As banks navigate the transition to a low-carbon economy, they face a myriad of challenges and opportunities in managing Environmental, Social, and Governance (ESG) risks. The draft guideline issued in January 2024 by the European Banking Authority (EBA) marks the next significant milestone towards a more sustainable and responsible finance sector, aligning with broader efforts to address climate change and social inequalities. The EBA is expected to release the final version of the guidelines an extension of Basel III by the end of 2024.
Increasing legislative requirements
The draft guideline emphasizes the challenges posed by ESG risks to the financial sector and the need for institutions to identify, measure, and manage these risks. It covers various aspects, including the identification and measurement of ESG risks, management and monitoring standards, and the development of (transition) plans to address these risks. To effectively manage ESG risks, banks are urged to adopt a holistic approach that encompasses various dimensions of sustainability. The aim is to ensure that these factors are properly reflected in the internal risk classifications of financial institutions. This includes conducting thorough climate-risk assessments to evaluate the potential impacts of climate change on their operations and portfolios.
Transition Plans for a Sustainable Future Across the entire Portfolio
Banks are also required to develop transition plans that align with broader sustainability objectives outlined in the Paris Agreement. From an inside-out perspective, these plans should comprehensively outline strategies for reducing emissions, promoting investments in renewable energy, and facilitating the transition to a low-carbon economy. By integrating ESG considerations into their business strategies, banks can position themselves as leaders in sustainable finance, thus contributing to positive environmental outcomes. From an outside-in perspective, banks should not only proactively engage with companies to ensure alignment with global sustainability goals but also comprehensively understand the opportunities and risks that arise from climate change. Since operational emissions represent only a small fraction (often <1%), a meaningful ESG risk management must extend to the entire portfolio. Therefore, it is crucial for banks to collect detailed data on ESG risks associated with their corporate clients and integrate this information into their risk assessment processes. Next to the lending portfolio, this includes the evaluation how climate-related factors could impact business operations, investments, and the overall financial landscape, thereby positioning themselves to capitalize on emerging opportunities while mitigating potential risks.
Overcoming and Mastering Implementation Challenges
Implementing the EBA guideline and wider ESG regulation presents a challenge for many banks, as this exercise requires more than just the collection of data and the establishment of comprehensive processes. It demands a fundamental shift in mindset and operational practices across all levels of the organisation.
“Having worked closely with many banks, we’ve seen the challenges firsthand: Accessing reliable data on GHG emissions and ESG performance metrics often proves to be a daunting task, but should not hinder the accurate assessment of sustainability within the loan book. The data landscape is the best we have had so far and with reasonable approximations based on scientific data a lot can be achieved to obtain a solid basis for risk assessments as well as impact steering.”
Urata Biqkaj-Müller, Founding Partner at Magnolia Consulting
From our experience, we see six fields of action that require special attention:
- Access to Data and Metrics: Banks often face challenges in accessing reliable and consistent data on ESG performance metrics, which are essential for assessing the sustainability of lending and investment opportunities and portfolios. Especially, data on SMEs is hard to come by and often approximations via proxies are necessary.
- Risk Assessment and Management: Identifying and quantifying ESG risks associated with lending decisions can be complex, particularly when assessing long-term environmental and social impacts. Banks need robust risk assessment frameworks to evaluate the potential financial implications of ESG factors accurately. However, the available ESG data is often not of the necessary quality, so it is advisable to start with the evaluation of climate risks in order to have meaningful and tangible analyses as a basis for decision-making. Scenario analyses have come a long way since the publication of the first TCFD (Task Force on climate-related Financial Disclosures) recommendations in 2017. Similarly, the work on nature and biodiversity assessments is developing fast, allowing for meaningful risk analyses.
- Balancing Financial and Sustainability Objectives: Sustainable finance involves balancing financial objectives with environmental and social considerations. Banks must navigate this tension effectively, ensuring that lending activities deliver both financial returns and positive impact. Currently, this tension persists in a number of sectors, e.g. renewable energy. In our view, however, it pays to re-assess this disparity in the long run, since the current margin distribution is likely to change in favour of sustainable economic activities in the future.
- Product Development and Innovation: Developing innovative financial products and services that align with sustainability objectives requires creativity and market expertise. Banks need to design products that meet the evolving needs of corporate clients and contribute to positive environmental and social outcomes. It is key, however, to also engage with corporate clients on these products.
- Regulatory Compliance and Reporting: Compliance with evolving regulatory requirements related to sustainable finance such as the CSRD, the SFDR and increasingly under Pillar 3 is a significant challenge for banks. Meeting disclosure obligations while navigating a complex regulatory landscape requires dedicated resources and expertise.
- Stakeholder Engagement and Transparency: Building trust and credibility with stakeholders, including corporate clients, investors, customers, and regulators, is crucial going forward. Banks need to engage with stakeholders transparently and communicate their sustainability efforts effectively to demonstrate their commitment to responsible finance.
Magnolia Consulting: Your Trusted Partner in ESG Risk Management in accordance with the EBA expectations
At Magnolia Consulting, we understand the complexities of climate, nature and ESG risk management and are committed to helping banks navigate this evolving landscape. Our team of experts offers tailored solutions to address your specific needs, from conducting comprehensive risk assessments to developing sustainable lending strategies. With our support, you can meet the requirements from regulators and other stakeholder and position your bank for long-term success in a rapidly changing world.
