Furthermore, banks must assess the magnitude of ESG risks within their portfolios by defining benchmarks aligned with climate objectives, local regulatory guidance, nationally determined contributions and Sustainable Development Goals (SDGs), to provide additional guidance in their ESG screening and due diligence processes.  

Action #2: Establish a credible sustainable-lending strategy 

Explicitly integrating climate commitments and SDGs into the business strategy and adopting a three-pronged approach focussed on avoidance, rebalancing and growth to align the loan portfolio with goals would help to establish a credible sustainable-lending strategy.

Setting short- and medium-term targets for sustainable finance shares is crucial too. Banks must identify growth opportunities in sustainable lending, align credit strategies with national development priorities, enhance sustainable product offerings, and provide transition finance for decarbonisation. Offering sustainability-linked loans, addressing high-risk clients through enhanced due diligence, setting reduction targets for harmful activities, and revising exposure targets for controversial sectors would complete this comprehensive strategy for credible sustainable lending.

Action #3: Assess and quantify E&S risks and climate sensitivity of lending portfolio  

Banks must conduct a comprehensive evaluation of E&S risks within their loan portfolios, with a specific focus on assessing and quantifying climate-related risks to meet regulatory requirements. Recent materiality assessments across banks highlight the increasing significance of transition and physical climate change risks, acknowledged by both Boards and investors. 

Look like this - E&S exposure of a loan book

This entails examining exposure to carbon-related sectors, assessing carbon earnings at risk, and exploring physical risks in loan portfolios and branch operations linked to climate factors. Banks could also develop E&S heatmaps to pinpoint high-risk sub-sectors. All this would guide strategic risk management decisions better.

Action #4: Upgrade scorecards and sector guides

Next, banks must integrate ESG factors into their counterparty-level processes and develop sector-specific scorecards for high and moderate-risk sectors, recognising that risk factors vary by sector. Counterparties should be assessed on E&S parameters using a qualitative overlay, and initially, scorecards based on expert judgment. As data quality and disclosures improve, banks could transition to a combination of qualitative and quantitative scoring models across sectors.

Sector-specific guides aligned with credit strategy and sector exposure can enhance risk assessment. These guides should be complemented by sector-specific ESG risk assessment templates, providing relationship and credit risk managers with a structured approach to evaluate risks within their financing decisions. This would provide a comprehensive understanding of sector-specific ESG risks and informs sound risk management practices.

Action #5: Revamp E&S data and metrics

Improving data collection methods and establishing relevant E&S metrics is vital for accurate credit risk analysis. Banks could leverage internal due diligence processes to address gaps in ESG data and define the ESG risk profile.

Banks must also tap into various public sources, including company annual reports, sustainability reports, and reports from government entities, NGOs, and industry groups. Additionally, sector-specific reports and databases such as the Carbon Disclosure Project can provide valuable insights into environmental and social performance. For private firms, banks may primarily rely on responses from due diligence.

Action #6: Prepare for ESG-integrated stress testing

Integrating E&S scenario analysis into stress testing is pivotal, enabling banks to assess the repercussions of E&S risks on capital and liquidity metrics during stress scenarios. Banks should employ these insights to shape their credit strategy and risk tolerance.

Initially, predefined scenarios such as orderly, delayed and accelerated transition can be used. These are often provided by regulatory bodies. Over time, banks should expand their scenario repertoire as data and modelling capabilities mature. Adhering to regulatory guidelines, creating phased scenario narratives for priority sectors, and developing purpose-specific models enhance risk management.

Conclusion

The sustainability imperative calls upon banks to undergo a comprehensive transformation in their approach to risk management to successfully integrate ESG risks into their credit risk frameworks. This transformation involves revisiting their risk appetite frameworks, assessing and quantifying climate sensitivity in lending portfolios, establishing credible sustainable lending strategies, upgrading scorecards and sector guides, revamping E&S data and metrics, and preparing for ESG-integrated stress testing.

By incorporating these actions into risk management practices, banks can make informed lending decisions, enhance transparency, contribute to long-term sustainability goals, and meet regulatory requirements. That would also ensure their resilience in the face of emerging ESG-related challenges.