Many would agree that the sustainable finance regulatory agenda has been increasingly growing in both intensity and complexity over the last few years. We hope that 2023 will be the year in which this regulatory framework is consolidated, all the pieces fit together, and the inconsistencies found are corrected.
Aware of the challenges we face, as reinforced at the last COP held in Sharm El-Sheikh last November, the European regulatory agenda continues to move forward decisively, in line with the goal to be climate neutral by 2050 as set out in the European Green Pact and the Paris Agreement.
On the prudential front, the EBA will publish its report on the prudential treatment of ESG risks in the middle of next year. Last May, it released a discussion paper, where it assessed the need and justification for possible changes to prudential Pillar 1 and asked for comments that will underpin this eagerly awaited report. Among its preliminary conclusions it suggests that minor modifications to the current framework seem more appropriate, rather than the use of the infamous adjustment factors that increase or reduce the capital consumption of brown or green assets by a certain percentage, respectively, given the challenges associated with their design and implementation. The EBA report will be used to design the capital regulation reform, referred to as CRR3, which is expected to be published in 2023.
And herein lies an interesting debate on the issue of whether to apply capital surcharges for exposures considered “brown”, i.e., emission-intensive or, conversely, to reduce them in the case of exposures considered “green”. Pillar 1 of the prudential framework seeks to cover expected losses with a one-year horizon and the only tool currently available to classify as green, the taxonomy, does not classify activities based on their ability to pay, i.e., their risk. We in the industry therefore advocate that the prudential framework should be risk-based, and we are warning of the dangers that could arise from the use of these factors.
The penalty for these brown exposures could discourage their financing, something badly needed to facilitate their transition and, on the other hand, a possible support factor for “green” or low-emission exposures, could result in a “green bubble”. It is also important to note that the prudential framework can certainly support, but is by no means the tool, to achieve environmental policy objectives. This was recently noted in a report by the European Systemic Risk Board (ESRB), and to do so would set a precedent for policy objectives to be pursued with bank capital in the future. Moreover, one cannot overlook the fact that in an increasingly globalized economy, changes in capital requirements, in particular a brown penalty factor, would likely result in a shift of funding to countries outside the European Union or to other non-bank players.
On the supervisory front, in 2022 we debuted the first climate stress test, a bottom-up exercise where the authorities assessed how institutions are incorporating these risks into their processes. And while several areas for improvement were flagged, a number of best practices were also identified, which the European Central Bank (ECB) will publish as a guide by the end of 2022. Although the exercise will not be repeated in 2023, its conclusions will guide supervisory actions going forward.
By the end of 2023, the ECB expects banks to include climate and environmental risks in their governance, strategy, and risk management. In other words, the ECB is setting deadlines for banks to progressively meet all supervisory expectations by the end of 2024 at the latest, as Andrea Enria, Chair of the ECB's Supervisory Board, points out. During 2023, the ECB will also continue its on-site inspections of these risks.
In 2023, and most likely under Spain's Presidency of the Council, the Due Diligence Directive will be approved, which will include the obligation for large companies, financial or otherwise, to apply a human rights and environmental due diligence process on their own operations, those of their subsidiaries and those of their value chain. This new regulation will reinforce the due diligence processes that financial institutions are already carrying out in the onboarding processes of their wholesale clients.
In 2023, however, two key players will be at the forefront of the regulatory agenda: transition financing and greenwashing.
With respect to the first of these, a sustainable financing framework will be required to define what we understand by transition, going beyond the green sector and setting sectoral guidelines that will mark the path to be followed. In this context, we, the financial institutions, will continue to support the investment plans of companies with financing and advice, while understanding that change takes time and that the speed of change will vary according to the activity sector.
Greenwashing is a danger that regulators are beginning to warn of, if companies advertise as green what is not, or if they exaggerate its virtues. There is a danger that the recently created term “green-hushing”, or the fear of some companies to make public their green commitments because of possible reputational or litigation risks, will end up overshadowing greenwashing. Any regulation in this regard should seek a balance so that it does not end up discouraging companies in their climate commitments and in their transition.
Ultimately, in 2023, we hope to have a European regulatory framework for sustainable finance that is more consolidated and key to supporting the race in which we are all immersed, because it is not a question of who gets there first, but rather that we all manage to cross the finish line.