EBA Consults on Incorporating ESG into Risk Management and Supervision

Paper focuses on counterparty risks and climate change impacts for European investment firms and credit institutions.

The European Banking Authority (EBA) has published a new consultation paper in preparation for its final report on ESG risk management and supervision of investment firms and credit institutions.

Providing comprehensive proposals on how ESG factors and risks could be better included in the business models, governance, risk management, and supervisory frameworks for credit institutions and investment firms, the paper identifies common definitions of ESG risks and provides an overview of current evaluation methods.

The consultation paper follows the release of the EBA’s ‘Action Plan on Sustainable Finance’ last December, which outlines the authority’s deliverables and activities related to ESG factors and risks. The EBA’s actions are in line with the European Commission’s broader action plan, which calls on all three European Supervisory Authorities for the finance sector to provide guidance on how sustainability considerations can be effectively taken into account in relevant EU financial services legislation and help to identify existing gaps.

The consultation paper assesses both qualitative and quantitative criteria in regard to ESG risks in the short, medium and long term and elaborates on the mechanisms, strategies and arrangements currently implemented by institutions to identify ESG risk, and assess potential inclusion of ESG risks in review and evaluation processes.

Focusing mainly on the risks to which institutions are exposed via the impact of ESG factors on their counterparties, the paper places particular emphasis on risks stemming from environmental factors, including climate change. Ongoing progress and initiatives within this subject are also illustrated as part of a broader evaluation of ESG risk factors.

The EBA said there is a need to increase incorporation of ESG risks into firms’ business strategies and processes “and proportionally incorporating them into internal governance arrangements”. The authority says this is achievable partially though evaluating long-term resilience of institutions’ business models, setting ESG risk-related objectives and engaging with and considering the development of sustainable products.

“Adjusting the business strategy of an institution to incorporate ESG risks as drivers of prudential risks should be considered a progressive risk management tool, mitigating potential impact of ESG risks,” the EBA said. Methodologies and approaches to climate risk stress tests are also discussed within the paper, with the EBA stating a need to gradually improve development alongside methodological and data constraints.

With existing supervisory review processes potentially not sufficient in enabling supervisors to understand the longer-term impact of ESG risks on future financial positions and vulnerabilities, the paper also proposes enhancing existing supervisory reviews with ESG factors and introducing a new area of supervisory analysis and evaluation of long-term business model resilience .

Running until February 2021, the consultation includes a public webinar hearing, scheduled for November 26, 2020. Feedback received through the paper will inform the EBA final report on management and supervision of ESG risks and will be taken into account for the EBA’s ongoing work in fulfilling its legal mandates regarding ESG risks.

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