Financial institutions and companies are facing mounting pressures from environmental organizations (activists, NGOs, etc.) to be more accountable for their actions. Besides, we have been witnessing the development of a new wave of European regulations (CRR2/CRR3, Green Taxonomy, SFDR, MIFID II, ESG, etc.) aimed at transforming economic activities toward a greener and a more sustainable economy, and to enhance the resilience of the financial sector against ESG risks in accordance with the European Commission’s Action Plan.

Therefore, the European Banking Authority (henceforth, EBA) stresses the necessity to enhance the incorporation of ESG risks into credit institutions’ and investment firms’ business strategies and processes. In this regard, the adjustment of the business strategy of those institutions to incorporate ESG risks as drivers of financial risks can be considered a progressive risk management tool to mitigate the potential impact of ESG risks (EBA, report 2021).

Consequently, credit institutions and investment firms are compelled to address ESG risks in an all-inclusive manner when incorporating them into their risk business strategies and building them into their management frameworks. This process includes adjusting business and risk strategies and corresponding risk appetite statements, making sure roles and responsibilities are fully transparent throughout all three lines of defense.

Being unprepared for such fast-moving ESG-related regulatory pressures, institutions as well as clients are feeling the burden of adapting to the mounting ESG-related regulatory inflation. Thus, they face significant challenges to fully embed ESG factors into their management systems and business strategies. Difficulties in collecting necessary information and data related to ESG risks, definition of comprehensible methodological approaches, and relevantly appropriate skills to perform the dedicated duties, are some of the numerous hurdles that institutions need to overcome.

Amid growing concerns about climate change along with scarcity of resources, considerable social mutations as well as significant related governance implications, there is an increasing pressure on the financial institutions to shift towards a greener and more sustainable finance model aiming at supporting sustainable economic activities. Therefore, sustainable finance seeks to integrate Environmental, Social or Governance (ESG) criteria into financial services to support the sustainable economy’s progress. In addition, it is admitted that ESG risks manifest through different transmission channels and can impact the overall risk exposure with a subsequent impact on the institutions’ capital and liquidity adequacy.

Thus, the EBA, in its recent Report on ESG Risks Management and supervision (2021), has recommended that credit institutions as well as investment firms consider sustainability and the risks stemming from ESG factors in their internal financial risks assessment framework and business strategies. The main purpose is to increase the financial actors’ awareness and transparency regarding the urgent necessity to mitigate ESG risks by implementing appropriate risk management systems, considering the uncertainty with regard to their valuation and pricing, as well as the longer- term nature of those risks. Besides, financial institutions (such as banks and investments firms) not merely face a reputational liability along with the potential financial risks associated with those ESG factors, but also have a moral duty to join in the growing efforts to cope with ESG risks. Therefore, they have been called into action to fine-tune their risk management frameworks and therefore build resilience against such risks. Furthermore– given the potential impact of sustainability on institutions’ entire value chains– the institutions are compelled to implement new ESG-related policies and setup appropriate regulatory frameworks by integrating the ESG risks into their business strategies, internal control, and governance.

Therefore, both institutions and supervisors should continue to develop their understanding and advance their identification and assessment processes related to social and governance factors, and gradually integrate related risks into the management and supervision of ESG risks. Thus, as more regulation around ESG risks looms, banking institutions ought to act accordingly by:

a)  reviewing their business strategies in relation to their clients;

b)  sharpening their brands and designing new sustainable products;

c)  defining new sustainability strategies as well as setting new targets and limits.

In this paper, we discuss the EBA’s proposals for a potential incorporation of ESG risks into financial institutions’ business strategies and risk management frameworks.

In 2015 the UN adopted the so-called the Global Goals, which includes 17 Sustainable Development Goals (SDGs) and 169 associated targets to be reached by 2030. The SDGs under the UN 2030 Agenda aim at ending poverty, protecting the planet, and ensuring peace and prosperity for all people. More than 190 governments have adopted the UN SDGs 2030 and committed to supporting further progress on sustainability, through a wide range of interconnected and cross-cutting economic, social and environmental objectives.

Accordingly, legislators in the European Union and around the world are taking quick action to change economic activities with significant adverse impacts on ESG factors. In this respect, it is believed that the financial sector is expected to play a crucial role in financing the transition to a greener and more sustainable economy in accordance with the EBA’s Action Plan. Thus, EU legislators encourage institutions(including credit institution and investment firms) to approach ESG risks from a strategic perspective.

Therefore, the banking regulatory provision for the incorporation of ESG factors and risks into institutions’ business strategies and procedures, the CRR 2/CRD 5, provide three important mandates for the EBA around sustainable finance:

1. In Article 98(8) of the CRR2/CRD 5 related to Pillar II, the EBA is called to assess the potential inclusion of ESG risks in the Supervisory Review and Evaluation Process (SREP) carried out by respective competent authorities in each State.

2. In Articles 434a and 449a of CRR 2 related to Pillar III, large institutions with publicly listed issuances are required to disclose information on ESG risks (under the EU taxonomy, including a proposal for a Green Asset Ratio/GAR), physical and transition risks as defined in the EBA report.

3. In the third mandate (Article 501c of the CRR2) related to Pillar 1 capital requirements, the EBA is mandated to assess whether a dedicated prudential treatment of exposures pertaining to assets or activities associated substantially with environmental and/or social objectives would be justified. Similar mandates are to be included in the IFR and IFD package.

ESG stands for Environmental, Social and Governance. ESG criteria help assess the consideration of the sustainable development and related long-term impacts in the strategy of economic players (companies, local authorities, etc.).

In this respect, it is important to note the difference between ESG risks and ESG factors. ESG risks comprise three pillars, whose definitions including some related indicators are given in the table below:

It is noted that the main drivers of environmental risks are physical risks and transition risks. The notion of transition risks encompasses all the risks related to the depreciation of assets due to policy, technological, and/or behavioral changes. Those are directly correlated with policy choices by governments and the expectations of key stakeholders, notably shareholders and customers. In other words, Transition risks are the risks of any negative financial impact on the institution stemming from the current or prospective impacts of the transition to an environmentally sustainable economy on its counterparties or invested assets.

These include:

• Climate and environment related policy changes: as a result of energy efficiency requirements, carbon- pricing mechanisms that increase the price of fossil fuels, or policies to encourage a sustainable use of environmental resources.

• Technological changes: if a technology with a less damaging impact on the climate or the environment replaces a technology that is more damaging, hence making it obsolete or uncompetitive.

• Behavioral changes: if the choices of consumers and investors shift towards products and services that are more sustainable; or if climate change impacts vulnerable industries such as agriculture or tourism.

In the context of climate risk, transition risks are identified through similar risk drivers such as:
• policy and legal risk
• technology risk
• market risk
• reputational risk.

Furthermore, physical risks involve all impacts of climate change which are liable to affect the financial performance of companies’ and institutions’ assets. For instance, credit institutions, insurance companies and funds that have outstanding loans or corporate stocks in the fossil fuel industries may experience decline in the value of their investments in the long run. The assessments of those risks can sometimes also cover the retail book (e.g. residential mortgages) of banks.

Methodological approaches for the identification and assessment of ESG risks

The challenge for financial institutions like banks and investment firms remains how to incorporate ESG risks in their risk management framework and then manage them properly. What are the appropriate approaches and indicators needed to identify and assess those risks, given their broadly multi-sectoral characteristics, and the dearth of related data, comprehensive approaches, and management tools?

As the EBA has pointed it out, there are a growing number of challenges facing institutions regarding the incorporation of ESG risks into their business strategies:

• The growing wave of ESG-related regulation, which poses numerous challenges for institutions in setting up comprehensible standardized frameworks and methodological approaches to ESG risks.

• Coping with the level of uncertainty regarding the materiality and the effects of those risks.

• Dearth of good quality ESG data (the scarcity of relevant, comparable, reliable and user-friendly related data):The issue of access to non-financial data represents one of the main challenges in the implementation of directives related to sustainable finance, mainly those related to ESG risks.

• Methodological constraints, where the existing risk management methodologies based on historical data assess risks by computing risk parameters such as the probability of default (PD) or loss given default (LGD), without providing any ground to ESG factors.

• Time-horizon mismatch between existing management tools and the timeframe for the materialization of ESG risks.

• Multi-point impact of ESG risks on institutions through different financial risk categories (e.g. credit risk, market risk, capital and liquidity adequacy, etc.) and the non- linearity of the effects of most those risks.

Regarding methodological approaches for assessing and evaluating ESG risks, to date, most of the work has been done in the area of climate risk, while

other ESG factors have been left out. Therefore, three different risk-based methods are proposed for the identification and evaluation of ESG risks, necessary for the incorporation of those risks into institutions’ decision-making processes:
1) Portfolio alignment method
2) Risk framework method (including climate-stress test)
3) Exposure method

The risk-based approach should consider the likelihood and the severity of the materialization of risks, since ESG risks materialize through their impact on financial risk categories.

These aforementioned methods (table 2) can be used in the context of both exposure origination and existing portfolio monitoring, albeit to varying degrees, as shown in the figure below:

Managing ESG risks is a complex task , fraught with considerable uncertainty. Given the consistency of Basel III reforms with other EU policies (ref. European Commission’s Action Plan: Financing Sustainable Growth,2018)the potential incorporation of ESG-related risks into institutions’ business strategies has gained increasing momentum. Moreover, with the recognition of those risks and the incorporation of ESG elements in the prudential framework, this initiative complements the EU’s broader strategy for a more sustainable and resilient financial system (ref. Basel III reform/CRR3, Oct 2021).Therefore, the EBA aims to enhance the full incorporation of ESG risks by supervisors and institutions in their business strategies, internal governance arrangements and risk management frameworks in the short, medium, and long run.

In this regard, the EBA has presented some proposals on how institutions can embed ESG risks into their governance and risk management. Accordingly, the ESG-related risks should be factored into the institutions’ strategies and operations through three main elements where the incorporation of the ESG risks is seen as essential:

1) ESG risks in business strategies and processes

The incorporation of ESG risks into institutions’ business strategies and processes is not without challenges and has significant implications for banks and investment firms in terms of transformation of their business models as well as organization. Accordingly, the implementation by the institutions of the whole set of ESG-related regulatory frameworks along their entire value chains should take into consideration the following factors, as shown in this figure (ref. source: EBA Report, 2021 ):

a) Monitoring the changing business environment and evaluating long-term resilience;

b) Setting ESG risk-related strategic objectives and/or limits;

This refers to the determinations aiming at managing the institution’s exposure to ESG risks, over the short, medium and long-term time horizons ”. Those strategies include the definition of related key performance indicators, in accordance with the institution’s risk appetite while considering the size, nature and complexity of their activities. Institutions should seek to complement qualitative ESG risk- related objectives and/or limits with quantitative ones on the progressive availability of data.

c) Engaging with counterparties and other relevant stakeholders;

The engagement policy of the institutions should take into consideration at least two main perspectives, namely:

(1) the internal perspective: referring to the capacities and expertise of an institution needed to understand the business models of its counterparties and the impact of ESG factors on these;

(2) the external perspective: denoting how an institution can interact with borrowers, investee companies, and possibly other stakeholders (e.g. academia) to mitigate ESG risks for the institution that originate from these stakeholders.

d) Considering the development of new sustainable products.

Generally, financial institutions offer a wide range of financial products to their clientele. In the matter of sustainability, in addition to the products and services that meet customers’ expectations, credit institutions and investment firms are summoned to adapt their portfolio in a timely manner to reduce ESG risks, which poses a new set of challenges for institutions. The urgency is to develop sustainable products deemed to be more resilient to ESG risks. Therefore, according to EBA, institutions having set portfolio alignment with ESG international or EU objectives as a strategic ESG risk-related objective could increase their share of sustainability-linked loans or bonds linked to sustainability standards, such as the EU taxonomy. More precisely, the range of identified sustainable products may encompass, for instance:

• Green loans: Originating or developing green and energy-efficient mortgage loans; environmentally sustainable credit facilities; green commercial building loans; green automotive loans with high fuel efficiency; green credit or debit cards; and other types of green loans for retail customers including households, corporate, and sovereigns. In this respect, the Green Loan Principles sets up four key components: (a) the use of loan amounts for verifiable environmental benefits that must be quantifiable by the borrower, (b) the process of evaluation and selection of projects, (c) the management of funds including tracking, and (d) reporting.

• Green bonds: In accordance with the Green Bond Standards, these are built around four key components: (1) use of proceeds, (2) process for project evaluation and selection, (3) management of proceeds, and (4) reporting.

• Social products such as ‘social loans’ and ‘social bonds’, which aim to finance activities with positive social outcomes.

• Sustainable securitization: Collateralizing ‘green’ exposures on the balance sheet or collateralizing any exposures on the balance sheet in order to use the proceeds or freed-up capital for investments in ‘green’ assets.

1) ESG risks in institutions’ internal governance

The successful incorporation of ESG risks into institutions’ internal governance should include the full involvement of the management body in establishing a risk culture and setting the risk appetite and the implementation of a robust internal control framework. Thus, institutions will have to build on the current framework the proper specifications to ensure an internal governance framework that enables them to manage ESG risks, pertaining to the management body and committees, internal control framework, and remuneration.

2) ESG risks in the risk management framework

Unquestionably, active ESG risk management is fundamentally crucial to identify such risks in a timely manner and respond in a proper way. In this respect, the EBA suggests an incorporation of ESG risks into institutions’ risk management based on the following relevant aspects:

a) Risk appetite, risk policies, and risk limits

In this regard, institutions are expected to embed material ESG risks in their risk appetite frameworks. That should include not only a description of the risk appetite, tolerance levels, thresholds and limits set for the identified material risks, but also describing how the risk indicators and limits are allocated within the banking group, different business lines and branches. It also involves setting out appropriate policies and procedures as well as criteria for the assessment of the repayment capacity and creditworthiness of counterparties, taking ESG factors and ESG risks into account.

In this regard, the institution’s credit risk appetite should encompass:

• Specification of the scope and focus of the credit risk exposition;

• Composition of the credit portfolio, including its concentration and diversification objectives in relation to business lines, geographies, economic sectors, and products;

• Implementation of the credit risk appetite should be supported by appropriate credit risk metrics and limits: client segments, currency, collateral types, and credit risk mitigation instruments;

• Credit metrics: combination of backward-looking and forward-looking indicators in accordance with the business model, business lines, and units bearing credit risk;

• Managing concentration risk: setting out quantitative internal credit risk limits for aggregate credit risk, portfolios with shared credit risk characteristics, sub-portfolios, and individual borrowers’ consolidated and sub-consolidated position.However, the main question remains– given the pace with which ESG-related regulations are moving and all the uncertainty around that subject– do the financial institutions have enough time and relevant resources to efficiently implement all the ESG-related policies? Next, the challenges are evident, ranging from appropriate methodologies and availability of relevant data to proper skills and ESG risk culture, in credit institutions as well as investment firms. Considering all those factors, wouldn’t this encourage or lead to further green washing behavior?

b) Data and methodological approach

Regarding data and methodology, the main challenge institutions face is to collect necessary information and data related to ESG risks associated with counterparties at the loan origination phase. Next, they will have to review and update this information throughout the lifecycle of the transaction, where and when needed.

c) Risk measurement, monitoring, and mitigation

Currently, ESG risks measurement appears to be a very tedious task due to the lack of reliable data, relevant comparable indicators, and proper methodologies.

This phase also requires the development of risk monitoring metrics at exposure-,counterparty- and portfolio-level , categorizing them according to their ESG characteristics and risks associated with these, according to their size and complexity.

Thus, the EBA recommends that institutions manage ESG risks as drivers of financial risks within their current risk management frameworks, in coherence with risk appetite, and as reflected in both ICAAP and ILAAP frameworks. Meanwhile, they should take into consideration the relevance of ESG-related impacts on their business lines when designing scenarios for recovery and mitigation planning processes.

d) The phase of testing resilience to ESG risks

The testing phase encompasses the climate risk stress testing framework for banks, which is still at an very early stage. Institutions are still learning the main ESG-related practices and face challenges in the implementation of a climate risk stress test framework.

According to the EBA, the core challenges relating to data availability should be alleviated by the gradual development of such data, methodologies, and approaches. Developing relevant ESG-related data and fitting methodologies is crucial to(1) support the setting of ESG risk-related strategic objectives and/or limits, and (2)test the long-term resilience of institutions to the long-term negative impacts of environmental, social and governance factors. Once these methodologies and approaches are sufficiently tested, they will provide institutions with additional inputs into the assessment of their ICAAP and ILAAP. Therefore, to successfully build ESG-related testing capabilities, institutions should build their related data infrastructures, according to their size, complexity, risk and business profile. That will facilitate the successful performance of the testing phase and cover all material risk factors.

To sum up, ESG risks, encompassing climate and transition risks, are evident and should be taken into consideration while managing risks.ESG risks have gained momentum this last decade – especially with Europe leading the game with large set of regulations, while awaiting global guidelines pertaining to the management of ESG risks. ESG risks are, in addition, understood to be drivers of traditional financial risks, which is an important step towards more coordinated actionable decisions for a greener economy. Thus, financial institutions should prepare to be able to capture the risks associated with ESG factors when they account for them in their risk appetite and apply their risk management frameworks with appropriate and accurate risk metrics and limits.

In this context, managing the ever-changing ESG risks (including climate and transition risks) implies that institutions must develop ESG-sensitive solutions intending to assist in collecting relevant data, defining proper methodologies to identify and assess ESG risk exposures, for reporting disclosures supporting business decisions. In addition, ESG risks may pose a real test for institutions mainly in the area of credit and counterparty risk, in all stages of the process from granting to monitoring, as they are susceptible to impact the main credit parameters, such as:

• PD: An increase in the PD of vulnerable counterparties can be triggered.

• Exposure at Default (EAD): Counterparties subject to physical risk might need to draw more from their committed credit lines to respond to sudden shocks, like floods.

• LGD: (1) in a transition scenario, decrease of value of stranded assets, lower collateral values; (2) in a default scenario, lower recovery values.

Furthermore, reliable and good quality data along with appropriate skills capable of managing those risks are among the top challenges faced by businesses (including financial institutions).Hence, the EBA has suggested that the institutions should use loan origination as a crucial phase to collect the necessary ESG-related information and data associated with the different elements of the transaction, such as the product itself, collateral, counterparty, etc.

However, considering all the challenges surrounding ESG risk management and the pace with which the ESG-related standardized requirements (from the EBA and European Securities and Markets Authority, ESMA) are moving, there are heightened debates on whether credit institutions and investment firms are ready to fully implement the ESG risk requirements into their business strategies and properly manage those risks.