European policymakers have published new guidance for regulators on incorporating environmental, social, and governance (ESG) risks into their industry stress tests.
In a joint release Thursday, the European Supervisory Authorities — including securities, banking, insurance and pension regulators — issued guidance that sets common standards on how to integrate ESG risks into supervisory stress tests.
“The guidelines are designed to support a consistent, long-term approach to ESG stress testing while allowing flexibility to accommodate future methodological advances and improvements in data availability,” the regulators said.
The final guidance, which was developed following public consultation, also provides input on designing ESG-inclusive stress tests and details expectations for organizational and governance arrangements in carrying out these exercises.
“ESG risks can have far-reaching implications for the stability of both individual financial entities and the financial system as a whole,” the paper said. As a result, it argued that regulators should “consistently factor those risks” into their supervisory activities, including their compliance reviews and stress testing.
The guidance noted that ESG stress testing remains relatively new, compared to traditional financial stress testing, and said regulators should keep their approach to ESG stress testing under review, “as new methodologies become available” and financial firms gain experience with these kinds of exercises.
To start, regulators may initially focus on climate-related risks, including both physical and transition risks, before extending the coverage of their stress tests to broader environmental risks (including biodiversity and deforestation) as well as other ESG factors (social and governance factors) as tools are developed to enable these kinds of tests.
“The guidelines also clarify how ESG stress testing and scenario analysis can serve different objectives and time horizons, encompassing both the assessment of the financial entities’ resilience to significant short-term shocks and the resilience of their business model over a longer time horizon,” it said.
The new guidelines take effect Jan. 1, 2027.