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Opinion 23 March 2020

Sustainable finance: “I’m late, I’m late, I’m late!”

The sustainability debate is here to stay. And with it, a whole series of measures by public and private authorities, regulators and supervisors, with the aim of advancing as soon as possible and in an orderly manner in this regard. Arturo Fraile, from BBVA’s Regulation team, analyzes the decisions made so far and those that are yet to come.

Sustainable finance is starting to actually become more sustainable and mature. But time is running out and we’re late (like the white rabbit in Alice in Wonderland) for a organized and fair transition. We need to push forward with audacity and caution, as demonstrated by recent developments in regulation that we will discuss below.

On an international level, the Climate Change Conference (COP 25) and the World Economic Forum (WEF Davos) reinforced the consensus that environmental — including climate change — social and governance (ESG) risks are global, and increase over time in a non-linear manner and are not easy to predict. In fact, WEF’s Global Risks Report 2020 notes that the five most concerning risks are related to environmental issues. Furthermore, the Bank for International Settlements and the Bank of France qualify climate change risks as the “green stork”. In other words, they could have a tremendously disruptive impact, and even lead to the next systemic financial crisis.  We have to internalize the ESG factors and risks when setting prices, in business strategies and in the prudential management of financial risks in order to stay ahead and adapt to the extent possible.

In December, the European Union reached a formal agreement on a taxonomy that classifies environmental economic activities. This dictionary establishes an official language for the financial actors and will have to be applied starting in December 2021 for mitigation and adaptation goals. It is an important step in the right direction, among other things because it takes into consideration transition activities (those for which there is currently no economically viable alternative) and enabling activities (which facilitate other activities that significantly contribute to environmental goals).

On March 9th, the European Commission’s (EC) technical group of experts  published three documents: the final report on taxonomy, a technical annex with evaluation criteria for activities that contribute to adaptation or mitigation, and a user guide for green bond standards. The EC also launched a public consultation to revise its 2030 climate objective plan (from March 18th through April 15th).

It also recently presented the European Green Deal, which represents a milestone because all policies and legislative proposals should take sustainability into account in a cross-cutting manner.  The Sustainable Finance Action Plan is also expected to be updated in 2020.

The European Banking Authority (EBA) launched its Sustainable Finance Action Plan in December. Among other things, it includes a voluntary exercise to raise awareness on transitional risks (second half of 2020); stress tests and scenario analysis considering physical and transitional risks (2022); and a report on the classification and prudential treatment of assets from a sustainability perspective (2025). In addition, the EBA published a document on sustainable finance market practices in January. It concludes that although banks are increasingly aware of the ESG risks, their inclusion in their strategies, governance and risk management is at an embryonic stage.

Also in Europe, the Single Supervisory Mechanism (SSM) indicates in its recently published annual report (March 19th) that among other things, banks are increasingly working together on methodologies to measure the risks of climate change and enhance the dissemination of information and comparability. In addition, the Network for Greening the Financial System (NGFS) will publish its Manual on the Management of Environmental and Climate Change Risks in April. The Bank of England (in its 2021 stress tests) and the EBA (2022) are expected to use the tools provided by the NGFS in this document because both are members and have helped put together the report.

On a domestic front, the Bank of Spain has communicated that it is already working on methodologies that include different transition scenarios and their effects in stress tests. It looks like its goal could be to do the first exercise in 2021.

Without leaving Spain, the Ministry for Environmental Transition and the Demographic Challenge released for public consultation the updated draft of the 2021-2030 Integrated National Plan for Energy and Climate. It is predicting a 1.8 percent increase in GDP and a 1.7 percent increase in employment from 2020-2030 as one of the foreseen impacts. Finally, in January, the Center for Responsible and Sustainable Finance (Finresp) was launched, evidence of the Spanish private sector’s commitment to economic activity that is more sustainable and responsible.

As final reflections, at least three conditions seem necessary in order to speed up the pace in a way that makes it possible to achieve the organized and fair transition mentioned earlier:

  1. A regulatory framework and supervisor that provides certainty and offers a long-term vision, and which takes into account the different capacities and speeds of the countries.
  2. The most flexible and inclusive taxonomy possible that also avoids fragmentation and which fosters the investments that are needed to allow sectors heavier in emissions to transition toward a new paradigm. (This is easy to write but hard to do.)
  3. A sequential, prudential approach that first: makes it possible to disseminate useful information, and which is mandatory for large companies (so that the financial sector can make progress in measuring, analyzing and managing the risks of their exposures and helping their clients); then, which takes into account the supervisory review and evaluation process (stress tests); and finally, if necessary and grounded in solid empirical evidence, which differentiates capital requirements by assets (green and brown) based on the associated financial risks.

Nonetheless, perhaps the first stress tests that incorporate climate change risks could focus on the resilience of the financial system and business models, instead of on additional capital requirements until the degree of comprehension, methodologies and analyses are more advanced.

In the meantime, it seems like financial actors are starting to internalize the new paradigm. For example, according to a Bank of England and PwC study, evidence is starting to show a correlation between higher share prices and the quality of companies’ financial reporting that takes into account the risks of climate change.

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