ESG in EU prudential regulation: is the framework ready for environmental risks?

The European Banking Authority (EBA) published an insightful discussion paper in May 2022 on the role of environmental risks in the EU Pillar 1 microprudential framework for credit institutions and investment firms. The EBA thereby launched a consultation on the appropriateness of this framework, exploring the extent to which environmental considerations are already reflected in the existing rules and what adaptations will be needed.

Key questions in this context, such as whether a “green supporting factor” (GSF) or “brown penalising factor” (BPF) should be introduced, were also considered at the 9th Conference on the Banking Union held in September 2022. Below we summarise key takeaways from the discussion.

What should the prudential framework achieve?

Should prudential requirements depend not only on the riskiness of exposures but also on the environmental impact of the underlying activities? This is the central question examined by the EBA with regard to the mandates in Article 501c of the CRR and Article 34 of the IFR, under which the EBA is required to assess whether introducing a dedicated prudential treatment for exposures substantially associated with environmental objectives would be justified.

In approaching this question, the EBA clarifies in its discussion paper that, in its view, the purpose of the prudential framework is to strengthen the financial resilience of credit institutions and investment firms, including by considering relevant environmental risks. It is not to accomplish other – eg environmental – policy purposes (for which other policy instruments may be better suited). However, the EBA acknowledges that supporting environmental objectives could be the effect of the risk-based prudential framework (especially if combined with other policy actions) – to the extent that the environmental impact of exposures correlates with the level of risk.

In essence, the EBA is, therefore, advocating an approach that keeps the focus of the prudential framework on financial stability and resilience, rather than widening it to include other policy objectives. In light of this approach, as well as discussions in similar areas, such as monetary policy, it remains to be seen whether this “traditional” approach will prevail.

Do we need green supporting or brown penalising factors?

Based on this risk-oriented approach, the EBA takes a cautious stance on the introduction of a specific prudential treatment of exposures depending on their environmental impact, such as by way of a GSF or BPF.

1. What is a GSF/BPF?

The basic idea of a GSP or BPF is making prudential capital requirements dependent on whether exposures are environmentally sustainable (ie capital relief for “green” exposures) or environmentally harmful (ie additional capital requirements for “brown” exposures). This could be achieved, in principle, by modifying risk weights or applying adjustment factors to risk-weighted assets.

2. What is the EBA’s position on a GSF/BPF?

In its discussion paper, the EBA emphasises challenges regarding the design and implementation of both a GSF and a BPF. These challenges include, for example, obstacles related to the classification of “green” versus “brown” exposures, and a lack of evidence on their risk profile, as well as on the consequences of addressing any such risk by way of special factors.

To avoid the risk of “double counting”, the EBA suggests focusing on investigating the extent to which environmental risks are already captured by the existing prudential framework (taking into account the proposed CRR III which, amongst others, expressly addresses ESG risks including environmental risks). Tailored modifications to further integrate environmental risks into the current framework, in the EBA’s preliminary opinion, would likely address environmental risks more effectively than a new, distinct treatment by way of a GSF or BPF.

Up to now, non-risk-based factors are included in the prudential framework with respect to SMEs, infrastructure finance and (under the draft CRR III) project finance (“specialised lending”), subject to certain conditions. In this context, the EBA points to the possibility of strengthening the environmental criterion within the infrastructure supporting factor (Article 501a(1)(o) of the CRR) by permitting the application of this factor only where the project contributes to environmental objectives.

3. How is a GSF/BPF seen by other supervisors and market players?   

Pros and cons of a GSF and/or a BPF have been intensively discussed in the market over the last years. For example, certain banking representatives have expressed concerns regarding the costs of a BPF, noting that it would imply capital being “locked” in banks which would be required to finance the transition to a sustainable economy, while welcoming certain types of GSF as an incentive to provide green or sustainability-linked financing.

In her keynote speech at the 9th Conference on the Banking Union, Anneli Tuominen, Member of the Supervisory Board of the European Central Bank (ECB), stated that, in her view, prudential requirements should respect banks’ risk profiles and that no non-risk-based GSF or BPF should be introduced.

Is the prudential framework fit for purpose for sustainability?

In its discussion paper, the EBA also sets out some key interim findings as to how Pillar 1 capital requirements interact with environmental risks.

1. What are environmental risks and are they new types of risks?

For purposes of its discussion paper, the EBA defines “environmental risks” as the risks of negative financial impacts stemming from environmental factors through counterparties or invested assets, taking into account “double materiality”, ie: (i) the impact of environmental factors on the economic and financial activities of such counterparties/assets (outside-in); and (ii) the impact of such activities on environmental factors (inside-out), but only where this affects the value of the activities and, in turn, the financial (eg credit, market or operational) risks of the regulated entity.

Based on an initial analysis, the EBA takes the view that environmental risk is not a new risk category, but rather a risk driver that translates through a range of transmission channels into traditional categories of risk.

2. Does the current framework adequately reflect environmental risks?

a. Credit institutions

For credit institutions, according to the EBA’s discussion paper, the framework already provides for mechanisms allowing for the inclusion of new types of risk drivers such as those related to environmental risks (eg via external ratings, internal models, or the valuation of collateral). Nevertheless, targeted adjustments and clarifications may be helpful – for example, to explicitly specify environmental risks in selected contexts (eg due diligence requirements).

To address concentration risk, the EBA also puts up for discussion whether requirements under the large exposure regime should be extended to include a new concentration limit related to environmental risks or reporting of the most environmentally risky exposures (similar to the reporting of the 10 largest exposures to shadow banks under Article 394(2) of the CRR and seemingly on top of the ESG-related reporting under the CRR III). 

Furthermore, the EBA suggests considering the incorporation of a forward-looking perspective in the methodology, given the forward-looking nature of environmental risks. Ms Tuominen (ECB) also addressed this aspect in her keynote and noted that, due to the forward-looking nature of environmental risks, reliance on historical data may affect risk measurement, which could require the consideration of new tools to complement the existing Pillar 1 framework. 

b. Investment firms

For investment firms, in the EBA’s opinion as expressed in the discussion paper, environmental risks might potentially be relevant for capital requirements based on K-factors (while not directly affecting the permanent minimum capital and fixed overheads requirement).

To the extent the rules are comparable to those for credit institutions, any enhancement in the CRR could be mirrored in the IFR (subject to the proportionality principle). Differentiating requirements might especially be suitable with a view to the composition of assets under management, considering potential reputational and business model risks if such assets are not environmentally sustainable.

Limitations and open questions

The ‘S’ and ‘G’ of ESG

So far, the EBA has only touched upon the environmental (E) aspect of ESG in the context of prudential regulation. The social (S) aspect – but not governance (G) – would also have been included in the EBA’s mandate under the CRR and IFR but will be addressed at a later stage.

Scientific challenges

The EBA highlights uncertainties from an empirical perspective in its discussion paper: a lack of available data makes a robust assessment of whether the prudential framework sufficiently addresses environmental risks impossible. How environmental risks ultimately translate into financial risks is as yet unquantifiable, and it remains unclear how the various aspects of ESG influence each other and what this implies for the calibration of prudential requirements.

Against this background, the EBA underlines the importance of data collection – both to allow firms to improve their risk management practices and as a basis for regulation.

The bigger regulatory picture

Finally, the discussion paper covers Pillar 1 capital requirements, but does not address aspects such as the leverage ratio and the liquidity ratios, which the EBA considers to be mostly unaffected by environmental risks, or requirements outside the Pillar 1 microprudential framework.

However, the EBA stresses the need for a holistic regulatory approach and refers to its broader work related to sustainability, for example in the following areas:

• Risk management – the EBA issued a report on the management and supervision of ESG risks for credit institutions and investment firms in June 2021 and is developing further guidelines on the identification, measurement, management and monitoring of ESG risks. The ECB also published a guide on climate-related and environmental risks in November 2020 and a report on climate and environmental risk management in the banking sector in November 2021 – summarised in this blogpost;
• Additional requirements within Pillar 2 – the EBA is working on the integration of environmental risks into Pillar 2, including in the Supervisory Review and Evaluation Process and stress tests. The results of the recent climate risk stress test by the ECB can be found in its July 2022 report;
• Disclosure and transparency within Pillar 3 – the EBA published final draft implementing technical standards on prudential disclosures on ESG risks in accordance with Article 449a of the CRR in January 2022. Moreover, the ECB issued a report on banks’ progress towards transparent climate-related and environmental risk disclosure in March 2022 and a paper on the disclosure of climate change risk in credit ratings in September 2022. The European Commission is also assessing the need for regulatory safeguards for ESG ratings;
• Macroprudential regulation – environmental risks were also considered in the EBA’s response to the European Commission’s call for advice on the review of the macroprudential framework of April 2022. A report by the ECB and the European Systemic Risk Board of July 2022 evaluates the systemic nature of climate risks; and
• Interlinkages with the accounting framework – see the EBA’s letter to the IASB of January 2022. As the EBA emphasises in its discussion paper, the Pillar 1 prudential requirements are designed to only cover “unexpected losses”, while “expected losses” would normally be covered by accounting provisions.

A holistic approach across all pillars of the Basel framework is also followed by the Basel Committee on Banking Supervision (BCBS) and supported by the ECB.

In her keynote, Ms Tuominen (ECB) stated that substantial progress has been made on the use of the Pillar 2 framework with the publication of the BCBS’ principles for the effective management and supervision of climate-related financial risks in June 2022 (summarised in this blogpost). Yet, the materiality of climate-related financial risks implies that all pillars of the Basel framework should be considered, including potential Pillar 1 measures, Ms Tuominen said.

In light of the ECB’s March 2022 report (see above), Ms Tuominen also noted that although both types of environmental risks – physical and transition risks – become increasingly material, banks appear to focus their strategies more on transition risks than on physical risks. In her speech, she described this as concerning, considering “the large impact of physical risk events again this summer, when drought and flooding heavily disrupted industries and regions”. In addition, she pointed to the importance of further improving the incorporation of climate risk into credit ratings, including to provide transparency to investors and reduce “greenwashing”.

Key takeaways from the consultation 

The consultation on the EBA’s discussion paper was completed in early August.

The European Banking Federation (EBF) was amongst those providing feedback. While supporting the risk-based and risk-sensitive approach, the EBF pointed out that banks should not be used as the primary enforcers of EU climate policy, but suggested that they can channel finance to sectors and companies in line with public policy objectives.

In the EBF’s view, the prudential treatment should be based on the actual financial risk posed by an exposure and not on political considerations. The EBF also highlighted that banks already include environmental risks in their risk management framework, and encouraged collaboration between regulators and banks with a view to developing methodologies that include forward-looking aspects.

What’s next? 

Based on the consultation, additional analyses and further monitoring of international efforts, the EBA will submit a report on whether a dedicated prudential treatment for exposures associated substantially with environmental objectives should be introduced to the European Parliament, the Council and the European Commission.

While the CRR deadline for the EBA’s report is 28 June 2025, the EBA plans to deliver its report in the first half of 2023, anticipating that the proposed CRR III will likely move the deadline to 28 June 2023 (the deadline under the IFR was 26 December 2021). Based on the report, the Commission shall, if appropriate, submit a legislative proposal to the European Parliament and the Council.

The final shape of policy recommendations in the report remains to be seen, and thus it is uncertain whether and how these could result in legislative changes. 

If you would like to discuss any of the topics in this blogpost, please do not hesitate to get in touch.

Please visit the website of the 9th Conference on the Banking Union for presentation materials and a video recording of the discussions on ESG in banking regulation and supervision, including on topics such as the opportunities and challenges of regulation based on double versus single materiality, and addressing ESG risks by way of prudential regulation. 

More insights into sustainability can be found here, including our overviews Sustainable Finance Regulation, Sustainability Regulatory Horizon and Hot Issues in ESG for Financial Services Firms.