Sustainability risks are becoming ever more important for banks and supervisors, the Bundesbank’s economists write: Banks should pay more attention to the physical impact of environmental risks on their portfolios, as these risks will increase in the future.

ESG risks part of the risk inventory

Institutions participating in a survey of less significant institutions (LSIs) reported that they assess, as part of their risk inventory, whether and in what way environmental, social and governance (ESG) risks impact on traditional types of risk, such as credit, market and operational risk. Whereas in 2023 many institutions were still awaiting guidance on this topic from their respective associations, that guidance is now available and being put to use. In addition, many institutions are tailoring this guidance to individual circumstances.

Most of them are assessing ESG risks over different time horizons, though these are not yet long enough in some cases, the Bundesbank’s experts write.

Environmental risks in the forefront

The surveyed institutions identify environmental risks as the most significant ESG risk drivers. The main transition risks they mention are rising carbon prices and increasing energy costs, followed by sustainability requirements in the construction sector. Transition risks arise from the action taken to reduce emissions to reach net-zero greenhouse gas emissions. “Flooding and droughts are regarded as the most significant physical risks,” the authors note.

According to the institutions, these risk drivers mainly affect credit risk by impairing borrowers’ ability to repay their loans and thus increasing the risk of default. Respondents noted that the impact on market and operational risk is more limited, with some reporting that physical risk drivers could also impact on operational risk.

ESG metrics widely used, target values rarely mentioned

Many institutions are using ESG-related risk metrics for management purposes. “However, specific target values for implementing the strategy are rarely mentioned,” the experts write. This meant that strategic implementation was still vague in many instances.

Some institutions take action such as excluding certain sectors or making transactions with elevated ESG risks subject to prior approval. Only a handful of the banks have been measuring their financed emissions – that is, the emissions produced by firms they lend to and projects they invest in.

Integrated into key risk processes

Most institutions are incorporating ESG risks as risk drivers into their internal capital adequacy policies. Their integration into stress tests is highly advanced, with institutions either using dedicated ESG scenarios or embedding ESG risk drivers into existing scenarios.

Data availability still limited

The data situation continues to be a key challenge. While many institutions have developed strategies to improve data coverage, the Monthly Report notes that current availability is still limited. The same can be said about the accuracy of ESG scores. These measures are widely used by institutions to assess how sustainably and responsibly a firm is operating in terms of its ESG exposures.

Taken into account in lending practices

“In general, the majority of institutions in the LSI survey take climate-related risks into account in their lending practices, in particular by excluding certain economic sectors, segments or issuers and in the valuation of collateral,” the Monthly Report article explains. More advanced measures, such as reflecting ESG risks in loan pricing or the calculation of probabilities of default, are less common at present.