Evolving drivers of ESG integration in bank credit risk assessments

Lea Reitmeier reviews the regulatory and business environment for banks in Europe and explains why integrating environmental, social and governance risks into credit assessments is becoming more than a regulatory baseline.

The integration of environmental, social and governance (ESG) considerations, including on climate change, into banks’ decision-making processes has been given more importance over the last few years, predominantly driven by regulatory pressures – especially in the EU. Corporate clients are also increasingly making similar demands. This commentary outlines the regulatory context, and the key challenges and opportunities for banks as they tackle the necessary methodological changes to their credit risk assessment processes.

The regulatory context takes shape

The financial sector has come under increasing pressure to identify, assess and manage ESG risks. Financial regulators globally recognise that high concentrations of climate-related risks within a single large client or multiple entities can threaten the stability, risk profile and creditworthiness of a bank. International bodies and networks, such as the Financial Stability Board and the Network for Greening the Financial System, have published guidance on how banks can manage and how supervisors can integrate climate-related risks into their respective processes. In 2024 the Basel Committee on Banking Supervision revised its Core Principles for effective banking supervision to cover climate-related financial risks, including a recommendation to incorporate such risks into the assessment of client risk profiles during credit application or credit review processes.

Several jurisdictions have already taken concrete steps to integrate ESG factors into microprudential frameworks. The EU has required banks to incorporate ESG factors into risk management since 2019, while the European Banking Authority (EBA) in its guidelines on loan origination and monitoring calls for banks to consider ESG factors in their credit policies and procedures. EBA further lay the groundwork for a common supervisory approach in its detailed reports of 2021 and 2022 on the integration of ESG factors in risk management. Further guidelines are being developed over the course of 2024. In 2020 the European Central Bank (ECB) published a Guide on climate-related and environmental risks, setting out its expectations as a supervisor for how banks should integrate such risks into their internal governance and disclosures, and in relation to loan origination and credit risk processes (in line with the EBA guidelines).

The forthcoming implementation of the reforms under the Basel III framework  will require that banks make further improvements to their internal processes to identify, measure and address ESG risks, such as through prudential transition plans. They will also require supervisors to assess the adequacy of these processes. This assessment will specifically involve supervisors taking into account sustainability-related product offerings, transition finance policies and related loan origination policies. Further, the ECB recently increased pressure on banks to implement these expectations by warning it would impose penalty payments and additional Pillar 2 capital requirements for those that fail to manage climate and environmental risks adequately.

Progress and challenges in complying with regulatory demands

To comply with regulatory requirements, banks have had to expand their internal expertise and adjust processes and policies to include climate-related risks. To do this, they first had to overcome the limitations of the existing models and processes. The traditional parameters of risk management models, such as probability of default and loss given default, were designed to incorporate historical financial data and as such are not well-suited to integrating ESG factors, which needs to account, inter alia, for the growing frequency and scale of climate-related risks over time. Evolving forward-looking approaches can help here, although these bring further challenges related to the inadequate availability of relevant and high-quality data and a lack of a common and complete classification system across jurisdictions and exposure types. Where these systems are in place, the definitions used are often binary and non-dynamic, and therefore ill-suited to capture activities that are part of the transition to net zero. This makes estimating financial losses due to ESG risks a complex process.

In responding to the increasingly granular regulatory requirements and methodological limitations, banks have taken different routes, each with their own drawbacks. Some rely on credit rating agencies that also assess companies’ ESG factors, while others use dedicated ESG ratings or scores to complement their credit assessments. In 2023, some credit rating agencies dropped their ESG credit scores from credit ratings, introducing narrative paragraphs in place of quantitative data points, which makes it more challenging for banks to incorporate the information into their internal credit models. For banks relying on ESG ratings, there have also been concerns about the varying reliability of ESG ratings, lack of transparency about methodologies, potential conflicts of interest and generally low levels of trust. Given these shortcomings, banks might not adequately price and incorporate ESG risk data into their credit assessments. Further, the high level of reliance on external providers creates a dependency risk on its own.

In light of these limitations, some banks have begun to develop their own methodologies and in-house solutions to integrating ESG into credit assessments. To ensure their approach is sufficiently robust, a materiality assessment of ESG factors in the business context is first required, with banks preparing ESG metrics using existing frameworks and creating a data repository with clearly indicated sources. A suitable assessment methodology should include the weighting of different relevant factors and an internal scoring system. Dedicated ESG assessment processes should then be integrated into existing credit risk assessments, the bank’s IT infrastructure and governance structure. For credit risk assessments, individual scores could be incorporated directly into the assessment, or an ESG rating could be generated that is then combined with the existing internal credit rating.

Embedding sustainability in client relationships in the EU

A critical piece of the puzzle for creating a robust methodology for integrating ESG factors into credit assessment processes is bank–client relationships, which can be supported with the help of new disclosure rules. Companies have already significantly increased their internal knowledge and capabilities on ESG, driven by disclosure regulation and demands from investors, non-governmental organisations and the public. For instance, the EU’s Corporate Sustainability Reporting Directive (CSRD) will progressively extend reporting obligations to a total of around 50,000 companies by 2028, leading to an expected “explosion” of data. In other jurisdictions companies also disclose forward-looking metrics, following the UK’s Transition Plan Taskforce Disclosure Framework or the International Sustainability Standards Board’s IFRS S2 standards, for example.

• Beyond the increasingly demanding regulatory baseline for ESG integration, two further factors will drive the integration of ESG factors into bank–client relationships:

• Growing interest by European corporate clients across sectors to engage in discussions with banks on their low-carbon transition, in part to seek associated financial benefits
• Companies becoming less inclined to mandate banks that have a reputation for being laggards on sustainability.

As a result, many companies will be keen to demonstrate to banks how their strategies and actions can reduce their ESG risk exposure and influence the assessment of their credit risk.

Publicly available information about the interactions and dialogue between borrowers and lenders is very limited, but BMW’s €8 billion Credit Revolving Facility is a notable example. During the syndication process, BMW asked over 40 international and regional banks to reflect on its sustainability performance, targets and the effectiveness of its ESG disclosure and communication via a detailed questionnaire. The company’s questions to its lenders included: How does the bank perceive BMW’s sustainability approach? What information does the bank miss from the current reporting? Are ESG ratings used as red flags or as scores? The banks were also asked to provide insights into how they assess ESG risks. BMW also facilitated an exchange between its sustainability experts across departments and the banks to provide even more detailed technical and strategic information on its sustainability strategy.

The BMW example highlights the increasing pressure placed on banks by companies regarding sustainability, which requires banks to have sufficient capacity to respond. It also points to the potential for banks to leverage client engagement to overcome current data limitations and develop a more granular and holistic understanding of ESG risk exposures.

Next steps for banks

In the EU, more companies are expected to enter into dialogue about the net zero transition with their banks that includes discussion of sustainability risks and opportunities following implementation of the CSRD and the resultant improvement to quality and quantity of data. Companies with ambitious and robust strategies and transition plans will also expect banks  to acknowledge their efforts to reduce ESG-related risks. This also gives banks an opportunity to overcome some of the current challenges and improve the integration of ESG risks into their lending and monitoring processes.

We have outlined a number of drawbacks to the current state of play, particularly associated with the reliance on external providers. But some banks have begun to develop their own methodologies for integrating ESG factors into credit assessments, and they will benefit from clients’ increased engagement on this topic as they do so. They will also gain recognition for their internal expertise and knowledge, and be able to refine and adapt their methodologies. It remains to be seen how this will impact smaller banks or banks in jurisdictions where there is less supervisory pressure, but if they do not make ESG integration an internal priority, it is likely they will fall behind.

For banks, integrating ESG into credit risk assessments is more than a regulatory baseline: it is a business opportunity. But success will require significant upskilling, refinement of methodologies and tools, and the introduction of suitable governance structures. Rising to this challenge will lead to the better translation of ESG risks into credit risk and therefore into financing costs, setting a bank apart from its competitors.

The views in this commentary are those of the author and do not necessarily represent those of CETEx. The author would like to thank Agnieszka Smoleńska for her feedback and helpful comments.