The negative impact of climate change on future generations is undeniable. The EU estimates that without immediate action, annual economic losses will amount to EUR 190 billion, in addition to other physical losses. To address climate risks and, more broadly, ESG risks, a first step would be to establish a common definition for these risks. Therefore, as part of its Sustainable Finance Action Plan (2019 ), the European Banking Authority (EBA) has committed to creating a comprehensive understanding of what ESG risks are and how they can be addressed by financial market participants. Specifically, the EBA published its report on the management and supervision of ESG risks for credit institutions and investment firms in June 2021.
According to this report, a distinction is made between ESG factors and ESG risks, whereby the former can merge into the latter. While there is no clear definition of ESG factors, a list of characteristics can be used to identify them. The EBA summarizes that ESG factors are generally non-financial in nature and sensitive to public preferences. There is uncertainty about the timing of their impact and patterns can be observed in the value chain. ESG factors result in negative externalities. From this, the EBA deduced that ESG factors can be considered as any type of ESG concern that has a positive or negative impact on the financial performance of market participants.
ESG risks, on the other hand, can be defined as negative financial impacts resulting from the effects of current ESG factors on the invested assets. There is therefore an outside-in and an inside-out perspective. The outside-in perspective refers to the negative impact that ESG factors have on the physical locations of financial institutions, for example. The inside-out perspective, on the other hand, covers the negative impact on ESG issues resulting from the financial institutions' own activities. All ESG risks go through a transition process and ultimately lead to financial risks, e.g. credit, market, operational, liquidity or reputational risks with potential systemic impact.
So far, environmental risks have been emphasized the most and are divided into physical risks and transition risks. Physical risks arise from the physical effects of climate change and environmental degradation, which can occur gradually over a longer period of time or are related to specific climate events. Transition risks, on the other hand, relate to uncertainty regarding the timing and speed at which market participants will progress towards an environmentally sustainable economy, including political, technological and behavioral changes.
Transition risks and physical risks should not be viewed in isolation. The related interactions and areas of tension are omnipresent.
Finally, a definition of social and governance risks has also been put forward, although these have received minimal attention from regulators and the market. Social risks include negative financial impacts on institutions arising from social factors related to people's rights, welfare and interests, such as security, inequality, inclusivity, labor relations, etc. Governance risks refer to the negative financial impact of an institution resulting from governance factors such as non-inclusive management style, board independence, tax avoidance, corruption, bribery, to name but a few.
