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EU bank regulator to develop climate stress tests, assess green prudential rules

The EU bank regulator will ask companies to incorporate sustainability risks into their strategies, develop climate stress tests and assess whether banks should have preferential capital treatment for environmentally friendly lending.

Under a new action plan published Dec. 6, the European Banking Authority will require banks to include environmental, social and governance factors in their risk management policies, and those offering green loans will have to develop green lending policies.

The regulator will look at ESG risks to understand their impact on financial institutions and will hold a public consultation in 2020 and complete a report by June 20, 2021.

The plan comes at a time when EU regulators and policy makers are stepping up action on climate change, as they seek to assess the impact on banks' balance sheets. There are concerns lenders may be left with "stranded" or worthless assets as some industries, particularly those connected to fossil fuels, become obsolete as the economy transitions to low-carbon energy.

Banks must 'act now'

The EU has developed a green classification system to define green investments, and central banks are considering climate stress tests.

The EBA is also developing ESG standards on disclosure, applicable from June 2022, that will include the work from the EU's classification system.

Banks need to "act now" and should use metrics such as a green asset ratio to measure and monitor ESG risk, the regulator said.

"The urgent need to act explains why we have also set out early expectations for interim measures, including the identification of simple metrics that can foster market discipline and allow banks to set clear green strategies," EBA Chairperson José Campo said.

The EBA also said it plans to develop "a dedicated climate stress test" to identify how vulnerable banks are to climate risk and how much of their exposure could be hit by physical risks, which include extreme weather, and transition risk, which includes policy changes.

'Sensitivity analysis'

In addition, the body may undertake a "sensitivity analysis" in the second half of 2020 for a sample of volunteering banks, focusing on long-term transition risks.

Such a test would provide a better understanding of banks' exposure to lending to environmentally friendly and polluting industries. It will also give guidance to banks and supervisors on the stress tests and may update its guidelines on risk management and stress testing.

The EBA also said it would look into whether dedicated prudential rules for green investments are justified. Banks have lobbied for preferential capital treatment for financial green investments such as solar power or wind farms.

The regulator will first publish a discussion paper and then publish a report on this subject in 2025.