Recently, the three major EU financial regulators jointly issued the "Joint Guidelines on ESG Stress Testing (Draft)", which aims to guide the competent authorities of the banking and insurance industries to include environmental, social and governance (ESG) risk factors in regulatory stress testing.

The three major institutions include: European Securities and Markets Authority (ESMA), European Banking Authority (EBA) and European Insurance and Occupational Pensions Authority (EIOPA).

The guidelines are formulated in accordance with the Capital Requirements Directive (CRD) and Solvency II Directive (Solvency II), aiming to coordinate the methods and practices of banking and insurance regulators in ESG stress testing, ensure regulatory proportionality, and improve the effectiveness and efficiency of testing. The public consultation will last until September 19, 2025.

The draft clearly states that although it is not mandatory for each regulatory authority to conduct ESG stress testing, it provides a systematic framework and practical guidance for it. Its content covers the following aspects:

● Test design and methods: clarify how to set ESG scenarios, select test methods (such as top-down or bottom-up), define time perspectives (short-term and long-term) and risk granularity (such as division by industry, region, asset class, etc.);

● Resource and organizational guarantee: propose that stress testing should have corresponding human resources, and personnel should have professional knowledge in ESG risks, stress testing and financial supervision, and build high-quality data collection and management systems;

● Data and governance arrangements: It is recommended that regulators use the existing regulatory reporting system and disclosure framework, supplemented by necessary temporary data collection, and fill data gaps through reasonable assumptions or expert judgment;

● Supervision integration and result application: encourage the inclusion of ESG stress test results in a wider regulatory process, guide financial institutions' risk assessment and strategic adjustments, and propose subsequent regulatory measures when necessary;

● Cross-industry and cross-border collaboration: advocate that regulators share methods and data between banking, insurance, securities and other fields, and coordinate the regulatory practices of multinational groups to avoid regulatory fragmentation.

The draft states that although ESG stress testing is a relatively nascent field compared to more traditional financial stress testing, significant progress has been made to explore available data and models, in particular for environmental risk linked to climate change.

The draft encourages authorities to adopt a “progressive” approach, starting with environmental (E) risks first, initially focusing on physical risks and transition risks related to climate change, and then gradually expanding to other environmental factors, social (S) and governance (G) related risks.

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 risk (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.

In deciding on the level of granularity, competent authorities should strike an appropriate balance between complexity and precision. More granular data might be needed to, for example, appropriately capture activity- or entity-level impacts oftransition risk or regional/local effects of physical risks.

At a minimum, competent authorities should consider the following granularity dimensions:

a. Portfolio level: Differentiation by asset class (e.g., corporate loans, mortgages, sovereign exposures, equity and corporate bond holdings).

b. Sectoral level: Classification based on industry sector (e.g., high-carbon industries, energy, real estate, agriculture). For specific sectors a higher granularity may be explored (e.g., electric power, sector impacted by a breakthrough technology). For real estate, a distinction between commercial and residential real estate exposures may be explored.

c. Geographical level: Distinction by region (e.g. NUTS level 3) to assess exposure to location-specific ESG risks, particularly physical risks.

d. Counterparty level: Granularity by individual obligor or groups of obligors where concentration risks are significant.

e. Risk category: Separate identification of physical risks (acute and chronic climate hazards), transition risks (policy, technology, and market shifts), and other ESG factors (e.g., social and governance risks).

In addition, the draft joint guidelines will be finalized by the end of 2025, and the final version will be officially released by the joint committee of the three major regulatory agencies before January 10, 2026.

Author：Qinger