By: Iain MacLennan

As someone relatively new to the sustainability space, trying to get to grips with Europe’s approach to the sustainability agenda felt like navigating an abbreviation soup: CSDDD, SFDR, and CSRD, to name a select few.

However, as I have spent time trying to navigate the intentions of these various directives, regulations, guidelines, or adjustment mechanisms, what has helped make sense of the EU approach is to consider the ESG regulatory stack.  

There are four main areas to this stack, which at a very high-level are:

1.     A common language, delivered via the EU Taxonomy, which establishes a classification system for identifying when an economic activity can be considered sustainable.

2.     Corporate disclosure via the Corporate Sustainability Reporting Directive (CSRD), which sets out how a company, depending on size, must report in accordance with the European Sustainability Reporting Standard (ESRS).    

3.     Financial market disclosure via the Sustainable Finance Disclosure Regulation (SFDR). Requiring financial market participants to disclose how they integrate ESG risk into their investment decisions. This is designed to work in tandem with the corporate CSRD that the companies they invest in report.

4.     Corporate Sustainability Due Diligence Directive (CSDDD), which legally obligates companies, again dependent on size, to identify, prevent, mitigate, and end adverse impacts to the environment and human rights.

However, of more recent interest to me (and I would hope to financial institutions operating in the EU) is the latest addition to the landscape, the European Banking Authority’s (EBA) Guidelines on the Management of ESG Risks. These came into effect in January of this year and extend to what the EBA describes as ‘Small Non-Complex Institutions’ (SNCI’s) in January of next year.

They extend the existing prudential framework by specifying how banks must manage ESG risks. These guidelines have altered how financial institutions must quantify risk if they operate in the EU. Financial Institutions must treat sustainability factors not as stand-alone risks; they need to be considered as amplifications of existing banking risks. Organisations need to consider how the various risk categories will be impacted; credit, market, operational, concentration, and liquidity risks need to be addressed. For instance, credit risk needs to consider the physical risk in both chronic (e.g., water scarcity) and acute (e.g., wildfires destroying collateral) terms.

A core of the approach lies in the Capital Requirements Directive (CRD VI) based transition plans. The EBA now requires financial institutions to look past short-term decision-making and to assess their resilience over a forward-looking time horizon of at least 10 years. Financial institutions must now test how transition or acute climate events will impact their counterparties’ creditworthiness and solvency, now and on an ongoing basis.

Therefore, the impact of the EBA’s Guidelines on the Management of ESG Risks moves the lens from disclosure, reporting, and scoring to origination and ongoing validation of the lending portfolio. The guidelines, for instance, mandate that financial institutions monitor concentration risk related to the transition risk drivers.

While the approach can be seen as restrictive and challenging, the EBA has been clear to emphasise that the objective is not to force an immediate or short-term exit from greenhouse-gas-intensive industries. They want the guidelines to act as a driver to address financial institution investment approaches and ultimately the business plans of the businesses that they support.

To this end, as well as their portfolio review and ongoing origination decisions, financial institutions are expected to engage with their own client base in understanding their transition strategies. With a view that if a client has an effective transition plan in place to mitigate their own risks, then the financial institution will be encouraged to support this plan. Where transition risk is material, institutions are expected to reflect the lack or weakness of a credible transition plan or adequate ESG risk data in their credit assessment and pricing, not through a single mandatory rule, but through integrated risk classification and broader risk management measures.

To this point, we have focused purely on the EU, but what happens in the EU rarely stays in Europe; the “Brussels Effect” is well known. Just as the General Data Protection Regulation (GDPR) became a global benchmark for data privacy, the EU’s ESG regulatory approach is also likely to function as a blueprint for foreign regulators.  

The message to the market, then, is that sustainability is no longer a corporate social responsibility (CSR) exercise. Institutions need to consider what they are financing and be able to defend their decision-making process moving forward.  The days of talking about a separate class of “Sustainable Finance” products are over.

It is no longer sustainable finance, but finance that must be sustainable.