Identification and measurement of ESG risks
4.2.1General principles
As part of the minimum standards to identify and measure ESG risks, institutions’ internal procedures should include tools and methodologies to assess ESG risk drivers and their trans-mission channels into the different prudential risk categories and financial risk metrics affect-ing the institution’s exposures, including with a forward-looking perspective.
To ensure a proper identification and management of ESG risks, institutions should consider the potential impact of these risks in the short, medium and long term. The level of granularity and accuracy of data points, quantification tools, methods and indicators used by institutions should take into account their materiality assessment and their size and complexity and gen-erally be higher for the short and medium term. Long-term time horizons should at least be considered from a qualitative perspective and support strategic assessments and decision-making.
With regard to environmental risks, internal procedures and methodologies should allow in-stitutions to:
quantify climate-related risks, such as by estimating the probabilities of materialisa-tion and magnitude of financial impacts stemming from climate-related factors;
properly understand the financial risks that may result from other types of environ-mental risks, such as those stemming from the degradation of nature, including bio-diversity loss and the loss of ecosystem services, or the misalignment of activities with actions aimed at protecting, restoring, and/or reducing negative impacts on nature;
establish key risk indicators (KRIs) covering at least short- and medium-term time ho-rizons and a scope of exposures and portfolios determined in line with the results of the materiality assessment.
With regard to social and governance risks, where quantitative information is initially lacking, institutions’ internal procedures should provide for methods that start by evaluating qualita-tively the potential impacts of these risks on the operations of, and financial risks faced by, the institution, and should progressively develop more advanced qualitative and quantitative measures. Institutions should gradually enhance their approaches in line with regulatory, sci-entific, data availability and methodological progress.
With regard to the interactions between the different categories of, respectively, environ-mental, social and governance risks, institutions’ internal procedures should ensure that each category of risk is first assessed taking into account its specific characteristics, before consid-ering potential interconnections and interdependencies in the measurement of these risks.
4.2.2Data processes
Institutions’ internal procedures should provide for the implementation of sound information management systems to identify, collect, structure and analyse the data that is necessary to support the assessment, management and monitoring of ESG risks. Such systems should be implemented across the institution as part of the overall data governance and IT infrastruc-ture. Institutions should regularly review their practices to ensure they remain up to date with public (e.g. increased data availability due to regulatory initiatives) and market developments and should have in place arrangements to assess and improve data quality.
Institutions’ internal procedures should ensure that institutions gather and use the infor-mation needed to assess, manage, and monitor the current and forward-looking ESG risks they may be exposed to via their counterparties, by aiming at collecting client- and asset-level data at an appropriately granular level.
Institutions’ internal procedures should build on both internally and externally available ESG data, including by regularly reviewing and making use of sustainability information disclosed by their counterparties, in particular in accordance with European Sustainability Reporting Standards developed under the Directive 2013/34/EU (opens EUR-Lex in a new tab) or voluntary reporting standard for non-listed Small and Medium-size Enterprises (SMEs) as per the Communication COM (2023) 535 on the SME relief package(9).
Institutions should assess which other sources of data would effectively support the assessment, management and monitoring of ESG risks, such as information obtained through engagement with clients and counterparties as part of new and existing business relationships, or third-party data. When institutions use services of third-party providers to gain access to ESG data, institutions should ensure they have a sufficient understanding of the sources, data and methodologies used by data providers, including their potential limitations.
Where the quality or availability of data is initially not sufficient to meet risk management needs, institutions should assess these gaps and their potential impacts. Institutions should take and document remediating actions, including the use of estimates or proxies, e.g. based on sectoral- and/or regional-level characteristics and, when feasible, making adjustments to account for counterparty-specific aspects. Institutions should seek to reduce the use of estimates and proxies over time as ESG data availability and quality improve.
For large corporate counterparties as defined by Article 3(4) (opens EUR-Lex in a new tab) of Directive 2013/34/EU (opens EUR-Lex in a new tab), institutions should consider collecting or obtaining the following data points, where applicable:
For environmental risks:
geographical location of key assets (e.g. production sites) and exposure to environmental hazards (e.g. temperature-related, wind-related, water-related, solid mass-related hazards) at the level of granularity needed for appropriate physical risk analysis, and availability of insurance;
current and, if available, targeted greenhouse gas (GHG) scope 1, 2 and 3 emissions in absolute value and, where relevant, in intensity value;
dependency on fossil fuels, either in terms of economic factor inputs or revenue base;
energy and water demand and/or consumption, either in terms of economic factor inputs or revenue base;
level of energy efficiency for real estate exposures and the debt servicing capacity of the counterparty;
the current and anticipated financial effects of environmental risks and opportunities on the counterparty’s financial position, financial performance and cash flows;
transition-related strategic plans, including transition plan for climate change mitigation disclosed in accordance with Article 19a (opens EUR-Lex in a new tab) or Article 29a (opens EUR-Lex in a new tab) of Directive (EU) 2022/2464 (opens EUR-Lex in a new tab), when available;
b. For social and governance risks:
alignment with the OECD Guidelines for Multinational Enterprises, UN Guiding Principles on Business and Human Rights and International Labour Organisation Declaration on Fundamental Principles and Rights at Work;
negative material impacts on own workers, workers in the value chain, affected communities and consumers/end-users including information on due diligence efforts or processes to avoid and remediate such impacts.
For exposures towards other types of counterparties than large corporates, institutions should:
determine the data points needed for the identification, measurement and management of ESG risks, considering the list provided in paragraph 28 to support that assessment;
where needed to address data gaps, use expert judgment, qualitative data, portfolio-level assessments and proxies in line with paragraph 27.
4.2.3Main features of reference methodologies for the identification and
measurement of ESG risks
Institutions’ internal procedures should provide for a combination of risk assessment methodologies, including exposure-based, sector-based, portfolio-based, and scenario-based methodologies, as set out in paragraphs 31 to 42. The combination of methodologies should be put together in a way that allows institutions to comprehensively assess ESG risks over all relevant time horizons. In particular, institutions should at least use exposure-based methods to obtain a short-term view of how ESG risks are impacting the risk profile and the profitability of their counterparties, use sector-based, portfolio-based and scenario-based methods to support the medium-term planning process and the definition of risk limits and risk appetite for steering the institution towards its strategic objectives, and assess through scenario-based methods their sensitivities to ESG risks across different time horizons including long-term ones.
a. Exposure-based methods
At an exposure-based level, in line with the provisions in paragraphs 126 and 146 of the EBA Guidelines on loan origination and monitoring, institutions should have internal procedures in place to assess the exposure of their counterparties’ activities and key assets to ESG factors, in particular environmental factors and the impact of climate change, and the appropriateness of the mitigating actions. To this end, institutions should ensure that ESG factors, in particular environmental factors, are properly reflected in their internal risk classification procedures, are taken into account in the overall assessment of default risk of a borrower and, where justified by their materiality, are embedded into the risk indicators, internal credit scoring or rating models, as well as into the valuation of collateral.
With regard to the assessment of environmental risks at exposure level, institutions’ internal procedures should include a set of risk factors and criteria that capture both physical and transition risk drivers. For large institutions, this includes, where applicable, at least the following:
the degree of vulnerability to environmental hazards, taking into account the geographical location of the key assets of counterparties and guarantors, or of the physical collateral backing the exposures, considering both on-balance sheet and off-balance sheet exposures;
the degree of vulnerability to transition risks, taking into account relevant technological developments, the impact of applicable or forthcoming environmental regulations affecting the sector of activity of the counterparty, the current and if any targeted GHG emissions in absolute and, where relevant, intensity value of the counterparty, the impact of evolving market preferences, and the level of energy efficiency in the case of residential or commercial real estate exposures together with the debt service capacity of counterparties;
the exposure of the counterparty’s business model and/or supply chain to critical disruptions due to environmental factors such as the impact of biodiversity loss, water stress or pollution;
the exposure of the counterparty to reputational and litigation risks taking into account completed, pending or imminent litigation cases related to environmental issues;
the (planned) maturity or term structure of the exposure or asset;
risk-mitigating factors, such as private or public insurance coverage, for example based on applicable national catastrophe schemes or similar frameworks, and the capacity of the counterparty to ensure resilience to transition and physical risks including through forward-looking transition planning.
Where data needed to assess certain criteria is not yet available, such as for smaller corporate counterparties, institutions should follow the steps outlined in paragraphs 26, 27 and 29.
With regard to the assessment of social and governance risks at exposure level, institutions should implement due diligence processes with a view to assessing the financial impacts stemming from, and the vulnerability of counterparties’ business model to, social and governance factors, taking into account the adherence of corporate counterparties to social and governance standards such as those mentioned in paragraph 28 b(i), the exposure of the counterparty to litigation risk driven by social or governance issues, as well as the applicable legislation in the jurisdiction where the counterparty operates.
b. Sector-based, portfolio-based and portfolio alignment methods
Institutions’ internal procedures should provide for sector-based and portfolio-based methodologies, in particular heat maps that highlight ESG risks of individual economic (sub-) sectors in a chart or on a scaling system as referred to in paragraphs 127 and 149 of the EBA Guidelines on loan origination and monitoring. Institutions’ methodologies should allow to map their portfolios according to ESG risk drivers and identify any concentration towards one or more type(s) of ESG risks.
With regard to non-climate related ESG factors, large institutions should develop:
methods to identify sectors that are highly dependent on, or have significant impact on, ecosystem services, and tools to measure the financial impact of nature degradation and actions aimed at protecting, restoring and/or reducing negative impacts on nature;
approaches to measuring the positive or adverse impacts of their portfolios on the achievement of the UN Sustainable Development Goals and evaluating potential related financial risks.
With regard to climate-related risks, institutions’ internal procedures should provide for the use of at least one portfolio alignment methodology to assess on a sectoral basis the degree of alignment of institution’s portfolios with climate-related pathways and/or benchmark scenarios. Institutions should also consider assessing the alignment at counterparty level e.g. by comparing the GHG emissions intensity of a given counterparty with an applicable sectoral benchmark.
For the purposes of paragraph 37, institutions should use scenarios that are science-based, relevant to sectors of economic activity and the geographical location of their exposures, up to date and originating from national, EU or international organisations such as national environmental agencies, Joint Research Center of the EU Commission, the International Energy Agency, Network for Greening the Financial System, International Panel on Climate Change. Sectoral decarbonisation pathways should be consistent with the applicable policy objective, such as the EU objective to reach net-zero GHG emissions by 2050 and to reduce emissions by 55% by 2030 compared to the 1990 level, or any national objective where applicable.
For the purposes of paragraph 37, institutions should determine the appropriate scope of the portfolio alignment assessments and the degree of sophistication of the methodologies used based on the characteristics of their portfolios, the results of their materiality assessment and their size and complexity. Large institutions with securities traded on a regulated market within the Union should take into account the list of sectors included in Template 3 of Annex I (opens EUR-Lex in a new tab) of the Commission Implementing Regulation (EU) 2022/2453 (opens EUR-Lex in a new tab)(10). SNCIs and other non-large institutions may use representative samples of exposures in their portfolios to undertake portfolio alignment assessments.
Institutions should justify and document their methodological choices including the choice of scenario(s) and the base year, the selection of sectors and, for SNCIs and other non-large institutions, the identification of a representative sample of exposures, as well as any significant methodological change over time. When data needed to measure alignment is missing, institutions should follow the steps set out in paragraphs 26, 27 and 29.
Institutions should consider insights gained from climate portfolio alignment methodologies to:
assess and monitor climate-related transition risks stemming from misalignments of counterparties and/or portfolios with EU, Member State or third-country regulatory objectives and pathways consistent with applicable climate goals, and potential related financial risks;
inform their decision-making process on the formulation and implementation of their risk appetite, business strategy and transition planning including regarding prioritisation of engagement with certain counterparties.