Objectives

Pursuant to the sectoral legislation, competent authorities should implement these Joint Guidelines in accordance with the principle of proportionality⁵ .

Competent authorities should consider all ESG risks and their potential evolution when designing their framework for supervisory stress testing and keep under review the relevance of ESG risks to such framework, especially while progressing towards gradual extension of the coverage to other ESG factors Competent authorities should precisely define their objectives when performing ESG stress testing, considering two main types of stress testing exercises:

• ▪ testing the robustness of capital and liquidity position and the loss-absorption capacity of financial entities in the face of economic and financial shocks linked to all material risks including ESG risks over a short-term horizon (e.g. up to five years);
• ▪ testing the resilience of financial entities’ strategy and business model to a range of ESG - related scenarios over a long-term (at least 10 years⁶ ) horizon.

Materiality assessment

Competent authorities should adopt a risk-based approach, starting with a materiality assessment to identify the most relevant and impactful risks and determine which of those material risks should be part of a stress test exercise ’s scope.

As part of the materiality assessment, competent authorities should identify which ESG risks are most material to financial entities, considering their business model, portfolios, geographic exposures, and sectoral activities over a short- to long-term horizon. Competent authorities should consider, over the different time horizons, both:

• ▪ the exposure of assets and liabilities to transition risks (for example, based on their carbon footprint) and physical risks (for example, based on their geographical location); and
• ▪ the potential impacts of ESG factors on the traditional categories of financial risks, i.e. market risk, credit risk, counterparty risk, underwriting risk, as well as operational risk, reputational risk and strategic risk through the identification of the main transmission channels.

5 As these guidelines are addressed to competent authorities, the application of proportionality should follow the proportionality requirements laid down in sectoral legislation. 6 In accordance with the objectives enshrined in the Paris Agreement (2015). 7

Competent authorities should consider using clear qualitative and/or quantitative criteria and/or thresholds for materiality, leveraging existing regulatory frameworks, industry standards, and supervisory experience. The materiality assessment should allow for adjustments over time as ESG risks evolve, new data becomes available, and financial entities refine their own risk identification processes.

Gradual extension of the scope of ESG factors in ESG stress testing

Competent authorities are encouraged to continue their efforts and research to gradually extend the coverage toother ESG factors in the implementation of ESG stress tests, initially prioritising environmental risks. In a first phase, competent authorities should focus on climate and environmental risks, addressing both physical risks (e.g., extreme weather events, biodiversity loss) and transition risks (e.g., policy shifts, market re-pricing) aiming to distinguish impacts, even if indirect, on the main risk exposures.

This gradual roll-out should be accompanied by continuous methodological refinement, capacity building, and stakeholder engagement, ensuring that financial entities and competent authorities are adequately prepared for the expanding scope of ESG risk assessments.

Integration of ESG factors into existing stress testing frameworks

Competent authorities should aim to fully integrate ESG factors into overall stress testing framework.

Competent authorities should review and reconsider as appropriate the types of ESG risks covered, also based on how the availability of data and the use of models develop over time.

Interconnection/spillover between financial sectors

Although these Joint Guidelines do not cover system-wide financial sector stress testing, competent authorities should, where possible, coordinate across financial sectors to ensure a consistent approach to ESG risk assessment and facilitate data sharing where appropriate. The banking, insurance, and securities regulators should collaborate with a view to help identify and model transmission channels (for instance the role of insurance on banks loans collaterals), align scenario assumptions, and prevent regulatory blind spots.

Competent authorities should ensure, to the extent possible, that ESG stress tests account for interconnections and spillover effects between financial sectors. They should consider how ESG-related risks can propagate through the financial system, amplifying vulnerabilities across banking, insurance, asset management, and other financial sectors.

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