EBA published a discussion paper that sets out a comprehensive proposal on how environmental, social, and governance (ESG) factors and risks could be included in the regulatory and supervisory framework for credit institutions and investment firms. The Capital Requirements Directive (CRD) 5 and the Investment Firm Directive (IFD) mandate EBA to develop a report assessing the potential inclusion of ESG risks in the review and evaluation performed by competent authorities and elaborating on the arrangements, processes, mechanisms, and strategies to be implemented by institutions to identify, assess, and manage ESG risks. The purpose of this discussion paper is to present the understanding of EBA on the relevance of ESG risks for a sound functioning of the financial sector and to collect stakeholder feedback with a view to further informing the report of EBA. The comment period for this discussion paper ends on February 03, 2021 and the report is expected to be delivered in June 2021.
The discussion paper elaborates on the relevance of ESG risks for the financial sector and provides a uniform definition of ESG factors and ESG risks, including definitions of physical risks and transition risks as the main transmission channels for environmental risks. The discussion paper includes proposals for common definitions of ESG risks to credit institutions and investment firms as risks that stem from the current or prospective impact of ESG factors on its counterparties. In the discussion paper, ESG factors and ESG risks are identified and explained, giving particular consideration to risks stemming from environmental factors and especially climate change, reflecting ongoing initiatives and progress achieved by institutions and supervisors on this particular topic over the recent years. Social and governance factors are also included in the analysis, in accordance with the EBA legal mandates, and the paper explores why and how these factors can also be sources of risk for institutions. The paper also defines, elaborates, and presents examples to substantiate the relevance of ESG risks for the financial sector. One example is also dedicated to social impact triggered by the COVID-19 pandemic. As a third transmission channel for ESG risks, this discussion paper also identifies liability risks as the financial risks stemming from the exposure of institutions to counterparties potentially held accountable for the negative impact of their activities on ESG factors.
The paper also presents a non-exhaustive list of quantitative and qualitative definitions, indicators, and metrics for a non-exhaustive list of ESG factors, together with a description of several tools and methodologies that can support the identification, evaluation, and assessment of ESG risks, namely the alignment method, risk framework method, and the exposure method. The methods may be used to better understand and compare the interaction of ESG risks in given exposures and portfolios. Together with the progress made in the definition of common taxonomies (like the EU Taxonomy Regulation), these analytical tools can help overcome some of the challenges for the assessment of ESG risks. The discussion paper argues that the impact of ESG risks materializes in the form of existing prudential risks (such as credit risk, market risk, operational risk). After presenting the rationale for the incorporation of ESG risks in the institution’s business strategy and business processes, the paper includes several policy recommendations regarding the way in which institutions can embed ESG risks in their internal governance and risk management frameworks in a proportionate manner. Finally, the paper elaborates on the effective way to proportionately reflect ESG risks in the supervisory review for credit institutions and makes several policy recommendations in this respect.
Comment Due Date: February 03, 2021
Keywords: Europe, EU, Banking, Securities, COVID-19, ESG, Climate Change Risk, CRD5, IFD, Basel, Proportionality, Sustainable Finance, EBA
Dr. Denton provides industry leadership in the quantification of sustainability issues, climate risk, trade credit and emerging lending risks. His deep foundations in market and credit risk provide critical perspectives on how climate/sustainability risks can be measured, communicated and used to drive commercial opportunities, policy, strategy, and compliance. He supports corporate clients and financial institutions in leveraging Moody’s tools and capabilities to improve decision-making and compliance capabilities, with particular focus on the energy, agriculture and physical commodities industries.
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