EBA Highlights Progress And Challenges In ESG Risk Data

The European Banking Authority (EBA) has published a report outlining the remarkable advancement made in enhancing the availability and accessibility of data important for determining environmental, social, and governance (ESG) risks. This follows various regulatory efforts toward promoting transparency and risk management, especially in banks. While significant improvements have been noted, the report also points out a number of long-standing issues in the ESG data environment that continue to impact credit risk determinations.

Over the past few years, efforts like the Corporate Sustainability Reporting Directive (CSRD) and European Sustainability Reporting Standards (ESRS) have been instrumental in accelerating ESG data enhancements. These standards have brought about increased transparency in ESG scoring, allowing it to be more efficiently evaluated by investors and institutions based on environmental and social conditions. To complement this, External Credit Assessment Institutions (ECAI) started incorporating ESG factors into credit risk ratings as well, propagating the agenda of including ESG factors within financial decision-making.

While the EBA's report conveys that ample gaps exist within the ESG data landscape, some progress was made. That being said, the data pertaining to evaluating the ESG risk is still patchy, subjecting credit risk evaluations to recognisable shortcomings. One of the most urgent problems that have been identified is the lack of standardization and inconsistency in ESG risk approaches. Standardization has been better applied in certain areas, including corporate and mortgage portfolios, but other exposure classes are underdeveloped, and therefore, it is difficult to conduct holistic risk assessments.

For corporate portfolios, the most sophisticated ESG risk approaches are mainly centered on transition risks, which deal with the financial risks of climate change. These approaches commonly use sector classifications, the magnitude of greenhouse gas emissions, and counterparty transition plans. These tools offer a formalized process for evaluating how firms are handling the transition towards a low-carbon economy, a key factor in consideration for financial institutions wishing to reduce the possible risks involved in climate change.

Mortgage exposures have been somewhat standardized, however, especially in terms of location of property and energy efficiency. Although these are useful in evaluating the potential climate-linked risks embedded in real estate investments, they do not yet capture the entire range of ESG risks, especially those social and governance risks. This means that financial institutions have only incomplete information to rely on when making judgment calls about the wider implications of ESG factors for credit risk.

Even more troubling is underdevelopment of methodology for evaluating other classes of exposures, including those associated with social and governance risk. While risk associated with climate has seen lots of attention and development, greater ESG risk has been paid scant attention to in risk management frameworks. The gap results in most financial institutions not having means to properly estimate social and governance-related risks that are essential for comprehending all aspects of the impact of ESG on investment.

Data quality and access continue to be important obstacles in refining ESG risk assessments. Even when data are available, its granularity tends to be inadequate for undertaking nuanced and precise risk evaluations. This shortfall is augmented by the fact that most institutions center mainly on climate risk, while considerably less is allocated to other ESG issues, including labor practices, human rights, and corporate governance. Consequently, most institutions are left to depend on qualitative opinions, which are not standardized, to evaluate governance risks. This absence of standardization causes inconsistencies in the assessment of governance risks among various financial institutions.

In the future, the EBA's report stresses that a standardized approach to identifying and qualifying ESG-related credit risks would necessitate a step-by-step, tailored approach. Regulatory actions to harmonize ESG risk assessment methods will have to take into consideration the different levels of maturity in the various types of risk, necessitating a phased approach that addresses these differences gradually. This will enable financial institutions to build the tools and frameworks necessary to evaluate all dimensions of ESG risks in a complete and consistent way.

The path to a universally standardized and complete methodology for ESG risk assessment is certainly a work in progress. As much as there has been progress in some areas, notably with regard to climate risk, there are still considerable challenges in establishing strong methodologies for other ESG factors. As regulatory agencies continue to refine and build out their work, it is essential that institutions and stakeholders stay active in the evolution of ESG risk assessments. The expectation is that, with time, this work will create a more standard, transparent, and robust framework for the measurement and management of ESG-related credit risks and contribute to a more sustainable and resilient financial system.