Unveiling the European Central Bank’s strategy: data, scenarios and models

Thu 07 Mar 2024

In January 2024, the European Central Bank (ECB) published its Climate and Nature Plan for 2024-2025.

This plan aims to:

1. clarify what actions the ECB intends to take to progress its climate and nature agenda; and
2. define what banks need to focus on to further strengthen their climate risk management framework.

This plan underscores those financial risks stemming from climate change remain a key area of attention for the ECB. The ECB will continue working on several topics including stress testing, scenarios and climate-related data, and initiating new focus areas such as nature-related risks and the transition to a green economy.

Banks must therefore continue their work with implementing the ECB expectations on climate-related and environmental (C&E) requirements by end of 2024. The need to continue enhancing climate risk models as well as improving data governance and collection is crucial.

This article explains how the ECB’s latest plan defines such expectations for data and models, and what banks should consider.

Banks to be fully compliant with the ECB expectations by end 2024

The ECB published in 2020 its Guide on climate-related and environmental risks, setting out its expectations for C&E data and modelling. It subsequently communicated in November 2022 a clear schedule for banks under its supervision to comply. All requirements must be implemented by the end of December 2024.

The ECB has reiterated numerous times that banks which do not comply with these expectations can expect impacts on their Pillar 2 capital requirements, as well as more rigid binding qualitative requirements as part of the annual Supervisory Review and Evaluation Process (SREP).

A large portion of the expectations defined in the ECB Guide on C&E data, scenarios and models. These were also some of the main areas identified as being challenging for banks during the Climate Stress Test (CST) 2022 and from the outcome of the thematic review of 2022. This thematic review highlighted the need for more sophisticated methodologies and granular information, underpinned by significant C&E risk underestimation.

Consequently, the ECB reiterated that for during the 2023 Supervisory Review and Evaluation Process, climate risk has been primarily assessed under Element 1 (business model) and Element 2 (internal governance), underscoring the importance of models and data governance on the topic.

We provide below our assessment of the likely pressure points remaining in banks for compliance with the ECB requirements in these areas, and our views on what banks can do:

Data

The ECB requires banks to adopt a holistic approach to data governance; up-to-date data must be collected and aggregated to allow assessing C&E risks in a timely manner.

This is however still one of the most challenging areas for banks, especially for accessing relevant and granular data on C&E. For existing loans, information was often not compiled at time of origination and is now difficult to obtain. Historical data necessary for modelling is also often limited in time and therefore difficult to use. Consequently, these data challenges have a knock-on-effect on the banks’ ability to comply with developing C&E stress-testing frameworks and strengthening risk management.

Such deficiencies were identified by the CST 2022, with data gaps and inconsistencies identified across institutions. This was mostly due to the extensive use of proxies instead of actual counterparty data to measure greenhouse gas (GHG) emissions and energy performance certificates.

To reiterate the ECB’s point, robust data governance in banks is essential, but also to enhance customer engagement and processes for gathering data at loan origination.

Guidelines on the use of data and proxies, including what can be used and how, would also help a more standardised approach for banks in the EU. To our understanding the EBA is working on such document. Meanwhile, it is crucial that banks attempt to collect actual Scope 3 GHG emission or develop robust estimation approached, as the extensive use of proxied data affects the accuracy of quantitative results.

Scenarios

The ECB introduced in its guide scenario analysis as a tool to assess C&E risks, which is also referred to in the context of Internal Capital Adequacy Assessment Process (ICAAP)[1]. The ECB expects the following aspects to be considered for both the normative and economic perspectives:

• how the institution might be affected by physical risk and transition risk;
  • how C&E risks might evolve under various scenarios, considering that these risks may not be fully reflected in historical data;
  • how C&E risks might materialise in the short, medium- and long-term depending on the scenarios considered.

The ECB’s CST conducted in 2022 was a bottom-up exercise, meaning banks provided their own data and stress test projections subject to a common methodology and common scenarios. The six scenarios provided by the ECB were largely based on the Phase II Network for Greening the Financial System (NGFS) model output released in June 2021.

Following the learnings from this exercise, the ECB recommended that banks incorporate climate risk scenarios into their own stress-testing models, reflecting both physical and transition risks, as well as long- and short-term horizons. The ECB also made clear that institutions should integrate C&E risks into credit, operational and market risk management, as well as into the ICAAP overall, including risk quantification by means of scenario analysis.

The challenges for banks to implement this related the lack of elaboration of criteria used for the C&E materiality assessment, while most of these criteria were mostly qualitative. As such, banks are expected to increase their criteria sophistication by making them more quantitative.

Models

As mentioned earlier, the ECB requires banks to integrate C&E risks into their risk management framework. This must be done across all relevant areas of risks, such as credit and market:

For example, credit risk is a key topic when considering C&E for banks’ models. The ECB Guide on C&E stipulates that banks are expected to incorporate C&E risks into credit risk from a qualitative and / or quantitative perspective. This includes adjusting their existing probability of default (PD) and loss given default (LGD) models where required, eventually leveraging these to form an opinion on how C&E risks affect the borrower’s default risk and also incorporating into collateral valuations.

Following its assessments in 2022, the ECB highlighted that banks were still at an early stage of adoption of these requirements due to challenges to model long-term projections and how to incorporate these into PD and LGD models.  More specifically, the ECB noted the lack of sectoral dimension in these models, which often lacked relevant C&E variables such as carbon price shock or emissions pathways. The ECB also emphasised the benefit of using entity-level data for more accurate C&E credit risk quantification.

Market risk is also an area where banks are expected to incorporate C&E factors into their positions and future investments monitoring, and to develop C&E stress tests for all market risk-related instruments. In 2022, the ECB highlighted that climate risk was not yet properly integrated into banks’ market risk stress-testing models, underpinned by the lack of sectoral shock sensitivity leading to lower-than-expected market risk impacts

Future developments anticipated

The EU regulatory landscape and supervisory expectations for C&E are also expected to continue to significantly evolve in the coming years.

For example, the EBA recently published a consultation paper seeking inputs from credit institutions on the classification methodologies for exposures to environmental, social, and governance (ESG) risks. Most of the C&E themes align with the ECB’s expectations and, as such, some of these may be incorporated into future SREP exercises, translating into potential Pillar 2 add-ons for banks.

The ECB also published on 19 February 2024 its final revised guide to internal models, which introduces the need to consider material C&E risk drivers when calculating own funds requirements. Banks have already identified potential implementation challenges due to lack of data availability and the limited length of historical information.

The upcoming Fit-for-55 stress test also marks a significant evolution of climate scenario analysis in the EU. It is a collaborative exercise between EBA and the ECB, the European Supervisory Authorities (ESAs), and the European Systemic Risk Board (ESRB). The EBA is also mandated to develop and implement a regular C&E stress testing exercise in the coming years. Banks should therefore consider investing in their in-house capabilities for analysing the impact from different climate scenarios.

In October 2023, the NGFS published a conceptual note on short-term climate scenarios, which are essential to understanding near-term consequences of severe natural disasters and macro-financial impact of net zero transition. This indicates these types of scenarios will soon be introduced in climate scenario analysis exercises. Once completed, they will likely form part of future regulatory climate stress tests.

Regarding climate-related data, the ECB plans to expand and release updates on climate change-related indicators. This means more physical and transition risks will be covered in climate risk analysis, and additional data will be collected from both public and commercial sources. Recently, the ECB published new climate-related statistical indicators to narrow climate data gaps and it is expected to continue expanding on this initiative. The ECB also announced it would integrate climate data points into its own data collections. This will enable the ECB to continue improving the quality and availability of climate data for banks. Banks will need to build additional capabilities for analysing the portfolio impact from new climate risk indicators and obtain access to relevant data, whether it will be from the ECB or from commercial vendors.

The ECB will also incorporate climate aspects in its own macroeconomic modelling work. This will increase the accuracy of climate change estimates impacts on key economic indicators, such as employment, inflation, or gross domestic product growth. This in turn should lead to more accurate regulatory climate scenarios, that may be used as part of future climate stress tests. Banks should closely follow the changes and incorporate them into their climate modelling approaches.

What’s next for banks?

The ECB clearly reinforced its strong focus on climate risks in the SSM supervisory priorities 2024-2026. By the end of the year 2024, banks are expected to have implemented all the expectations defined in the ECB Guide on C&E, including the full integration of C&E risks in the ICAAP and stress testing.

The ECB announced it will conduct this year targeted on-site inspections and deep dives on C&E and follow up with banks on shortcoming identified in the context of the 2022 climate risk stress test and thematic review.

Ensuring the banks’ robustness of C&E data, scenario and models will therefore remain crucial in the coming years.

[1] In its report on banks’ ICAAP practices, the ECB highlights banks’ progress to incorporate C&E risks into their ICAAP notably through credit risk where scenario analysis is used.