Banks’ Climate Exposure and Sustainability Risk

The sustainability of financial activities has attracted significant attention on the part of policy makers and regulators on account of the pressing need to address the impact of climate change on banks’ activities. There is growing concern about the implications of environmental risks in banks’ business models, which show limitations in establishing a governance framework aimed to ensure compliance with climate reporting (Nieto 2018). Banks lack adequate methodologies and clear indicators for the assessment of environmental hazards: the absence of an international consensus on green investments creates information imbalances that limit the effectiveness of monitoring systems (Financial Stability Board 2022). Accurate estimation of banks’ climate exposures lowers the costs of tracking pollution emissions and contributes towards the mitigation of endogenous financial shocks arising out of climate damages. An important indicator is the environment, social and governance (ESG) factors elaborated by the Task Force on Climate-related Financial Disclosures (TCFD) which afford a benchmark for firms’ business strategies on climate change and sustainability.

A worldwide forum of global regulators significantly contributed to the classification of climate change and sustainability risks in the banking and finance sector. The TCFD provides guidance to corporations for the reporting of climate change implications for investment decisions. The TCFD aims to standardise the reporting requirements of climate change by issuing a set of voluntary recommendations to be incorporated in companies’ business models and regulatory monitoring process. The recommendations are articulated in such a way as to stimulate companies to measure climate exposures through detailed financial indicators applicable to internal corporate controls. It is recommended to disclose the models and data used to assess and manage relevant climate risks so as to make it easier for participants to acquire information about the potential vulnerabilities of a given company’s management and oversight by the board.

The TCFD expands the regulatory policies of the United Nations Framework Convention on Climate Change and the Paris Agreement, which established a comprehensive agenda of ‘green targets’ to be attained through inclusive and sustainable practices.

Further improvements in climate change regulation are recorded at the EU level, where the Commission has adopted the Action Plan on Financing Sustainable Growth, which was followed by the Taxonomy Regulation, an innovative piece of legislation which provides for harmonisation of the climate and energy objectives set in the UN 2030 Agenda. However, the degree of flexibility allowed in the implementation of the EU initiatives raises doubts as to the successful achievement of the Plan which exhibits a number of gaps (absence of standardised climate data, lack of uniformed definitions of financial sustainability, high costs in gathering data) when it comes to establishing a taxonomy of sustainable investments. To address this gap, the Commission released a proposal for a Corporate Sustainability Reporting Directive (CSRD) to introduce more stringent requirements with regard to the reported social and environmental information. The CSRD aims to impose mandatory disclosure standards on sustainable activities to large companies (listed companies, large private companies, banks and insurance firms) and further clarify the element of ‘materiality’ for non-financial indicators. Specifically, the Commission’s proposal would increase transparency and accuracy of corporate reports by adopting assurance criteria for auditing sustainability information.

The European Banking Authority (EBA) seems to be taking the path of mandatory reporting in that it published an Opinion in favour of introducing a green asset ratio (GAR) for credit institutions as an indicator of their climate activities (EBA 2021a). Aligning information on banks’ climate exposure with the EU Sustainable Finance Disclosure Regulation should enhance common definitions of sustainability risk, sustainability factors and sustainable investment. The GAR should estimate the amount of assets which are environmentally sustainable and impose reporting duties with regard to financial investments related to climate change events. This proposal supports the recommendations published in the Paris Agreement and the EU ‘Green Deal’ in order to establish common key performance indicators for the risk management assessment process. The Opinion incorporates the policy guidelines published in the EBA Report on the scope of financial activities and exposures that should be covered by the proposed GAR, documenting to what extent these activities should be covered retroactively, or only those corresponding to the disclosure period, and identifying possible proxies as an alternative to the taxonomy (EBA 2021b). The EBA further engages in a pilot exercise to classify and measure climate risk factors using existing assessment tools: the objective is to test whether banks’ corporate exposures are aligned with the taxonomy criteria (EBA 2021c). Models for assessing the economic impacts of climate change have elaborated sophisticated stress-testing and scenario analysis approaches in order to formulate predictions of risk outcomes (Baudino & Svoronos 2021). Stress tests estimate the resiliency of financial institutions to potential adverse climate conditions: they are designed to assist regulators in measuring the societal impact of climate change.

In my view, market-driven strategies have characterised banks’ responses to environmental hazards, although the existing assessment processes face limitations when it comes to providing accurate predictions. Banks’ business models exhibited poor engagement with regulatory initiatives relating to long-term sustainable investments that require expedited organisational systems and effective measurement of climate data. Therefore, there is a need to identify a suitable modelling approach for assessing the material factors of climate change: different models have been proposed among regulators to predict potential losses stemming from climate risks. However, current methodologies for predicting exposures, namely scenario analysis, sensitivity analysis and stress tests, show weaknesses in relation to capturing climate data, which make the comparison of results meaningless. Data gaps, lack of clarity and the various ESG metrics in the taxonomy render climate risk measurement models inadequate to classify and differentiate environmental hazards, which in turn leads to discrepancies in the evaluation of financial losses.

The broader challenge is standardisation. Data is held in consistent formats, or at least translatable into consistent formats, across all institutions. Standardisation will include a variety of granular data: agreement and support by regulators of standardised representations of contracts will support greater efficiency in many aspects of regulatory reporting and oversight. Standardisation of data to improve accuracy and clarity in climate-risk reporting would highlight the lack of transparency in the disclosures but also the high degree of subjectivity as to what constitutes ESG performance. Improved standardisation would then help to facilitate the climate-risks assessment process among potential ESG investors, who would have access to transparent data to which to apply their own risk modelling and valuation techniques. A key area of climate disclosure that needs improvements and consistency is strategic resilience in banks’ business strategies. Considerable attention should be paid to enhancing this part of disclosure owing to lack of consolidation of global regulatory standards. 

Andrea Miglionico is Lecturer at the University of Reading, School of Law.