Regulatory Environment
Although the regulatory framework is in its infancy, it is currently being strengthened by policymakers who are zealously pursuing the goal of fostering a more sustainable economic system in which financial institutions play a central role. The commitment to sustainability, evidenced by the increase in European regulatory requirements centered around ESG considerations, is significantly changing the risk landscape across the banking value chain.
In 2020, the ECB published a guide on climate-related and environmental risks that outlined comprehensive supervisory expectations regarding financial institutions’ strategies, future projections and approaches to environmental risks. Banks were then asked to carry out self-assessments based on the ECB’s guide in early 2021 and develop action plans that will be reviewed later.
In 2022, the ECB launched a comprehensive review of banks’ strategy, governance and risk management frameworks, taking follow-up measures where deemed necessary, and provided a set of good practices from a wide range of institutions to meet the supervisory expectations set out in the Guide.
In 2022, the ECB conducted an industry-wide Climate Risk Stress Test (CST) as part of its wider activities to assess banks’ preparedness on climate risk management. The CST included a structured questionnaire, an assessment of banks’ transition risk exposures, and bottom-up stress tests to comprehensively assess how banks are incorporating these risks into their strategies, governance and risk management frameworks, as well as the extent to which banks are aligned with the ECB’s supervisory expectations on climate-related risks.
Also in 2022, the EBA published its final draft implementation of the Technical Standards (ITS) for Pillar 3 disclosures related to ESG risks. The ITS, which apply to large institutions whose securities trade on regulated markets, are a set of qualitative and quantitative disclosure standards related to the management, exposure and mitigation of ESG risks. Due to the urgency and associated data challenges, the EBA is adopting a sequential approach, focusing initially on climate change-related risks.
The main goal is to increase the transparency and comparability of ESG risk disclosures in line with best practice, both at EU and international level.
The EU Non-Financial Reporting Directive (NFRD), introduced in 2016, essentially consists of principles-based requirements for large public interest entities (more than 500 employees) to disclose non-financial information on environmental and social issues, and will be replaced by the Corporate Sustainability Reporting Directive (CSRD), which came into force in January 2023.
In contrast to its predecessor, the CSRD will enhance the reporting of social and environmental information by expanding the scope of compliant companies and including more extensive and detailed disclosure requirements in accordance with the EU Sustainability Reporting Standard (ESRS) adopted in July 2023.
These standards take into account technical advice from the European Financial Reporting Advisory Group (EFRAG) and are in accordance with the requirements set out in the Taxonomy Regulation and the SFDR. The goal of the CSRD is to provide stakeholders with essential information to evaluate a company’s social and environmental impacts and assess financial risks and opportunities related to sustainability.
The new rules will first apply in fiscal year 2024, and the report will be published in 2025.
The EU Taxonomy, introduced in July 2020, also plays an important role in the EU’s sustainable finance framework by harmonising the definition of business activities that are considered environmentally sustainable, in line with the disclosure requirements applicable to NFRD companies.
Through delegated and implementing acts, such as the Delegated Act on Economic Activities launched in June 2023, the EU Taxonomy established technical screening criteria for each environmental objective and outlined four overarching conditions that economic activities must meet to be certified as environmentally sustainable.
A uniform definition would provide guidance for investments in activities essential to the transition, while preventing greenwashing and market fragmentation.
In addition, the EU will introduce the Sustainable Finance Disclosure Regulation (SFDR) in 2021 as a framework requiring financial market participants to disclose sustainability and ESG-related information, enabling investors to support companies and projects that promote sustainability and properly assess sustainability risks.
The SFDR expands its scope beyond environmental sustainability to also encompass social objectives as part of the EU’s broader sustainable finance agenda.
Furthermore, the European Commission published proposals in 2021 to review MiFID II, which has been in force since 2018, and amend Directive 2014/65/EU on markets in financial instruments. These adjustments, aimed at embedding sustainability in the EU financial system, go beyond the scope of the SFDR and required MiFID institutions to integrate specific ESG considerations into product governance arrangements.
In August 2023, ESMA published new guidelines on MiFID II product governance requirements, including specification of the sustainability-related objectives that products will comply with.
