- Overview of EBA Consultation Paper
The European Banking Authority (EBA) published a consultation paper on draft implementing technical standards (ITS) on Pillar 3 disclosures on Environmental, Social and Governance (ESG) risks. The draft ITS put forward comparable disclosures that show how climate change may exacerbate other risks within institutions’ balance sheets, how institutions are mitigating those risks, and their green asset ratio on exposures financing taxonomy-aligned activities, such as those consistent with the Paris agreement goals.
One of the core objectives of integrating ESG disclosures as part of pillar 3 is to establish comparability on quantitative impact of physical and transition climate risks, it also includes quantitative disclosures on institutions’ mitigating actions supporting their counterparties in the transition to a carbon neutral economy and in the adaptation to climate change. EBA requires banks to report ESG risks as per suggested templates.
- How Does it Impact Financial Institutions ?
Inclusion of ESG risks as part of pillar3 disclosures has an impact across capital requirement regulatory value chain right from data sourcing till regulatory reporting. Since most the granular climate specific data segments are to be newly sourced and loaded into institutions risk data repository for calculations & aggregation, it is mandatory to ensure data quality and firms must periodically review relevance and validity of DQ processes.
From risk taxonomy alignment perspective , considering cross cutting nature of ESG risks, orchestration of regulatory mandates like pillar3 disclosure comes up with challenges on risk data governance, engagement with stakeholders across business units, complexity in transforming/linking climate change metrics to financial impact and in ensuring consistent understanding of regulatory obligation across different business units.
Based on our conceptual understanding of EBA regulatory consultation on ESG risks we feel that below core components of CRR business architecture are impacted and requires institutions to assess and develop systems and processes to meet expected disclosures.
- What Banks Need to do to Implement Proposed Regulation
Banks must review existing risk management & regulatory compliance capabilities and assess core capabilities which requires potential enhancement to comply with pillar3 reporting of ESG risks and to ascertain if there is a need to develop new capabilities. We feel that below are core capabilities that requires consideration & enhancement to navigate the path of successfully complying with Pillar3 disclosure of ESG risks.
Risk Data Acquisition: Banks will need to formulate core group that focuses on identifying risk data requirements to analyze, measure and disclose physical risks and transitions risks. As far as pillar 3 templates are concerned banks must report granular climate risk data points (both quantitative and qualitative metrics) like GHG emissions by sector, asset class, energy efficiency of collaterals, exposures classified to climate change mitigation and adaptation activities for each of financial product lines.
Firms need to conduct an assessment exercise to understand data points, data sources and availability and perform a gap analysis to know to address challenge of identifying right data sources either by engaging with transition risk /physical risk data providers in markets or put in place structured road map to source required data segments.
Taxonomy Alignment of Exposures: EBA advises firms to understand and adhere to EU Taxonomy Regulation to classify banking and trading book exposures and follow economic activity-based climate classification.
Institutions are required to formulate processes & tools to align with EU climate risk taxonomy to classify exposures as per climate mitigation & adaptation.
Climate Data Transformation & Aggregation: Pillar3 disclosure requirements necessitate disclosure at various granularities including by asset type, economic activity, Nature of assets, Energy Efficiency of collateral, carbon emissions.
It is important for firms to assess risk data aggregation and reporting capabilities to tackle necessary data transformation requirements of pillar3 disclosures and uplift data framework components to handle numerous unstructured climate data & convert them to usable formats , Increased DQ obligations. Firms must ensure on flexibility of risk aggregation framework to aggregate and breakdown of lending & trading book exposures against climate risk.
Climate Risk Measurement Methodology: As required for template4 disclosures ‘’firms that are not yet estimating their scope 3 emissions shall disclose information on their plans to implement methodologies to estimate and disclose this information”.
Firms must start agreeing with counterparties on methodologies to gather their climate risk mitigation road map & support counterparties’ transition toward taxonomy alignment. It is essential to understand client economic activities that is a pre-requisite to accurately map it to taxonomy & determine level of taxonomy aligned exposure. Since Green Asset Ratio will enable comparability among institutions, it is important to agree with clients on how sooner they can start sharing information on their climate risk mitigations and future project road map plan and plug in changes to reflect on GAR ratio.
Risk Disclosures & Review: Current risk reporting landscape need to be reviewed for scalability, flexibility, and consistency to report additional climate metrics included in EBA templates.
It is evident that regulators across globe will come up with stringent regulatory requirements regarding disclosure of ESG risks enabling investors and stakeholders with comparability and transparency of sustainability performance of institutions. This will result in institutions being faced with regulatory pressure across jurisdictions & creates strong need for effective compliance. It is critical for banks to review and perform assessment on possible pathways in which climate risk specific regulatory domain would evolve. Capabilities like Alignment of banking book & trading book exposures with EU taxonomy will be foundational component & it could obviously be leveraged for any other upcoming EBA regulation on ESG risks. We recommend that banks proactively assess risk management & compliance capabilities and be better prepared when final EBA regulations come into effect to benefit from competitive advantage.
Sudalaimuthu Gurusamy is a Domain Consultant with the Risk Management practice of the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). During his 13 years of experience in consulting, he has worked on several global risk and compliance engagements as Risk Domain Consultant/Senior Business Analyst.
A GARP certified Financial Risk Manager™, Sudalaimuthu holds a master’s degree in Business Administration from the Anna University, Chennai, India. His risk consulting experience revolves around Credit risk Transformation, Risk Data Transformation Initiatives, BCBS 239, BASEL II, BASEL III, Liquidity risk management, Loan loss forecasting and provisioning, and risk regulatory reporting. Recently he is working on developing risk solutions to cater to emerging risks domains including operational resiliency & climate risk.