors and regulators, certain international organizations/fora, civil society organizations, academics, associations, and data and ratings provider. The study analyzed the key elements of integration of ESG risks into EU banks’ risk management processes and these elements are ESG risk definition and identification; ESG risk governance and strategy; ESG risk management processes and tools; and ESG risk reporting and disclosure. The report outlines challenges and enabling factors associated with the development of a well-functioning EU market for green finance and sustainable investment. The study identifies a range of best practices for integration of ESG risks into prudential supervision as well as into risk management processes, business strategies, and investment policies of banks and presents the following findings:

    • Banks and supervisors should work to develop coherent definitions of ESG risks and consider the double-materiality perspective. The definitions should consider the double-materiality perspective and be continually reviewed and should consist of a granular list of underlying factors under each of the ESG pillars and create a common framework for the understanding of such risks while allowing for geographic or business model related idiosyncrasies. 
    • Many stakeholders demand that banks and supervisors should develop ambitious, publicly stated ESG risk strategies with measurable objectives, priorities, and timelines. Banks and supervisors will need to develop internal capabilities, requiring ESG related training, methodologies, and data to implement these strategies. In addition, ESG key performance indicators (KPIs) could be included in managerial incentives.
    • Banks should make significant efforts to enhance data quality, availability and comparability, and infrastructure improvements. Banks can develop interim proxies and additional ESG data can be sourced from third parties and through client questionnaires. These exercises should be supported by supervisors.
    • The approaches to measure exposure to ESG risks, such as stress testing and scenario analysis, should be further refined through more market collaboration and the development of dedicated methodologies. The number of scenarios should be increased and scenarios should be sufficiently ambitious and granular to standardize approaches and enhance comparability of results. Regardless of involvement in supervisory exercises, banks should conduct internal climate scenario analysis to deepen their understanding of climate-related risks. Many stakeholders indicated that supervisors should conduct regular, mandatory climate stress tests for banks to assess vulnerabilities and foster capability building. 
    • Where possible, ESG risks should be integrated in risk management frameworks through quantitative approaches. This includes the introduction of quantitative KPIs in the risk assessment framework.
    • The identification of portfolio-related quantitative KPIs is a key requirement for furthering ESG integration into risk management and credit processes. This should be pursued through mandatory regulatory and legislative measures, such as the recent proposal for a Corporate Sustainability Reporting Directive (CSRD)—which would amend existing Non-Financial Reporting Directive (NFRD) reporting requirements—as well as through stronger adherence to market initiatives. Such measures should adhere to the proportionality principle. Regulatory developments, such as those related to the EBA mandate on Pillar 3 disclosures, should be closely observed by banks and supervisors. Supervisors should encourage disclosure of ESG risks ahead of the effective date, in particular for climate-related risks.
    • To help address data challenges, definition of common technical standards (via regulation) on ESG data collection requirements for banks. The definition and implementation of such standards could support the assessment and understanding of ESG risks in the banking sector and, hence, the resilience of supervised institutions against ESG-related risks, in line with the prudential objectives. These instruments could also include mandatory reporting of ESG indicators and metrics. 
    • To harmonize ESG product classification, compliance with certain standards, such as the EU Green Bond Standard or the EU Taxonomy, could be made compulsory. This could improve the consistency of product offering observed in the market and mitigate the risk of greenwashing, while the application of an expanded taxonomy could also increase harmonization of disclosure of ESG activities.
    • Measures aimed at increasing accountability at executive and board levels could be introduced. This could mean encouraging banks, including at executive and board levels, to take responsibility for alignment of their ESG strategies with international agreements and initiatives.

     

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    Keywords: Europe, EU, Banking, ESG, Climate Change Risk, Sustainable Finance, Reporting, NFRD, CSRD, Stress Testing, Scenario Analysis, Disclosures, Data Gaps, EC

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