EBA’s binding standards on Pillar 3 disclosures on ESG risks

This publication fits nicely into the ‘horizon priority’ of the EBA to provide tools to banks to measure and manage ESG-related risks. In this article we present a brief overview of the way the ITS have been developed, what qualitative and quantitative disclosures are required, what timelines and transitional measures apply – and where the largest challenges arise.

By requiring banks to disclose information on their exposure to ESG-related risks and the actions they take to mitigate those risks – for example by supporting their clients and counterparties in the adaptation process – the EBA wants to contribute to a transition to a more sustainable economy. The Pillar 3 disclosure requirements apply to large institutions with securities traded on a regulated market of an EU member state.

In an earlier report², the EBA defined ESG-related risks as “the risks of any negative financial impact on the institution stemming from the current or prospective impacts of ESG factors on its counterparties or invested assets”. Hence, the focus is not on the direct impact of ESG factors on the institution, but on the indirect impact through the exposure of counterparties and invested assets to ESG-related risks. The EBA report also provides examples for typical ESG-related factors.
While the ITS have been streamlined and simplified compared to the consultation paper published in March 2021, there are plenty of challenges remaining for banks to implement these standards.

Development of the ITS

The EBA has been mandated to develop the ITS on P3 disclosures on ESG risks in Article 434a of the Capital Requirements Regulation (CRR). The EBA has opted for a sequential approach, with an initial focus on climate change-related risks. This is further narrowed down by only considering the banking book. The short maturity and fast revolving positions in the trading book are out of scope for now. The scope of the ITS will be extended to included other environmental risks (like loss of biodiversity), and social and governance risks, in later stages.

In the development of the ITS, the EBA has strived for alignment with several other regulations and initiatives on climate-related disclosures that apply to banks. The most notable ones are listed below (and in Figure 1):

Figure 1 – Overview of related regulations and initiatives considered in the development of the ITS

• Capital Requirements Directive and Regulation (CRD and CRR): article 98(8) of the CRD³ mandated the EBA to publish the EBA report on Management and Supervision of ESG risks, which includes the split of climate change-related risks in physical and transition risks. Article 434a of the CRR⁴ mandated the EBA to develop the draft ITS to specify the ESG disclosure requirements described in article 449a.
• EBA report on Management and Supervision of ESG risks²: the report provides common definitions of ESG risks and contains proposals on how to include ESG risks in the risk frameworks of banks, covering its identification, assessment, and management. It also discusses the way to include ESG risks in the supervisory review process.
• Task Force on Climate-related Financial Disclosures (TCFD)⁵: the Financial Stability Board’s TFCD has published recommendations on climate-related disclosures. The metrics and Key Performance Indicators (KPIs) included in the ITS have been aligned with the TCFD recommendations.
• Taxonomy Regulation⁶: the European Union’s common classification system of environmentally sustainable economic activities is underpinning the main KPIs introduced in the ITS.
• Climate Benchmark Regulation (CBR)⁷: In the CBR, two types of climate benchmarks were introduced (‘EU Climate Transition’ and ‘EU Paris-aligned’ benchmarks) and ESG disclosures for all other benchmarks (excluding interest rate and currency benchmarks) were required.
• Non-Financial Reporting Directive (NFRD)⁸: the NFRD introduces ESG disclosure obligations for large companies, which include climate-related information.
• Corporate Sustainability Reporting Directive (CSRD)⁹: a proposal by the European Commission to extend the scope of the NFRD to also include all companies listed on regulated markets (except listed micro-enterprises). One of the ITS’s KPIs, the Green Asset Ratio (GAR) is directly linked to the scope of the NFRD/CSRD.
• Sustainable Finance Disclosure Regulation (SFDR)¹⁰: the SFDR lays down sustainability disclosure obligations for manufacturers of financial products and financial advisers towards end-investors. It applies to banks that provide portfolio management investment advice services.

Compared to the consultation paper for the ITS, several changes have been made to the required templates. Some templates have been combined (e.g., templates #1 and #2 from the consultation paper have been combined into template #1 of the final draft ITS) and several templates have been reorganized and trimmed down (e.g., the requirement to report exposures to top EU or top national polluters has been removed).

Quantitative disclosures

The ITS on P3 disclosure on ESG risks introduce ten templates on quantitative disclosures. These can be grouped in four templates on transition risks, one on physical risks, and five on mitigating actions:

• Transition risks
  Two of the required templates are relatively straightforward. Banks need to report the energy efficiency of real estate collateral in the loan portfolio (#2) and report their aggregate exposure to the top 20 of the most carbon-intensive firms in the world (#4).
  The main challenge for banks though will be in completing the other two templates:
  • Template #1 requires banks to disclose the gross carrying amount of loans and advances provided to non-financial corporates, classified by NACE sector codes and residual maturities. It is also required to report on the counterparties’ scope 1, 2, and 3 greenhouse gas (GHG) emissions. Reflecting the challenge in reporting on scope 3 emissions, a transitional measure is in place. Full reporting needs to be in place by June 2024. Until then, banks need to report their available estimates (if any) and explain the methodologies and data sources they intend to use.
  • In the last template (#3), banks also need to report scope 3 emissions, but relate these to the alignment metrics defined by the International Energy Agency (IEA) for the ‘net zero by 2050’ scenario. For this scenario, a target for a CO2 intensity metric is defined for 2030. By calculating the distance to this target, it becomes clear how banks are progressing (over time) towards supporting a sustainable economy. A similar transitional measure applies as for template #1.
• Physical risks
  In template #5, banks are required to disclose how their banking book positions are exposed to physical risks, i.e., “chronic and acute climate-related hazards”. The exposures need to be reported by residual maturity and by NACE sector codes and should reflect exposure to risks like heat waves, droughts, floods, hurricanes, and wildfires. Specialized databases need to be consulted to compile a detailed understanding of these exposures. To support their submissions, banks further need to compile a narrative that explains the methodologies they used.
• Mitigating actions
  The final set of templates covers quantitative information on the actions a bank takes to mitigate or adapt to climate change risks.
  • Templates #6-8 all relate to the GAR, which indicates what part of the bank’s banking book is aligned with the EU’s Taxonomy:
    • In template #7, banks need to report the outstanding banking book exposures to different types of clients/issuers, as well as the amount of these exposures that are taxonomy-eligible (that is, to sectors included in the EU Taxonomy) and taxonomy-aligned (that is, taxonomy-eligible exposures financing activities that contribute to climate change mitigation or adaptation). Based on this information, the bank’s GAR can be determined.
    • In template #8, a GAR needs to be reported for the exposures to each type of client/issuer distinguished in template #7, with a distinction between a GAR for the full outstanding stock of exposures per client/issuer type, and a GAR for newly originated (‘flow’) exposures.
    • Template #6 contains a summary of the GARs from templates #7 and #8.
      In these templates, the numerator of the GAR only includes exposures to non-financial corporations that are required to publish non-financial information under the NFRD. Any exposures to other corporate counterparties therefore are considered 0% Taxonomy-aligned.
  • The main challenge in this group of templates is in template #9. To incentivize banks to support all of their counterparties to transition to a more sustainable business model, and to collect ESG data on these counterparties, the EBA introduces the Banking Book Taxonomy Alignment Ratio (BTAR). In this metric, the numerator does include the exposures to counterparties that are not subject to NFRD disclosure obligations. The BTAR ratios obtained from the information in template #9 therefore complement the GAR ratios obtained in templates #7 and #8.
  • In the final template (#10), banks have the opportunity to include any other climate change mitigating actions that are not covered by the EU Taxonomy. They can for example report on their use of green or sustainable bonds and loans.

An overview of the templates for quantitative disclosures in presented in Figure 2.

Figure 2 – Overview of the required quantitative ESG disclosures

Qualitative disclosures

In the ITS on P3 disclosures on ESG risks, three tables are included for qualitative disclosures. The EBA has aligned these tables with their Report on Management and Supervision of ESG risks¹¹. The three tables are set up for qualitative information on environmental, social, and governance risks, respectively. For each of these topics, banks need to address three aspects: on business strategy and processes, governance, and risk management. An overview of the required disclosures is presented in Figure 3.

Figure 3 – Overview of qualitative ESG disclosures (based on templates & section 2.3.2 of the EBA ITS on P3 disclosures on ESG risks)

Timelines and transitional measures

The ITS on P3 disclosure on ESG risks become effective per 30 June 2022 for large institutions that have securities traded on a regulated market of an EU member state. A semi-annual disclosure is required, but the first disclosure is annual. Consequently, based on 31 December 2022 data, the first reporting will take place in the first quarter of 2023.

The EBA has introduced a number of transitional measures. These can be summarized as follows:

• The reporting of information on the GAR is only required as of 31 December 2023.
• The reporting of information on the BTAR, the bank’s financed scope 3 emissions, and the alignment metrics is only required as of June 2024.

The EBA has further indicated in the ITS that they will conduct a review of the ITS’s requirements during 2024. They may then also extend the ITS with other environmental risks (other than the climate change-related risks in the current version). The EU Taxonomy is expected to cover a broader range of environmental risks by the end of 2022. Sometime after 2024, it is expected that the EBA will further extend the ITS by including disclosure requirements on social and governance risks.

An overview of the main timelines and transitional measures is presented in Figure 4.

Figure 4 – Overview of the main timelines and transitional measures for the ESG disclosures

Conclusion

Society, and consequently banks too, are increasingly facing risks stemming from changes in our climate. In recent years, supervisory authorities have stepped up by introducing more and more guidance and regulation to create transparency about climate change risk, and more broadly ESG risks. The publication of the ITS on P3 disclosures on ESG risks by the EBA marks an important milestone. It offers banks the opportunity to disseminate a constructive and positive role in the transition to a sustainable economy.

Nonetheless, implementing the disclosure requirements will be a challenge. Developing detailed assessments of the physical risks to which their asset portfolio is exposed and to estimate the scope 3 emissions of their clients and counterparties (‘financed emissions’) will not be straightforward. For their largest counterparties, banks will be able to profit from the NFRD disclosure obligations, but especially in Europe a bank’s portfolio typically has many exposures to small- and medium-sized enterprises. Meeting the disclosure requirements introduced by the EBA will require timely and intensive discussions with a substantial part of the bank’s counterparties.

Banks also need to provide detailed information on how ESG risks are reflected in the bank’s strategy and governance and incorporated in the risk management framework. With our extensive knowledge on market risk, credit risk, liquidity risk, and business risk, Zanders is well equipped to support banks with integrating the identification, measurement, and management of climate change-related risks into existing risk frameworks. For more information, please contact Pieter Klaassen or Sjoerd Blijlevens via +31 88 991 02 00.

References
1) See the EBA 2022 Work Programme.
2) The EBA’s Report on Management and Supervision of ESG risks for credit institutions and investment firms, published in June 2021.
3) See the EBA’s interactive Single Rulebook.
4) See Regulation (EU) 2019/876.
5) See the TCFD’s Final Report on Recommendations of the Task Force on Climate-related Financial Disclosures published in June 2017.
6) See the EBA’s response to EC Call for Advice on Article 8 Taxonomy Regulation.
7) See Regulation (EU) 2019/2089.
8) See Directive 2014/95/EU.
9) See the European Commission’s Proposal for a Corporate Sustainability Reporting Directive.
10) See Regulation (EU) 2019/2088.
11) The EBA report can be found here.