Banking and finance in stressed times: bank ‘net zero’ pledges and prudential uses of transition plans

By Nejc Smole (European Central Bank & EBI)

Bank transition plans (TPs) panel discussion included the following panelists:

• Eila Kreivi, Chief Sustainable Finance Advisor, EIB

• María Nieto, Senior Advisor, Banco de España

• Agnieszka Smoleńska, Polish Academy of Sciences and EBI

• Lara de Mesa, Global Head of Responsible Banking. Banco Santander

Moderated by: Nejc Smole, European Central Bank and EBI.

The discussion had a significant depth and touched upon the following major themes around bank TPs:

• Bank TPs are considered to be a new risk management tool that should take into consideration the specific characteristics of climate risk, which are different from the traditional financial risks. Bank TPs will be reviewed by market conduct authorities as well as prudential regulators.

• The “risk of misalignment” with the objectives of the EU policy enshrined in the 2021 Climate Law is the focus of the EC to make the bank TPs into a prudential tool – turning the long–term adjustment into an imminent concern.

• Prudential bank TPs can help address some of the shortcomings of the current prudential framework with regard to climate–related and environmental (C&E) risks such as the current short–term horizon of supervisors and risk management methodologies based on historical data. TPs have a crucial role to play as a climate risk materiality assessment tool – allowing to see the banks’ balance sheet through the lens of climate concentration risk, portfolio alignment, assessment of emissions, assessing client transition plans.At the same time, the new regulatory tool poses numerous challenges in terms of multiplication of regulatory requirements and significant differences in approaches across jurisdictions.
• 3 different ways to go about the bank TPs: (i) voluntary, market-led net zero TPs leading the way, (ii) mandatory corporate disclosure net zero TPs, and (iii) mandatory prudential TPs focused on financial risk of misalignment with transition.

• Banks are already starting to disclose the basic tenets of transition plans based on voluntary approaches (e.g. under TCFD disclosures, GFANZ – Net Zero Bank Alliance initiatives), which helped build guidelines to substantiate banks’ ‘net zero’ pledges. Policymakers, especially in the EU, are following up with mandatory disclosures rules on what corporate ‘net zero’ plans should contain (e.g. under CSRD). From a prudential supervisory perspective this is not enough – hence the prudential transition plans are currently discussed as part of the reform of EU’s microprudential framework (CRR/CRD).

• Even as the new requirements are coming online, uncertainties about the goals and means prevail. Sustainability/net zero transition is about: (i) from where, (ii) to where, (iii) by when and (iv) how. It is clear by when we are supposed to achieve a successful transition: 2050 goal enshrined in EU Climate Law. The rest remains quite unclear, especially given the different starting points and transition pathways across Member States. In the larger context of ESG, approaching C&E risk is somewhat easier for banks than the “social” goals in particular, as there is more clarity about what needs to be measured and what the targets are.

• Bank balance sheets can’t become green on brown economies; it is crucial that banks help supporting further evolution of clients in their transition. ‘Amber’ as an intermediate stage in the transition–alignment categorization of the economy is very important, as many current bank exposures fall within that scope. There are no definitions about the ‘amber’ types of transition business activities though, despite efforts of the Platform on Sustainable Finance to develop an Extended Taxonomy. At the same time, the banks are asked to report on the green activities, but not on the brown sector – it is difficult to have a reasonable idea of transition requirements unless the brown sector exposures are also defined and disclosed. This will change with the new Pillar 3 ESG disclosures from 2023: however these are expected to be rife with patchy data in the first years of reporting and are mandatory only for large banks.
• Barriers to effective prudential bank TPs: (i) difficulty in ensuring global interoperability and comparability, (ii) absence of reference transition pathways at the level of individual economies and key relevant sectors (iii) underdeveloped methodologies (further forward–looking methodologies are needed), (iv) significant data gaps and insufficient quality of the available data (v) lack of awareness among the real economy firms – SMEs to be implicitly and effectively regulated by international transition requirements and standards as part of global value chains (GVCs).

• Despite the challenges, given the looming spectre of climate change, the policymakers remain undeterred and we see a significant regulatory push. Difficult to keep up the new regulatory initiatives. The risk is that there is a large amount of regulation introduced in an uncertain terrain that might have several unintended consequences, some of them are: (i) possible migration of risks – the non–regulated financial sector entities might substitute and increase the exposure to more emitting and in the short–term more profitable sectors, (ii) green–hushing – the more details large corporates and banks are expected to provide, the more the litigation risk increases, so these entities choose to report less. This is a much bigger risk than marginal green–washing. Additionally, (iii) just transition and (iv) energy security should also be considered carefully in further regulatory developments.

• Whatever form prudential TPs will ultimately take, they will trigger significant institutional change within the banks and supervisory authorities. 2023 already has been heralded ‘the year of the transition plans’.