How adequate is Pillar 1 for ESG risks?
A discussion has started
Last week the European Banking Authority (EBA) has initiated a discussion on potential changes in the prudential regulations under Pillar 1 Capital Requirements* to account for the emerging environmental and social risks.
Introducing new capital requirements should not be a problem for the adaptive prudential framework. However, the complexity comes from several challenges including the fact that social risk factors are not uniquely defined at European level. Therefore, the discussion focuses primarily on the environmental risks and their most prominent category of climate risks.
The challenges to measure and incorporate these risks into the existing risk framework are fundamental:
1) First, the occurrence of “negative externalities” associated with environmental risks, which may or may not directly impact the economic agent but affect the society at large. This makes the nature of environmental risk much more comprehensive and multidimensional than any other common risk type. The risk transmission channels are overarching with complicated interrelationships of socio-political and physical character.
2) Second, environmental risks are considered long-term on general. Acute physical and transition risks might occur in the mid-term, but chronic physical risks would rather span several decades and economic cycles. They are thus forward-looking and non-cyclical. It is expected that the magnitude of the environmental risks will increase over time, i.e. incremental in nature with the potential to create structural shifts not compatible with the business cycle concepts. All this makes a risk-based approach of quantification of environmental risks within the current Pillar 1 framework quite difficult.
A major question is: How to account for long-term and forward-looking risks of environmental factors into the capital requirement?
A more flexible measurement approach might be possible under Pillar 2 complemented by Pillar 2 Guidance and forward-looking stress tests.
3) Another major challenge is the lack of data availability on environmental risks. Data quality, consistency and relevance are together with the resource intensity (time and money) to obtain it the major obstacles in measurement and translation of ESG risk drivers into financial or other impacts. The capital framework relies strongly on historical data and current market prices, which are not considered to deliver the necessary information for the forward-looking and long-term nature of the environmental risks. Lack of observations on losses due to climate-related events or transition trends leads to insufficient identification of risk drivers. The regulatory initiatives around the CSRD and Pillar 3 ESG disclosure, as well as the CRR3 proposal on supervisory reporting, are providing first attempt to tackle these problems.
4) Lastly, the lack of common and comprehensive classification system on environmental risks regarding definitions and risk drivers adds complexity in the risk measurement. The fragmented definitions (i.e. green, environmentally harmful or neutral) increase uncertainty and model risk in addition to the existing inconsistency across the industry. The EU Taxonomy is an important step towards a standardized classification of environmentally sustainable economic activities, but it does not give any indication of the riskiness of the financial positions (such as credit quality for example).
The challenges to expand the risk management framework over environmental and social factors are so fundamental that a revolutionary change might be needed. If so, the regulators cannot trigger this alone and need in any case the active participation from a broader circle of stakeholders, including financial institutions, industry experts and related associations.
Based on the discussion paper (Link) stakeholders are invited to contribute to the analysis and decision-making by 28 of July 2022. It covers 31 detailed questions which are referenced to analysis at the current level of knowledge. It is highly recommended to give an evidence-based feedback and thus to facilitate a deliberate decision-making process of higher quality.
*Pillar 1 of the Basel II framework sets the minimum capital requirements banks and other credit institutions need to fulfil for their exposures to the major risk types: credit, market, operational and liquidity risks. The regulatory capital is important supervisory measure to sustain solvability and stability of the financial sector.
