Regulators expected to get tough on non-compliance with climate-related obligations.

With banks falling short of expectations to manage and disclose climate risks, European regulators are set to turn up the heat on the banks in the months ahead, suggests Morningstar DBRS.

In a new report, the rating agency said the European Central Bank (ECB) has signalled it intends to start penalizing banks that fail to comply with regulatory requirements involving their climate and environmental risks, such as their emissions reporting obligations.

“We anticipate this might be a turning point for regulators in their mission to make banks more accountable to climate and environmental exposures,” it said.

The prospect of ramped up enforcement action comes in the wake of various exercises the regulators have carried out — including stress testing, thematic compliance reviews and self-assessment exercises — that have uncovered a lack of action by the banks on their climate-related risks.

“The ECB concluded earlier this year that many banks are still lagging in terms of availability and quality of ESG disclosures,” it said. It also noted that a recent review of 95 large European banks found that over 90% of the banks had corporate portfolios (lending and investment banking) that weren’t aligned with their climate commitments, and that 70% were exposed to heightened legal risk as a result.

The physical effects of climate change are intensifying too, the report said.

“In Europe, floods, droughts and heatwaves have already started to cause considerable financial damage,” it said, noting that, last year floods in Slovenia caused damage equivalent to 16% of its GDP.

Against this backdrop, DBRS said it expects banking regulators to get tougher with banks and their climate-related regulatory obligations.

“In our view, the European regulators’ tolerance bandwidth around banks addressing climate-related risks is likely to continue to narrow,” it said.

Along with fines, this could also mean raising capital buffers and restricting dividend payouts at banks that aren’t meeting their requirements, it noted.

“Though these measures appear unlikely for the time being, we anticipate the ECB’s recent signalling that it will escalate penalties on noncompliant banks to mark the beginning of the authorities flexing their regulatory muscles,” the report said.