May 27. 2024. 9:34

The Daily

Read the World Today

Climate transition plans for banks: EU legislators on a razor’s edge

EU legislators are currently discussing the introduction of mandatory climate transition plans for banks. The European Commission, Council, and Parliament will soon start trialogue negotiations, and while all three seem to agree on the idea itself, differences remain in how these plans are defined, explains Anuschka Hilke.

The European Parliament has adopted its final position on the Banking package. The package consists of a revision to the Capital Requirements Directive and Regulation and Solvency II rules.

This is done in order to implement the Basel III international framework which has the objective of increasing the resilience of the banking sector to future financial crises. Yet, another important requirement has been included to address climate change.

The text obliges banks to adopt climate transition plans as part of a broader ambition to better manage environmental, social and governance (ESG) risks.

This new obligation has been proposed by the Commission and is confirmed in the positions of the European Parliament and Council. I4CE has supported the discussions on climate transition plans for banks through dedicated research for more than a year now.

A significant leap forward or just another sidestep?

Mandatory climate transition plans for banks have the potential to become a game changer for financial risk management as well as for aligning financial flows with the transition to a low-carbon economy.

Banks could potentially be required to restrict or limit their business with regard to carbon-intensive activities, adjusting their business models, governance structures and risk management procedures, or revising their strategies.

However, while there is a consensus at this stage on the principle of making climate transition plans for banks mandatory, the exact formulations differ in ambition and clarity.

In order to develop their game-changing potential, three key parameters need to be clarified in the final version that remains to be negotiated.

The first parameter is the prudential treatment of the plans: if the obligation is restricted to transparency requirements, the focus is moved towards the need to publish a plan and away from the need to actually implement it.

This is one of the problems currently debated with regard to voluntary climate transition plans. Conversely, if supervisors are mandated to oversee the implementation of such transition plans as part of the supervisory review and evaluation process (SREP), they have several tools at hand to ensure the proper implementation of transition plans.

The second parameter is the scope: a very limited scope focused only on a few asset classes and key sectors such as fossil fuel production would encourage banks to focus on these sectors and activities only. Yet, the economy as a whole needs to be transformed and faces transition risks.

Moreover, banks are unlikely to develop a coherent approach across all their activities if they are discouraged to finance high carbon activities via loans, bonds or direct investments on the one hand, but may still provide guaranties or advisory services on how to best finance such activities on the other.

It also gives the incentive to shift the exposure to high-emitting assets to those asset classes not covered by the transition plan, thus shifting problems rather than managing them.

Conversely, a holistic approach covering all sectors and all on-balance and off-balance sheet activities would ensure that they develop a consistent approach across all their activities and also align their overall business model and strategy with a transition to a low-carbon economy.

The third parameter concerns the objectives of such plans: traditionally, banks are only expected to manage measurable financial risks. Yet, to date banks have difficulties properly identifying climate-related financial risks, limiting their management in the first place.

Moreover, if they keep financing carbon-intensive activities rather than the transition away from those, they keep building up future financial risks for the economy and eventually for the financial sector itself.

A limited focus on managing short-term financial risks is thus likely to allow banks to keep building risks that will materialise in the future. Only a fully integrated management of financial risks and climate impacts can overcome this contradiction.

The integrated treatment is very important because financing the transition of the economy also comes with financial risks, which need to be managed. In addition, such an integrated approach would ensure full coherence with the new requirements under the Corporate Social Responsibility Directive (CSRD).

Some say due to a lack of data and appropriate metrics banks are not ready yet for introducing transition plans that cover financial risks and climate impact with a holistic scope and fully integrated into the SREP.

Yet the strength of integrating the requirement into the SREP is that it would allow to set an ambitious framework from the start but leaves enough flexibility to stretch the full implementation of these new obligations over time as data and metrics issues are resolved.

Moreover, supervisors could require banks to contribute more actively to data collection and development of appropriate metrics, leaving less room for false excuses.

What are the next steps?

The trialogue negotiations between the European Commission, Council and Parliament can now begin and should be concluded before the end of this year.

Once the revised directive enters into force, EBA will have 12 months to develop more detailed guidelines to promote a harmonised application of the new requirements across the EU. Member States will also have to transpose the directive into national law.

The final framing negotiated in the trialogue will be a clear indicator of the ambition that legislators are putting behind these new obligations for banks. It needs to bring more clarity with regard to the three aforementioned parameters.

Yet as is often the case with negotiation results, it could also leave grey zones of interpretation, which would then shift the responsibility over to the EBA to interpret the negotiated text.

Even if the ambition is clearly set out from the start, the technical details of the EBA guidelines will be decisive to see if climate transition plans come with real teeth and the capacity to make our financial system fit for the challenges of the 21st century.