ON MANAGEMENT AND SUPERVISION OF ESG RISKS FOR …

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

Contents

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

2

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

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

5.3.5 ESG risk-related considerations as longer term resilience of the institution's

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

3

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

List of figures

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

4

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

List of tables

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

5

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