Implications for Risk Managers: A Summary of the EBA Guidelines on Environmental Scenario Analysis (EBA/GL/2025/04)

1. Introduction: A New Mandate for Forward‑Looking Risk Management

The European Banking Authority (EBA) has issued new guidelines that mark a significant regulatory push for financial institutions to embed a forward‑looking perspective into their management of environmental risks, particularly those related to climate change. These guidelines (EBA/GL/2025/04) complement the existing framework on ESG risk management (EBA/GL/2025/01) and are underpinned by legal mandates in the Capital Requirements Directive (CRD Article 87a) and the Capital Requirements Regulation (CRR Article 177(2a)). For risk managers, this represents a new mandate to move beyond traditional risk assessment and embrace sophisticated, forward‑looking analytical tools.

The core conceptual shift demanded by the EBA is the move from traditional risk modeling, which relies heavily on historical data, to scenario analysis. Environmental risks are characterized by their unprecedented nature, deep uncertainty, and extended time horizons, rendering historical data an insufficient guide to the future. Scenario analysis is designed to navigate this uncertainty. The Task Force on Climate‑related Financial Disclosures (TCFD) defines scenario analysis as a tool to explore a "range of plausible future states of the world," enabling institutions to enhance preparedness and anticipate risks in a structured way. This "what‑if" approach is fundamental to building resilience in a rapidly changing economic and environmental landscape.

This summary dissects the key implications of these guidelines for risk managers. It focuses on the dual framework for resilience testing, the practical prerequisites for implementation, the critical principle of proportionality, and the timeline for compliance. The objective is to translate the EBA's regulatory requirements into a clear and actionable overview for those tasked with its implementation. The guidelines are structured around two primary applications of scenario analysis, which together form the core of the EBA's new framework.

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2. The Dual Framework: Two Core Applications for Resilience Testing

The EBA has structured its guidelines around two distinct but complementary applications of scenario analysis, each with a different time horizon and objective. Understanding this dual structure is the first critical step for risk managers in organizing internal efforts and allocating resources effectively.

Application 1: Testing Short‑Term Financial Resilience (The Environmental Stress Test)

The first application integrates environmental risks into existing, well‑understood stress testing frameworks. Its primary purpose is to test an institution's immediate financial resilience to severe but plausible short‑term shocks, such as those over a horizon of, e.g., less than five years.

• Objective: The goal is to assess the shock‑absorbing capacity of an institution's capital and liquidity reserves. The results of these environmental stress tests are expected to be incorporated into the Internal Capital Adequacy Assessment Process (ICAAP) and the Internal Liquidity Adequacy Assessment Process (ILAAP).
• Methodology: The process involves defining a baseline scenario and a set of adverse scenarios that incorporate material environmental risk drivers. For institutions using the Internal Ratings‑Based (IRB) Approach, the guidelines explicitly require the inclusion of physical and transition risks in their credit risk stress tests.

Application 2: Assessing Long‑Term Business Model Resilience (The Strategic Resilience Analysis)

The second application is a more strategic, forward‑looking tool designed to challenge the long‑term viability and adaptability of an institution's business model. It extends beyond immediate financial shocks to assess how the institution can navigate profound economic transformations over a medium to long‑term horizon of at least 10 years.

• Objective: This analysis functions as an extension of the Business Model Analysis conducted under the Supervisory Review and Evaluation Process (SREP). It aims to challenge an institution's ability to adapt its strategy, mitigate long‑term environmental risks, and seize related opportunities.
• Methodology: The approach involves projecting a selection of key metrics‑spanning profitability, risk, and environment‑under a reference scenario (the institution's view of the most likely future) and a set of distinct, plausible alternative scenarios. This analysis is directly linked to the institution's strategic planning and, where applicable, its transition plan, ensuring that long‑term resilience is a core component of its strategic direction.

Comparative Overview of the Dual Framework

The following table provides a clear comparison of the two applications:

This dual framework provides a comprehensive structure for assessing environmental risks. The next step for risk managers is to understand the foundational work required to implement these analyses effectively.

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3. The Implementation Roadmap: Key Prerequisites and Methodologies

Before an institution can conduct a meaningful scenario analysis, risk managers must build a foundational understanding of how environmental risks impact the institution's specific exposures and operations. The EBA outlines several critical prerequisites to ensure the analysis is robust, relevant, and well‑grounded.

Prerequisite 1: Identify and Model Transmission Channels

The EBA requires institutions to identify and map "transmission channels"‑the pathways through which environmental risk drivers propagate through the economy and materialize as traditional financial risks. This involves a structured process of tracing how a factor like a new carbon tax or a severe flood translates into measurable impacts on credit, market, operational, and liquidity risk. The following lists provide illustrative examples drawn directly from the EBA's Annex to guide this process.

Transition Risk Channels

These channels arise from the shift towards a more sustainable and low‑carbon economy. Key examples include:

• Increasing operational costs for corporates due to carbon pricing, higher energy costs, or investments in greener technologies, impacting their profitability and creditworthiness.
• Assets becoming stranded or significantly impaired as they no longer meet new standards or consumer preferences, affecting collateral values.
• Households bearing significant transition costs, such as upgrading property energy efficiency or facing higher taxes on emissions‑intensive goods, affecting their financial condition.

Physical Risk Channels

These channels arise from both acute events (e.g., floods, heatwaves) and chronic shifts (e.g., rising sea levels, changing weather patterns). Key examples include:

• Damage to household properties or corporate assets from extreme weather events, leading to direct losses and increased reconstruction costs.
• Severe disruptions to business operations or value chains due to adverse environmental conditions, impacting corporate profitability and stability.
• Knock‑on effects on the entire economy of a geographical area following a severe event, causing widespread impacts on workforce productivity, supply chains, and prices.

Prerequisite 2: Select, Justify, and Customize Scenarios

Institutions are mandated to use credible, science‑based scenarios developed by recognized international or regional organizations. The EBA distinguishes between sources for climate risks and other environmental risks to guide risk managers.

• Key Sources for Climate Risk Scenarios:Institutions should draw from reputable sources, including:
  • The Intergovernmental Panel on Climate Change (IPCC)
  • The Network for Greening the Financial System (NGFS)
  • The International Energy Agency (IEA)
  • The United Nations Environment Programme (UNEP)
  • The Joint Research Centre of the EU Commission (EU JRC)
• Key Sources for Other Environmental Risk Scenarios:For risks beyond climate, such as biodiversity loss or resource scarcity, relevant sources include:
  • The Intergovernmental Science‑Policy Platform on Biodiversity and Ecosystem Services (IPBES)
  • United Nations specialised agencies (e.g., UNEP, FAO)
  • The European Environment Agency (EEA)
  • The World Resources Institute (WRI)
• Customization is Critical: The guidelines stress that institutions should not simply adopt these external scenarios wholesale. Risk managers must refine and customize them to align with the institution's specific portfolios, business model, and the unique risk characteristics of its operating environment and geography. This step is crucial for making the analysis relevant and actionable.

Methodological Tool: The Role of Sensitivity Analysis

The EBA recognizes that a full, quantitative scenario analysis can be complex. As a practical and simplified tool, it endorses the use of sensitivity analysis. This approach helps identify key vulnerabilities by quantifying the impact of a change in a single risk factor (or a simple combination of factors) on the institution's key indicators.

• Application: For large institutions, sensitivity analysis can serve as an initial step to explore emerging, non‑climate environmental risks. For smaller institutions, it may be a primary tool for resilience testing where a full scenario analysis would be disproportionate to its capabilities or expected benefits.

Successfully navigating these methodological steps requires a pragmatic approach that acknowledges the real‑world challenges of data availability and modeling complexity.

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4. Navigating Proportionality and Key Challenges

The EBA has adopted a pragmatic stance, explicitly acknowledging that environmental scenario analysis is a nascent field with significant limitations in data, models, and methodologies. The guidelines are therefore designed to be implemented in a proportionate manner, balancing regulatory expectations with practical realities.

The Proportionality Principle in Practice

The application of the guidelines is driven by two primary factors: the materiality of the environmental risks identified by the institution and the institution's size and complexity. This ensures that the effort and sophistication of the analysis are commensurate with the risks faced and the resources available.

The EBA provides specific guidance on the expected level of sophistication for different types of institutions:

Limitations and the Role of Expert Judgment

Risk managers must be aware of the inherent limitations of the models used for this analysis. The guidelines identify several shortcomings in traditional macroeconomic models, including:

• Poor representation of energy and agricultural systems.
• Difficulty in incorporating feedback loops and non‑linear tipping points.
• Significant uncertainty introduced by long time horizons and the need for numerous assumptions.

Given these limitations, the EBA explicitly instructs risk managers to use expert judgment to compensate for data gaps, model shortcomings, and deep uncertainty. Therefore, the EBA emphasizes that much of the value lies in the process itself‑fostering strategic reflection and cross‑functional collaboration‑rather than in the precision of the quantitative outputs alone. The role of the risk manager is therefore elevated from a purely technical modeler to a strategic advisor who can interpret results with caution and contextualize them for decision‑making.

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5. Governance, Timeline, and a Call to Action

Successful implementation of these guidelines requires more than just analytical capability; it demands robust governance structures that integrate the process across the entire institution and a clear plan to meet the regulatory deadline.

Cross‑Functional Collaboration

The EBA mandates a cross‑functional approach to scenario analysis. Risk managers must collaborate with other departments‑including strategy, finance, and business lines‑to ensure that assumptions are consistent, expertise is shared, and the analysis is relevant and usable across the organization. This collaborative process is essential for building a shared, coherent narrative about the institution's future operating environment. Furthermore, institutions are required to clearly document all scenario and modeling choices, assumptions, proxies used for data gaps, and the main results and conclusions.

The Critical Timeline

The guidelines set a definitive application date: 1 January 2027. While this may seem distant, the significant challenges involved in data collection, model development, and capacity‑building require proactive preparation to begin immediately. Institutions are expected to use the intervening period to develop their capabilities over time, building an analysis framework that will become an increasingly useful tool for both risk and strategic management.

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6. Conclusion: The Strategic Evolution of the Risk Management Function

The EBA's guidelines on environmental scenario analysis are not merely another compliance exercise. They represent a catalyst for a fundamental evolution in how risk management is perceived and practiced within financial institutions. The core message for risk managers is that the discipline must adapt to a world of deep uncertainty by embracing forward‑looking tools that move beyond the confines of historical data.

This new mandate positions the risk management function to transcend its traditional role. By using scenario analysis to test financial resilience and challenge long‑term business strategy, risk managers are empowered to become more effective strategic partners to the business. The ultimate goal is to enhance the institution's long‑term resilience and help it navigate the profound economic and societal transformations being driven by environmental change. This is a mandate for risk managers to lead their institutions in building a more forward‑looking, adaptable, and resilient financial posture.