New pillar 3 ESG risks requirements to offer a partial snapshot of banks’ transition

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On January 24th, 2022, the European Banking Authority (EBA) released standards setting out requirements for European banks’ reporting on key Environmental, Social and Governance (ESG) risks, particularly climate change. The final draft implementing technical standards (ITS)[1] details “Pillar 3” prudential disclosures institutions will be required to make covering ESG risk governance, specific exposures to climate risk, and more generally on energy efficiency and carbon intensity of their lending books. The standards represent a material step in the amount and granularity of ESG disclosure and aim to improve comparability across different countries and institutions. Alongside qualitative disclosures, the requirements include a raft of data measures which will allow stakeholders to judge progress towards specific net zero goals, overall exposures to at-risk sectors, and banks’ lending towards climate-aligned activities.

For stakeholders, the ability to compare banks on standardized metrics for ESG risks, particularly climate risk, is highly desirable, and these requirements are a step in that direction. However, some shortcomings in the quantitative disclosures may impair the initial usefulness of the data, namely:

(1) a point-in-time position does not address transition either in banks’ lending or in borrowers’ climate alignment,

(2) that the data underlying some parts of the disclosure will make extensive use of estimates, methodologies will differ between banks and data will be challenging to reliably gather, and

(3) that the linkage between lending, climate risk and credit risk remains hard to quantify.

Further, the data excludes certain assets, particularly in the trading book, which may also be relevant in assessing banks’ transition stories and ESG risks.

The new pillar 3 requirements reflect European banks key role as providers of credit to retail, SMEs and corporate borrowers, and place emphasis on banks’ corporate and real estate lending, as well as specific focus on sectors and borrowers with high carbon intensity. First disclosures are expected to be published in early 2023. For some measures, relating particularly to lending to non-NFRD borrowers[2], banks are expected to conduct their own data gathering; given the additional complexity this data will be first published in 2024. Given the potential for CSRD[3] to be delayed, some data sets may not become available on this timeline.

For investors, ESG Pillar 3 is intended to be a step towards effective comparison of climate-change risks and net zero contributions across different institutions. In time, this clarity may help turn management & investor focus away from headline grabbing statements and towards a more holistic and thorough approach to climate change. We expect investor focus initially on transition & headline risks, namely banks’ exposures to global top 20 carbon emitters, a blunt measure, and on specific exposures to highly polluting sectors. Two key ratios, the “Green Asset Ratio” (GAR) and the “Banking book Taxonomy Alignment Ratio” (BTAR) provide a more positive slant, giving insight into lending to climate-aligned activities as a percentage of banks’ lending books, but exclude assets in the trading book.

For banks, the finalization of these requirements thematically complements the European Commission’s banking package 2021[4], which will place ESG at the heart of risk management & governance regulations. A November European Central Bank’s (ECB) report into climate and environmental risks[5] showed some shortcomings relative to supervisory expectations[6] on climate & environmental risks. The first Pillar 3 reports will be published in early 2023, when the results of the ECB’s climate stress test will already be public (July 2022). Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, made clear in a blog post[7] that banks should expect climate & environmental risks to influence minimum capital requirements.

At Natixis, the Green Weighting Factor, launched in 2019, helps to steer portfolios toward climate objectives. Designed as a strategic tool to drive risk assessment as well as commercial perspectives of the bank, it has been deployed on the whole balance sheet of the bank and served as the bedrock of its freshly published 2024 climate strategy and 2050 net zero carbon target.