To complete its Guidelines on the management of ESG risks, the EBA has conducted a consultation on Guidelines on ESG Scenario Analysis – which was part of the mandate under the revised Capital Requirements Directive (CRD). The purpose of these Guidelines is to build a robust framework for banks to assess and mitigate climate-related financial risks.
Finance Watch welcomes the work of the EBA on the climate risk assessment. By aiming for full transparency and disclosure at the scenario level and modelling level, the EBA paves a way to ensure a better comparability and understanding among all stakeholders. Furthermore, regarding the development of climate scenarios, the EBA’s efforts in identifying climate-related factors and transmission channels provide a solid foundation upon which banks can rely. Finally, the EBA recognised the significant limitations behind the current quantitative approach to reflect the impact of climate change in risk management and highlighted the importance of a qualitative approach to overcome these limitations.
In its response, Finance Watch shares key elements to enhance the EBA recommendations:
- The relationship between the CSA and existing EBA Stress Test Guidelines needs to be clarified, especially regarding the interplay between Scenario Analysis and Climate Stress Tests
- Notwithstanding their work on scenario development, the EBA’s approach risks understating the compound risks from climate change. The simultaneous occurrence of climate-related economic shocks and other stress events such as geopolitical instability, economic downturns, or pandemics should be mandatory when building adverse climate scenarios.
- The EBA should consider incorporating Reverse Stress Testing, as it can provide valuable insights to banks when developing adverse climate scenarios.
- Qualitative adjustments to the results of scenario analysis should address deficiencies in scenario modelling (including tipping points, chronic physical risks), economic modelling, as well as deficiencies in risk management, such as data availability and quality, and risk metrics modelling.
Finance Watch welcomes the EBA proposals and appreciates the opportunity to contribute to enhance them; yet, the nascent stage and complexity of climate scenario exercises will need a robust review and monitoring process from the supervisors. Given the materiality of climate change risks for the financial system, supervisors cannot let financial institutions rely on approximative exercises. Therefore, mitigation actions should rely on both the conclusion and quality of the Climate Scenario Analysis exercises.
Hence, considering the significant limitations of climate scenario exercises, as well as other risk management tools for climate-related financial risk, Finance Watch urges the EBA to advance its work on prudential treatment of climate-related risks, in particular to consider implementing a precautionary approach to effectively mitigate these risks.
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