Methodological requirements to incorporate the consideration of relevant ESG factors in the credit risk ratings should be strengthened, Finance Watch recommends in the EC’s targeted consultation. Priority should be given to other immediately feasible legislative measures to reflect climate-related financial risks throughout the financial system, namely prudential capital requirements and central banks’ independent credit risk assessments.
The necessity of a legislative intervention is grounded in the fact that the current trends in the market, alongside regulatory and supervisory actions to-date, have not been able to ensure that ESG risks are being systematically and consistently considered by the CRAs.
There are a number of reasons for the missing consideration of ESG risks:
- Data and methodological limitations to quantify ESG-related risks in a similar manner as it is done for other financial risks. Most notable aspects of these include: lack of common definitions of the ESG factors and corresponding risk metrics, lack of comparable and granular data/disclosures, need for forward-looking data (as opposed to historical data used for financial risk modelling), lack of sufficiently advanced models to quantify ESG risks.
- Difference between the time horizons of ESG risk materialisation. This can range from short- to long-term and feature an element of radical uncertainty, and shorter time horizon captured by credit ratings, as most commonly ratings cover a one-year horizon. In reality, not addressing the short-term ESG risks leads to accumulation of risk at systemic level, which is in particular the case for climate- and biodiversity-related risks that are recognised to be of systemic nature. Such accumulation will, in turn, lead to a cliff effect of risk materialisation followed by numerous asset devaluations and defaults.
- Legal limitations in regards to data and methodologies used by CRAs per the current CRA Regulation, in particular due to the provisions of the Delegated Regulation EU 447/2012, Articles 4(b) and 7. Specifically, these provisions are oriented towards “traditional” financial risk analyses in that they require CRA methodologies to be “supported by statistical, historical experience or evidence” (Art. 4(1)8b), describe “the historical robustness and predictive power of credit ratings” (Art. 7(2)(a).)
Given the nature of the above challenges, it becomes clear that further “soft” guidance, in particular focusing on disclosures, will not be sufficient to ensure consistent approaches by CRAs to incorporate ESG risks considerations into their ratings.
Legislative interventions should focus on the following:
- Addressing the most urgent issue of climate-related financial risks, which are growing with the time of inaction – this includes i) transition risks which are growing the longer effective transition is delayed and the more disorderly it will be; ii) physical risks of climate-related disruptions, which grow the longer climate change remains unabated and which will inflict damage to our economy and financial system. As explained in our report, the most impactful and immediately feasible tool to start addressing these risks are prudential Pillar 1 capital requirements for financial sector exposures to fossil fuels (in the Capital Requirements Regulation and Solvency II Directive). These fossil fuel assets are associated with a high risk of stranding, as they need to be increasingly phased out in line with the global climate commitments.
Developing independent in-house credit risk assessments by central banks to be used for the monetary policy purposes (in particular, collateral framework), will consider ESG factors in an independent manner and be able to incorporate the systemic risk perspective (refer to the report “Driving sustainability from within”).
Regulators and supervisors should further establish minimum standards for the assessment of relevance and materiality of ESG factors to be taken into account, uniform criteria for ESG data quality and its verification and minimum standards for ESG methodologies to make sure the outcomes are credible and comparable. Establishment of robust comparable ESG disclosures, possibly aligned internationally, will serve a pre-requisite for the ESG factors being considered by CRAs.
Importantly, we also emphasise that the suggested obligation for CRAs to consider ESG does not and should be made to interfere with our proposals to integrate climate-related risks of fossil fuel exposures in the prudential framework. The risks associated with fossil fuel financing are very clearly identifiable and should be addressed without further delays via incorporating them into Pillar 1 credit risk weights in the prudential regulation as a segregated measure.
Legislative requirements for CRA methodologies should be amended to allow for the use of forward-looking methodologies and data derived based on those methodologies (without possibility to validate and backtest assessment models based on historical time series for this type of data), which is key to the assessment of climate-related and possibly other ESG-related risks.