Common minimum standards for incorporating climate change risks into in-house credit assessment systems in the Eurosystem

Prepared by Julia Körding and Florian Resch^[1]

Published as part of the ECB Economic Bulletin, Issue 6/2022.

In-house credit assessment systems (ICASs) need to take all relevant risk factors, including climate change, into account to ensure the collateral pledged in monetary policy operations remains adequate. Climate change and the transition to a greener economy affect the ECB’s primary objective of maintaining price stability, due to the impact they have on the economy and the risk profile and value of assets on the Eurosystem balance sheet. On 8 July 2021 the ECB published an action plan accompanied by a roadmap towards including climate change considerations in its monetary policy strategy and operations. One aspect covered in the latter document is the assessment of climate change risks in credit ratings for collateral. Both transition and physical risks need to be taken into account when assessing credit risk, as they can affect the growth, financial performance, market position and business model of a company, and hence its creditworthiness. The Eurosystem has therefore developed common minimum standards for incorporating climate change risks into ICAS ratings. These have been agreed by the ECB and will enter into force by the end of 2024, as announced on 4 July 2022.

ICASs – the Eurosystem’s internal source for rating credit claims

Within the Eurosystem collateral framework, the ICASs developed by seven euro area national central banks are an important source of credit risk assessment for non-marketable collateral (credit claims).^[2] Counterparties can use ICAS ratings to mobilise loans granted to non-financial corporations, including small and medium-sized enterprises (SMEs), as collateral; in most cases these are not covered by external credit assessment institutions. At the end of 2021, ICASs rated 34% of non-marketable collateral value after haircuts. A set of Eurosystem-wide rules ensures they follow harmonised processes and incorporate relevant key risk factors into their assessments. The rating process involves a statistical model, which typically features financial ratios, followed by an expert analysis covering qualitative information and additional quantitative data. The expert assessment comprises a review of the corporation’s strengths and weaknesses, its links with parent and subsidiary companies, an evaluation of management and an analysis of the industrial and economic environment. ICASs have already started to recognise climate change as a risk factor in their analyses. The ECB’s Governing Council has agreed on a set of common minimum standards for incorporating climate change risks in the rating process, which will be implemented by the end of 2024.

Core principles for incorporating climate change risks in ICAS ratings

The common minimum standards stipulate that the analysis of climate change risks must meet the same high standards for quality and reliability as the assessment of any other risk factor and must be integrated into the regular rating process. The standards specify requirements governing data sources, methodology and processes to be used. Because ICAS ratings are used within the European Credit Assessment Framework as a source for credit risk assessment, ICASs will follow the concept of single materiality, i.e. these will only consider risks that are relevant and material to a company’s creditworthiness. In their assessment, they will distinguish between transition and physical risks and consider the different transmission channels. The analysis should be carried out at firm level whenever sufficient and reliable data are available. The definition of climate change risks and incorporation in the rating process to assess their financial impact are in line with the recommendations of the Financial Stability Board’s Task Force on Financial Disclosure.^[3]

ICAS assessments of climate change risks will mainly focus on the companies most affected and those which pose the highest risk to the Eurosystem because of their size; the analysis of these will therefore be more comprehensive. Following the principle of proportionality is consistent with the greater availability of data expected under the proposed Corporate Sustainability Reporting Directive (CSRD).^[4] Analysis of climate change risks affecting the creditworthiness of non-financial corporations will be conducted in the following order of priority:

• large corporations from high-polluting sectors;
• SMEs from high-polluting sectors for which firm-level data are available;
• other large corporations;
• other SMEs for which firm-level data are available.

For all other firms, ICASs are strongly encouraged to carry out an assessment at sectoral/regional level.

Data and methodologies for incorporating climate change risks

ICASs will strive to obtain firm-level information to assess climate change risks. When making their assessments, these need to combine data on a company’s risk drivers (e.g. carbon prices), risk exposure (e.g. greenhouse gas emissions) and vulnerability after mitigating measures (e.g. technology to reduce emissions) for each type of climate change risk. Having reliable and comparable data available for them all will be a challenge for both ICASs and other credit assessment sources, especially in the short run. The disclosure requirements proposed under the CSRD represent a great leap forward in addressing this issue in a harmonised way. ICASs will use companies’ disclosure under the CSRD as the primary source for data on climate change risks as soon as they are available. They are also strongly encouraged to obtain firm-level data from other sources (e.g. disclosures under the Non-Financial Reporting Directive^[5] or the EU Emissions Trading System) and to use sectoral or regional information where no firm-level information is obtainable.

ICASs recognise the difficulty of assessing the implications of longer-term climate change risks over the one-year prediction horizon of their ratings. The ICASs intend to address this methodological challenge by proceeding in stages. In step 1, they will identify and assess the relevant climate change risks for a company looking beyond the credit risk prediction horizon. In step 2, they will then focus on assessing the materiality of these risks, i.e. the extent to which they affect the short-term credit risk of the company.

The methods for climate change risk assessment will rest on state-of-the-art techniques. ICASs will consider methods and metrics based on harmonised disclosure and industry standards and apply forward-looking approaches. When disclosing under the CSRD, companies are expected to publish an extended set of indicators based on standardised and comparable methodologies whenever possible.^[6] These data can be directly used in metrics or combined with data from other sources. As the expected effects of climate change risks are observable at a lower frequency and amplitude in historical data, the methods and metrics applied will include forward-looking approaches. These will rest on harmonised scenarios taken from industry standards, e.g. those of the Network for Greening the Financial System (NGFS),^[7] to support consistent assessment by different ICASs.

ICASs’ climate change risk assessments will be transparent and objective. ICASs will document their data sources and usage and the methods and processes used to assess climate change risks. For each rating, the outcome of the climate change risks assessment and the adjustment to the ICAS rating stemming from its explicit consideration will be documented. This information may be used in the annual review of the appropriateness of the ICASs’ credit risk assessments and to support checks on the validity of climate change risk assessments. Given the lack of historical data for back-testing, the latter may be limited to benchmarking exercises and qualitative assessments in the short run.

Application and further evolution

The common minimum standards for ICASs are a milestone for better incorporating climate change risks into the Eurosystem’s collateral framework. By explicitly incorporating them into ratings, the minimum standards support coherent assessment of these risks and the implementation of related risk management decisions. ICASs are currently further intensifying their work to incorporate climate change risks into their assessments. All ICASs will abide by the common minimum standards from end-2024 onwards. Wider availability of reliable and comparable data and improved methods are expected to lead to further evolution in best practices. ICASs are committed to continuously developing, following and contributing to this evolution and will consider incorporating related aspects such as environmental and biodiversity risks. They will therefore aim to lead by example, embracing a culture of credit assessments that appropriately reflect one of our current key challenges: climate change risks.