EU banking package and sustainability

On 27 October 2021, the European Commission adopted a review of EU banking rules (the Capital Requirements Regulation – CRR – and the Capital Requirements Directive – CRD IV). These new rules will ensure that EU banks become more resilient to potential future economic shocks.

The package implements Basel III, stablishes new sustainability rules, and provides stronger enforcement tools for supervisors overseeing EU Banks.

Concerning Sustainability, it intends to strength the resilience of the banking sector to ESG risks, aligned with the Commission’s Sustainable Finance Strategy. It improves the way banks measure and manage these risks, ensuring that markets can monitor what banks are doing. This proposal will require banks to systematically identify, disclose and manage ESG risks as part of their risk management. It includes regular climate stress testing by both supervisors and banks. Supervisors will need to assess ESG risks as part of regular supervisory reviews. All banks will also have to disclose the degree to which they are exposed to ESG risks. To avoid undue administrative burdens for smaller banks, disclosure rules will be proportionate.

The proposed measures will not only make the banking sector more resilient, but also ensure that banks take into account sustainability considerations.

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Climate Change and prudential policy

Central Banks’ objective of maintaining price stability, enables climate protection goals. For example, low inflation rates will allow households and firms to detect price signals from climate policy and adjust thus their behaviour. Putting the right price tag on greenhouse gas emissions is arguably the most powerful weapon  in the fight against climate change.

Central Banks should not slip into the role of a climate policy actor as they have different segregation of responsibilities. Unlike monetary policy, climate policy changes the distribution of resources and income distinctly and permanently. Democratic processes and direct political accountability are important when making such decisions. Central Banks should guarantee independence to safeguard price stability objective.

A clash of objectives could arise as well if, say, the Central Bank attempted to use its monetary policy asset purchase programmes  to pursue environmental policy objectives, as these programmes  need to be scaled back as soon as warranted  to ensure price stability. Ultimately, monetary policy is not a structural policy instrument: it is cyclical in nature, balancing each other out over the long run through  the interplay of monetary policy loosening and tightening.

However, Central Banks can step up their game to protect the climate without running the risk of overstretching their mandate of preserving price stability. As climate change affect firms and lenders, Central Banks need to ensure that climate-related financial risks are appropriately taken into account as part of risk management.

So, from a monetary policy, perspective, Central Banks are within their rights to request better information. The Eurosystem should consider purchasing or accepting as collateral only those securities whose issuers meet certain climate-related reporting requirements. Hence, the importance of the ratings of agencies to adequately and transparently reflect climate-related financial risks.

Other further measure may be to limit the maturities or the volume of securities from certain issuers in the monetary policy portfolio, if required to contain financial risk.

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EU social taxonomy and taxonomy extension linked to environment reports

The draft proposal for a social taxonomy will argue that in the face of a pandemic, unanswered social questions around a sustainable transition, continuing human rights abuses and continuously rising costs for housing, the time is right to identify economic activities that contribute to advancing social objectives. Just as the EU environmental taxonomy defines activities that substantially contribute to environmental objectives, a social taxonomy would do the same for social objectives.

Built on the foundation of international norms and principles like the sustainable development goals (SDG) and the UN guiding principles for businesses and human rights, a social taxonomy would help investors to contribute to finance solutions around ensuring decent work, enabling inclusive and sustainable communities and affordable healthcare and housing. A social taxonomy would be a tool to help investors identify opportunities to contribute to these objectives.

The Public Consultation Report on Taxonomy extension options linked to environmental objectives will be focussed on support for the environmental transition needed in the whole economy – it proposes further clarity on both: activities that are significantly harmful to environmental sustainability, and those that have no significant impact on it. The aim is to support transitions in areas currently of “significant harm”. They should transition to a level that at least does not cause significant harm, even if they do not actually reach substantial contribution (green). The report will set out options to build on the existing taxonomy and its use.

The Platform on Sustainable Finance will welcome stakeholder feedback on both drafts through two calls for feedback, which will run from 12 July to 27 August 2021. Platform’s advice on this will feed into Commission’s report on potential extension of taxonomy framework to be adopted by the end of 2021.

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Commission puts forward New strategy for Sustainable Finance and proposes new European Green Bond Standard

The Commission also adopted yesteday a Delegated Act on the information to be disclosed by financial and non-financial companies about how sustainable their activities are, based on Article 8 of the EU Taxonomy.

Thus, EU took another major step towards achieving the goals in the Green Deal by ensuring a comprehensive approach to funding the green transition.

EU proposed incorporating climate-related risks into banks’ capital requirements. The challenge for lenders is weaning themselves off their lending exposure to fossil fuels. Their initial disclosures have been limited and commercial lenders still have “patchy” data regarding their exposure to climate change.

The ECB will hold a stress test next year to see how their balance sheets may fare as the climate and economy shifts. EU states will be asked to assess by June 2023 how their financial markets contribute to reaching the bloc’s climate goals. ECB will then calibrate the right pace for the transition by setting intermediate targets for the financial sector. Insurance capital rules may also be similarly amended.

The Commission confirmed it will publish taxonomy rules later this year for agriculture, certain industries and possibly nuclear and gas power plants. EU needed to guard against the risks associated with the transition, thus considering an “intermediate taxonomy” that would allow transition bonds.

The strategy seeks to empower individuals and the bloc’s 23 million SME by defining green loans and mortgages by 2022. New accounting rules may also be needed to “recognise and report” ESG risks in financial statements.

The strategy sets out a positive vision of the reform needed in the financial system to support the European economy.

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New EU measures for transitioning to a Sustainable Economy

The EU Strategy for Financing the Transition to a Sustainable Economy, and the rulebook for green bonds will be unveiled next week. They center around the Green Deal to reach net-zero emissions by 2050.

The EU strategy will propose tightening reporting requirements for financial entities, by incorporating climate-related risks into credit ratings and bank capital requirements. It will also enable supervisors to address greenwashing.

The European Commission (EC) will invite the ESMA to assess how ESG factors are incorporated by credit rating agencies and will consider proposing an initiative to make sure those risks are captured by the assessments. The EC will also ask the ECB to conduct regular climate change stress tests.

The strategy paves the way for financing activities such as natural gas during the transition, after Germany and Poland pushed for including it in the taxonomy, despite the resistance of the others member states. Thus, BAU is falling under the agenda of sustainable finance.

Supervision of ESG risks for credit institutions and investment firms

The European Banking Authority (EBA) published yesterday a report which provides recommendations for institutions to incorporate ESG risks-related considerations in strategies and objectives, governance structures, and to manage these risks as drivers of financial risks in their risk appetite and internal capital allocation process. The EBA also recommends developing methodologies and approaches to test the long-term resilience of institutions against ESG factors and risks including the use of scenario analysis.

EBA sees a need applying at least a 10 years horizon to capture ESG related risks, proposing a phase-in approach. This Report should be considered in conjunction with the EBA and ESAs disclosure publications under the Capital Requirements Regulation (CRR), the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFDR). The EBA will publish Pillar 3 disclosure requirements on ESG risks, transition risks and physical risks, as defined in this Report, later this year.

The report will be taken into consideration in the context of the Renewed Sustainable Finance Strategy, the review of CRR/CRD, and an update of the SREP Guidelines to include ESG risks in the supervision of credit institutions.

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Countries’ map developing National Action Plans (NAPs) on Business and Human Rights

NAPs are policy documents in which a government articulates priorities and actions that it will adopt to support the implementation of international, regional, or national obligations and commitments with regard to a given policy area or topic.

The UN Working Group on human rights and transnational corporations and other business enterprises (UN Working Group), mandated by the Human Rights Council to promote the effective and comprehensive implementation of the UN Guiding Principles on Business and Human Rights (UNGPs), noted in its 2016 Guidance on business and human rights NAPs that they can be an important means to promote the implementation of the UNGPs.

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The ESG Green Bond Principles (GBP) 2021 edition has been updated by the International Capital Market Association @ICMA

The GBP seek to support issuers in financing environmentally sound & sustainable projects that foster a net-zero emissions economy & protect the environment. An estimated 97% of sustainable bonds issued globally in 2020 referenced the Principles.

The four core components that an issuer should disclose to align with the GBP remain unchanged (use of procedes, evaluation & selection, management of procedes, & reporting). The GBP identifies recommendations regarding green bond frameworks and external reviews for heightened transparency. It recommends heightened transparency for issuer-level sustainability strategies & commitments. It recognises that ongoing developments of taxonomies may require parties to consider such taxonomies when determining the environmental sustainability of projects.

The 2021 editions of the the Social Bond Principles (SBP) & the Sustainability Bond Guidelines (SBG) have been similarly revised. The 2021 edition of the Guidance Handbook has also been updated & reflects such revisions.

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The EU Green Bond Standard (EU GBS

It will be logically voluntary. It will be ready to be used in 2022 and aims to set the global standard. Global ESG debt market tops 3 TUSD, with Europe taking a lead as nearly a quarter of its bond sales this year were related to social factors.

Sovereign issuers will be granted some flexibility to assess government spending programs based on their terms and conditions. The 27-member bloc itself is set to become one of the largest issuers, with 30% of its 800 BEUR pandemic recovery funding planned as green debt.

The ESMA will determine whether a bond is green or not, with external reviewers to be approved by the body. Issuers should disclose impact assessments at least once, as well as annual allocation reports for how the funds were used and they will be free to align their bonds alongside other standards.

EU GBS affords issuers an opportunity to launch taxonomy-aligned green bonds at a potentially lower cost of capital. For investors, the standard affords an opportunity to make investments in green bonds that are credible and easier to report on.

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Network for Greening the Financial System (NGFS) update of their economic scenarios

Reaching net zero by 2050 could lift growth and employment but would require an inflation-boosting $160 per tonne carbon price — or equivalent “shadow price” — by the end of the decade. This will push up inflation and also raise unemployment in some countries with energy-intensive industries.

Only a relatively quick and orderly transition to a low carbon economy would add to growth while a delayed transition or no action would cut deep into the economy.If these changes occur in an orderly fashion, the scenarios suggest that it could lead to some increase in global GDP, and lower unemployment relative to prior trends.If the transition fails, the scenarios suggest that up to 13% of global GDP would be at risk by the end of the century, even before accounting for the potential consequences of severe weather events.

Currently about a fifth of the world’s greenhouse gas emissions are covered by a carbon price.

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