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EBA REPORT

ON MANAGEMENT AND SUPERVISION OF ESG

RISKS FOR CREDIT INSTITUTIONS AND

INVESTMENT FIRMS

EBA/REP/2021/18

EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

List of figures 4

List of tables 5

Glossary 6

Abbreviations 8

Executive summary 10

1. Background and rationale 14

1.1 Structure of the report 19

2. Common definitions of ESG factors, ESG risks and their drivers and transmission channels 22

2.1 Definition and general features of ESG factors 27

2.2 Definition of ESG risks 32

2.3 Environmental factors and environmental risks 34

2.3.1 Environmental factors and environmental risks 34

2.3.2 Physical risk 36

2.3.3 Transition risk 38

2.3.4 Interaction between physical and transition risks 42

2.4 Social factors and social risks 43

2.5 Governance factors and governance risks 47

3. Quantitative and qualitative indicators, metrics and methods to assess ESG risks 50

3.1 Quantitative and qualitative indicators for the identification of ESG risks 55

3.2 Methodological approaches for assessing and evaluating ESG risks 61

3.2.1 Portfolio alignment method 62

3.2.2 Risk framework method 66

3.2.3 Exposure method 71

3.2.4 Comparison of methods and their application 75

4. Management of ESG risks by institutions 80

4.1 Business strategies and business processes 82

4.1.1 Current practices 84

4.1.2 Monitoring the changing business environment and evaluating long-term resilience 87

4.1.3 Setting strategic ESG risk-related objectives and/or limits 89

4.1.4 Engaging with counterparties and other relevant stakeholders 91

4.1.5 Considering the development of sustainable products 93

4.2 Internal governance 97

4.2.1 Current practices 97

4.2.2 Management body and committees 99

4.2.3 Internal control framework 101

4.2.4 Remuneration 103

EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

3 4.3 Risk management framework 106

4.3.1 Current practices 106

4.3.2 Risk appetite, risk policies and risk limits 110

4.3.3 Data and methodology 113

4.3.4 Risk measurement, monitoring and mitigation 117

4.3.5 The climate risk stress testing framework for banks 119

(i) Main challenges of a climate risk stress test framework 119 (ii) Main practices for climate risk stress test 120

4.4 Specific considerations for investment firms 124

5. ESG factors and ESG risks in supervision 128

5.1 Scope of supervisory review in the CRD and the IFD 129

5.2 Main links between ESG factors, ESG risks and supervisory review 130

5.3 ESG risks in business model analysis 132

5.3.1 Business environment and long-term resilience 133

5.3.2 Understanding the current business model from an ESG risks perspective 134

5.3.3 Analysis of the strategy and financial plans 135

5.3.4 Assessing business model viability and sustainability 136

strategy 137

5.4 Internal governance and institution-wide controls 139

5.4.1 Overall internal governance framework 139

5.4.2 Management body, corporate and risk culture 140

5.4.3 Remuneration policies and practices 141

5.4.4 Internal control framework 141

5.4.5 Risk management framework 141

5.4.6 Information systems 142

5.5 Assessment of risk to capital 143

5.5.1 Assessment of credit and counterparty risk 143

5.5.2 Assessment of portfolio credit quality (with focus on loan origination) 145

5.5.3 Assessment of market risk 146

5.5.4 Assessment of operational risk 147

5.5.5 Risk identification, measurement, monitoring and reporting of social and

governance risks 148

5.6 Assessment of risks to liquidity and funding 148

5.7 SREP capital assessment 150

Annex 1 Non-exhaustive list of ESG factors, indicators and metrics 152 Annex 2 Feedback received on the Discussion Paper and main changes in the report 163 EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

Figure 1 Main content of this report 21

Figure 2 Commonalities of ESG factors 28

Figure 3 Visualisation of the relationship between institutions and ESG factors through the outside-in and inside-out perspecives 30 Figure 4 Summary of ESG risk drivers, their transmission channels and how these can impact financial risk categories 34 Figure 5 Theoretical example on the ESG cycle: impact of environmental factors through physical risk on credit institutions' balance sheets and investment firms' balance sheets 37 Figure 6 Theoretical example on the ESG cycle: impact of environmental factors through transition risk on credit institutions' balance sheets and investment firms' balance sheets 40 Figure 7 Theoretical example on the ESG cycle: impact of social factors on institutions' balance sheets 47

Figure 8 Challenges of incorporating ESG risks 52

Figure 9 Approach to the assessment of ESG risks 53

Figure 10 Sources that refer to ESG indicators 60

Figure 11 Overview of the three methodological approaches 76 Figure 12 ESG in business strategies and processes 84 Figure 13 Incorporation of ESG risks at the point of loan origination 102 Figure 14 Links between ESG factors and supervisory review 130 EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS Table 1 Examples of ESG factors included in the most commonly used frameworks 26 Table 2 The three methodological approaches in the context of loan origination and portfolio management 27 Table 3 The three methodological approaches: pros and cons 79

Annex 1 Table 1 Environmental factors 156

Annex 1 Table 2 Social factors 158

Annex 1 Table 3 Governance factors 161

EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS Climate-related risks Climate-related risks are the financial risks posed by the exposure of institutions to counterparties that may potentially contribute to or be affected by climate change. attributes by changing some of the inputs in financial models based on and policies). Climate stress test Assessment featuring fully fledged scenarios that map out possibl e future development paths of transition variables (e.g. carbon prices), physical variables (e.g. temperature increases) and the related changes in ma cro variables (e.g. output in di fferent secto rs, GDP, unemployment) and financi al varia bles (e.g. interest rates). These scenarios are then translated into changes in portfolio (risk) attributes. Environmental factors Environmental matters that may have a positive or negative impact on the fi nancial performance or solvency of an entity , sover eign or individual. Environmental risks The risks of any negative financial impact on the institution stemming from the current or prospective impacts of environmental factors on its counterparties or invested assets. ESG factors Environmental, social or governance matters that may have a positive or neg ative impact on the financial perform ance or solvency of an entity, sovereign or individual.

ESG-related investment

benchmarks Benchmarks which incorporate specific sustainability-related objectives and help to assess and compare t he performance of susta inable investments over time. ESG risks ESG risks are the risks of any negative financial impact on the institution stemming from the current or prospective impacts of ESG factors on its counterparties or invested assets.

ESG risk-related strategic

risks, over the short-, medium- and long-term time horizons. Exposure method Methodological approach for the assessment of ESG risk which focuses on ho w indiv idual exposures and count erparties perform on ESG factors. Governance factors Governance matters that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual. Governance risks The risks of any negative financial impact on the institution stemming from the current or prospective impacts of governance factors on its counterparties or invested assets. EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

7 Physical risks The risks of any negative financial impact on the institution stemming

from the c urrent or prospective impacts of the physical effects of environmental factors on its counterparties or invested assets.

Portfolio alignment

method Methodological approach for the assessment of ESG risk which focuses targets. Risk drivers Avenues throu gh which ESG fact ors can lea d to nega tive financial impacts Risk framework method Methodological approach for the assessment of ESG risk which focuses portfolio and its standard risk indicators. Social factors Social matter s that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual. Social risks The risks of any negative financial impact on the institution stemming from the c urrent or prospective i mpacts of social factors o n its counterparties or invested assets. Taxonomies Frameworks which classify different elements within a given set (e.g. economic activities, social practices or conventions) by defining them and linking them to different categories based on certain criteria. Transition risks The risks of any negative financial impact on the institution stemming from the c urrent or prospective i mpacts of the transition to an environmentally sustainable economy on its counterparties or invested assets. Transmission channels The causal chains that explain how these risk drivers impact institutions through their counterparties and invested assets. EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

CET 1 Common Equity Tier 1

CO2 Scientific code for carbon dioxide

CRR Capital Requirements Regulation

CRD Capital Requirement Directive

CSR Corporate Social Responsibility

CSRD Corporate Sustainability Reporting Directive

EAD Exposures at Default

EBA European Banking Authority

ERM Enterprise Risk Management

ESAP European Single Access Point

ESG Environmental, Social and Governance

ESMA European Securities and Markets Authority

EU European Union

GAR Green Asset Ratio

GDP Gross Domestic Product

GHG Green House Gases

ICAAP Internal Capital Adequacy Assessment Process

IFD Investment Firm Directive

ILAAP Internal Liquidity Adequacy Assessment Process

ILO International Labour Organization

IPSF International Platform on Sustainable Finance

ISO International Standards Organization

ITS Implementing Technical Standards

IEA International Energy Agency

KPI Key Performance Indicator

LGD Loss Given Default

NFRD Non-Financial Reporting Directive

NGFS Network for Greening the Financial System

NGO Non-Governmental Organisation

OECD Organisation of Economic Co-operation and Development PACTA Paris Agreement Capital Transition Assessment

PCAF Platform for Carbon Accounting Financials

PD Probability of Default

RAF Risk Appetite Framework

SASB Sustainability Accounting Standards Board

EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

9 SFDR Sustainable Finance Disclosure Regulation

SREP Supervisory Review and Evaluation Process

SDG Sustainable Development Goals

TCFD Task Force on Climate-related Financial Disclosures

UN United Nations

UNEP FI United Nations Environment Programme Finance Initiative

USD US dollar

EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS The EB A has received severa l mandates to assess how to include Environmental, S ocial and Governance (ESG) risks into the three pillars of the banking prudential framework. This report assesses their p otential in clusion in Pillar 2 by pr oviding common definit ions of ESG risks, elaborating on the arrangements, processes, mechanisms and strategies to be implemented by

credit institutions and investment firms (institutions) to identify, assess and manage ESG risks, and

recommending how ES G risks should be inc luded in the sup ervis ory review and evalu ation performed by competent authorities. The report focuses on the resilience of institutions to the potential financial impact of ESG risks across different time horizons, which needs to be carefully assessed and ensured by institutions and su pervisors by taking a comprehensive and forward- looking view, as well as early, proactive actions.

Definitions and assessment methodologies

ESG risks to institutions are defined as risks that stem from the current or prospective impacts of

ESG factors on their counterparties or invested assets, i.e. the risks arising from the core activities

of institutions. ESG risks materialise through the traditional categories of financial risks (credit risk,

market risk, operational and reputational risks, liquidity and funding risks). Various methods for the assessment of ESG risks exist in the market and these are rapidly evolving. The EBA has identified three diff erent approaches: ( i) portf olio alignment method, (ii) risk framework method (including scenario analysis) and (iii) exposure method. These approaches serve sustainability goals or of of fering insigh ts int o the r isk caused by expos ures to (including investments in) certain activities. The EBA does not prescribe the use of one particular approach and sees merit in the application of a combination of approaches.

Management of ESG risks

The EBA sees a need to enhance, in a risk-based and proportionate manner, the incorporation of management frameworks.

Business strategies

Whilst institutions are, and should remain, responsible for setting their strategies, the impacts of ESG risks should be appropriately taken into account in order to ensure the resilience of business models over t he short-, m edium- and lon g-term tim e horizon s. The EBA recommends that institutions achieve this by: EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

11 - incorporating ESG risk-related considerations when setting business strategies, in particular

by exten ding the time ho rizon for stra tegic planning to at least 10 years, at least qualitatively, and by testing their resilience to different scenarios; - setting, disclosing and implementing ESG risk-related strategic objectives and/or limits, appetite; - engaging with borrowers, investee companies and other stakeholders; - assessing the potential need to develop sus tainab le products o r to adjust features of existing products, as a way to contribute to and ensure alignment with strategic objectives and/or limits.

Governance

The EBA recommends that institutions integrate ESG risks in governance structures, establishing clear working procedures an d responsibilities for business lines, internal control functions, the relevant committee(s) and management body, with a view to ensuring a sound and comprehensive approach to the incorporation of ESG risks into business strategy, business processes and risk

tasks and responsibilities related to ESG risks as drivers of financial risk categories in the decision-

making process, adequate internal capabilities and arrangements for an effective management of business strategy and objectives.

Risk management

The EB A recommends that institutions incorporate E SG risks into their risk management framework, taking into account an assessment of their materiality over different time horizons, by: - embedding material ESG risks in the risk appetite framework; - managing ESG risks as drivers of financial risks, in a manner consistent with the risk appetite, and as reflected in both the ICAAP and ILAAP frameworks; - identifying the gaps they are facing in terms of data and methodologies and take remedial action; - setting out appropriate policies taking ESG risks into account for the assessment of the financial robustness of counterparties; - developing risk monitoring metrics at exposure, counterparty and portfolio level; - developing methodologies to test their resilience to ESG risks, with a view to improving understanding on the robustness of their business model and investment strategies.

Supervision of ESG risks

The EBA sees a need to reflect ESG risks in the supervisory evaluation of institutions falling under the scope of the CRR/CRD. ESG risks should be proportionately incorpor ated into the business model analysis, in particular with regard to the analysis of the business environment, the current business model, the strategy analysis and the assessment of the viability and sustainability of the EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

12 business model. However, the existing assessment under the Supervisory Review and Evaluation

Process (SREP) may not enable supervisors to sufficiently understand the longer-term impact of ESG ris ks. In this context, the EBA sees a need to introduce a new aspect of analysis in the

supervisory assessment, in the form of an evaluation of whether credit institutions sufficiently test

the long-term resilience of their business models against the time horizon of the relevant public policies or broader transition trends, applying at least a 10 year horizon. The supervisory review should also proportionately incorporate ESG risks into the assessment of

incorporate ESG risks as drivers of financial risks, in particular risks to capital and risks to liquidity

and fun ding. The assessment of these ESG ris ks should pr ogressively and proportionally be incorporated into the supervisory capital assessment. The supervisory framework applicable to investment firms is still being developed and the EBA does not include specific recommendations for the supervision of ESG risks for these firms at this stage. Taking into a ccount the legislative and reg ulator y initiatives and the progress achieved by institutions and supervisors over the recent years1, the management of ESG risks by institutions, in

addition to the incorporation of ESG risks in supervision should, in an initial stage, give particular

prominence to climate-related and broader environmental risks. Inst itutions and s upervisors 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.

Next steps

ESG risks. It should be considered in conjunction with the EBA and ESA disclosure publications under the CRR (the EBA will publish Pillar 3 disclosure requirements on ESG risks, transition risks an d physical risks as defined in this report later this year)2, the Taxonomy Regulation3 and the SFDR4, which provide key metrics to support strategies and risk management. The report leverages on work conducted by the EU as part of the regulatory agenda on sustainable finance, international forums providing analysis, best practices and recommendations to contribute to the development of environmental and climate risk management, such as the Network for Greening the Financial System (NGFS) and the Basel Committee on Banking Supervision (BCBS), and other stakeholders5.

2 EBA Consultation paper on draft ITS on Pillar 3 disclosures on ESG risks.pdf (europa.eu).

3 See the EBA opinion and full report and the ESAs consultation paper.

4 See ESA final report.

5 The work in the area of ESG risks is expanding fast. While this report includes a number of references to ESG-related

the references and examples provided are non-exhaustive and for illustrative purposes only. EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND INVESTMENT FIRMS

13 Recommendations to institutions ʹ need for early and proactive actions to ensure

preparedness for ESG-related challenges and regulatory developments The report is based on the feedback received from the consultation organised by the EBA on its

discussion paper on the management and su pervision of ESG risks for credit institutions and investment firms6. This report has been transmitted to the EU Parliament, the Council and the Commission, and will be used by the EBA as a basis for the development of Guidelines on the management of ESG risks

by institutions and the supervision of ESG risks by EU competent authorities. Institutions are invited

to actively reflect on the content of the report and its recommendations.

6 Click here for the discussion paper. A summary of the feedback received and main changes in the report compared to

the discussion paper is included in Annex of this report. Discussion paper on ESG Risk

Management &

Supervision

November 2020 -

February 2021EBA Report on ESG

Risk Management

& Supervision

June 2021Possible legislative

changes to include

ESG risks under the

scope of Risk

Management &

Supervision

EBA Guidelines

and Standards on the basis of this report

Business strategy

ESG-related considerations,

e.g. longer time horizon

Setting out ESG risk related

objectives and limits

Engagement with

counterparties and clients

Assessing the need to

develop sustainable productsRisk management

Introducing ESG risks in RAF;

incorporation in ICAAP and ILAAP

Identifying data gaps and

adequate methodologies

Setting out policies covering

ESG risks

Establishing risk monitoring

metricsGovernance

ESG risks in arrangements for

business lines, control functions, management body and risk culture

Internal capabilities (e.g.

awareness, training)

ESG risks taken into account

when setting remuneration policy EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND

INVESTMENT FIRMS

1. In 2015, m ore than 190 governm ents around the world adopted the UN 2030 Agenda f or

Sustainable Development, aiming to support further progress on a wide range of interconnected and cross-cutting economic, social and environmental objectives. These objectives aimed at strengthening the global response to the eradication of poverty, the threat of climate change and access to equitable and universal health, food security, nutrition, education and decent work in more pea ceful and inclusive soci eties. The agenda included s eventeen Sustainable Development Goals (SDGs) and 169 associated targets to be reached by 2030. Achieving the SDGs requires major societal transformations and will depend on the mobilisation of significant financial resources from the public and private sectors, with an SDG financing gap currently estimated at an incremental USD 2-3 trillion per year for all countries.7

2. Also in 2015, signatories to the Paris Agreement committed to undertake ambitious efforts to

limit the increase in the global average temperature to well below 2°C above pre-industrial levels

and to pursue efforts to limit the temperature increase to 1.5°C above these levels.8 This implies

a need for early action to reduce greenhouse gas emissions as soon as possible.9 In the long term, an unabated warming pathway would lead to significant declines in global GDP by 2100.10

3. Indeed, economies and societies are increasingly facing the complex and severe consequences

of biodiversity loss and climate change, resource depletion, income inequality, migration and other environmental and social concerns.11 Against this background, legislators in the European Union (EU) and around the world are taking actions to change economic activities that have significant adverse impacts on ESG factors and to alleviate the worst consequences. While these policies will be gradually introduced and take full effect for financial market participants over a longer time period, it is crucial to develop strategies to be able to cope with such changes. economy sustainable, containing a package of measures ranging from cutting greenhouse gas

7 See Sustainable Development Solutions Network: see http://www.unsdsn.org.

8 Art. 2 and 3 of the Paris Agreement.

Debates - Is migration good for the economy?'

12 https://ec.europa.eu/info/files/communication-european-green-deal_en.

EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND

INVESTMENT FIRMS

15 Specifically for climate, EU targets set in 2015 included a commitment to a binding target of at

least a 40% domestic reduction in greenhouse gas emissions by 2030, compared to 1990.13 In September 2020, the Commission proposed to raise this target to at least 55%.14 In addition, the EU has designed a long-term strategy aiming to become climate neutral - an economy with net- zero greenhouse gas emissions - by 2050.15 In April 2021, co-legislators reached a provisional climate neutral ity by 2050 and the i ntermedi ate target o f reducin g net g reenhouse gas emissions by at least 55% by 2030.16

5. In the area of financial regulation, a number of actions are being taken following the Report of

which sets an EU strategy on sustainable finance and a roadmap for work across the financial system. In addition, the European Commission is expected to present its Renewed Strategy on Sustainable Finance mid-2021, building on the 2018 Action Plan, with new actions to increase private investment in sustainable projects and activities to support the different actions set out in the European Green Deal and to manage and integrate climate and environmental risks in the financial system. a. reorienting capital f lows towards susta inable inves tment in order to achieve sustainable and inclusive growth; b. managing financia l risks stemming from climate chan ge, resource depletio n, environmental degradation and social issues; c. fostering transparency and long-termism in financial and economic activity. It is co mplemented with broader l egislativ e efforts to sup port the transition t o a more sustainable economy.

7. The financial sector is expected to play a key role in financing the transition to a greener and

more sustainable economy in accordance with the Action Plan. Reorienting private capital to

13 Intended Nationally Determined Contribution of the EU and its Member States, submitted by the Latvian Presidency

and the European Commission on 6 March 2015.

14 https://ec.europa.eu/clima/policies/strategies/2030_en.

15 The EU submitted its long-term strategy to the United Nations Framework Convention on Climate Change (UNFCCC)

in March 2020. https://ec.europa.eu/clima/policies/strategies/2050_en.

16 https://ec.europa.eu/clima/news/commission-welcomes-provisional-agreement-european-climate-law_en.

17 https://ec.europa.eu/info/publications/180131-sustainable-finance-report_en.

18 https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52018DC0097&from=EN.

EBA REPORT ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR CREDIT INSTITUTIONS AND

INVESTMENT FIRMS

16 more sustainable investments requires a comprehensive shift in how the financial system works.

This transformation will certainly spur new business opportunities, but the financial sector will also be exposed to the financial risks stemming from the transformation of the economy and worsening physical conditions. The det ermination of the EU legislators to fundam entall yquotesdbs_dbs31.pdfusesText_37

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