The Brazilian Central Bank's (BCB) latest wide-ranging mandatory ESG regulations have been praised by industry experts.
Predominantly targeting banks, the updated regulations cover a spectrum of topics, including disclosure, risk management, stress testing, scenario analysis, positive impact and governance.
They are the result of a series of public consultations, and are part of the ‘Sustainability Component’ of the BCB’s Agenda, launched last year.
“The key feeling is that Brazil is back. We used to be a leader in sustainable finance in 2015, but then with political changes, things got messy,” Gabriel Webber Ziero, Head of Policy Outlook at ECOFACT, told RI. “It's interesting to observe that after the independence of the central bank has been formalised, change has been happening at a very fast pace.”
‘Everytime financial regulators in Brazil address ESG, it starts with the Central Bank’
Strengthened climate, environmental and social risk requirements
Climate risk is at the centre of the new regulations. The BCB has introduced definitions of climate-related transition risks and physical risks for banks, and will require large banks to report on these risks and to conduct scenario and stress testing at portfolio level by July 2022.
“Brazil is the first emerging economy to include this with such a reach in banking regulation,” said Luciane Moessa, a former legal counsel for the BCB and the founder of consultancy Sustainable Inclusive Solutions.
The central bank has also strengthened the definitions in banking regulation of social and environmental risks, introducing a concept of environmental and social transition risks – for example changes in environmental and social regulations that might negatively impact banks – which Moessa said is “something I have never seen in ESG regulations elsewhere in the world”.
The new definitions establish what criteria must be used for risk classification, and banks are required to incorporate this into their portfolio analysis. “This will allow banks to compare the financial performance of their loans and investments according to the environmental, social and climate risk level," explained Moessa.
For Ziero, a component that particularly stands out is the inclusion of “act or activity that, despite being regular, legal and not criminal, negatively impacts the institution's reputation, as it is considered harmful to the common interest” as a defined social risk. He said this raises several questions, however. “What happens if harm takes place – how can interested parties address that? Access to remediation and accountability also need to be included.”
Furthermore, RI reported last month that the BCB was believed to be looking at social scenario analysis as part of the consultation of the new ESG disclosure requirements.
The latest updates again mention financial institutions should “consider different scenarios” with regards to social risks.
Bringing positive impact into banking regulation
Another important update involves including definitions of positive impact in the Social, Environmental and Climate Responsibility Policy (PRSAC). This is a document required to be prepared and publicly disclosed by financial institutions and is defined by the BCB as consisting of “the set of principles and guidelines of a social, environmental and climatic nature to be observed by the institution in the conduct of its business, activities and processes, as well as in its relationship with stakeholders.”
‘We need a taxonomy: these regulations are the first seed, but we are still far from having one’
The BCB has now included definitions for positive climate, environmental and social impact in the PRSAC regulation. It stipulates for example that environmental, social and climate impacts must be considered in all financial products and services offered by financial institutions. These changes also take effect from July 2022 for larger financial institutions.
“It's very positive that it now specifically includes climate change, as well as opportunities beyond purely prudential risk management,” explained Alessandra Lehmen, Head of Environmental, Climate, and Regulatory Law at Juchem Advocacia in Brazil.
Within this, Moessa was particularly excited about nods to biodiversity.
“With regards to climate mitigation, they recognised clearly the connection with biodiversity, because the preservation of natural carbon sinks are included [in the definition of positive climate impacts]. For Brazil, action regarding biodiversity is very relevant because the number one cause of GHG emissions is deforestation, not fossil fuels.”
Expected impacts and next steps
Overall, Lehmen believes the bank has created “a robust framework of regulations.”
“I think it's going to have an impact on what projects banks choose to finance and might have an impact on capital requirements, depending on how it's implemented,” she added.
For Moessa, the regulations could produce a wider impact in South America, and other emerging economies. “There is a positive competition on who is most proactive on this topic.” Ziero is less confident this will be the case, saying Brazil’s soft power isn’t “in the best shape” in the region.
Moving forward, Moessa believes the next step would be to strengthen due diligence regulations.
In addition, she said Brazil needs to follow in the footsteps of the EU and others and develop a taxonomy. “These regulations are the first seed one, but we are still far from having one.” She noted a good place to start would be to set out rules for green and social loans, as Brazil’s lending market is notably bigger than its investment market.
On lending, Ziero thinks the BCB could work out how to link sustainable finance with microfinance as well as access to credit for individuals and SMEs.
De Souza also hopes Brazil’s other financial regulators will take note of the bank’s work.
“Everytime financial regulators in Brazil address ESG, it starts with the Central Bank,” she said. “Now it has made another big step, we might have new steps from the other three [insurers, pensions, and capital markets] which currently have very generic regulations.”
For Lehmen what would be desirable would be more laws through Congress that would expand climate regulation beyond financial institutions. “But of course, right now we have a rollback of significant environmental policies.”