Financing the orderly transition to a low carbon economy in the EU: the regulatory framework for the banking channel

Abstract

Among the largest economies of the world, the EU not only has set the most ambitious and legally binding objectives for the reduction of the GHG emissions but also it has accompanied these objectives with a “state of the art” regulatory framework in the realms of investor protection and safety and soundness. Our paper focuses on the bank financing channel and highlights regulatory areas for improvement. To mobilize the necessary funds worldwide, a degree of interoperability of regional taxonomies is required, which calls for international cross-pollination and coordination to mitigate financial risks and the risk of harmful market fragmentation (BCBS 2022, FSB 2022). Also, the full interoperability between the international and the EU corporate reporting standards is a desirable objective. A building bloc methodological approach would make such interoperability easier having the sustainability impact perspective of the “double materiality objective” as an additional layer of the international requirements well understood to all investors in EU undertakings. As per the inclusion of climate risks in prudential regulation, it is completed for Pillar 3 disclosures relating effectively with the EU Taxonomy. Climate risk’s long-term horizon still needs to be implemented in Pillar 2 by linking bank transition plans with stress testing based on climate risk scenario analysis covering both transition and physical risk. The inclusion of climate risks in Pillar 1 faces challenges similar to those of supervisors internationally. Fostering global ambition is an explicit objective of the EU. Its leadership on the realms of investor protection and prudential regulation of climate risks should ideally inform international cooperation and impregnate international standards. This will secure that investments for the fulfillment of the EU climate objectives will flow from in and outside the EU.

Introduction

The orderly transition to a low carbon economy demands high investments in energy efficiency, renewable energies for electricity as well as technologies to capture and permanently storage CO2 in the next ten years until 2030 (IEA, 2021, Wolf et al. 2021).¹ The European Union (EU) has a legally binding strategy to fulfil the net zero GHG emissions around 2050 pledge enshrined in the EU Climate Law.² The academic research has so far focused on the impact of climate risk on financial stability, the macroeconomic effects and implications for the conduct of monetary policy ([14, 29, 16, Diffenbaugh et al. [18, 36]), as well as banks’ exposure to climate transition risk, an assessment of the effectiveness of capital requirements, and the impact of a climate shock on banks Nguyen et al. [41, 45], de Marco and Limodio (2022), Nieto (43, 44). Our paper, while taking into account the above research, focuses on bank regulatory prudential and business conduct approaches, and analyses the extent to which this new regulatory framework is consistent with channelling resources to finance the transition to a low carbon economy.

Considering the importance of bank financing in the EU (European [23], the objective of this paper is to make a critical assessment of the regulatory development of the European Commission’s 2018 Action Plan on Sustainable Finance (the 2018 Action Plan) based on its three main objectives: i reorienting capital flows towards sustainable investment in order to achieve sustainable and inclusive growth; ii managing financial risks stemming from climate change and resource depletion and iii fostering transparency and long-termism in financial and economic decisions. Following the European Green Deal in 2019, the Commission published the ‘Strategy for financing the transition to a sustainable economy’ (the ‘2021 Strategy’) as a new edition of the 2018 Action Plan with an added objective: (iv) fostering global ambition.³ Our assessment covers safety and soundness, as well as market conduct financial regulation relevant for banks and it is based on the objectives in the 2021 Strategy.

We conclude that the EU not only has set ambitious objectives for the reduction of the Green House Gas (GHG) emissions but also it has accompanied these objectives with a “state of the art” regulatory framework in the realms of investor protection and safety and soundness following the implementation of the 2021 Strategy. The EU framework under development fosters international and EU investments for the fulfillment of the climate objectives.

This paper is organized in four sessions in addition to this introduction. Section "How ambitious are the EU objectives to decarbonize? The importance of the bank financing channel" presents the EU decarbonization objectives and briefly describes the policy levers to be used and the existing sustainable and green bank financing. Section "Market conduct regulation as a tool to reorient capital flows towards sustainable bank finance" analyses the EU market conduct regulations that will most directly affect banks in light of the objective of attracting capital flows and correcting market failures. Section "Managing financial risks from climate change and natural depletion: The prudential regulatory approach" assesses the developing EU prudential regulatory approach for climate risks. The last section concludes and highlights the challenges going forward.

How ambitious are the EU objectives to decarbonize? The importance of the bank financing channel

Although the EU GHG emissions only account for approximately 6% of the global emissions at the end of 2019,⁴the EU abatement policies are ambitious in terms of objectives and policy levers.⁵ Figure 1 shows the negative historical correlation between GDP (current prices PPP international USD) and CO2e (GHG in Mt -CO2e-) from peak in 1990 to 2018 (Panel A) and the estimated larger negative correlation needed for the 2020–2050 period (Panel B) to reach Net Zero around 2050.

Fig. 1

EU27 Correlations between nominal GDP and CO2e emissions to meet Net Zero emissions around 2050 Source: Historical data, Climate Data Watch (CAITS) 2009–2018. Nominal GDP current prices 2017 PPP international USD, IMF, World Economic Outlook April 2021. CO2e emissions projections REMIND-MAgPIE 2.1–4.2 model. Authors´ elaboration

The main legal instrument of the EU strategy is the EU Climate Law, approved in June 2021.The Climate Law sets a legally binding target of net zero GHG emissions and bounds both Member States and the “relevant” EU institutionsto take the necessary steps to achieve the target. Among the largest economies of the world, the EU is the only one that has enshrined the net zero objective in law [42]. In order to operationalize these objectives, the EU Commission (EC) has proposed a package (denominated “Fit for 55”)⁶that heavily relies on emissions pricing as a policy tool. Annex 1 summarizes the policy levers and the sectors affected by the “Fit for 55” package. In October 2022, the REPowerEU plan ramps up the ambition of objectives on renewables, energy efficiency and key hydrogen infrastructure. In order to finance key investments and reforms that will help achieve the REPowerEU objectives, Member States will be able to add a new REPowerEU chapter to their national recovery and resilience plans under NextGenerationEU (recovery plan to emerge from the pandemic and transform the EU economies including the environmental dimension).⁷ According to the calculations of the EC, this greater ambition of objectives demands an additional investment push (public and private) of up to 210 billion euros in total until 2027, in addition to what was calculated in the “Fit for 55” (520 billion euros per year in the next decade).⁸ At least 37% of the Next Generation EU funds need to be allocated to climate change projects. In December 2021, as a comparison, the participation of EU banks in the syndicated environmental loans and sustainability loan markets amounted to 5.7 billion and 9.3 billion USD, respectively (REFINITIV LPC Deal Scan). Although these figures only represent bank financing via syndicated loans, they are indeed, far from the annual objectives set in the “Fit for 55” and the REPowerEU plans.⁹ The objective of Environmental Loans is to finance in whole or in part new and/or existing eligible Green Projects, which should provide clear environmental benefits and comply with the Green Loan Principles, subject to a review process. The objective of Sustainability-Linked Loans is to incentivize the borrower´s achievement of ambitious, predetermined sustainability performance objectives (Environmental, Social, Governance or ‘ESG’). Hence, in terms of the environmental objectives, this type of financing is key for the transition to a low carbon economy. The borrower’s sustainability performance is measured using predefined sustainability performance targets that should be consistent with the borrowers overall ESG strategy.¹⁰ Figure 2 shows the syndicated Environmental Loans by type of industry in USD. Figure 3 shows the syndicated ESG loans (December 2021) in USD. Energy is the leading sector for use of proceeds as it is the case worldwide.

Fig. 2

Source: REFINITIV LPC Deal Scan

Fig. 3

Source: REFINITIV LPC Deal Scan. Environmental and ESG syndicated lending peaked in 2021 showing a growing upward trend from 2017

Market conduct regulation as a tool to reorient capital flows towards sustainable bank finance

Based on the 2021 Strategy, the foundations of the EU sustainable finance strategy for financing the transition to a sustainable economy rests on three pillars: Taxonomy, disclosures, and a tool to prevent green washing (climate benchmark regulation and green bond standards).¹¹ This section focuses on the first two given their importance for fair market conduct of deposit taking institutions.

The EU classification system for sustainable activities: the Taxonomy

The EU defined the sustainable economic activities in the Taxonomy Regulation and delegated regulations (‘EU Taxonomy’)¹² and will periodically incorporate the scientific evidence available over the long cycle of decarbonization.Taxonomy-aligned (green) activities are those contributing substantially to one or more of the six environmental objectives and that do no significant harm to any others (DNSH principle) (climate change mitigation and adaptation, protection of water and marine resources, transition to a circular economy, pollution prevention, protection and restoration of biodiversity and ecosystems). In parallel, they must comply with minimum social safeguards and the technical screening criteria established in delegated regulations.

The EU Taxonomy is complemented by the technical criteria of the Sustainable Finance Delegated Regulation (Delegated Regulation)¹³ which determine the economic activities that contribute substantially to climate change mitigation by avoiding and reducing greenhouse emissions, or by increasing long-term carbon storage. This shows the breadth of the financing needed to redirect the EU economy to sustainable activities [47]. The degree of alignment with the EU Taxonomy is monitored via the Green Asset Ratio (GAR)¹⁴, i.e. a banks’ taxonomy-aligned exposures to counterparties subject to disclosure under Directive 2014/95/EU compared to its total assets. The Delegated Regulation is being extended to significantly harmful and low impact activities with a transition focus.

This classification system is important because it helps to identify the recipient sectors and activities of the financing to reduce their emissions. For instance, transport accounts for 23% of EU direct greenhouse emissions, followed by energy (22%) and manufacturing (21%), and are subject to technical screening criteria to finance their decarbonization. In 2021, only an estimated 1.3% of the EU bond and equity markets financed taxonomy-aligned activities (bonds and equity borrow the taxonomy character of the activities they finance) [2]. There is growth potential for capital markets [10] and banks¹⁵ to redirect more financial resources towards sustainable activities. For a taxonomy to be usable, it needs to be coupled by data from borrowers and banks that enable supervisors to assess if banks finance taxonomy-aligned activities and benchmark with peers [38].

As the transition to a low carbon economy is a worldwide effort, in comparison with other regions [38]¹⁶), the EU Taxonomy provides for clarity and disclosure for financial and non-financial firms, is dynamic, science-based, mindful of transition activities and international standards to ensure that green activities attract the requisite capital from in and outside the EU.

Corporate sustainability reporting directive (CSRD) and the European sustainability reporting standards (ESRS)¹⁷

The CSRD is a regulatory framework for disclosure relevant for banks both directly (because they fall into its scope) and indirectly (because of the enhanced data stemming from corporates' disclosures).¹⁸ More generally, the scope includes all large companies and all listed companies (except listed micro enterprises) and non-EU companies with branches or subsidiaries in the EU above certain thresholds expanded to include upstream and downstream value chain within the EU and third countries, when necessary to allow understanding of material impacts.^{19, 20}

The ESRS implement the CSRD principles. Hence, the urgency of European institutions to develop this framework in parallel to the International Sustainability Standards Board (ISSB) that it is developing the International Financial Reporting Standards on sustainability (IFRS-ISSB). Note that the ISSB implementation will depend upon governments requiring their use.

A principle that is central to the CSRD is the “double materiality,” which is represented accordingly in the ESRS materiality assessment approach: a sustainability matter meets the criteria of double materiality if it is material from an impact perspective or from a financial perspective or from both.²¹ Furthermore, the CSRD explicitly acknowledges that both “impact and financial materialities” are not only on equal terms but also intertwined. However, it must be recognized that it is not always easy to determine when impact materiality could affect cash flows of the company.²²

A sustainability matter is material from an impact perspective if the undertaking is connected to actual or potential significant impacts on people or the environment over the short, medium or long term. This includes impacts directly caused or contributed to by the undertaking and impacts which are otherwise directly linked to the undertaking’s upstream and downstream value chain.²³ This approach is different from the one of the IFRS-ISSB that focuses on “financial materiality” (Enterprise Value Impact), although it could be argued that “impact materiality” is implicitly considered as a source of risks and opportunities in the IFRS-ISSB S1 that requires to locate the information in the general purpose financial reporting.²⁴ By contrast, the CSRD requires the sustainability disclosure to be an identifiable and dedicated part of the management report.²⁵ This is a relevant difference of approach with the IFRS-ISSB. Assurance of such information by the statutory auditor or audit firm is an obligation, which confirms the integrated approach of the CSRD. The Commission shall adopt delegated acts in order to provide assurance standards for reasonable assurance of sustainability reporting no later than 1 October 2026.²⁶ The approach will be gradual from limited to reasonable assurance.²⁷ At present, the sustainability reporting requirements are sector agnostic, although in a second stage by 30 June 2024, the EU Commission will adopt a set of sustainability standard obligations specific to sectors.²⁸

The list of sustainability matters to be covered includes ESG related matters.²⁹ The European Banking Authority (EBA) has publicly stated concerns in the implementation of double materiality when undertakings are asked to disclose how the prioritization of the negative impacts “on people or the environment over the short, medium or long term” reflects their severity and likelihood.³⁰

³¹The reporting time horizon covers the short term (one year), the medium term (two to five years) and the long term (more than five years).³² Estimation uncertainties regarding possible future events influence on future cash flows, impacts on people or the environment and the likelihood of the possible outcomes are contemplated and also are subject to requirements. The CSRD on sustainability reporting standards for SMEs specifies reporting requirements for listed SMEs. This is a reduced list from the requirements that will apply to other companies under scope. Also, the CSRD opens the possibility for SMEs to opt-out after a transitional period of two years.³³

Reflecting the principle of double materiality, the scope of application of CSRD/ESRS refers to a broader group of stakeholders than just primary users that need the information to assess the enterprise value (investors, lenders and other creditors). Indeed, the scope of application reflects the needs for transparency corresponding to sustainability as “European public good.”³⁴ Moreover, explicit sustainability due diligence requirements will be legally binding.³⁵ The presentation of sustainability information should be clearly differentiated from other information included in the management report.³⁶

Source: ESRS 1 paragraph 86 and authors´ analysis.

Given the global nature of capital markets, the full interoperability between the IFRS-ISSB and the CSRD-ESRS is the most desirable objective. A building bloc methodological approach would have made such interoperability easier having the “double materiality objective” as an additional layer of requirements well understood to all investors in EU undertakings.

Managing financial risks from climate change and natural depletion: The prudential regulatory approach

The ESG risks must be included in Union law owing to their materiality (EBA 2021), namely in the prospective revised banking regulation (Capital Requirements Regulation (CRR3)³⁷/Capital Requirements Directive (CRD6)³⁸) and the mandates to the EBA on sustainable finance: Under Article 98(8) CRD5, EBA shall first, assess the potential inclusion in the supervisory review and evaluation process (SREP) of ESG risks; second, define the Pillar 3 quantitative and qualitative disclosures of ESG (Article 449 a) CRR); and third, whether a dedicated prudential treatment for exposures associated with climate and environmental risk would be justified (Article 501c CRR and Article 34 IFR).

The above legislation will have three consequences.³⁹ First, banks will be required to manage their exposures to ESG risks. Second, it will have an impact on banks’ lending behaviour and will induce them to lend to carbon reduction and renewable energy activities.⁴⁰ Third, the disclosure mandated by the regulation indirectly mitigates the financial markets’ inefficient pricing of carbon risk because information about climate risk has been usually ignored.⁴¹ However, information on GHG emissions (particularly Scope 3) face methodological limitations as well as limited reliability and comparability [14].⁴² For example total emissions may not be a reliable measure: in the automobile industry, Volkswagen AG declared similar average emissions with Stellantis NV by using different methodologies—even though the scope 1–3 emission intensity of Volkswagen AG was 4 times higher. Moreover, environmental ratings do not often match low carbon emissions [38], while existing transparency around their data and methodologies is insufficient (Nieto, 2020).

More in general, in parallel with the addition of ESG risks in the banking regulation, supervisors in and outside the EU⁴³ published their expectations for the identification of climate and environmental risks. In the euro area, the ECB’s supervisory expectations apply to 111 significant institutions.⁴⁴ In comparison, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) proposed six principles targeting the 32 largest US banks concerning governance, risk management, limits, disclosure, scenario analysis.⁴⁵ What all these expectations have in common is that they aim at instilling a forward-looking approach in banks’ risk management with the use of long-term scenario analysis, since past historical records are not suitable to gauge climate risks. In addition, the results of the 2022 climate stress test feed qualitative elements into the SREP and may have an indirect effect on Pillar 2 capital requirements (P2R), but no direct impact on Pillar 2 guidance (P2G). An international alignment regarding the management of climate-related financial risks for banks and supervisors ([6], BCBS 2021) will help mitigate these risks and the risk of harmful market fragmentation (FSB 2022).

Climate risk in Pillar 2: long-term horizon, regional and sectoral challenges

Climate and environmental risks are to be incorporated in their risk assessment by banks and their supervisors. On the one hand, the EBA [20, 22] expects banks to cover their ESG risks in internal capital adequacy assessment process (ICAAP) and attribute capital for each risk or explain if the bank thinks this is not the case. A big challenge for banks and supervisors is to develop methodologies to detect and quantify those risks with a longer horizon that extends to 2050,⁴⁶ so this is work in progress, and quantitative considerations go in parallel with advancements in data quality, risk assessment methodologies, and disclosure.

On the other hand, the losses from the materialization of climate risk cannot be underestimated,⁴⁷ however, asking banks to set aside capital for risks that might materialize from 10 to 30 years, if economic policy tools and technological changes in the meantime are not successful in fighting climate change, is incompatible with the Pillar 1 prudential framework which relies on annual cycles (probabilities of default have one-year time horizon).⁴⁸ Instead, Pillar 2 is more flexible to handle climate risk as supervisors can avail themselves of a variety of “deterrence” tools before they opt for a capital add-on. Such measures vary from climate stress tests and thematic reviews to gauge banks’ preparedness and climate risk literacy, setting limitations on certain exposures or distribution of dividends, asking for a strategic plan to address climate in the context of ESG risks and other qualitative requirements. Ultimately, bank-specific Pillar 2 additional capital can be imposed based on stress testing scenario based analysis and assessments of the business strategies and processes (EBA Guidelines on loan origination and monitoring⁴⁹), governance (EBA Guidelines on internal governance⁵⁰ and on remuneration⁵¹), risk management (future EBA Guidelines on ESG risk management⁵²), and business models, which need to be analysed until 2050.

While financial institutions committed voluntarily to financing green activities and drawing up transition plans [32] for that purpose, proposed Article 76 (2) of the future CRD6 renders transition plans a legal obligation. The current wording is risk-based concerning a potential misalignment of the business model with ‘Union policy objectives or broader transition trends towards a sustainable economy in relation to environmental, social and governance factors’. It should be improved by linking the transition plans to the climate scenario analysis, requiring the management body to develop milestones and Key Performance Indicators (KPIs) how bank products and services will become taxonomy-aligned over five-year intervals until 2050. Supervisors will be tasked to assess the transition plans (Articles 87a (4) CRD6).

The [26] stress testing showed that development/regional and small retail banks’ income relies disproportionately heavily on GHG-emitting sectors in Europe, while G-SIBs hold the largest share of exposures to carbon-intensive sectors. This shows that not only physical,⁵³ but also transition risks are not negligible, while their impact on banks may be heterogeneous. Since more than 60% of bank revenue is derived from 22 carbon-intensive EU sectors, banks need also to assess their customers’ transition plans to green activities.⁵⁴

The long-term transition perspective that permeates the EU Taxonomy and the CSRD/ESRS framework is not yet reflected in the EBA SREP Guidelines, therefore, the ΕΒA intends to update them with the ESG risks.⁵⁵ The EBA (2021) recognized that the existing assessment under the SREP may not enable supervisors to sufficiently understand ‘the longer-term impact of ESG risks’, which requires the introduction of a longer-term perspective in the supervisory assessment, in the form of an evaluation of whether credit institutions sufficiently test the ‘long-term resilience of their business models against the time horizon of the relevant public policies or broader transition trends, applying at least a 10-year horizon’.⁵⁶ Introducing this long-term approach is desired and vital because the Commission’s targets for the next decade up to 2030 and the target of net zero carbon emissions by 2050 is given for banks and supervisors. This long-term perspective should be enshrined in law to ensure that all banking supervisors follow this perspective, which is a novelty for the prudential framework. Systemic risk buffers⁵⁷ are thinkable in response to unaddressed systemic climate risk [5], but they do not introduce the long-termism required in Pillar 2, which is a novelty for the existing prudential framework that focuses on historic trends and a short horizon of 1–5 years.⁵⁸

On the other hand, the four SREP elements, business model, governance and risk management, risks to capital, and risks to liquidity need to be calibrated so that supervisors may assess different geographical and sectoral determinants of physical risks, as well as transition risks [39, 40].⁵⁹ The above considerations suggest that in the future, prudential assessments will likely assess the results of forward-looking scenario analysis⁶⁰ based on banks´ dynamic balance sheets, sectoral and geographical determinants of climate risk, and monitor long-term qualitative requirements for banks.

To sum up, climate and environmental risk is part of the ESG objective to be introduced in EU banking regulation, implementing the 2021 Strategy. In addition, banks’ transition plans⁶¹ need to be linked more explicitly with climate stress testing providing a supportive narrative, as well as with the EU Taxonomy which defines sustainable activities. As a result of consensus reached in international fora (BCBS 2022a, BCBS 2022b, FSB 2022), the long-termism of climate risk will gradually inform Pillar 2 for transition plans and stress testing, which both should be aligned in terms of targets and scenarios.⁶² For example, the International Energy Agency Net Zero Emissions by 2050 scenario is mandated by the EBA as a benchmark for emissions reduction targets in the Final draft implementing technical standards on prudential disclosures on ESG risks in accordance with Article 449a CRR. Stress tests should be based on climate risk scenario analysis in order to capture the uncertainties around climate risks, while progress is made with data availability, data quality and methodologies for forward-looking climate risk analysis.

Pillar 3 disclosures for ESG risks

Market assessment of the attainment of climate objectives requires data from banks based on a reliable and consistent reporting framework. This explains why this is the first time that the prudential regulatory process prioritizes disclosure over capital requirements, without excluding a capital add-on at a later stage.⁶³ In the same vein, the Financial Stability Board (FSB 2022) sees the need for banks to report data, regularly, and ad hoc via thematic reviews, supervisors to conduct stress tests with climate scenarios.

A credible Pillar 3 framework demands consistent and comparable disclosures from banks. In line with the 2021 Strategy, the EBA [20, 22] closed this gap by following a sequential approach focusing first on the climate change risks. Using its powers under Article 434 a CRR, the EBA published Implementing Technical Standards on ESG (P3 ITS ESG), including reporting templates to cover ESG, and in particular climate risk.⁶⁴The P3 ITS ESG apply to large banks with instruments traded in EU regulated markets and introduced the Banking Book Taxonomy Aligned Ratio (BTAR), i.e. green exposures to all counterparties over all assets to address the GAR’s limitations.⁶⁵

The EBA links the EU Taxonomy with the banking regulation because the P3 ITS ESG include templates for quantitative disclosure concerning climate change transition risk, and KPIs on climate change mitigating measures, including the GAR and the BTAR from the EU Taxonomy. Templates for qualitative disclosure concern climate change physical risk. Under Article 449a CRR large, listed banks must disclose information on ESG risks on a regular basis from 28 June 2022.

As mentioned in Sect. "Corporate Sustainability Reporting Directive (CSRD) and the European Sustainability Reporting Standards (ESRS)", disclosure increases transparency as part of market conduct regulation, however, it may also intensify the wave of private climate-related litigation. The first private lawsuit seeking compensation owing to climate impact is true. In 2017, the Higher Regional Court of Hamm in Germany, ruled that a lawsuit brought by Saúl Luciano Lliuya from the Huaraz region in Peru against RWE, the energy company, (the Huaraz case) was admissible. Relying on research showing that the retreat of Andean glaciers is due to GHG emissions, the plaintiff asked for EUR 17,000 which represent the costs of preventing damage from a potentially devastating outburst flood from Lake Palcacocha. The plaintiff computed that RWE had contributed to 0.47% of historical global emissions and sued the company for compensation to cover 0.47% of the cost of draining Lake Palcacocha and building a dam to save his house.⁶⁶ Other large GHG-emitters could face similar litigation in the future, as disclosure of ESG risks and more reliable data render computations easier to link the GHG-emitters to climate risks.⁶⁷

Finally, litigation can provide impetus for more progress in respect of governments’ climate commitments.⁶⁸ In this regard, when the German Federal Climate Change Act was challenged successfully at the Federal Constitutional Court, the latter affirmed that a lack of precautionary measures which are required by fundamental rights to guarantee freedom over time and across generations is incompatible with the state’s duty of care which extends also to the future. As a result, the German Federal Parliament advanced the GHG-emission neutrality by five years to 2045 and raised the emission reduction rate by 2030 at 65% (instead of 55%).⁶⁹

The ECB’s priority until 2024 is to determine how resilient banks are to climate-related and environmental risks. As part of the 2022 thematic review, the ECB reviewed the risk management, strategy and governance, but also risk management practices for risks other than climate risks including biodiversity, water stress, and pollution.⁷⁰ Climate risks will be embedded in day-to-day supervision by joint supervisory teams (JSTs) and qualitatively integrated in the SREP scores, and thus may indirectly impact capital requirements, while supervisory measures are possible if banks fail to conduct a materiality assessment of climate and environmental risks.

To sum up, inclusion of climate risks in Pillar 2 and, definitely, in Pillar 3 is less controversial, while inclusion in Pillar 1 requires more analysis because it would transform the prudential framework profoundly.⁷¹ Pilar 3 requirements are already in place, while the shape and form of Pillar 2 is under discussion.

Is there a need for a dedicated prudential treatment for exposures to assets/activities associated with environmental risk (Pillar 1)?

In the context of the 2021 Strategy, the EBA was mandated to assess whether a dedicated prudential treatment for banks´ exposures to environmental risk would be justified (Article 501c CRR and Article 34 IFR). Such mandate was subject to two restrictions: first, the sequencing of the mandate, which was only after the assessment of the potential inclusion of ESG risks in the SREP and the definition of the quantitative and qualitative Pillar 3 disclosures; and, second, the approach that EBA is asked to follow, which is a prudential risk-based approach as opposed to an economic policy approach.⁷²

From the conceptual viewpoint, the prudential risk-based capital approach of climate-related financial risks faces a number of challenges. Most important, the particular characteristics of climate risks, which are global, characterized by nonlinearities and materialize over long-term horizons with high uncertainty.⁷³Hence, scenario analysis [40] is an essential tool to assess the impact of climate risk on the economy and the financial system. In turn, the existing regulatory capital framework is backward-looking, as it relies on dependable historical data to calibrate the relationships between risk factors and exposures, including under adverse economic conditions or unexpected events. In the existing capital regulatory framework, long-term probabilities of default over the past business cycle are used to produce one-year estimates under the strong assumption of invariability of the banks´ portfolio composition. This is at odds with the differences of vulnerability to climate risks across countries, regions, sectors and activities. Against this background, physical risks (particularly acute) that have materialized in the past and on which there is reliable data on the impact on defaults should already be incorporated in the capital assessment.

Regarding climate transition risks, the NGFS (2022b) concludes the historical analysis of the risk differential between green and non-green activities and or assets does not reach robust conclusions on the existence of evidence of such historical risk differentials. Other important limitation is the lack of dependable data on climate-related risks and the parameters to assess particularly transition risks (FSB 2012). Bressan et al. (2022) highlight the need of harmonization of the methodologies used to gauge scope 1, 2 and 3 emission intensities.

These challenges of quantifying and modelling climate-related financial risks also limit the possibility to use macroprudential tools to disincentivize banks´ exposure to climate risks as discussed above.⁷⁴ In this context, the use of non-risk-weighted prudential tools such as the limits to large exposures are open to debate. Any penalizing treatment should be fully consistent with the EU Taxonomy still under development and in line with Pillar 3 requirements. The climate risk conceptual framework would need to be based on the assessment of corporate activities and not on a particular corporate or a group of connected firms. Hence, the revision of the current framework for large exposures would be needed. Still, we could only speculate whether a large exposures limit to corporate activities that are not aligned with EU Taxonomy would provide the sufficient incentive to lend to sustainable activities and, in case the climate risks materialize, whether it would be sufficient to cover the ensuing losses.

Against this background, the EBA has published a Discussion Paper on the role of environmental risks in the prudential framework for credit institutions and investment firms.⁷⁵ The Paper explores whether and how environmental risks are to be incorporated into the Pillar 1 prudential framework. It launches the discussion on the potential incorporation of a forward-looking perspective in the prudential framework. It also stresses the importance of collecting relevant and reliable information on environmental risks and their impact on institutions’ financial losses.⁷⁶ Table 1 summarizes the limitations to assess climate risks for the purpose of the bank capital framework. The leverage ratio, liquidity ratios, securitizations and macroprudential tools are excluded from this consultation process. The Paper acknowledges that to the extent that environmental risks are already captured in the existing prudential framework, any further adjustment should be designed bearing in mind that double counting should be avoided. The EBA does not favour risk-weighted adjustment factors “given the various challenges associated with their design and implementation.” Last but not least, the EBA acknowledges that “Fundamental questions remain as to whether risks to the overall system are likely to grow due to increased environmental risks or if it is more likely that environmental risks imply the need for a reassessment of the risk profiles of firms and sectors in a way that is predominantly neutral to the overall capital requirements.”

Table 1 Challenges to assess climate risks

Conclusions

⁷⁷Among the largest economies of the world, the EU not only has set the most ambitious and legally binding objectives for the reduction of the GHG emissions but also it has accompanied these objectives with a “state of the art” regulatory framework in the realms of investor protection and safety and soundness following the implementation of the 2021 Strategy. The EU framework fosters investments for the fulfillment of the climate objectives. Our paper focuses on the bank financing channel.

As the transition to a low carbon economy is a worldwide effort, international Taxonomy benchmarks would be desirable. Thus far, the EU Taxonomy has focused on ensuring that green activities attract investments. The Taxonomy is being extended to significantly harmful and low impact activities with a desirable transition focus. To mobilize the necessary funds worldwide, a degree of interoperability of regional taxonomies is required, which calls for a global approach to mitigate climate-related financial risks and the risk of market fragmentation.

While the EU will mandate the Corporate Sustainability Reporting standards developed by EFRAG through the CSRD, the ISSB will depend upon governments requiring their use. The tension with the EU is obvious also because the EU “double materiality” approach will demand that sustainability information, material from an impact perspective, should be clearly differentiated from other information included in the management report. Furthermore, explicit sustainability due diligence requirements are expected to be legally binding. The scope of application reflects the needs for transparency corresponding to sustainability as a “European public good.”

Climate risk will be introduced via the ESG risks in banking prudential regulation. The inclusion of climate and ESG risks in Pillar 3 disclosure is almost completed and links effectively with the EU Taxonomy. Climate risk long-term horizon still needs to be implemented in Pillar 2 to complete the 2021 Strategy by linking bank transition plans not only with the EU Taxonomy, but also with stress testing based on climate scenario analysis for transition and physical risks using banks´ dynamic balance sheets, in line with the guidance of the BCBS (2022). As per the inclusion of climate risks in Pillar 1, EU regulators face challenges similar to those of supervisors in other countries: 1) lack of good quality data and harmonized methodologies on environmental factors (e.g. Scope 1,2 and 3 emissions measurement); 2) lack of fully developed standardized classification system or taxonomy with a transitioning approach; 3) incomplete information necessary for the quantification of acute physical risk (e.g. geolocation information) and mitigation strategies; 4) lack of transparency of methodologies and comparability of ESG ratings.

As stated in the 2021 Strategy, fostering global ambition is an explicit objective of the EU. Its leadership on the realms of investor protection and prudential regulation of climate risks should ideally inform international cooperation and impregnate international standards on investor protection and safety and soundness regulation. This will secure that investments for the fulfillment of the EU climate objectives will flow from in and outside the EU.

Appendix

See Table 2.

Table 2 Table summarizing the policy levers and the sectors affected by the “Fit for 55” (including the new REPowerEU chapter) Source: Authors´ analysis