READY, SET, GO … GREEN! The new European rules on sustainable finance are now at a starting point

The alert is available for download with the list of references and footnotes in EnglishSpanish and Italian.

Authored by Daniela Dela Rosa, Giovanni Sagramoso, María H. De La Peña and Beatrice Cazzanelli.

What emerges from the special report on climate change published by the Intergovernmental Panel on Climate Change (IPCC) (IPCC, 2018) is yet further confirmation of what we are all aware of: maintaining our current pace of waste and consumption is taking us perilously close to the point of no return to save planet Earth.

The Organisation for Economic Co-operation and Development (OECD) estimates that a total of US$6.9 trillion per year will be needed to achieve the objectives of the Paris Agreement on Climate Change by 2030 (OECD, 2018), which means that the solution to the climate challenge will, necessarily, pass through the economy; the financial world must develop new strategies to attract new investment.

Public and private capital must act together to finance the transition to a greener economy and to ensure the achievement of objectives in line with the UN Sustainable Development Goals (SDGs).

The appetite for investing in sustainable finance is growing in both individuals and companies. The latest edition of the Eurosif Study on Sustainable Finance in Europe has shown a significant progression from 3% to over 30% for the period between 2013 and 2017 (Eurosif, 2018), while the latest Global Sustainable Investment Alliance reports that the volume of sustainable investments reached US$31 trillion in 2018 (GSIA, 2018).

The growing attention given to green issues has made banks adapt their financial offerings accordingly. The Vice-President of the European Investment Bank (EIB), Dario Scannapieco, announced in a recent interview (Capozzi, 2020) that by 2025 the EIB’s commitment will be to increase by 20% the annual funding that positively impacts on climate and the environment, and to stop funding energy projects that burn standard fossil fuels. For its part, Moody’s indicates that banks issued a record US$121.8 billion of green, social and sustainable bonds in 2019, which represents an increase of 41% on the previous year (Moody’s, 2020), and Associazione Bancaria Italiana (ABI) recently announced that issuances in green and sustainable bonds by Italian banks have so far raised more than 2 billion euros, with a clear acceleration in the two-year period 2019-2020 (ABI, 2020).

The boom in the green bond market has also led to a significant growth in the issuance of this type of bond by financial institutions and companies, which amounted to around US$142 billion in 2019, with corporate issuances alone growing by 90% compared to the previous year (Stéphane Rüegg, 2020).

The article discusses the new European rules on sustainable finance whilst touching upon the below topics.

· The EU Green Bond Standard

· The European Action Plan

· Harmonizing Transparency Rules For Financial Markets – Regulation (eu) 2019/2088

· A Taxonomy Of Sustainable Finance – Regulation (eu) 2020/852

· Non-Financial Reporting (nfrd) – Directive 2014/95/eu

The alert is available for download with the list of references and footnotes in EnglishSpanish and Italian.

EBA’s Action Plan on Sustainable Finance

Climate change and the response to it by the public sector and society in general have led to an increasing relevance of environmental, social and governance (ESG) factors for financial markets. It is, therefore, essential that financial institutions are able to measure and monitor the ESG risks in order to deal with risks stemming from climate change (learn more about climate change related risks in our previous Blogpost.

To support this, on 6 December 2019, the European Banking Authority (EBA) published its Action Plan on Sustainable Finance outlining its approach and timeline for delivering mandates related to ESG factors. The Action Plan explains the legal bases of the EBA mandates and EBA´s sequenced approach to fulfil these mandates.

Why is EBA in charge ? EBA mandates on sustainable finance

The EBA´s remit and mandates on ESG factors and ESG risks are set out in the following legislative acts:

  • the amended EBA Regulation;
  • the revised Capital Requirements Regulation (CRR II) and Capital Requirements Directive (CRD V);
  • the new Investment Firms Regulation (IFR) and Investment Firms Directive (IFD) and
  • the EU the Commission´s Action Plan: Financing Sustainable Growth and related legislative packages.

These legislatives acts reflect a sequenced approach, starting with the mandates providing for the EBA to oblige institutions to incorporate ESG factors into their risk management as well as delivering key metrics in order to ensure market discipline. The national supervisory authorities are invited to gain an overview of existing ESG-related market risks. In a second step, the EBA will develop a dedicated climate change stress test that institutions should use to test the impact of climate change related risks on their risk-bearing capacity and to take appropriate precautions. The third step of the work will look into the evidence around the prudential treatment of “green” exposures.

The rationale for this sequencing is the need firstly to understand institutions´ current business mix from a sustainability perspective in order to measure and manage it in relation to their chosen strategy, which can then be used for scenario analysis and alter for the assessment of an appropriate prudential treatment.

Strategy and risk management

With regard to ESG strategy and risk management, the EBA already included references to green lending and ESG factors in its Consultation paper on draft guidelines on loan origination and monitoring which will apply to internal governance and procedures in relation to credit granting processes and risk management. Based on the guidelines the institutions will be required to include the ESG factors in their risk management policies, including credit risk policies and procedures. The guidelines also set out the expectation that institutions that provide green lending should develop specific green lending policies and procedures covering granting and monitoring of such credit facilities.

In addition, based on the mandate included in the CRD V, the EBA will asses the development of a uniform definition of ESG risks and the development of criteria and methods for understanding the impact of ESG risks on institutions to evaluate and manage the ESG risks.

It is envisaged that the EBA will first publish a discussion paper in Q2-Q3/2020 seeking stakeholder feedback before completing a final report. As provided for in the CRD V, based on the outcome of this report, the EBA may issue guidelines regarding the uniform inclusion of ESG risks in the supervisory review and evaluation process performed by competent authorities, and potentially also amend or extend other policies products including provisions for internal governance, loan origination and outsourcing agreements.

Until EBA has delivered its mandates on strategy and risk management, it encourages institutions to act proactively in incorporating ESG considerations into their business strategy and risk management as well as integrate ESG risks into their business plans, risk management, internal control framework and decision-making process.

Key metrics and disclosures

Institutions disclosures constitute an important tool to promote market discipline. The provision of meaningful information on common key metrics also distributes to making market participants aware of market risks. The disclosure of common and consistent information also facilitates comparability of risks and risks management between institutions, and helps market participants to make informed decisions.

To support this, CRR II requires large institutions with publicly listed issuances to disclose information on ESG risks and climate change related risks. In this context, CRR II includes a mandate to the EBA according to which it shall develop a technical standard implementing the disclosure requirements. Following this mandate, EBA will specify ESG risks´ disclosures as part of the comprehensive technical standard on Basel´s framework Pillar 3.

Similar mandates are contained in the IFR and IFD package. The IFD mandate for example requires EBA to report on the introduction of technical criteria related to exposures to activities associated substantially with ESG objectives for the supervisory review and evaluation process of risks, with a view to assessing the possible sources and effects of such risks on investment firms.

Until EBA has delivered its mandates, it encourages institutions to continue their work on existing disclosure requirements such as provided for in the Non-Financial Reporting Directive (NFRD) as well as participation in other initiatives. EBA also encourages institutions to prioritise the identification of some simple metrics (such as green asset ratio) that provide transparency on how climate change-related risks are embedded into their business strategies, decision-making process, and risk management.

Stress testing and scenario analysis

The EBA Regulation includes a specific reference to the potential environmental-related systemic risk to be reflected in the stress-testing regime. Therefore, the EBA should develop common methodologies assessing the effect of economic scenarios on an institutions´ financial position, taking into account, inter alia, risks stemming from adverse environmental developments and the impact of transition risk stemming from environmental political changes.

Also the CRD V mandate requires EBA to develop appropriate qualitative and quantitative criteria, such as stress testing processes and scenario analysis, to asses the impact of ESG risks under scenarios with different severities. Hence, EBA will develop a dedicated climate stress test with the main objective of identifying banks´ vulnerabilities to climate-related risks and quantifying the relevance of the exposures that could potentially hit by climate change related risks.

Until delivering its mandates, EBA encourages institutions to adopt climate change related scenarios and use scenario analysis as an explorative tool to understand the relevance of the exposures affected by and the potential magnitude of climate change related risks.

Prudential treatment

The mandate in the CRR II asks EBA to assess if a dedicated prudential treatment of exposures to assets or activities associated with environmental or social objectives would be justified. The findings should be summarised in a report based on the input of a first to be published discussion paper.

Upshot

Between 2019 and 2025, the EBA will deliver a significant amount of work on ESG and climate change related risks. The obligations for institutions with regard to a sustainable financial economy and a more conscious handling of climate change related risks are becoming increasingly concrete. Institutions should take the EBA’s encouragement seriously and consider applying the measures recommended by the EBA prior to the publication of any guidelines, reports or technical standards.