European financial institutions will have to assess whether ESG risks could threaten their business models and risk profiles under draft rules tabled by the EU’s top banking regulator.
The European Banking Authority (EBA) is consulting on guidelines that would apply to regulated banks across the EU, requiring them to collect and assess ESG-related data from their counterparties and ensure they are managing any risks that are identified.
The authority says climate change, environmental degradation and social issues are posing “considerable challenges” to the economy, which could in turn threaten the banking sector.
“To ensure the safety and soundness of institutions in the short, medium and long term, the guidelines set requirements for the internal processes and ESG risks management arrangements that institutions should have in place,” it says.
The draft guidelines would require banks to integrate ESG risks within their wider risk management framework, alongside credit, liquidity and reputational concerns.
Lenders would be expected to gather information on environmental risks, including data on scope one, two and three emissions, as well as social and governance risks such as negative impact on local communities. They should also avoid or mitigate greenwashing by large corporate clients.
For both new and existing relationships, banks should engage with clients to capture that information, for instance by providing questionnaires at the time of credit origination.
And where there are difficulties obtaining sufficient data, banks should identify and address any gaps, including by engaging third-party providers.
If material risks are identified, the EBA proposes that banks could adjust financial terms, tenors and pricing to reduce their exposure.
Although the reforms are only part of wider EU efforts to clamp down on ESG risk, the draft guidelines could pose a challenge to institutions that have largely focused on environmental improvements, notes Raza Naeem, a partner in Linklaters’ financial regulation practice.
“If you think about the banking sector, generally there has been a lot of focus on climate, and the EBA has acknowledged in the past that the infrastructure around reporting and disclosures on the climate side is much more developed,” he tells GTR.
“The EBA now seems to be pushing up expectations regarding management of all types of ESG risks, which is likely to be very challenging for the banking sector, given the information, disclosures and infrastructure do not exist in the same way and to the same extent across the board.”
Naeem adds that the EBA’s proposed requirement to collect and aggregate ESG-related information “is a big task and is labour intensive, so could be quite painful, if it is applied strictly”.
Data collection “is particularly important in trade finance because the high frequency of data and the prerequisite for scope three calculations mean that whole supply chains will need to be involved”, says Rebecca Harding, an independent trade economist at consultancy firm Rebeccanomics.
Harding notes that the International Chamber of Commerce is continuing its work on sustainability standards for the trade finance sector, but says that “still relies heavily on self-reporting, and this just perpetuates the risk that everyone continues to report and calculate risks in different ways”.
“This is where the banks will need to get their heads together and behave in a pre-competitive way,” she tells GTR.
Linklaters’ Naeem says other recent EU reforms, including the Corporate Sustainability Reporting Directive, could help provide banks with richer sources of data. However, the directive applies only to publicly listed companies and large corporates, and excludes unlisted SMEs.
“If your counterparty or client is in scope there will be published material information banks can use to assess the risks,” he says. “But outside of that, this is quite a large exercise. Hopefully there will be an expectation of reasonable materiality attached to it.”
The EBA consultation will close on April 18, and the regulator is hosting a public hearing on the reforms on February 28.
Separately, the regulator has this week launched a survey of credit institutions on the availability and accessibility of ESG-related data, closing on March 29.
The aim is to collect qualitative information on existing practices and assess the feasibility of introducing a standardised methodology.