Europe’s three primary financial regulatory agencies, the European Supervisory Authorities (ESAs) announced the publication of their finalized Guidelines on environmental, social, and governance (ESG) stress testing, aimed at enabling national regulators to integrate ESG risks into their supervisory stress tests for banks and insurance companies.

The ESAs include The European Securities and Markets Authority (ESMA), The European Banking Authority (EBA), and The European Insurance and Occupational Pensions Authority (EIOPA).

According to the ESAs the new guidelines are designed to establish common standards for embedding ESG risks into stress testing methodologies across the EU’s financial system, ensuring that competent authorities consistently integrate ESG risks into their national supervisory stress testing activities, and encompass the integration of ESG risks into existing frameworks, as well as new complementary assessments for measuring the impact of ESG risks under adverse scenarios.

While not creating any new requirements for regulators, the ESAs said that the new guidelines will be subject to a “comply or explain” procedure by the National Competent Authorities.

Among the key factors covered by the new publication is guidance for competent authorities to adopt a risk-based approach to their integration of ESG risks, starting with a materiality assessment to identify the most relevant and impactful risks, considering issues such as financial entities’ business model, portfolios, geographic exposures, and sectoral activities over various time horizons.

The new guidelines propose that authorities first focus on climate and environmental risks, including both physical and transition risks, and to gradually extend coverage to other ESG factors, based on factors including the availability of data and the use of models develop over time.

Additional factors included in the new guidelines include time horizon, with regulators guided to use a short-term time horizon when assessing financial resilience to adverse but plausible shocks, and a longer-term horizon for assessing the resilience of financial entities’ business models and strategies, as well as scenario designs, and considerations for the use of top-down vs bottom-up approaches, as well as level of granularity, with regulators guided to consider portfolio, sectoral, geographical, and counterparty-level dimensions, and to perform separate identification of physical risks, transition risks, and other ESG factors such as biodiversity loss, pollution, social and governance risks.

The guidelines also recommend that regulators allocate sufficient human and material resources to the ESG risk stress testing process, including involving staff with expertise in ESG risk assessment, and having data management and collection capabilities in place to support access to high-quality ESG data.

The ESAs said that the new joint guidelines will apply from the beginning of 2027.

Click here to access the new guidelines.