Assessing ESG risks presents challenges for banks

Banks embedded ESG in their creditworthiness assessments following the application date of EBA’s loan origination and monitoring guidelines in June 2021. Although most banks implemented practices for assessing ESG risks and experiment with updating credit risk scores, quantifying the risk remains a challenge. Relevant data remains scarce and a market standard on how to assess ESG risks does not exist yet.

Opportunities for enhancing the ESG risk assessment in creditworthiness

Enhancing the assessment of ESG risks is needed to better manage this risk and meet the expectations set by the European Central Bank (ECB) for 2023 and 2024. We currently see two main opportunities for taking the next step:

Exploring the use of tools

Tools on ESG risk are getting more sophisticated by the day and both financial institutions and corporate clients are exploring available options. Most tools are designed to assess the impact of the E in ESG, mainly focused on the climate risk aspects. It is exciting to see what these tools are capable of and might also serve as a starting point to have an open dialogue with clients on how they perceive their risk profile with regards to ESG. 

For example, the Geospatial Climate Intelligence tool assesses the materiality of events such as floods, heat waves and droughts based on location data and using various scenarios and time horizons. It gives a physical risk score from one to ten and uses geospatial data of the client. Combining the physical risk score with historic loss data of physical risk events enables assessment and quantification of the credit risk of an individual obligor or a portfolio as a whole.

Other tools assess the impact of transition risk on credit risk. For example, the Climate Excellence tool quantifies the impact on creditworthiness by using financial statement information of clients and assessing how projections of revenue and EBITDA develop under various scenarios. These projections are then fed into existing credit risk models to update credit risk scoring.  

Re-thinking ESG data collection

ESG data collection is a key step in enhancing the creditworthiness assessment and evolving risk-based pricing. Data can be retrieved from various sources of (internal) financial, transactional and client data as well as external data derived from third-party providers. The loan origination procedure is a natural yet crucial phase for the gathering of ESG-related information and may enable banks to fill a large part of the data gap.

The availability of data is rapidly evolving and banks need to have a sound strategy on ESG data collection that is sufficiently flexible to accommodate developments in the market. One example is the Corporate Sustainability Reporting Directive (CSRD) that will become effective from 2024 onwards. The CSRD requires collecting relevant ESG information that may enhance the creditworthiness assessment as data is based on a uniform set of standards and a review opinion of an auditor is required. Banks need to update existing processes in a timely manner to prepare for collecting this data.

Some banks in Europe are considering initiatives to collect ESG data together. These initiatives may yield significant cost savings and increase the quality of ESG data available to perform a comprehensive creditworthiness assessment. However, data privacy is a key concern that should be addressed.