European Banking Authority outlines plans for climate stress test, disclosure requirements and a Green Supporting Factor

New Action Plan on Sustainable Finance also highlights legal risks for financiers behind climate change

The European Banking Authority (EBA) has confirmed it will develop a climate stress test and further explore the possibility of offering banks favourable prudential treatment for lending to green projects. 

In its Action Plan on Sustainable Finance, launched today, the EBA urged financial institutions to “act now to incorporate ESG factors into their business strategies”, describing the matter as “urgent”. 

The EBA is the European Union supervisor for lending institutions, investment firms and credit institutions in Europe, with a focus on financial stability. As part of the European Commission’s own Action Plan on Sustainable Finance, released last year, it has asked the EBA to provide guidance on how sustainability could be integrated into financial services legislation in Europe.

Its new plan to monitor climate risk will begin by looking at strategy and risk management for member bodies, with emphasis on metrics and disclosure. Successful measurement of ESG risks by banks, it says, can then form the basis of scenario analysis “as an explorative tool to understand the relevance of the exposures affected by, and the potential magnitude of the ESG risks”. 

Building on such developments, the EBA said it will then create “a dedicated climate change stress test”.  

“The EBA aims to develop a dedicated climate change stress test with the main objective of identifying banks’ vulnerabilities to climate-related risk and quantifying the relevance of the exposures that could be potentially hit by physical risk and transition risk,” the Action Plan says, pointing out that the immature state of climate stress testing puts “multiple constraints on designing a robust framework”. 

It added that in the nearer-term, willing banks could volunteer to be assessed for climate risk in the second half of next year, to get the ball rolling. This could help “get a better understanding of banks’ vulnerabilities to climate risk and provide a first estimate of the amount of brown and green exposures held by banks”. 

 It is expected that ‘brown’ and ‘green’ exposures will be defined using the EU’s incipient taxonomy, which concluded its most recent phase of political negotiations yesterday. 

“The third stage of the work will look into the evidence around the prudential treatment of ‘green’ exposures,” it confirmed. This is a reference to the long-discussed and very controversial introduction of a Green Supporting Factor, in which capital requirements are lowered for loans that can be defined as green. 

The EBA’s 22-page Action Plan on Sustainable Finance acknowledges the risks from climate change, including transition and physical risk. “Legal risks for those deemed responsible for climate change and potentially their financiers may arise,” it adds. 

Meanwhile, the European Banking Federation, the umbrella group which represents c. 3,500 bank, is due to present its ‘Encouraging and Rewarding Sustainability’ report at an event at the UN climate talks in Madrid on Monday. It identifies how “public-private cooperation can be leveraged to accelerate sustainable finance”.