Legal development

EU Capital Requirements Regime: CRD VI and CRR III: ESG

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    The European Commission considers that credit institutions have a key role in financing the
    transition finance to a more sustainable economy. It has introduced a number of key initiatives
    such as the European Green Deal, Sustainable Finance Strategy and Corporate
    Sustainability Reporting Directive
    directly or indirectly impacting banks. The CSRD, for
    example, requires in scope entities (including credit institutions meeting certain criteria) to
    prepare transition plans documenting how they intend to contribute to and prepare for a transition
    to a low greenhouse gas emissions and a climate resilient economy (and to make disclosures in
    this regard).

    The existing EU Capital Requirements framework dealt in a limited way with sustainable finance.

    Article 449a, introduced via CRR II, requires large institutions with securities traded on a
    regulated market of any member state to disclose prudential information on ESG risks, including
    physical risks and transition risks. Implementing Regulation (EU) 2021/637 contains uniform
    disclosure formats and instructions for disclosures required under CRR.

    CRR II also introduced the so-called infrastructure supporting factor under article 501a,
    applicable under both the standardised approach and internal rating based approach. This
    aimed to support private and public investments in infrastructure projects by permitting a 25 per
    cent reduction in own fund requirements for certain exposures in corporate/specialised lending

    Key changes

    CRR III and CRD VI contain a number of changes in relation to ESG. This includes: new
    harmonised definitions of the different types of ESG risks as well as other definitions;
    amendments to the infrastructure supporting factor; requirements in relation to transition plans;
    disclosure requirements; amendments to the SREP process; and provisions for carbon trading
    under the alternative standardised approach.



    New ESG definitions in CRR III are: "ESG risks"; "environmental risk", "transition risk"; "ESG
    factors"; "fossil fuel sector entity"; and "exposures subject to impacts from environmental or
    social factors."

    • ESG risk means "the risk of losses arising from any negative financial impact on the
      institution stemming from the current or prospective impacts of ESG factors on the
      institution's counterparties or invested assets". ESG risks materialise through traditional
      categories of financial risks.
    • Environmental risk, which includes both physical risk and transition risk under CRR III,
      is defined as "the risk of losses arising from any negative financial impact on the
      institution stemming from the current or prospective impacts of environmental factors on
      the institution's counterparties or invested assets, including factors related to the
      transition towards certain environmental objectives". These are found in the Taxonomy
      Regulation and include objectives such as climate change mitigation.
    • Transition risk is defined as "the risk of losses arising from any negative financial
      impact on the institution stemming from the current or prospective impacts of the
      transition of business activities and sectors to an environmentally sustainable economy
      on the institution's counterparties or invested assets".
    • Physical risk is defined as "the risk of losses arising from any negative financial impact
      on the institution stemming from the current or prospective impacts of the physical
      effects of environmental factors on the institution's counterparties or invested assets".
    • ESG factors have "a positive or negative impact on the financial performance or
      solvency of an entity, sovereign or individual". The legislation cites greenhouse gas
      emissions, biodiversity; human rights, and labour and workforce considerations as
      common examples.

    ESG disclosures

    Provisions concerning reporting on prudential matters under article 430 have been amended to
    include a requirement to report information in relation to ESG risks. This will need to include
    existing and new exposures to fossil fuel sector entities; exposures to physical risks and
    transition risks.

    Disclosure of ESG risks under article 449a CRR now apply to all institutions, with a distinction to
    be made between environmental, social and governance risks, and between physical risks and
    transition risks for environmental risks. Information in this regard is to include (but is not limited
    to) total amount of exposures to fossil fuel sector entities; and information on how identified ESG
    risks are integrated into the business strategy and processes and governance and risks
    management. Small and non-complex institutions that are non-listed institutions are to disclose
    ESG risks referred to in Article 449a on an annual basis. The respective ITS are to be revised.

    Scenarios for stress tests for capital adequacy under Article 177 are to include ESG risk factors,
    in particular physical and transition risks arising from climate change.

    Capital requirements

    CRR III introduces a lower risk weight for the commodity delta risk factor related to carbon
    trading emissions (article 383v) via a specific risk category for ETS allowances under the
    alternative standardised approach. There is a risk weight of 60 per cent for non-EU ETS carbon
    trading and 40 per cent for energy EU ETS carbon trading. This will be welcomed by some trade
    associations, such as ISDA who had argued that the design of the ETS and political commitment
    in the EU to safeguard the stability in the EU market meant carbon trading in the EU was less
    volatile than elsewhere.

    CRR III introduces a new article 122a, setting out preferential treatment of 80 per cent risk weight
    under standardised approach for "High Quality Finance Project Finance" meeting certain
    conditions (the preferential treatment set out in article 122a and in article 501a is not to be used
    at the same time so as to prevent double counting).

    CRR III limits the scope of the infrastructure supporting factor under article 501a to provide that
    (from the date of application of CRR III) assets being financed must contribute positively to
    environmental objectives under the Taxonomy Regulation and not significantly harm the other
    objectives in the Taxonomy Regulation.


    Requirements for firms in relation to financial collateral and physical collateral under article
    207(4)(d); article 208(3)(b); article 210(g) have been amended to provide that collateral
    valuations should consider ESG risks, with an assessment to be carried out on ESG risks that
    could lead to a decline in the value of financial or physical collateral (decline materially relative to
    general market prices).


    Article 73 and 74 of the CRD have been amended to require that short, medium and long-term
    horizons of ESG risks be included in credit institutions' strategies and processes for evaluating
    adequate internal governance, as well as internal capital needs. Article 91 of the CRD now
    provides that the collective knowledge, skills and experience expected of the management body
    will include understanding the entity's impact in the short, medium and long term, taking into
    account ESG factors.

    Requirements for institutions in relation to internal capital under article 73 have been amended to
    include an express requirement to explicitly take into account short, medium and long term
    coverage of ESG risks.

    Under updated article 76 CRD, management bodies are to develop and monitor the
    implementation of transition plans, quantifiable targets and processes to monitor and address
    financial risks arising in the short, medium and long-term from ESG factors. Institutions
    disclosing information on ESG matters under CRD are to ensure that transition plans are
    consistent with transition plans referred to in article 19a/article 29a of the CSRD.

    The EBA has already published a consultation paper on the guidelines for the transition plans
    (see our briefing here). As explained by the EBA, transition plans under EU ESG legislation look
    at the compatibility of business models with the move to 1.5 degree and with the EU's aim to
    achieve net zero greenhouse gas emissions. Transition plans under updated CRD are intended
    to serve as a risk management tool allowing institutions to demonstrate that they are ready for
    the transition towards a sustainable economy. CRD-based transition plans are therefore likely to
    have unique aspects in comparison to non-prudential transition plans.

    A new article 87a in CRD has been introduced requiring governance arrangements include
    robust strategies, policies, processes and systems for identifying, measuring and managing and
    monitoring ESG risks over the short, medium and long-term. Competent authorities are also to
    ensure that institutions test their resilience to long-term negative impacts of ESG factors under
    baseline and adverse scenarios (starting with climate related factors).

    Dedicated treatment of prudential exposures

    Changes have been made to the existing EBA mandate under Article 501c that required a report
    on whether there is a dedicated prudential treatment of exposures related to assets/activities
    substantially associated with environmental or social objectives is needed The mandate has
    been split into a number of reports, which are to be completed by the end of 2024 and 2025.
    Additional areas that the EBA will be looking at include whether ESG risks are appropriately
    reflected in the credit risk ratings of counterparties/exposures that institutions have. The
    European Commission is to submit a legislative proposal within one year of the publication of the
    last report.

    EBA Mandates

    Mandates for the EBA include:

    • guidelines on, minimum standards and reference methodologies for the identification,
      measurement, management and monitoring of ESG risk under article 87a of CRD;
    • guidelines on the content of transition plans to be prepared in accordance with Article
      76(2) (to include specific timelines and intermediate quantifiable targets; qualitative and
      quantitative criteria for the assessment of the impact of ESG risks on the risk profile and
      solvency of institutions in the short, medium and long term);
    • draft ITS on uniform disclosure formats for ESG risks (the recitals state that the EBA is
      expected to consider whether the disclosures should cover pools of covered bonds and
      whether the revised ITS or the overall regulatory and disclosure framework for covered
      bonds should include information on exposures of pools of loans underlying covered
      bonds (directly issued by institutions or via transfer of loans using an SPV));
    • guidelines on scenarios for stress tests for capital adequacy under Article 177 to include
      ESG risk factors; and
    • ITS under article 430 in relation to exposures to ESG risk.


    The new regime introduces enhanced requirements for management bodies of banks. Large
    banks have been subject to disclosure requirements under article 449a since June 2022 but will
    need to prepare for enhanced disclosure requirements and for changes that are expected to be
    made to the disclosure templates by the EBA. Banks falling within scope for the first time as a
    result of CRR III will need to prepare to ensure that the quantitative and qualitative information
    expected to be disclosed can be provided. The assessment of transition plans to be carried out
    by competent authorities will include institutions' sustainability related product offering, their
    transition finance policies, related loan origination policies, and ESG-related targets.

    Changes brought by the CRR III and CRD VI also need to be viewed against other
    developments, such as the ECB's revisions to its internal model guide.

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.


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