On 27 September 2023, the European Systemic Risk Board (ESRB) published advice on the prudential treatment of environmental and social risks.

The advice highlights the specificity of risks related to climate change, which can be expected to become an important driver of broader environmental and social risks, and the challenges of tackling such risks in the existing prudential framework. The advice builds on established positions of the ESRB, as outlined in particular in its contribution to the European Commission’s call for advice on the 2022 Review of the EU Macroprudential Framework.

The advice highlights the following:

  • The conventional risk management methods used by financial institutions and supervisors have clear shortcomings and may not be suitable for properly capturing the full range of climate-related financial risks, as these methods are based on historical data that do not reflect the new risk patterns that will emerge as a result of climate change.
  • In view of the rapidly evolving nature of physical risks and transition risks linked to climate change, the ESRB welcomes the fact that the European Banking Authority (EBA) is assessing the prudential treatment of environmental and social risks well before the date stipulated in the regulation.
  • While some forward-looking elements can and should be used for the calibration of micro prudential requirements, macroprudential tools may also be needed to deal with the heightened overall uncertainty caused by climate change and the associated system-wide environmental, social and political risks that are to be expected.
  • The ESRB considers that macroprudential policies have a role to play in addressing the systemic dimension of climate-related risks and in contemplating micro prudential policies targeting climate-related risks.
  • The ESRB is of the view that the macroprudential framework can already be used in its current form to address climate risks, notably through systemic risk buffers (SyRB) and borrower-based measures (BBMs), although some targeted adjustments are needed.
  • The ESRB would welcome a review by the EBA, in the near term, of its guidelines on the appropriate subsets of sectoral exposures to which an SyRB may be applied.
  • The SyRB has already been identified as a possible macroprudential tool to guard against systemic aspects of climate risks in the EU.
  • A sectoral SyRB may be an adequate tool to increase resilience to concentrated exposures to those sectors or geographies that are most vulnerable to climate risks, provided that it can be designed with sufficient granularity.
  • BBMs could usefully complement capital-based measures to mitigate particular climate-related financial risks.
  • The ESRB is of the opinion that BBMs should already form part of national macroprudential toolkits in the short to medium term and that their design should allow them to be used to mitigate climate-related financial risks.

For further updates on regulatory developments in the ESG space please visit our Financial Services Regulatory Developments in ESG hub.