Sustainability and climate risk: what can banks expect?

Sustainability and climate risk: what can banks expect?

Thu 27 Jan 2022

The growing importance of sustainability issues and the role of credit institutions in financing transformation places climate and environmental risks at the core of regulatory and supervisory scrutiny today. For some years now, the Network for Greening the Financial System (NGFS), comprising central banks and national supervisory authorities, has been working to enhance sustainability and climate risk awareness in the financial sector. This approach involves promoting shared best practices, including providing climate scenarios for central banks and supervisors in environmental and climate risk management.

Recently, major banking supervisors, including the European Central Bank (ECB), Bank of France and Bank of England, have set out new expectations and developed requirements which, in 2022, will see the first European climate stress test run by the ECB take place.

In parallel, there are ongoing global efforts to develop, clarify and harmonise disclosure requirements to make sure everyone speaks the same language and avoid greenwashing.

Regulatory expectations and disclosure requirements

All major regulators have declared an interest in environmental issues and have recently put pressure on financial institutions to make sure they integrate such risks into their respective risk management practices. The French Prudential Supervision and Resolution Authority (ACPR) conducted its first climate stress test in 2020, and the ECB plans its first EU-wide climate stress test in 2022. In 2021 the ECB asked a large sample of European banks to conduct a self-assessment exercise related to climate and environmental risks and test results against the regulatory expectations described in the ECB guide published in November 2020. In addition, the banks were asked to submit their plans explaining how and when they will be in line with ECB expectations. Based on feedback received, the ECB published a report in November 2021 on the state of climate-related and environmental risk management in the banking sector. Due to the current regulatory focus on climate and environmental risk management, banks are likely to see a gradation of increasing requirements, ranging from awareness to potentially a capital charge in the future.

Where are we today?

In terms of supervisory dialogue, we are currently between the third and the fourth step, as shown in the diagram. As the ECB and national regulators have made their expectations clear through specific feedback in autumn 2021 and have provided some benchmarking, banks are now expected to have identified any shortcomings and data gaps and are taking steps to correct them.

It is particularly important to define clearly the banks’ understanding of definitions and coverage of climate and environmental risks. It is also essential to recognise and document the anticipated impact of these risks on the business environment in which the banks operate. At the same time, banks need to differentiate between physical risks, transition and responsibility risks and take them into account when defining the business strategy. In concrete terms, banks have to integrate those risks within their risk appetite and, like all other risks, manage to navigate them along the different business lines. Banks should also adapt their governance to ensure risks are managed at the appropriate organisational level and across the three lines of defence. Finally, these risks should be consolidated in internal reporting systems and reported to the management bodies and relevant committees.

At this stage, the ECB has noted that EU banks have begun to integrate some of those risks in their respective risk appetite and risk management frameworks. This is true for the more easily manageable environmental risks such as phasing out the financing of activities highly exposed to climate-related risks, financing coal or systematically evaluating real estate collateral towards climate risks. However, banks struggle to integrate climate risk exposure in existing credit, market and liquidity risk management operations and in internal reporting systems. For the latter in particular, few banks seem to have developed specific risk indicators. Therefore, the ECB pressure is likely to increase in 2022 with the outcome of stress tests included in the context of Supervisory Review and Evaluation Process (SREP) discussions.

Currently, only qualitative assessment requirements are expected. Nevertheless, as the Bank of England has already mentioned, capital discussions will follow shortly. However, this will not come before consultations take place as the solution is not obvious due to a time horizon that is quite different from traditional risk timelines. For example, how are regulators going to cope with the very long-term horizon of those risks? Also, will future regulation seek to have a higher capital charge on non-green activities or have a lower capital charge on green financing as an incentive? While these are open questions today, banks should be prepared to confront them.

Multiple new sustainability reporting requirements across Europe

Just as critical as moving the sustainability agenda across all industries is the need to improve the quality and relevance of sustainability reporting significantly, as there cannot be sound risk analysis and monitoring without robust and reliable data at the outset. This was identified as a key driver of an effective sustainable finance strategy by the EU back in 2018 and since then has led to a mushrooming of global initiatives.

In its 2018 Action Plan on Financing Sustainable Growth, the European Commission (EC) structured its whole sustainable finance strategy around three key objectives; reorienting capital flows towards a more sustainable economy, mainstreaming sustainability in risk management, and fostering transparency and long-termism.

Each of these three objectives led to the adoption of several new regulations and legislations in the EU. Some prompted the review and amendment of existing prudential and regulatory requirements for financial institutions, such as MiFID II, Solvency II, CRD and DDA directives. All had in common the creation of new sustainability reporting obligations.

Significant new reporting obligations

Three cornerstone texts creating significant immediate or near-term new sustainability reporting obligations for financial institutions in line with the above three key objectives. These include the Sustainable Finance Disclosure Regulation (SFDR) adopted in late 2019. The SFDR targets financial market participants and aims to enhance the integration of sustainability risks in investment policies and compensation policies, foster transparency on the principal adverse impacts of investments on the environment, society and governance practices, and on sustainability characteristics and objectives of so-called ESG products. Therefore, it requires financial market participants to disclose related information at entity and product levels in various places and documents. This includes websites, pre-contractual and contractual documents, and periodic reports. Implementation was phased in, starting in March 2021 until 1 July 2022, when all requirements will come into force.

The Taxonomy regulation, also called the green taxonomy, adopted in June 2020, establishes a classification of “green” or sustainable activities and will significantly and rapidly contribute to Europe’ sustainability agenda if performed according to demanding environmental performance conditions. Today, it only covers the climate change objectives of mitigation and adaptation. By the end of 2022, it will aim to cover all six environmental goals, including biodiversity, circular economy, water resources and pollution. The purpose is to provide financial institutions with science-based tools to make informed investment decisions on environmentally-friendly activities, projects and industries, thus contributing to financing sustainable growth, as announced in the 2018 Action Plan. 

All entities in scope of the taxonomy regulation, which includes all large Public Interest Entities (PIEs) and financial institutions, will have to publish the amount of turnover, capex and opex generated by taxonomy-aligned activities in their periodic report. For banks, it means reporting their Green Asset Ratio (GAR), which is the share of their assets that finance sustainable or green activities as defined by the taxonomy. Banking supervisory authorities will closely monitor GAR at national and EU levels. Implementation will start as early as 2022, progressively ramping up to reach full disclosure mode in 2024.

Corporate Sustainability Reporting Directive (CSRD) aims to standardise sustainability reporting on an equal footing with financial reporting. If adopted by the European Council and Parliament, the CSRD proposal will impose mandatory reporting requirements on all listed and large companies in the EU, including financial institutions. These requirements will cover all aspects of the ESG spectrum and the obligation to have sustainability reports audited by independent reviewers.

By creating a reliable, common sustainability language, based on clearly defined disclosures, and imposing high-quality sustainability reports that are independently reviewed, the CSRD should help streamline and refocus the reporting exercise and enhance relevance and usefulness of data provided to the users of sustainability information, starting with investors and banks. If adopted by mid-2022 as expected, the CSRD would come into force in 2024 for reporting year 2023[1].

International initiatives gaining momentum

In the wake of the leading European efforts, international players have also gathered momentum. Two recent moves that will require scrutiny in the next few months include the consolidation of SASB, IIRC and CDSB into the Value Reporting Foundation, which will pursue an investor approach to continue developing sector-specific standards of voluntary use by international companies. Also, the creation of an International Sustainability Standards Board (ISSB) alongside the IASB will help support initiatives. The ISSB’s recently appointed Chair confirmed that it will discuss and adopt its work program for the coming years in 2022 and will aim to adopt the final version of its first two prototypes on general presentation and climate-related disclosure by the end of 2022.

Both organisations have the support of the investor community because their approach to sustainability gives priority to valuable information for decision making, including elements that have consequences on the entity’s financial performance, also called financial materiality. The European approach gives equal importance to information relating to the entity’s impacts on its ecosystem. Such impact materiality is also important to other stakeholders.

However, they currently remain voluntary standards. So, the question is: will they be endorsed and made mandatory by some countries and when? Most likely not before the European effort is fully operational and implemented throughout Europe. Therefore, it is probable that Europe will continue to lead the way in sustainability reporting for some time.

The good news is that as the investor-focused international approach is a sub-part of the European approach, they are not contradictory and should largely overlap. This avoids the trap of multiple reporting obligations, which is good news for preparers and users of sustainability information alike.

[1] Based on current discussions in EU Parliament and Council, a one-year delay in implementation is highly likely. First time application of CSRD would then be 2025 on reporting year 2024.