The European Central Bank is pressuring banks under its purview to properly manage the risks of climate change to their portfolios, including to their real estate loan books.
In November 2022, the supervisory body of eurozone banks set targets for lenders to get a grip on climate risk. As a first step, it required banks to complete a full assessment of the impact of climate risk to their activities by the end of March.
By the end of 2024, the ECB expects banks to meet all the supervisory expectations on climate and environmental risks which it outlined in 2020, including full integration of capital adequacy assessments and stress testing.
The ECB warned there will be “supervisory consequences” if banks fail to meet their climate responsibilities, with deadlines closely monitored and “enforcement action taken” should the milestones it has laid out not be reached. These could include daily penalty payments for every day of non-compliance for up to six months. It may also include asking banks to hold additional regulatory capital in relation to climate-related risks.
“Climate change has made it to the top levels within banks and some first steps have been taken,” said Frank Elderson, vice-chair of the supervisory board of the ECB, in a public statement. “But there is a difference between talking about steps and beginning to act; and there is an even bigger difference in doing what is needed.”
“The ECB is concerned and for good reason. The majority of lenders are not doing climate risk assessments and it is not clear why”
Elderson said the ECB has identified that, while most banks’ strategy documents are “full of references to climate change”, it is often unclear how these initial steps will shelter their business models from the consequences of climate change and environmental degradation in the years to come.
The ECB’s tougher stance follows its deep-dive into how banks are approaching climate risk, and whether or not lenders are meeting expectations – an investigation that began in 2020 and culminated in a review paper released in November 2022 under the title ‘Walking the talk’.
The report said it had found “blind spots” in lenders’ climate and environmental processes at 96 percent of the 186 European banks it studied and concluded in the report that “too many banks are hoping for the best while not preparing for the worst”.
By the March deadline for assessments, the ECB wanted banks to have fully considered the impact of climate risk on their activities. It also wants, by the end of 2023, for lenders to manage climate and environmental risks in their governance, strategy and risk management processes.
The ECB also expects lenders to fully measure and price climate-related risk and wants to see boards set their organisations on “an unequivocal course” to longstanding resilience, said Elderson.
When it comes to real estate, the ECB believes lenders should have clarity over two types of risk. First, the potential threat to an asset as the market transitions to a low-carbon economy, meaning a property could become obsolete due to regulation and green-focused occupier and investor demand. Second, the physical risks of damage being caused to buildings by the extreme weather the climate is already experiencing.
The real estate market was a key area of the ECB’s investigation. Indeed, commercial real estate was identified by the ECB as an area of concern. The central bank said it found large information gaps in basic data, such as Energy Performance Certificates. This suggests property lenders have a way to go before they are able to meet expectations.
Last year, it published the findings of a review of 18 lenders’ commercial real estate exposures, which found that 63 percent of those exposures lacked information on EPCs – a certification designed to ensure properties measure up to legal requirements on energy efficiency. That report said of this sample of lenders: “While the ECB acknowledges that there are structural challenges preventing the collection of all data, certain banks were not doing everything they can to collect data…”
The ECB has since said that banks are “insufficiently prepared to properly account for climate and environmental risks in their real estate exposures”.
“Real estate has not been as high on the risk list [among regulators] as other high-emitting sectors, but that has changed,” says Kim Rybarczyk, counsel at law firm Linklaters’ ESG practice.
“Concern about physical risks, including risks that can impact the value of collateral – flood, subsidence, drought – all of that is absolutely a focus. It is a question of how to model accurately and assess that risk,” Rybarczyk explains.
Real Estate Capital Europe approached several commercial real estate bank lenders under the ECB’s supervision to discuss the extent to which they were meeting the regulator’s expectations, and what support they felt was needed – from borrowers and the wider industry. German lender Berlin Hyp was one of only a few banks willing to provide a statement.
“Implementing a Climate Risk Assessment of the entire loan portfolio in full breadth and depth is a big task,” the bank said. “The path to full Climate Risk Assessment is therefore a process where the financial sector as a whole still has a way to go. An essential key is the availability of sufficiently granular and comprehensive data. Obtaining this data is a particular challenge in many areas, especially in the real estate sector, and one that the entire industry is facing.”
Peter Cosmetatos, chief executive officer of property finance industry body CREFC Europe, believes lenders need support around improving access to data, to help banks improve the granularity of the information they can extract from borrowers.
Cosmetatos argues that banks are “very focused” on trying to figure out how they can use public and regulatory ratings, such as EPCs, to identify and promote solutions that reduce climate risk and improve the quality of real estate collateral. But he says more help is needed.
“Policymakers, such as financial regulators and government, can help by improving the availability of data, making it easy for landlords and their lenders to access tenants’ energy use data, for instance,” he says. “If policymakers cannot properly, reliably and accurately measure granular energy use, carbon emissions or climate risk – and they cannot – individual businesses obviously won’t be able to do so either.”
However, Jim Gott, head of asset diligence and asset surveillance, ESG at Mount Street, the London-based loan servicer, says his own experience in the sector reflects the findings of the ECB’s report. He argues lenders could do more with the tools they already have available to understand their risks to climate change, such as technology that can model how extreme weather events in the future will impact a building.
“The ECB is concerned, and for good reason,” he says. “The majority of lenders are not doing climate risk assessments and it is not clear why. With some of the legacy assets on loan books out there, [real estate] lenders should be very worried.”
Gott suspects one reason for the lack of preparation for the climate crisis is partly due to lenders taking the view that, with the 45 percent emissions reduction targets set by the Paris Agreement still seven years away, the ramifications of failing to comply will not affect the loans due to expire before then. It is a laissez-faire strategy he finds troubling.
“Lenders might think the climate risk will be for others to take but if the loans don’t get refinanced then it will be their issue,” Gott warns. “Borrowers may walk away from those loans, and hand keys back on assets that are actually obsolete. Few lenders have been taking notice of that scenario.”
As the ECB gets tough on banks, the European Banking Authority, which has responsibility for setting rules and regulations for banks in EU countries, is exploring whether to introduce new capital requirements that will force banks to set aside capital to cover environmental risk.
The EBA is currently investigating how the Basel Committee’s Pillar 1 – which sets minimum capital requirements to cover risks – should evolve to incorporate environmental risks. Its findings will be published in June.
Already this year, Pillar 3 disclosure standards have come into force, requiring European banks to report information about exposure to assets’ transition and physical risks, including information on exposure to assets subject to chronic and acute climate events, and outline the actions being taken to mitigate them.
Rybarczyk says banks recognise there “is a lot of work to do” in terms of collating and disclosing information, particularly around EPCs, as it is this kind of data that is needed for Pillar 3. “But there is a paucity of accurate information in this respect,” she adds.
This picture is at odds with where the ECB wants banks to be, which includes institutions maintaining data on day-to-day energy consumption. It also wants lenders to assess the likelihood of collateral becoming non-compliant with EU regulations – otherwise described as stranded assets. Banks, it has said, should be performing location-specific risk analysis to quantify physical risks using geospatial mapping that show vulnerability to certain weather events.
But Gott argues there is much to tackle across the industry before banks meet such expectations.
“Huge numbers of lenders and borrowers are not undertaking climate risk assessments,” he says. “We see capex plans that do not account for energy upgrades. Perhaps [lenders] think that governments will step in to help or roll back on targets. That isn’t going to happen, and as a result we will begin to see many assets that are not able to refinance.”
Against this backdrop of mounting pressure and faced with a climate crisis that is only set to intensify, banks may find themselves having to tackle the issues – quickly, and in a landscape of imperfect information.