20 October 2021

SSM Elderson: Overcoming the tragedy of the horizon: requiring banks to translate 2050 targets into milestones

Banks need to start thinking about the next important step in risk management which will require them to look at the thirty years ahead and devise intermediate targets for their risk exposures that can render them fit for a carbon-neutral economy by 2050.

Today, I want to look ahead – to next year, to the next five years and to the three decades up to 2050, the year by which the EU has pledged to become carbon neutral under the Paris Agreement. Thirty years is a hair’s breadth of time: merely one-hundred-and-fifty-millionth of the earth’s 4.5 billion years of existence. A brief span indeed.

There is no doubt that time is running out for us to tackle the climate and environmental crises. What does this mean for banks? This means that the time for preparations is over and the time for action is now. 

Banks can no longer simply declare their intention to be Paris-compliant by 2050. They must make structural changes to their way of doing business so as to make sure that they actually reach that goal and avoid the build-up of risks for them and the entire financial system.

Let me first share some of the insights gained from our benchmark of the banks’ self-assessment against our supervisory expectations. I will then turn to what I’ve just referred to as the next important step in risk management − transition planning − and what banks, as well as supervisors and other competent authorities, need to do in order to make it work.

Banks’ climate-related and environmental risk management capabilities

The ECB is committed to doing everything within its mandate to incorporate climate and environmental considerations into our activities.

On the supervisory side, we have been taking steps to increase our understanding of the impact of the climate crisis from a financial risk perspective and ensure that banks have a comprehensive, strategic and forward-looking approach to disclosing and managing all climate-related and environmental risks, or C&E risks for short. We asked banks to self-assess their position relative to these supervisory expectations and have been benchmarking their responses over the past months. We will soon publish the results and the good practices we identified in the process. I’ll offer a sneak preview of them now.

On the bright side, banks have started reflecting C&E risks in their current structures; roughly half of them are adapting their governance arrangements accordingly. Some banks have developed comprehensive dashboards for assessing C&E risks when granting credit, some are tightening their credit-granting criteria and others are measuring and disclosing the carbon emissions linked to their loan books.

The gloomier side of things, though, is that the banks themselves deem 90% of their practices to be only partially or not at all compliant with the ECB’s supervisory expectations. Tellingly, the only banks that did not identify as being exposed to medium and long-term C&E risks were those which did not conduct a materiality assessment. This is all the more problematic when our benchmarking shows that a majority of banks said they were exposed to medium and long-term C&E risks. We expected them to analyse how these risks can, or will, affect their different portfolios and products over the short, medium and long-term, considering various scenarios. Given the nature of C&E risks, this forward-looking type of analysis should be elementary practice.

But the vast majority have not done this analysis. Concrete and important management tools and practices are lacking in this area. When looking for actions that go beyond a mere screening of the business environment, we found that about half of the banks under our direct supervision have few or no concrete actions planned to embed C&E risks in their business strategy.

Only a quarter of the institutions have set key indicators to monitor and steer the performance of their different business lines, portfolios and products with regard to, for example, green loan origination or their exposure to high-carbon sectors. And only a quarter of those extend these key performance indicators to more than 25% of their portfolio. No more than a fifth of the banks under our direct supervision have set a key risk indicator for C&E risks in their risk appetite statement and only about a third of these have set a concrete limit on these indicators.

There are also encouraging examples: many banks have started to proactively manage their transition risks and set goals for decarbonisation, net zero emissions or alignment. Notably, a dozen banks have started measuring and monitoring the alignment of their portfolios, defining indicators and considering how to align their strategy to the Paris Agreement while avoiding an excessive build-up of transition risks. They are no doubt making progress. And if banks are not closing the gap with our supervisory expectations, we will step up our supervisory efforts correspondingly.

But my bottom line today is this: having processes and procedures in place, assigning responsibilities, conducting risk analyses of various sorts – these are all means to an end. Banks’ plans to align their practices with our expectations will ensure that they have adequate risk management capabilities to weather the storms – but these capabilities should be used more broadly.

It is time for banks to start using their toolbox for short and medium-term planning to mitigate the long-term impact of climate change on their strategies.

Transition plans

As the wider economy moves and changes on the path towards the Paris goals, economic sectors will have to adjust how they operate and respond to both greener consumer preferences and new public policies – such as the carbon tax just introduced by Austria.

Banks must incorporate these structural changes in their strategic considerations and decision-making and steer their business towards a smooth transition to carbon neutrality. In its sustainable finance strategy^[1], the European Commission acknowledges the need for financial institutions to improve their disclosures of sustainability targets and transition planning. In addition, the Commission’s proposal for a Corporate Sustainability Reporting Directive (CSRD) requires financial institutions to set out and disclose their transition plans – but it leaves their content and timing to the discretion of each bank, without stipulating any clear metrics, milestones or targets.

In parallel, there are moves within the financial industry itself to develop and implement credible plans for the transition. In an initiative of the COP26 Private Finance Hub led by Mark Carney, the Glasgow Financial Alliance for Net Zero brings together 53 banks from 27 countries, representing almost a quarter of global banking assets. These banks are committed to aligning their business practices to net zero by 2050 and have set intermediate targets for 2030 or sooner, committing to subsequent five-year decarbonisation plans along with annual progress reports....

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