Bank climate transition plans on course to enter EU capital rules

EU banking supervisors will be given new powers to assess bank climate transition plans, according to ongoing policy negotiations among the bloc’s legislative bodies.

There are already expectations that some banks will have to prepare transition plans as part of voluntary net-zero exercises or under the EU’s forthcoming sustainability reporting regime and, if approved, its due diligence directive. However, the transition plans themselves are not currently subject to any supervisory oversight.

Documents seen by Responsible Investor show that climate transition plans are on track to be made a component of the supervisory review and evaluation process (SREP) used by Europe’s financial supervisors to assess risks faced by individual banks and weigh up appropriate measures.

This would give the European Central Bank (ECB) the ability to force banks that are poorly prepared for the climate transition to set aside larger amounts of capital to absorb potential losses – but would also reduce the amount of funds that the banks have at their disposal for lending and investments.

Banking package

The treatment of transition plans is part of the overarching EU Banking Package, a major legislative initiative that will reform the EU’s prudential framework and bring it in line with global best practice.

The process, which began in 2021, is nearing completion, with the European Parliament and member-state representatives the European Council currently locked in trilogue negotiations over the finer details of implementation.

As of July, the negotiated legislative text mandates EU supervisors to “verify the robustness of [transition] plans as part of the SREP”, and includes an explicit requirement for transition plans to be consistent with those which have been disclosed under the Corporate Sustainability Reporting Directive (CSRD) and the EU’s overall climate goals.

Further details on how the transition plans will be assessed – including “specific timelines and intermediate quantifiable targets and milestones” – are due to be finalised by the European Banking Authority (EBA) within a year of the legislation’s entry into force.

Although the EBA is the primary prudential supervisor in the EU, enforcement of its rules is carried out by the ECB.

The ECB will also be responsible for ensuring that bank business models are sufficiently resilient to withstand “the scale, nature and complexity of the environmental, social and governance risks” over a 10-year period – although discussions are ongoing over the addition of the phrase “where appropriate”.

This would be a significant increase over the typical three- to five-year supervisory horizon currently used.

The draft rules would separately introduce requirements for banks to underpin any climate scenario or stress testing exercises with “robust scenarios, based on the ones elaborated by international organisations”, to ensure the integrity and comparability of findings among jurisdictions.

It comes as central banks start a global effort to develop short-term climate scenarios – as opposed to the commonly used 30-year horizon – in an attempt to more precisely capture the economic impacts of climate change and severe natural disasters.

The prospective move to make transition plans subject to supervision would help to standardise best practices on climate risks among banks and consequently in the real economy, said E3G banking analyst Pietro Cesaro.

Cesaro also called on EU legislators to maintain an explicit definition of a “long-term” supervisory horizon of at least 10 years and refrain from watering it down.

“With no clarity on its timeframe, we would witness less comparability among EU plans,” he said. “The materialisation of environmental risks usually take at least 10 years. Shorter time horizons would thus lead banks to not account for some of them.”

The draft text was also welcomed by Finance Watch’s research and advocacy head Julia Symon, who said transition plans should include consideration of the external climate impacts of bank exposures based on double materiality, in addition to their direct transition risk.

While the ECB has publicly indicated that it wants to move away from using higher capital requirements as the default lever to fix problems at lenders, Symon said the mechanism will remain indispensable as a supervisory tool to hedge against risks.

“Supervisors have a broad range of tools to use depending on the situation,” said Symon. “But if risks are deemed to not be adequately measured and/or mitigated, the supervisor needs to ensure that a bank has the capacity to bear this risk, which can only be achieved via capital requirements.”

There have been suggestions that the banking package could be adopted by EU co-legislators by the end of the year, but it is also likely that adoption could be put on hold to see how negotiations over an equivalent prudential reform package for insurers, known as Solvency II, will pan out.

Solvency II negotiations are due to begin this month and will address many of the same topics, including transition plans.

Prudential developments 

A “small number” of EU banks have already had their capital requirements raised by the ECB due to weaknesses in their climate and environmental risk management processes last year .

While the EU’s current capital framework does not have provisions for climate risks, the supervisor has long maintained that its broader focus on materiality means that climate and environmental risks are already captured in the rules.

The banking package will change this by requiring supervisors to explicitly consider the overall sustainability of business strategies, including transition plans, as part of the direct supervisory review meetings conducted with banks to set their capital levels (known as Pillar 2).

This is separate from an ongoing initiative by the EBA to assess the merits of using dedicated prudential treatments to determine capital requirements based on climate exposure. This relates to Pillar 1 capital requirements, which can be calculated independently by banks based on a predetermined formula as opposed to the supervisory engagements that take place around Pillar 2.

If adopted, banks may be able to reduce the capital buffers associated with green assets or conversely increase the requirements for polluting assets – known as a green supporting factor or a brown penalising factor, respectively.

The study is being undertaken by the EBA and is due to be finalised later this year.