Here’s why European banks need to strengthen their ESG risk management and scenario analysis

The European Banking Authority (EBA) has kicked off January 2025 with two important publications on Environmental, Social and Governance (ESG) risks.

1. Final guidelines on managing ESG risks, outlining requirements for institutions to identify, measure, manage, and monitor such risks as part of their overall risk management frameworks.
2. A request for feedback on a consultation paper regarding ESG scenario analysis. A separate set of guidelines that dive into the tools needed to assess both financial and business model resilience in the context of ESG.

These documents jointly cover the requirements of article 87a of Capital Requirements Directive (CRD) VI. We delve into each of these publications and pull out everything you need to know, including how to respond to the EBA’s updated guidelines.

Why banks should take the guidelines on managing ESG risks seriously

The finalised guidelines on managing ESG risks build on last years’ consultation paper. The guidelines offer detailed insights into key areas, including the identification of physical and transition risks, tools for ESG risk mitigation, and the incorporation of key risk indicators (KRIs) within banks’ risk appetite frameworks. Monitoring processes also have been expanded, featuring additional metrics and more specific procedures that institutions should adopt. Proportionality on topics such as data collection and metrics is allowed for institutions that fall under the definition of Small and Non-Complex Institutions (SNCI).

A notable change in the final guidelines compared to the draft released last year, is the transition plan content and design. These plans aim to enhance institutional preparedness for ESG risks while aligning institutions with the broader European Union (EU) sustainability framework. They emphasize the importance of robust governance, proactive stakeholder engagement, transparency, and accountability. To aid implementation, the guidelines include a detailed checklist and template for designing transition plans. This template covers objectives, timeframes, relevant metrics, and aims to align with existing frameworks such as the Corporate Sustainability Reporting Directive (CSRD).

The level of detail of the guidelines should be seen as a sign that banks in Europe are expected to make significant efforts to integrate ESG risks into their regular risk management framework. Institutions must understand how ESG risks materialise through traditional risk types and over short-, medium- and long-term horizons.

The guidelines on managing ESG risks take effect on 11 January 2026, with an extended deadline of 11 January 2027, for SNCI. Managing ESG risks is not new, and banks have been working on implementing the ECB’s supervisory expectations that were due end of December 2024.

We recommend banks to assess their current position and perform a detailed gap analysis to identify key areas for attention and produce a plan to remediate these gaps. Time is of the essence as the deadlines are short and the ECB has not been forgiving to banks that fall behind the pack.

What banks can learn from the draft guidelines on ESG scenario analysis

The EBA has published a separate set of draft guidelines for ESG scenario analysis. The guidelines are clear that scenario analyses should be an integral part of both risk management and strategy setting. It describes key building blocks such as the governance and the steps for conducting scenario analysis, including defining bespoke scenarios and transmission channels tailored to the specific features of key portfolios, markets, and geographic areas. An important aspect is the recognition of a learning curve. The world of ESG risk modelling is still in its infancies and data is (still) scarce. Therefore, the approach to developing proper ESG scenario analysis is an iterative process. To provide some relief to SNCI, approaches that are more qualitative are allowed.

A distinction is made between financial resilience and business model resilience. Financial resilience includes the ability to absorb shocks to capital and liquidity under periods of stress. Most banks have experience with this through Climate Stress Testing (CST) and have developed their capabilities over the past few years. The EBA recognises that CST might be separate from traditional stress testing in the interim but expects full integration in the future – something  4most considers as best practice.  Also, they recognise that backtesting will not always be possible due to lack of historical data. Therefore, models should be supplemented with sensitivity analyses and expert judgement (overlays) to understand non-linearities and ensure financial resilience.

For business model resilience, the EBA introduces a new tool called Climate Resilience Analysis (CRA). This tool helps set strategy over various time horizons, based on the assumption of a dynamic balance sheet. Banks should assess multiple scenarios and document the viability of its business model under each of those scenarios. The EBA recognises that the analysis over the short and medium term will be more quantitative with more qualitative assessments made on business model resilience for time horizons exceeding ten years.

We recommend banks to read the draft guidelines on ESG scenario analysis carefully and take the opportunity to provide feedback to the EBA before 16 April 2025. While these guidelines are being finalised, banks should not adopt a wait-and-see approach as progress can be made with and without these guidelines being final. These guidelines should inspire and improve ongoing initiatives within the bank and provide opportunity to show a pro-active attitude towards both society and the ECB.

Need more help?

Get in touch if you require support understanding and responding to the EBA’s updated guidelines – info@4-most.co.uk.