Background
The European Commission considers that credit institutions have a key role in financing the transition 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 categories.
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.
Requirements
Definitions
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 risk 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 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.
Collateral
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).
Governance
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. As explained by the EBA, transition plans under EU ESG legislation look at the compatibility of business models with the move to 1.5 degrees 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, 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.
Impact
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.
