The EU’s Banking Package nears the finishing line: ESG in the spotlight

Relevant to: Risk and Finance leads, heads of capital planning and heads of sustainable finance at banks operating in the EU.

At a glance

• Proposals for the EU Banking Package - CRD6 and CRR3 - set out new regulatory requirements for how banks manage ESG risks.
• For those banks supervised directly by the ECB, the new requirements seem broadly aligned with existing supervisory expectations. However, anchoring the requirements to ‘ESG’ instead of climate and environmental risks (as the ECB has done) broadens the range of risks for banks to consider. The change in requirements relative to existing expectations may be greater for banks that are not supervised by the ECB SSM, depending on the stance that their national supervisor has already set.
• The introduction of mandatory and enforceable requirements to develop transition plans is an intensification of ongoing efforts by policymakers to ensure that the actions banks take are aligned with public sustainability objectives. The proposed new supervisory powers related to transition plans are potentially wide-ranging and intrusive, and are accompanied by a mandate for supervisors to assess banks’ business model sustainability over a longer time horizon in the SREP.
• A few of the ESG-related requirements in CRR will have an impact on bank capital as soon as the new rules are implemented, but any more substantial changes are only likely to materialise later on once the EBA has published its final report on the prudential treatment of ESG risks.
• The Commission, Council and Parliament are broadly aligned on most of the ESG-related provisions in the banking package – although details still need to be ironed out on the provisions related to transition plans, and the follow-up to the EBA’s forthcoming report on the prudential treatment of environmental risks. The proposals are therefore likely to stay largely intact through the trilogues process.

As covered in the first blog of this series on the CRD6/CRR3 trilogues, the legislative process around the EU Banking Package is now entering its final stages. With the European Parliament having adopted its final position on CRD and CRR, trilogues are due to commence in March and will likely conclude towards the end of 2023. This will give EU firms in scope of CRR and CRD long-awaited certainty over the new rules and implementation deadlines.

The primary aim of the Banking Package is to implement the finalised Basel framework, Basel III. However, the proposals for CRD6/CRR3 also include numerous ESG provisions not present in the Basel III text that will be important to in-scope firms.

There are several regulatory and supervisory initiatives already in train in the EU related to ESG risks (in particular climate risks). For EU banks, it is therefore important to understand how the requirements included in CRD6/CRR3 compare to (and interact with) other policy initiatives and supervisory expectations.

In many cases, the ESG-related provisions in CRD6/CRR3 reflect established leading supervisory practice, serving to add the legal weight of regulatory requirements to existing guidelines. But there are nonetheless a number of important provisions, some of which are still likely to be debated in trilogues, that will change the nature of ESG risk management for EU banks.

New requirements to develop transition plans

CRD6 will create new mandatory requirements to develop transition plans. Under the proposals, bank management teams would have explicit responsibility for developing transition plans and reviewing them on an annual basis (or, as proposed by the Parliament, biennially for smaller banks).

Transition plans are not a new concept in EU regulation - requirements for the development and disclosure of climate transition plans are embedded in a number of forthcoming pieces of EU legislation, including the Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence Directive (CSDDD). And a number of EU banks have already developed transition plans as a result of their membership of industry groups such as the Glasgow Financial Alliance for Net Zero (GFANZ).

Under the present framework, transition plans are neither mandatory nor enforceable by supervisors. This will change, with supervisors set to receive new powers under CRD6 to assess and monitor the implementation of banks’ transition plans. The Commission and Council also propose to give supervisors potentially wide-ranging and intrusive powers to compel firms to change their business model, governance strategies or risk management to reduce risks from misalignment with relevant EU objectives (such as net zero). Assessment of banks’ transition plans will become a part of the Supervisory Review and Evaluation Process (SREP), supported by a new mandate for supervisors to assess business model sustainability over a time horizon of at least 10 years (compared to the typical three-five year horizon currently used by supervisors).

Further details on the exact nature of the requirements will come from the EBA, under a mandate to specify its expectations around the content of plans, including specific timelines, intermediate quantifiable targets and milestones, and the scientific pathways against which firms will be compared.

Trilogue negotiations will define the nature of the EBA’s mandate and guidelines – with the Parliament and Council not yet aligned on the required coverage of banks’ transition plans and the scope of supervisory enforcement powers, for example. Firms will monitor closely the alignment of the EBA’s eventual guidelines with standards for transition planning developing elsewhere (such as in the UK through the Transition Plan Taskforce). Internationally active banks will be wary of the prospect of having to align with divergent ‘gold standards’ for transition planning across their geographical footprint. The fact that the provisions are included in CRD, rather than CRR, leaves open the prospect that new rules and supervisory enforcement powers are applied unevenly within the EU.

At present, the timing of those guidelines is also uncertain – the Commission originally proposed delivery 18 months after entry into force of the Directive (potentially mid-2026), while the EBA has proposed to include guidance on transition plans in its planned 2023 consultation on risk management in stress testing, to be finalised in 2024.

ESG, not just 'E'

Most EU policy related to sustainability to date has focused on the ‘E’ in ESG, and in practice more specifically on climate change. Yet the term ESG is used across all of the Commission, Council and Parliament’s texts, with a broad definition of the ‘E’ in ESG drawing on the six objectives of the EU taxonomy¹. This is an important point of detail, as existing supervisory expectations predominantly focus on climate risks (and to a lesser extent broader environmental risks). Consequently, banks’ current capabilities for managing Social and Governance risks are relatively less mature. While it is likely that climate risks will remain the near-term priority for regulators, supervisors and firms, broader explicit requirements relating to Social and Governance risks are now coming down the track. Firms should take steps now to deepen their understanding of ESG risks beyond climate and to begin to map out and fulfil their data needs.

Formalisation of existing supervisory practices

CRD introduces explicit rules on the management and supervision of ESG risks, broadly in line with recommendations set out by the EBA in a 2021 report. A lot of the detail of the forthcoming requirements will not become clear until later this year, with the EBA due to consult on Guidelines for risk management, internal stress testing and the integration of ESG risks into the SREP by the end of 2023 (as proposed in its latest action plan on sustainable finance).

The EBA’s guidelines are likely to be broadly consistent with existing ECB guidelines and BCBS principles – meaning that firms in scope of those requirements may be able to leverage existing processes and capabilities to an extent – but firms will need to ensure that, as for climate risks, they are developing the internal expertise and data gathering capabilities to include broader ESG risks in their risk identification, measurement and mitigation processes.

Firms outside the scope of direct ECB supervision may have comparatively more work to do to – compounded by the fact that CRR3 will extend the scope of Pillar 3 requirements for ESG risks beyond its current scope of large, listed EU banks, and impose new supervisory reporting requirements.

A limited number of provisions that will have a direct impact on capital, but the prospect of more to come

Notably, none of the Commission, Council or Parliament’s proposed texts include the so-called “one-for-one” capital treatment for fossil fuel exposures, which would have required new fossil fuel exposures to be backed in their entirety by CET1 capital (while also imposing a higher risk weight on existing fossil fuel exposures). Despite significant publicity (and backing from numerous MEPs), the proposal is now highly unlikely to be adopted in the EU.

Even so, several provisions will have an impact on banks’ RWAs and capital once CRR3 applies. For example, all three institutions propose that improvements to energy efficiency should be recognised as having a positive impact on the value of immovable collateral, while the Parliament proposes a general requirement for banks to factor ESG risks into their collateral valuations under the Standardised and IRB approaches for credit risk (with the EBA to publish guidelines on how to do so). The impact of these provisions will be relatively limited for some banks, given that the ECB already expects banks to factor climate and environmental risks into their collateral valuations – but proposed guidelines from the EBA would provide useful clarity to industry and accelerate practices among less advanced banks.

Elsewhere, the Commission and Parliament propose creating a new, more favourable risk weight treatment in the market risk framework for allowances under the Emissions Trading Scheme. This is likely to be a point of debate in the trilogues process, as the Council proposed delaying any differentiated prudential treatment until the EBA and ESMA have published a report and the Commission has published a separate legislative proposal. Some industry stakeholders have argued that even the proposed discount is overly conservative.

EU legislators have chosen to retain the Infrastructure Supporting Factor – the criteria for which include assessment of Taxonomy alignment. And finally, CRD6 clarifies that the Systemic Risk Buffer can be used to address climate risks – although at present there is little detail in CRD6/CRR3 (or elsewhere) on how this would be implemented in practice.

More substantial revisions of the EU prudential framework to capture climate risks will likely follow separately in the next few years. As proposed in the EU’s renewed sustainable finance strategy in 2021, CRR3 accelerates the EBA’s mandate to publish a report on the prudential treatment of ESG risks by two years (from 2023 to 2025). The EBA’s work on this topic is now well underway, with an initial discussion paper published in 2022 and a final report likely to be published in the second half of this year. The content, timing and follow up for that report is a topic that will be debated in trilogues, with the Parliament also proposing a mandate for a follow up legislative proposal by the Commission. The Parliament also proposes that the ESAs report by 2026 on the integration of ESG risks into credit ratings, with a potential legislative proposal – this could have a high impact, given the importance of external credit ratings for calculating standardised risk weights.

Conclusion

Although Trilogues will determine the final framework, the Commission, Council and Parliament are broadly aligned on the overall objectives of the ESG-related provisions in the Banking Package – to formalise existing supervisory expectations (and, by including them in the CRD/CRR framework, extend them to a wider universe of banks), to create mandatory obligations for bank management to develop transition plans, and to accelerate the EU’s assessment of whether further more wholesale changes to the capital framework are justified. EU banks should ensure that they have a detailed understanding of the proposed requirements and their impact.

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Reference

1. The six environmental objectives of the Taxonomy are: (1) climate change mitigation, (2) climate change adaptation, (3) sustainable use and protection of water and marine resources, (4) transition to a circular economy, (5) pollution prevention and control, and (6) protection and restoration of biodiversity and ecosystems.