Taking stock of climate risk in your ICAAP: Flying blind is not an option

This blog was published on 20 May 2022.

For CROs, heads of capital planning, heads of ICAAP and climate financial risk leaders, in particular at mid-tier and fast growing banks. 

At a glance:

• The PRA and ECB have been clear for some time that banks must include climate risk in their ICAAP. From what we have seen, progress towards this goal varies significantly across banks.
• Previous feedback given to banks, in particular by the ECB, indicates that climate materiality assessments are a natural starting point – banks can’t manage what they can’t measure. Although there is no ‘one-size-fits-all’ approach to the materiality assessment, a robust one will have several common characteristics that banks should adopt.
• How far a bank’s ICAAP needs to go in quantifying the capital impact of its climate risk exposure depends on the nature and magnitude of its exposures. Even while data and methodological constraints persist, supervisors will expect materially exposed banks to be making progress in their analysis – including through the use of estimation techniques or proxies. 
• Supervisors know that there is no ‘quick fix’. Banks need to use their ICAAP to demonstrate that they have a fully costed, resourced and approved multi-year plan for enhancing their approach – to the materiality assessment, to scenario analysis, in their capital assessment, and to embedding climate risk in the way that they manage their risks and their balance sheet.

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What supervisors have said banks need to do

For banks in Europe and the UK, focus in Q2 2022 and in the coming quarters will shift to geopolitical, supply chain and macrofinancial issues that are generating stresses on the real economy and could have a material effect on their profitability and risk profile. However, it is vital that firms do not lose sight of climate-related risks, including in the context of the ICAAP.

Supervisors in both the EU and UK expect banks to address climate risk in their ICAAP, including in the capital adequacy assessment. The ECB Guide on climate and environmental risks, finalised in November 2020, and PRA Supervisory Statement SS3/19 (published in 2019) are both clear about this. The largest UK banks, and a sample of the others, are expected this year to prepare a short report on how they have embedded climate change into their risk management frameworks alongside their 2021/2022 ICAAP, and set out in those reports how they have gained assurance that they have sufficient capital to cover material climate risks.

This should not be news to banks. However, our experience indicates that the progress banks have made on this varies significantly – some have a fairly sophisticated assessment of the impact of climate-related risks in their ICAAP, while others have only started recently. Whatever a bank’s starting point though, supervisors expect to see tangible progress in 2022 ICAAP submissions and evidence of planning ahead for further improvements in future years. The PRA intends to assess banks’ approaches to integrating climate into the ICAAP by June of this year, and the ECB has an ongoing programme of horizontal reviews.

The innate challenge of assessing climate risk in the ICAAP is compounded by the lack of established industry practices and the fact supervisory expectations will evolve as capabilities and market practices mature. This blog gives our view of where banks that have yet to make significant progress should focus their efforts.

Focus on the materiality assessment

Feedback given by the ECB to banks in its November 2021 report on the state of banks’ climate and environmental risk management practices indicated that its supervisors would focus in particular on banks’ climate materiality assessments – both generally, and in the context of the ICAAP. This is a natural starting point and we expect the PRA to adopt a similar approach.

The emphasis here is on the approach banks take. Boards and senior management cannot simply assume that their bank’s exposure to climate risk is immaterial, even if that turns out to be the right answer. They must conduct a rigorous assessment to determine the materiality of their exposure. Flying blind is not an option.

There is no ‘one-size-fits-all’ approach to a climate materiality assessment, but there are several characteristics of a good approach: 

1) The assessment is sufficiently granular and broad in scope.

• A bank’s materiality assessment, at least in its end-state, should cover all of the asset classes, sectors and geographies to which the bank is exposed. A bank’s eventual aim should be to conduct an analysis that is granular to the counterparty level, considering for example counterparty-level (rather than sectoral) emissions data, information on the location and financial materiality of counterparties’ physical assets, and counterparties’ transition plans.
• A full assessment may not be possible this year (given data and resource constraints), and some banks have chosen to start with their largest exposures in sectors most likely to be affected by climate policies (referring, where relevant, to the Climate Policy Relevant Sector approach used by the EBA) or geographies most exposed to physical risk.

2) The bank’s exposures are classified according to a common classification system. 

• In the EU context, the most commonly used sectoral classification system is the Nomenclature of Economic Activities (NACE) code system. In the UK, banks may use the UK Standard Industrial Classification (SIC) system. This will help banks to leverage publicly available data. For example, carbon emissions data is available (through sources such as Eurostat) per NACE sector code. Using these data will allow banks to categorise their exposures by greenhouse gas emissions per sector, which will help to identify where transition risk (e.g. through sensitivity to changes in carbon price) is concentrated within the bank’s portfolio.

3) The bank applies materiality thresholds.

• It is important not only to determine which sectors or geographies within a bank’s portfolio are most exposed to climate risks, but also their financial materiality to the bank. In our experience, income at risk is the most commonly used metric here.

It is important to note that materiality assessments are only the first step in the process. Once a bank has identified its sectoral and geographic exposures which are most at risk from climate change, it will have to assess the extent of the risk by conducting short-term and long-term scenario analysis.

Whether or not the bank is participating in the ECB’s supervisory climate risk stress test, the scenarios used in that exercise are a useful starting point for the short-term analysis in the ICAAP. The short-term disorderly transition risk scenario, in particular, can be used to assess the capital impact of a tail risk transition scenario – e.g. a sharp increase in the price of carbon emissions, considerably more severe than current forecasts (even taking into account the current stress on energy prices) – over a period that fits within a bank’s typical capital planning horizon. Longer-term analysis, going beyond the ICAAP’s typical 3-5 year time horizon (again, leveraging scenarios developed by the ECB or BoE) can help a bank to identify strategic risks and opportunities.

The above steps will help banks to identify and measure their climate risk exposure. In addition, the ICAAP will need to describe the steps that banks are taking to monitor and mitigate climate risks. Having determined where material pockets of risk arise, banks should identify decision-useful and reliable key risk indicators (KRIs), and set thresholds and limits in relation to those KRIs as part of their risk appetite. The ICAAP should describe those KRIs, how they are monitored (at the portfolio level or at the sectoral or geographical level), and describe the early warning indicators, escalation procedures and management actions that the bank has put in place.

How far do banks need to go in quantifying the capital impact of their climate risk exposures?

This year, supervisors will not expect banks to be able to quantify perfectly the capital impact of their climate risk exposures. However, they will expect all banks to make progress towards providing internal capital estimates for all material risks, and explain the actions that they are taking to mitigate risks – whether they take a quantitative or qualitative approach.

The level of sophistication of the methodology used and the granularity of the assessment that supervisors expect to see will be proportionate to the materiality of a bank’s climate risk exposure – the materiality to the bank’s balance sheet, and to the financial system.

Limitations in data and methodologies, and uncertainty over time horizons, are commonly cited as constraints to performing an accurate capital impact assessment in 2022. However, supervisors have been clear that imperfect data is not an excuse for inaction, and firms need to ‘adopt alternative approaches to address these gaps in the short-to-medium term’ according to the PRA. Banks should consider the use of proxies and estimation techniques where appropriate – for example, modelling how changes in carbon price over different time horizons would affect the PD of certain parts of their portfolio.

Such an analysis may not yield perfect results – however, for UK banks, it will at least allow them to provide the PRA with some assurance that they have taken steps to ensure that they have sufficient capital to cover the risks to which they are exposed (as required by SS 3/19), or at least to identify where interim non-capital mitigation options should be put in place (such as requiring more collateral, introducing lending limits, or engaging with the senior management of highly exposed counterparties). In short, and in this context, banks cannot let the perfect be the enemy of the good.

In any case, the gaps should continue to close in the coming years as banks collect more data and learn lessons from supervisory stress testing exercises. Banks’ ICAAPs should set out the proactive steps that they will take over a multi-year period to improve their ability to capture the capital impact of climate risks (for example by building historical data sets with the aim of quantifying risks in terms of PD or LGD) - with those plans being fully costed, resourced and approved.

How do banks need to enhance their approaches to integrating climate risk into their ICAAP?

Supervisors expect all banks to improve their climate risk management capabilities over time. The ICAAP should set out a bank’s plan to improve its capabilities. For example, a bank’s ICAAP should explain how it will enrich the counterparty data that it is relying on, broaden and deepen the coverage of its materiality assessment (in terms of risk types and counterparties analysed, and the granularity of the assessment), perform more sophisticated scenario analysis that is tailored to the nature of its exposures, and further develop methodologies to quantify the impact of climate risks on capital (including from an economic capital perspective for SSM banks). Future ICAAP assessments will evaluate the extent to which the bank is achieving those plans.

Beyond improving the sophistication of a bank’s climate risk management practices, it is important that a bank’s future ICAAPs provide evidence that climate risk is truly embedded in how it steers its balance sheet. The ECB has been clear that it wants to see that the processes banks are putting in place to manage climate risk are yielding ‘visible consequences’. The PRA will no doubt expect the same as it reviews UK banks’ submissions this year and in future. In more concrete terms, the risks identified by the bank in its materiality assessment and scenario analysis, and the climate-related thresholds and targets it includes in its risk appetite, should be having a demonstrable impact on its overall strategy and risk profile.  Market leading banks have, in our experience, made more progress in this regard. Smaller banks, particularly those with more material climate risk exposure, will be expected to show evidence of this as well through the ICAAP.

Conclusion 

For all banks, the ICAAP should ultimately be a summation of their ability to manage climate risks. Through the ICAAP, bank Boards and senior management need to find a way to satisfy themselves (and their supervisors) that the bank is sufficiently resilient to those risks. This means investing time and resources in conducting a thorough materiality assessment and scenario analysis, and taking at least some interim steps towards determining capital adequacy. Banks will need to show in the coming years that the analysis that they do as part of the ICAAP assessment is having a tangible impact on their strategy and their risk profile.