EU Sustainable Finance Framework: What does it mean for banks?

The European Commission's (EC) Action Plan on sustainable finance is a major policy objective by the European Union (EU) to promote sustainable investment. As per the plan, banks are expected to finance sustainable economic activities to trasition to a carbon neutral economy. The plan was introduced in March 2018 in response to the Paris Agreement and to the United Nations' 2030 Agenda for Sustainable Development. The plan is also aligned with the goals of the European Green Deal, which aims to see the EU carbon neutral by 2050.

The plan aims to reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth, manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues and foster transparency and long-termism in financial and economic activity.

The EU’s sustainable finance and climate change agenda has brought forward a framework with challenging sustainability disclosure requirements for banks. Broadly speaking, the regime comprises the EU Taxonomy Regulation and the CRR Pillar 3 ESG Disclosures.

The EU Taxonomy, which was publsihed in June 2020, is a classification system for economic activities that aims to provide a reliable reference for what can be considered sustainable, primarily in the interest of transparency. It complements the EU banking sector’s commitments to deliver on its critical role in financing the transition to a more sustainable economy. Pillar 3 ESG Disclosures, on the other hand, require reporting of ESG risks under the CRR to demonstrante how banks are embedding sustainability considerations in their risk management, business models and strategy.

The Taxonomy regulation consists of Delegated Acts (DA) for each economic activity. The regulation has established the permanent Platform on Sustainable Finance in the European Commission and amended  the Sustainable Finance Disclosure Regulation (SFDR), which came into force in 2021 and applies to banks that provide portfolio management services. It has also revised the disclosure requirements in place under the Non-Financial Reporting Directive (NFRD), which lays down the rules on disclosure of non-financial and diversity information by large companies.

Article 8 of the Taxonomy regulation updates NFRD to include disclosure of information by banks on the extent to which their products are environmentally sustainable in their non-financial statements. The regulation also requires specific key performance indicator (KPI) disclosures on the proportion of revenue or turnover derived from products or services associated with environmentally sustainable activities, as well as proportion of economic capital (capex) and operational expenditure (opex) related to assets or processes associated with environmentally sustainable activities.

This means that banks should collect sustainability information on their investees and counterparties, which will be particularly challenging in the case of “non-NFRD entities”, i.e. those parties that are not required to make sustainability disclosures. For now SMEs and non-EU clients are currently not required to report but the Corporate Sustainability Reporting Directive proposal (CSRD) adopted in April 2021 by the EC will replace NFRD and extend its scope to capture all large companies and listed SMEs. CSRD will introduce more detailed reporting requirements. The legislative proposal is currently in the trilogue discussions between the European Parliament and the Council of the EU. CSRD is expected apply from January 2024 (reporting on 2023 activities).

Initially designed as a classification system to identify sustainable economic activities, the EU Taxonomy has evolved to serve both as a metric for sustainable reporting and as a benchmark for sustainable financial products, as well as a way to measure progress towards the policy objective of a sustainable financial and economic system in the EU.It encompasses six environmental objectives, namely climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, as well as protection and restoration of biodiversity and ecosystems. It introduces disclosure requirements with respect to financial products to facilitate sustainable investments to support environmentally sustainable “taxonomy-aligned” economic activities.

The European Commission has put in place a “double materiality perspective”, which means that companies have to report about how sustainability issues affect their business and about their own impact on people and the environment. So far the priority in the EU has been the implementation of the climate taxonomy, which became the law in December 2019. For now, the EU Taxonomy is operational only regarding the climate change mitigation and adaptation objectives, with the Commission Delegated Regulation (the Article 8 Delegated Act) already in place as of December 2021. The technical work on the remaining four environmental objectives is currently ongoing within the EU Platform on Sustainable Finance and are expected to become law through subsequent DAs.

For climate taxonomy, Article 8 DA provides for a phased implementation, focusing first on Taxonomy eligibility rather than alignment. This means that banks should first determine which economic activities have Technical Screening Criteria (TSC) set out in the Taxonomy DA. Disclosure requirements has started to phase in since January 2022. Banks are already required to report on Taxanomy eligibility of their assets in 2022 and 2023.

Next, banks will need to determine if eligible economic activities are aligned with the EU’s environmental objectives, i.e. make a substantial contribution (SC) to at least one of the climate and environmental objectives, while also doing no significant harm (DNSH) to the remaining objectives and meeting minimum safuguards (MS) on human rights, business and labour standards. While the SC and DNHS depend on the specific TSC, MS are determined by the relevant OECD and UN guidelines.

For now, only climate related TSC have been finalised, with the publication of the Commission Delegated Regulation (“the Climate Delegated Act”) in 9 December 2021. The DA sets out the relevant TSC for SC and DNHS for climate change. For the remmaining environmental objectives, European Supervisory Authorities is expected to publish the draft TSCs within 2022.

Regarding taxonomy alignment, reporting of KPIs are expected for non-financial companies in 2023, and for banks in 2024. This means banks should start working on their alignment and the reporting of their Green Asset Ratios (GAR) as soon as they finish working on eligibility. FAQ on eligibility assessment was published in December 2021 and FAQ on alignment assessment is expected soon.

The reporting of taxonomy-eligibile and taxanomy-aligned activities is required at both product and entity levels. While product-level disclosure are in alignment with the SFDR disclosures, entity level disclosures are in line with the NFRD disclosures. The latter relate to how, and to what extent, banks’ activities are associated with Taxonomy aligned activities. Since 2018, the NFRD requires large listed financal and non-financial companies to disclose how their activities are associated with the Taxonomy. 

In addition to the EU Taxonomy, SFDR and CSRD, the EU sustainable finance policy also comprises and the Green Bond Standards (GBS), a voluntary standard to help scale up and raise the environmental ambitions of the green bond market. GBS will enable bond issuers to demonstrate that they are funding legitimate green projects aligned with the EU taxonomy.  

Turning to the ESG framework, while the importance of ESG risks were already emphasised under the 2019 Banking Package, requiring banks to disclose transitional and physical risks, the 2021 Banking Package more explicitly requires banks to identify and manage their ESG risks, with standard templates and tables. It also harmonizes the definitions of ESG risks, aligning them with the EU Taxonomy.

The European Banking Authority (EBA) has opted for a sequential approach, with an initial focus on climate change-related risks. It published its final draft Implementing Technical Standards (ITS) on Pillar 3 ESG disclosures in January 2022. The ITS provide templates, tables and associated instructions for disclosure, giving banks clarity around expectations with tangible requirements. These include comparable disclosures and KPIs, including the GAR and the Banking Book Taxonomy Alignment Ratio (BTAR). The EBA considers only the positions in the banking book for now but banks will be expected to report on the Taxonomy-alignment of their trading books starting from January 2026.The scope of the ITS is expected to be extended during a review in 2024 to include other environmental risks such as loss of biodiversity, and social and governance risks.

For qualitative disclosures (environmental, social, and governance risks) the ITS introduce three tables. For each of qualitative disclosures, banks need to provide detailed information on how they address ESG risks in their strategy and governance and how they incorporate them in their risk management framework. For quantitative disclosures (transition risks, physical risks and mitigating actions), on the other hand, the ITS introduce ten templates. The GAR indicates what part of the bank’s banking book is aligned with the EU’s Taxonomy. The BTAR complements the GAR ratios, incentivizing banks to support all of their counterparties to transition to a more sustainable business model, and to collect ESG data on them.

The ITS on P3 ESG disclosures on climate risks will become effective as of June 2022 for large banks that have securities traded on a regulated market of an EU member state. A semi-annual disclosure is required, except the first disclosure which will be annual. In practice, this means that the first reporting will take place in Q1 2023. 

However, the EBA has introduced transitional measures for the GAR, the bank’s financed scope 3 emissions, the alignment metrics and the BTAR. The work on the GAR remains currently unfinished with some technicalities in the numerator and the denominator regarding the treatment of derivatives, SMEs, sovereign exposures. While the reporting of the GAR will be required as of 31 December 2023, for other disclosures this will be required starting from June 2024.