As the year comes to a close, the market is rapidly preparing for the introduction of a number of sustainability focused regulatory regimes that will fundamentally change the way ESG data is collected and shared across broad stakeholder groups. While nearly every financial market participant in Europe is impacted, banks are particularly exposed given the level of required data collection and current state of reporting systems.
In this guide, we give an overview of recent trends and market best practices on managing both mandatory and voluntary sustainability disclosures based on insights gathered from our partners and clients.
For many years now the finance sector has been actively promoting its impact on sustainable business initiatives, both voluntarily and by law. As deployers of capital, the finance world quite literally powers sustainable activities and other environmental initiatives. However, among the flurry of well publicized initiatives and impact reports came the inevitable backlash of greenwashing claims. Being green was good for business, so among the laxness of data standards or even a definition of what was “green”, financial players were able to package and sell products appealing to stakeholders without necessarily delivering on any of the stated objectives.
Commonly, we witnessed banks make commitments around their ambitions to support the flow of capital to sustainable investments and their intentions to drive the “greening” of the markets. But without common measurement systems, let alone lexicon, the rise of publicly stated ambitions often failed to meet reality. This is of course where the EU Taxonomy steps in. As a science based classification system, the Taxonomy provides the baseline to compare what is truly sustainable.
In particular, Article 8 of the regulation compels undertakings covered by the Non Financial Reporting Directive (NFRD), soon to be Corporate Sustainability Reporting Directive (CSRD), to disclose how their activities are associated with the Taxonomy’s defined environmentally sustainable activities. However, a deeper dive into the banking specific reporting requirements listed in Article 8 Delegated Act demonstrates a massive gap in data disclosures, and a level of transparency that leaves stakeholders asking for more.
This dynamic has led to a rise in voluntary reporting that nonetheless captures certain elements of SME data. Given the large scope of activities included in the denominator of the GAR, but a relatively limited inclusion within the numerator, there is a market consensus that the ratio might not provide a robust comparability of loan book sustainability across banks. Depending on the commercial strategy of a bank and geographical dispersion of loans, banks that otherwise have very sustainable practices might appear to be underperforming. As such, the market is demanding that banks provide a number of non-mandatory disclosures to compliment the GAR and provide a more comprehensive view of the sustainability performance of a given bank.
Beginning in 2022 banks were obligated to report on their exposure to taxonomy eligible activities, but from January 2024 they will be required to take the next step and track alignment. This is timed to ensure that the banks have the underlying data to compile their regulatory KPIs. While non-financial corporates are required to report three core KPIs linking their financial activity to sustainable activities (Turnover, Capex, Apex), Article 8 creates a different reporting mechanism for banks, namely the Green Asset Ratio (GAR).
Simply put, the GAR is a calculation of the exposure of their loan book to sustainable activities. The numerator is a calculation of the bank’s exposure to sustainable activities whereas the denominator is the value of the (almost) total loan book. The regulation includes a number of different manifestations of the GAR, including Stock GAR, Flow GAR, among others, all which assess sustainability exposure through different lenses.
The banking reporting is built heavily on the pipeline of data provided by the corporate reporting disclosure regulations. When looking through to the timelines imposed on banks, we can see that the regulation slows down disclosure timelines for banks to wait for corporate reporting to provide the underlying data. While CSRD substantially expands the number of firms required to report on non financial disclosures, SMEs (non listed) remain outside of the scope for now. However, for the purposes of the GAR disclosures this does not matter, as it is explicitly stated that banks should only include firms covered by mandatory reporting regimes in the ratio numerator (the part that captures the greenness of the banking activities).
When looking at the regulation from on high, we can see that simply put, banks need to look through to their lendees reported ESG performance - seems simple? Unfortunately, very little of implementing the Taxonomy is simple!
Tip: Start earlier rather than later. While the data collection will come from mandatory reporters, beginning the dialogue around additional data requests with clients can be a pain. By starting to build out the processes of collecting and managing data, and integrating sustainability into the broader client conversations you can make sure that you bring your clients along the sustainability journey.
The GAR is widely considered an imperfect tool in assessing the sustainability credentials of a credit institution and as such the approach has taken many critics, and defenders. Those against the GAR will claim that by leaving out both SMEs and non EU domiciled firms, the GAR does not accurately capture the sustainability profile of a loan book. On the other hand those in favour will claim that as there is no baseline of regulated data for these entities, they should not be included, and that the market will be able to look through a bank's unique activities to compare GAR profiles.
The United Nations Environment Programme Finance Initiative (UNEP FI) and the EBF developed a pilot study of applying the EU Taxonomy among a sample of 26 banks. The findings were fascinating, if not surprising. Banks particularly struggled with the application of retail loans and general purpose facilities. The lack of standardized and comparable data was the most significant challenge, particularly when reviewing the Do No Significant Harm (DNSH) criteria. However, it was the exposure to SME lending that really concerned the pilot group with one participant protesting “we are not talking about a few thousand of corporate clients, but hundreds of thousands or millions of customers”.
A report by the European Banking Federation (EBF) noted that the largest issue facing the application of the EU Taxonomy to SME lending products was the lack of data required to adequately assess the Technical Screening Criteria (TSC) for Substantial Contribution and DNSH. In order to bring the data quality to an actionable standard, lenders will need to invest substantially in engagement, monitoring and data collection with their SME clients.
In our conversations with banking partners we uncovered a common point of anxiety - the more they push their clients on ESG integration outside what is regulatorily mandated, the more likely they are to switch banks due to frustrations with data collection processes. While large corporations have the resources and manpower necessary to establish robust sustainability management teams - SMEs are generally not in the same position. Given the proliferation of ESG reporting frameworks and regulatory regimes, the issue only continues to expand.
Tip: Think strategically about where, when and how you work with your clients on collecting non financial data. By intelligently integrating data collection into the client onboarding process and by leveraging technology solutions, you can limit the pain of back and forth with clients and ensure a pleasant experience while collecting the data you need to tell the sustainability story of your bank.
Ultimately, the Taxonomy and sustainability reporting and transparency more broadly, should be viewed as a tool for SMEs to make their businesses more resilient as well as attractive to potential investors. The market leaders in the SME segment will effectively take advantage of the current market situation and establish themselves as first-movers to prepare for what will certainly become regulatory requirements over the next decade. By starting on establishing data collection and management systems around sustainability, SMEs can build a competitive advantage on the ongoing economic transition and set themselves apart, securing better funding and improving reputation among stakeholders.
As the primary provider of capital to SMEs, banks play a critical role in the adoption of sustainability practices across the sector, even for those averse to being trendsetters. By providing guidance on how to best assess climate risks and creating a dialogue around disclosure and planning, banks can give SMEs the supportive framework they need in order to come up to speed on ESG metrics.
While the EU Taxonomy and broader ESG regulatory regimes are clearly (and reasonably) targeted towards the largest firms in the market, the broader trends of sustainability assessments and measurements creates pressure elsewhere in the market around transparency. Even if SMEs are not obligated to disclose their non-financial metrics under regulation, their stakeholders are becoming used to this level of transparency and are clearly creating pressure on this smaller segment of the market.
While the regulatory tools are imperfect, stakeholders are impatient to align their capital and contributions behind truly sustainable impact. In addition to the benefits of responding to clear demands from the market for greater transparency around sustainable banking, institutions that establish data pipelines and processes are better positioned for a further expansion of ESG regulation. Effective sustainability policy requires a dialogue, and starting the conversation earlier allows for greater integration of ESG frameworks.
We have seen banks launch green financing programmes that provide targeted use of proceeds based lending to support sustainable transitions. In order to effectively market these without the specter of greenwashing claims, the banks have established internal processes to track and report on how their clients are using funds, even if they are SMEs and not required to report under the EU taxonomy framework. In addition, we have seen banks produce voluntary disclosures providing insights on how the GAR might perform if SME and non EU domiciled clients were included in the calculation. These non voluntary disclosures both help head off claims of greenwashing, but also provide necessary data to tell a more robust version of the sustainability profile of the bank.
As the GAR does not provide full transparency into the banks’ sustainability exposure, the European Banking Authority (EBA) introduced a separate requirement to report on the full banking book for all Pillar 3 banks. The Banking Book Taxonomy Alignment Ratio (BTAR) addresses the issues raised above on the scope of the KPI calculations and its usability. A report by the European Banking Federation (EBF) suggested that the BTAR would include both non-EU domiciled clients and EU based SMEs, thus providing the full scope view on a bank’s sustainability exposure and credentials.
The data collection efforts for banks reporting under the Taxonomy are massive. Every function of a bank touches the information, and processes need to be developed to match the new lens. With competitive banking environments the additional requests on clients creates a demand for better technology solutions to limit the amount of unnecessary data collection. In order to get this right banks will need to effectively utilize technology solutions. The scale of data collection and reporting for a bank is gargantuan, and involves communicating with non ESG savvy stakeholders, upping the challenge of integrating sustainability frameworks.
If you are interested to learn more about how Briink’s AI-powered solutions can help untangle the mess, reach out!
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