Under the European Green Deal, the financial system has an important role to play in supporting the long-term transition to sustainable development in general and especially the transition to climate neutrality by 2050. Or, as Commissioner Valdis Dombrovskis puts it, “As the EU economy transitions towards carbon neutrality, it is vital that banks can identify and manage sustainability risks and absorb financial losses that arise from them”.

Therefore, supervisors as well as legislators have been very engaged in gathering relevant information and input from stakeholders in order to establish harmonised and uniform rules particularly regarding environmental, social and governance (ESG) risks. Following the EBA’s report on management and supervision of ESG risks for credit institutions and investment firms in June 2021 (for further information, see also our FRQ on this report) and the European Commission’s Sustainable Finance Strategy in July 2021, the Commission now has adopted legislative proposals for a review of the EU banking rules, i.e. the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD).

While the package primarily aims at ensuring a stronger resilience of EU banks to potential future economic shocks by finalising the implementation of the Basel III rules (also known as Basel IV in the market), it is also intended to contribute to the recovery from the impact of the Covid-19 pandemic as well as the transition to climate neutrality. This blog post will focus on the proposed rules regarding ESG risks.

Introduction of uniform definitions

According to the Commission, to support the transition to climate neutrality it is essential to improve the way ESG risks are measured and managed and by this to improve the possibilities for the markets to monitor and assess the banks’ activities. To do so, ESG risks need to be clearly defined first. In its proposal to amend CRR (CRR III), the Commission, therefore, introduces several general definitions for types of ESG risks aligned with those definitions proposed by EBA in its June report (Art. 4 para 1 points 52d to 52i CRR).

Business strategies, processes and governance

The amendments foreseen in Articles 73, 74 and 76 of the CRD by the proposal to amend CRD (CRD VI) will require institutions to appropriately identify and manage in particular ESG risks as part of their internal governance arrangements and capital needs. According to the EBA report, institutions should extend their time horizon for strategic planning to at least 10 years when incorporating ESG risk-related considerations in their business strategies. This recommendation was taken into consideration by the proposals by requiring institutions to include short, medium and long-term horizons of ESG risks in strategies and processes for evaluating internal capital needs as well as adequate internal governance. The proportionality principle has to be taken into account when developing the relevant strategies, policies, processes and systems.

Stressing the challenges that ESG and in particular climate-related risks pose to the financial system, the proposals also introduce oversight over institutions’ management of these risks as well as regular climate stress tests (Art. 87a CRD). Institutions are required to carry out stress tests regarding their resilience to long-term negative impacts of ESG factors, both under baseline and adverse scenarios within a given timeframe, starting with climate-related factors (Art. 87a CRD).

To help implement the new rules, the EBA will develop guidelines to specify the criteria for the assessment of ESG risks, i.e. how they should be identified, measured, managed and monitored, as well as how concrete plans to address and internally stress test resilience and long-term negative impacts to the ESG risks should be drawn by credit institutions.

Requirements for the management body

CRD VI also foresees that the management body has to develop and sign off on specific plans and quantifiable targets to monitor and address the risks arising in the short, medium and long term from the misalignment of the business model and strategy of the institutions with the relevant EU policy objectives or broader ESG transition trends (Art. 76 CRD).

Furthermore, the management body should understand the potential impact of ESG risks on the business model (Art. 91 CRD). Hence, it is important that the members of the management board are, respectively, collectively and individually "suitable", that they possess sufficient knowledge and skills, and, where not already the case, develop their experience and understanding with regards to ESG factors. The same requirement is foreseen in the draft for the updated fit and proper guide, issued for consultation by the European Central Bank in June 2021.

Disclosure of risks

The transparency and sustainability reporting requirements that many institutions are subjected to, are intended to provide more granular data in a few years. Nevertheless, it is imperative for an effective supervision that competent authorities have at their disposal data that are granular, comprehensive and comparable from all institutions. Therefore, under CRR III, information on exposures to ESG risks is proposed to be included in the supervisory reporting of institutions (Art. 430 para. 1 lit. h CRR).

Under Article 449a of the CRR, large institutions which have issued securities that are admitted to trading on a regulated market of any Member State are obliged to disclose information on ESG risks on a regular basis starting in June 2022. To generate the aforementioned comprehensive data needed by the competent authorities, CRR III now extends this obligation to all institutions. For small and non-complex institutions, the disclosure frequency is reduced. The EBA will develop uniform disclosure formats (Artt. 449a and 434a CRR).

Supervisory reviews

Furthermore, the Commission empowers competent authorities to incorporate ESG risk in the Supervisory Review and Evaluation Process (SREP). The EBA has been asked to issue guidelines regarding the integration of ESG risks in the SREP process. The update of the SREP guidelines published during the summer does not yet cover this area.

Adjustments to capital requirements for ESG-related assets?

At present, the Commission does not yet have a sufficient data basis for the evaluation of whether capital requirements can or even should be adjusted for green or brown assets. With the amendments known as CRR II in 2019, the EBA was tasked to explore possible options for applying a dedicated prudential treatment of exposures subject to impacts from environmental and social factors, e.g. the possibility of a targeted calibration of risk weights for items associated with particularly high exposure to climate risk. The EBA is now expected to present its analysis sooner, namely in 2023 (due to an advancement of the deadline by CRR III).

Based on this analysis as well as the ongoing work at international level, the Commission will decide whether to propose any adjustments to the current capital requirements.

Next steps

The CRR III and CRD VI proposals will now follow the ordinary legislative procedure to become binding EU law. After being discussed by the European Parliament and the Council, a publication in the Official Journal of the EU can be expected for 2023 at the earliest.

Furthermore, the proposals also foresee additional time for banks and supervisors to properly implement the reform in their processes, systems and practices. The rules are expected to apply from 1 January 2025.

Even if the finalisation of the rules is only just looming on the horizon, it is advisable to follow the legislative progress of the drafts and to take appropriate preparatory measures if necessary.