Pentti Hakkarainen of ECB Outlines Work Needed to Tackle Climate Risks

Mr. Hakkarainen classified the climate-related risks into physical and transition risks. Physical risks directly arise from a changing climate while the transition risks arise from the potential shift to a more sustainable economy. These risks are spread unevenly and are complex, chaotic, and non-linear. Transition risks are greater for some sectors and regions than for others. Moreover, the risks span "a very long time horizon" as these changes will happen over decades. However, the risk models used by banks and regulators cover much shorter time frames and this means that there might be blind spots. The 2019 risk map of ECB for the banking sector features, for the first time, climate risk as one of the key risks for the European banking sector. Nonetheless, more needs to be learned about these risks in terms of how to measure and  mitigate them. He also discussed the following items on the to-do list of banking supervision:

• First, there is the issue of “green” assets. These are generating some hype and demand is growing fast. However, the definition of green assets is unclear and "a common and precise definition" is needed. EC has made a proposal on defining sustainable assets, which is now being discussed. This proposal just classifies “green” assets though. To get the full picture, “brown” assets will also need to be classified.
• Second, climate risks need to be integrated into the supervisory framework. In this respect, EBA has the legal mandate to propose an approach. This proposal will focus on the Supervisory Review and Evaluation Process or SREP—the main tool of supervisors. Supervisors also need to think about how banks should disclose climate risks. Here, approaches differ across countries and need to be harmonized.
• Third, coming back to “green” and “brown” assets, their respective risks need to be better understood. It is risks that determine how supervisors and regulators treat these assets. EBA will work on this over the coming years.

These are just a few of the items on the to-do list. However, given the scope of the challenge and its complexity, no one can solve it alone. Regulators, supervisors, and central banks have joined forces in a Network for Greening the Financial System. This network comprises 42 members worldwide, including the ECB and eight observers. It is encouraging that so many institutions share a common understanding of these problems and have joined forces to come up with solutions. To understand the way banks approach climate risks, ECB recently surveyed a sample of banks. It was found that banks are very much aware of climate change. So far, they have approached the topic from the angle of corporate social responsibility, but they also see the need to approach it from the angle of risk management. In this area too, more work needs to be done.

Related Link: Speech

Keywords: Europe, EU, Banking, Climate Change Risk, Banking Supervision, SREP, Green Assets, EBA, ESG, ECB