EU finance watchdogs are proposing that member state banking and insurance regulators add environmental, social and governance (ESG) risks into stress tests to harmonise the practice among EU supervisors.

“ESG risks can have far-reaching implications for the stability of both individual financial entities and the financial system as a whole,” the European supervisory authorities (ESAs) wrote in their joint consultation on the proposed guidelines and common framework. The consultation is open until 19 September. 

The ESA includes the European Securities and Markets Authority (Esma), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA).

Some regulators such as the European Central Bank already conduct climate- specific stress tests, but under the proposed guidelines the ESG risk would be included in overall stress testing.

The authorities acknowledge that ESG stress testing is still new compared to more traditional financing stress tests but that progress has been made, especially for “environmental risk link to climate change”.

Because of this, the ESAs propose that regulators focus on climate and environmental risks, including physical and transition risks, with a gradual rollout of other ESG considerations such as social and governance risks.

Authorities should also consider spillover and interconnections among different financial sectors when possible, while looking at short-term shocks of five years or less and longer-term horizons of at least 10 years.  

Concern about effectiveness of ESG stress tests

While stress testing is often used to assess potential financial risk, some economists have voiced concern that current climate stress tests may not be fully capturing the financial loss from climate risk. Others say the climate scenarios these tests are based on may be too simplistic. 

Central bank stress tests always leave out some risks which means the risks are often higher than assumed, said Yannis Dafermos, a professor at Soas University of London.

He also worries that financial regulators are just conducting stress tests and research while leaving it to governments and other stakeholders to take action.  

“You can always do an analysis and say, ah, the risks are very high. But then you can say, okay, there’s nothing we can do about that,” he said.

Dafermos pointed to the Bank of England’s climate stress test, which found customers would be hit by climate losses, but then said it was not the bank’s job to address the causes of climate change.

“It’s important to do stress testing analysis. I think there’s space to improve this quite a lot. But the question is, what exactly do you do with this stress testing analysis? And if the idea is that we don’t basically do anything, I think that’s a problem.”