Financial institutions will be required to incorporate ESG factors

EBA introduces consideration of environmental, social and governance (ESG) factors for the first time in the new loan origination guideline, published on 29th of May. The guidelines require institutions to incorporate ESG factors and associated risks in their credit risk appetite, risk management policies, credit risk policies and procedures by 30 June 2021.

In accordance with the guidelines, institutions should take into account the risks associated with ESG factors when assessing the creditworthiness of the borrower. One, quite straight forward, way to identifying the risks of climate change for the financial performance of enterprises could be reviewing the current and projected greenhouse gas emission of the borrower (if the borrower’s business model generates and emits high level of greenhouse gas, the probability could be higher for the borrower to be affected be regulatory changes, changes in demand of customer and so on in the transition to a low-carbon and climate-resilient economy).

Hence, in the assessment of enterprises creditworthiness, institutions should assess the borrower’s exposure to ESG factors, especially environmental factors and the impact on climate change, and the appropriateness of the mitigating strategies. For loans or borrowers associated with a higher ESG risk, a more intensive analysis of the actual business model is required. This analysis should include review of current and projected greenhouse gas emissions, the market environment and the likely impacts of ESG regulation on the borrower’s financial position.
The guidelines also set out requirement for institutions to take ESG factors affecting the value of the collateral into account when applicable in the valuation of property.

The objective of the guidelines is to improve institutions’ practices and governance in relation to credit granting, in order to ensure that institutions have robust and prudent standards for credit risk taking, management and monitoring, and that newly originated loans are of high credit quality. But the guidelines also aim to prepare the EU banking sector for the upcoming challenges in the climate change and the transition to a more sustainable economy. Even though this is the first guideline in which EBA includes ESG aspect, more will come within the intention of including ESG as an integral part of institutions’ practices and governance and as already mentioned these guidelines require institutions to incorporate ESG factors and associated risks in their credit risk appetite, risk management policies, credit risk policies and procedures by 30 June 2021.

You can find the final report here