EBA action plan on sustainable finance

Following the European Banking Authority's (EBA) action plan published on 8 March 2018 which set out an EU strategy on sustainable finance and future roadmap for work across the financial system, on 6 December the EBA published a further action plan, this time focused on deliverables and activities related to environmental, social and governance (ESG) factors and ESG risks. Through this action plan, the EBA is emphasising three areas where institutions are encouraged to take steps (even before the EU legal framework is formally updated and mandates delivered) being: strategy and risk management, disclosure, and scenario analysis.

Background

The EBA considers sustainable finance as financing and related institutional and market arrangements that contribute to the achievement of strong, sustainable, balanced and inclusive growth through the Sustainable Development Goals (set out by the G20). The EBA identifies that climate change and the response to it by the public sector and society in general have led to the identification of new sources of financial risk to which the regulatory and supervisory community is paying increased attention, notably both transition risk and physical risk. This has led to a number of mandates which give the EBA power to consider and take action in relation to ESG factors and risks.

EBA mandates

The EBA is mandated on ESG factors and ESG risks through the amended EBA Regulation, revised Capital Requirements Regulation and Capital Requirements Directive (CRR 2 and CRD 5, respectively), the new Investment Firms regulation and Investment Firms Directive (which we reported on here) and finally the Commission's Action Plan.

The revised CRR 2/CRD 5 package includes three mandates for the EBA in the area of sustainable finance. The first one (Article 98(8) of CRD 5) calls on the EBA to assess the potential inclusion of ESG risks in the supervisory review and evaluation process performed by competent authorities. To that end, the EBA’s assessment must comprise, amongst others:

• the development of a uniform definition of ESG risks including physical risks and transition risks;
• the development of criteria for understanding the impact of ESG risks on the financial stability of institutions in the short, medium and long terms;
• the arrangements, processes, mechanisms and strategies to be implemented by the institutions to identify, assess and manage these risks; and
• the analysis methods and tools to assess the impact of ESG risks on lending and the financial intermediation activities of institutions.

The second mandate is related to Article 449a of CRR 2, which requires large institutions with publicly listed issuances to disclose information on ESG risks, physical risks and transition risks as defined in the report referred to in Article 98 of the CRD. In this context, Article 434a of CRR 2 includes a mandate to the EBA according to which the EBA shall develop a technical standard implementing the disclosure requirements

Lastly, the third mandate (Article 501c of CRR 2) requires the EBA to assess whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified (as a component of Pillar 1 capital requirements). In particular, the EBA must assess:

• methodologies for the assessment of the effective riskiness of exposures related to assets and activities associated substantially with environmental and/or social objectives compared with the riskiness of other exposures;
• the development of appropriate criteria for the assessment of physical risks and transition risks; and
• the potential effects of a dedicated prudential treatment of exposures associated substantially with environmental and/or social objectives and activities on financial stability and bank lending in the Union.

(See diagram below for illustration.)

EBA work on sustainable finance

The EBA is expected to deliver a significant amount of work between 2019 and 2025 in relation to the outcomes from these mandates. In addition to the specific mandates, there is a general mandate included in the EBA Regulation on ESG risk monitoring, which fits well into its overall work of improving the stability of the banking sector. The EBA has set out in today's action plan that it will look at these in the following sequence:

• strategy and risk management;
• key metrics and disclosure;
• stress testing and scenario analysis ; and
• prudential treatment.

Strategy and risk management

In line with the expectation that consideration of ESG factors will be incorporated into all regulatory products, the EBA 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 CRD5 mandate, the EBA shall assess the development of a uniform definition of ESG risks, the development of criteria and methods for understanding the impact of ESG risks on in situation, the arrangements and strategies to be implemented by the institutions to valuate and manage the ESG risks, and the potential inclusion of ESG risks in the supervisory review and evaluation process. The EBA expects to produce a report by 28 June 2021 for the management of ESG risks following a discussion paper to be published in Q2-Q3 2020.

Key metrics and disclosure

The EBA is developing comprehensive technical standards to implement the disclosure requirements included in Part Eight of the CRR. The deadline to submit the technical standards to the Commission is June 2020. Although most of the disclosure requirements in Part Eight of the CRR are applicable from June 2021, there are some exceptions, such as the ESG-related disclosure, that will be applicable from June 2022.

Stress testing and scenario analysis

Article 23 (Identification and measurement of systemic risk) of the EBA Regulation includes a specific reference to the potential environmental-related systemic risk to be reflected in the stress-testing regime. The EBA should develop common methodologies assessing the effect of economic scenarios on an institution’s financial position taking into account, inter alia, risks stemming from adverse environmental developments and the impact of transition risk stemming from environmental policy changes. The mandate in Article 98 of CRD 5 also requires from the EBA to develop appropriate qualitative and quantitative criteria, such as stress testing processes and scenario analyses, to assess the impact of ESG risks under scenarios with different severities.

The EBA aims to develop a dedicated climate change stress test with the main objective of identifying banks’ vulnerabilities to climate-related risk and quantifying the relevance of the exposures that could be potentially hit by physical risk and transition risk. Since climate risk stress-testing frameworks are developing, there are multiple constraints on designing a robust framework.

Prudential treatment

The mandate from Article 501c of CRR 2 asks the EBA to assess if a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified (the findings of which will be summarised in a report). The EBA considers the scope of this mandate as quite comprehensive, requiring substantive data and quantitative analysis.

The EBA plans to conduct this work in two phases, first publish a discussion paper and then consider feedback received to finalise the report. As the deadline for the report is in June 2025, the EBA considers that this will give it more time to collect relevant data and possibly benefit from the use of the new EU taxonomy on sustainable activities.

Next steps

There will be considerable work undertaken by the EBA in relation to each of these outputs over the next five years. Until some of the outputs above have been produced, the EBA is keen to stress that institutions should be proactive in incorporating ESG considerations into their business strategies and risk management as well as adopting climate change related scenarios and scenario analysis as an explorative tool to understand the relevance of the exposures affected by and the potential magnitude of physical risk and transition risk.

It is clear that institutions cannot simply wait to be pushed by the regulators, this is an issue for immediate action.