Preparing for 'perfect storms': EBA publishes consultation and survey on ESG risks

On 18 January 2024, the European Banking Authority (the EBA) published a public consultation on draft guidelines for the management of ESG-related risks. 

The EBA notes that ESG-related risks are causing significant adverse impacts on the financial sector. The draft guidelines are aimed at setting mandatory standards for internal processes and ESG risk management for institutions, including principles for institutions' plans in line with the EU Capital Requirements Directive (the CRD6).

Legal background

The guidelines have been developed to address the mandate set out in the CRD6 (notably Article 87(a)(5) of CRD (a), (b) and (c). Mandate (d) will be addressed through subsequent EBA work relating to climate related scenarios).  A new Article 87a has also been included in the CRD6, according to which competent authorities shall ensure that:

• institutions have robust strategies, policies, processes and systems for the identification, measurement, management and monitoring of ESG risks over the short, medium and long term; 
• those strategies, policies, processes and systems shall be proportionate to the scale, nature and complexity of the ESG risks of the business model and scope of the institution’s activities, and consider short, medium and a long-term horizon of at least 10 years.
• institutions test their resilience to long-term negative impacts of ESG factors, both under baseline and adverse scenarios within a given timeframe, starting with climate-related factors; and
• they assess and monitor developments of institutions’ practices concerning their ESG strategy and risk management, including the plans, quantifiable targets and processes.

To align stakeholders' understanding of ESG risks, Article 4 of the CRR sets out definitions of: ESG risks, environmental risk, physical risk, transition risk, social risk and governance risk. The CRD6 has been amended to make it compulsory for credit institutions to consider short, medium and long-term horizons of ESG risk in relation to their internal capital needs and internal governance. Furthermore, the CRD6 requests that institutions' management bodies develop concrete plans to address ESG risks.

The 53-page EBA public consultation invites views on guidelines that seek to specify: (a) minimum standards and reference methodologies for the identification, measurement, management and monitoring of ESG risks; (b) the content of transition plans to be prepared in accordance with the CRD6, which shall include specific timelines and intermediate quantifiable targets and milestones to monitor and address financial risks originating from ESG factors; and (c) qualitative and quantitative criteria for the assessment of the impact of ESG risks on the risk profile and solvency of institutions in the short, medium and long term.

Prudential (transition) plans

The EBA notes that the aim of prudential plans is not to mandate institutions to divest from carbon intensive sectors, but to stimulate institutions to reflect on technological, business and behavioural changes driven by the sustainable transition as well as risks and opportunities, thereby preparing or adapting accordingly. Given the amount of resources the EU has directed towards ESG considerations and the increasing urgency of sustainability issues, some may view this 'softly-softly' approach as surprisingly academic or idealistic.

The EBA seeks comments on:

• its understanding of the plans required by the CRD6; and
• the articulation of such plans and other ESG-related EU requirements, namely the EU Corporate Sustainability Reporting Directive and the EU Corporate Sustainability Due Diligence Directive.

Given the focus on transition plans more widely, under the CSRD and CSDDD for example, the prudential plans are slightly distinct in nature and are aimed at preparing and adapting to the transition. Firms will however be keen to consider the distinction between the prudential plans and transition plans under other legislation. 

The E, the S and the G

The EBA acknowledges that the guidelines have a focus on environmental risks (the 'E' in ESG) and by contrast set certain minimum requirements in relation to other ESG risks. It recognises that institutions are typically more sophisticated in their measurement and evaluation of climate-related risks and notes that it is crucial for institutions to develop practices in relation to other environmental risks and other ESG risks.

The EBA: 

• invites comments on its approach regarding the consideration of climate, environmental, social and governance risks; and
• asks whether, from a risk management perspective, there is a need for further guidance on handling interactions between various types of risks.

Measurement and assessment principles

The draft guidelines state that institutions' procedures should provide for a combination of methods, including the below, and put these together in a way that allows comprehensive assessment across time horizons:

• Exposure-based: Assessing the exposure of counterparties' activities and key assets to ESG factors and the appropriateness of mitigating factors. This could feed into a short-term view;
• Portfolio-based: Assessing the degree of alignment of institutions' portfolios with targets, including climate-related sustainability targets. This could feed into a medium-term view; and
• Scenario-based: Performing climate / environmental scenario-based analyses – to be further set out in future EBA guidelines. This could feed into medium- and long-term views.

The EBA asks for comments on the measurement and assessment principles as well as the methodologies.

ESG risk methodology survey

On 29 January 2024, the EBA also launched an industry survey to gather information on: (i) credit institutions' methodologies for classifying exposures to ESG risks and; (ii) the accessibility and availability of ESG data for such purpose. The survey is aimed at collecting qualitative information on credit institutions' practices, which is relevant to the EBA's exploration of the workability of introducing a standardised methodology to identify and qualify exposures to ESG risks.

The survey consists of the following six sections:

• general information about the participating credit institution;
• general information on the methodology used for the identification of ESG risks and (where relevant) the qualification of exposures subject to them;
• exposures to non-financial corporates;
• exposures to non-retail small and medium-sized enterprises (SMEs);
• exposures to retail SMEs; and
• exposures to households.

The survey is open until 29 March 2024.

Next steps

The consultation is open until 18 April 2024.

In-scope institutions may wish to take the opportunity to provide input on the consultation and/or the survey so as to shape the EBA's approach to ESG risks. It is anticipated that the guidelines will be finalised by the end of 2024. The effective date will depend on the effective date of the CRD6.

UK institutions – not in scope - may want to consider how they assess ESG risks in their risk management frameworks and whether transition plans are appropriate for them.