EU banking regulator expects banks to measure net-zero gaps

New guidance provides detail on the ESG disclosures and risk management systems that will be assessed under the EU’s prudential regime.

Major EU banks will be expected to assess how closely their carbon-intensive exposures are aligned with net-zero scenarios issued by the International Energy Agency as part of their regulatory prudential disclosures, according to draft requirements by the European Banking Authority.

This will apply to EU-listed banks for the following sector portfolios: energy, fossil fuel combustion, automotive, aviation, maritime transport, cement, clinker and lime production, iron and steel, coke and metal ore production, and chemicals.

Smaller banks will be able to determine for themselves which portfolios are sufficiently material for disclosures.

The new rules are part of an extensive sweep of proposed regulatory expectations published on Thursday by the EBA in response to a soon-to-be-approved EU banking law which will introduce bank climate transition plans and ESG risk-monitoring to the bloc’s capital regime.

This would give the European Central Bank – which enforces rules set by the EBA – new powers to force banks that are poorly prepared for the climate transition to set aside larger amounts of capital to absorb potential losses.

The legislation was endorsed by the EU’s co-legislators at the end of 2023 but will need to be transposed by member states before officially becoming law. Responsible Investor reported on leaked draft texts of the law in September.

The update from the EBA sets out the scope of information that EU banks will be expected to provide the ECB during its yearly supervisory review and evaluation process. The information will not be publicly available unless done so voluntarily or if the EU’s broader corporate sustainability reporting directive (CSRD) requires it in the future.

EBA expectations

EU banks are faced with two main tasks: to develop transition plans and to put in place systems to monitor and manage ESG risks.

With regards to the former, banks are required to show what they are doing to prepare for the green transition. This includes changes in financing choices, approaches to mitigation and adaptation of climate risks, and the development of green products and services among others.

Banks should demonstrate “a clear approach to proactively engaging with counterparties” as part of their transition plans by providing advice and guidance to their clients or even terminating client relationships “as a last resort”.

The plans should also include estimates of how transition efforts could impact profitability and planned targets for the short, medium and long term.

The EBA acknowledged that there are already transition plan provisions under the CSRD and the incoming due diligence directive for banks as corporates in their own right, but said that its prudential-based transition plans are squarely focused on prudential risks and do not require banks to set themselves the objective of aligning with the EU’s climate goals.

“It is also important to bear in mind that the goal of prudential plans is not to force institutions to exit or divest from carbon-intensive sectors but rather to stimulate institutions to proactively reflect on technological, business and behavioural changes driven by the sustainable transition,” the EBA added.

ESG risks

Banks face a separate and lengthy to-do list if they are to meet EBA expectations on monitoring and managing ESG risks.

They will first have to implement a data collection process to capture relevant ESG information on clients – including at minimum the location of key assets at enough granularity for physical risk analysis – environmental and social litigation risks, current and forecasted Scope 1-3 emissions, dependency on fossil fuels and negative impact on local communities.

Banks can use estimates or proxy metrics but must seek to reduce their usage, in addition to conducting “regular quality assurance” when sourcing from third parties.

They should also be able to assess the degree of vulnerability to both physical and transition climate risks for each client and the “the likelihood of critical disruptions to the business model and/or supply chain of the counterparty due to environmental factors such as the impact of biodiversity loss”.

At portfolio level, both large and small banks must have the capacity to assess their overall net-zero alignment against IEA scenarios, with more extensive disclosure requirements for larger institutions.

Once the systems are in place, banks will be expected to conduct annual materiality assessments for ESG risks “on all conventional financial risk categories to which institutions are exposed, including credit, market, liquidity, operational, reputational, business model and concentration risks”.

“The EU’s ideal outcome in transition planning is to consolidate target setting and risk-based plans into a single transition plan for many users,” said E3G policy adviser Pietro Cesaro. “The EBA’s new guidelines show progress in establishing this unified framework, referencing CSRD and [the] due diligence directive.”

“However, we need to move beyond interoperability and consolidate banks’ business trajectories and risk management strategies into one transition plan.”

The EBA’s proposals are open for stakeholder feedback until 18 April. The regulator will provide guidance on climate scenario analysis, which is also required by the new EU banking law, within the next 18 months.