Transformation of the European economy towards a sustainable model is one of the priorities but also one of the biggest challenges facing the European Union in the coming decades. The financial industry has a particularly important role to play in this transformation.
Role of the financial sector in the EU climate transformation
According to estimates of the European Commission, modernising the energy sector alone to reduce its emissions will cost €350 billion annually until 2030. And this is just one of the sectors where changes are necessary. Due to the scale of the transformation, it is necessary to find private capital for its financing. Involvement of financial institutions is therefore necessary in order to meet this challenge. The European Commission also aims to make the financial sector more resilient to risks associated with sustainable development, in particular to climate-related risks. One example of such risks are the so-called climate shocks – sudden weather events such as floods or wildfires caused by climate change.
New regulatory requirements for financial institutions
Due to the role that the financial sector is expected to play in the EU climate transformation, new regulatory requirements are being imposed on financial institutions. These requirements may also have an impact on other market participants. Many financial sector companies are already subject to general reporting requirements related to ESG issues, as stipulated in the Non-Financial Reporting Directive 2014/95 (NFRD). Institutions covered by the NFRD must report on the alignment of their portfolios with the EU Taxonomy, which is a classification of environmentally sustainable activities derived from EU Regulation 2020/852. In the future both the number of entities subject to ESG reporting and the scope of reporting obligations themselves will be expanded with the introduction of the widely discussed Corporate Sustainability Reporting Directive (CSRD).
Financial institutions are also subject to additional reporting and prudential obligations aimed at assessing their approach to environmental and climate-related issues. Institutions supervised under the CRR/CRD regime, insurance and reinsurance companies, as well as investment firms under the MiFID II Directive, are obliged to measure, analyse, and assess ESG risks in their activities. Listed entities (primarily banks) under the CRR/CRD regime must also report on these matters starting from this year. Entities offering financial products and investment advisory services on the other hand are required to disclose how they incorporate ESG risks into their investment decisions and whether they take into account the adverse impacts that these decisions may have on ESG factors, all in accordance with the SFDR Regulation 2019/2088. European supervisors are also considering different treatment of assets based on their impact on ESG factors within the framework of capital regulatory requirements.
Impact on borrowers and issuers
The aforementioned changes are significant not only for financial institutions themselves but also for their counterparties, particularly entrepreneurs seeking financing in the market. Financial institutions, due to regulatory requirements described above, must examine their portfolios and consider how they allocate funds. It can be expected that reporting and prudential obligations of financial companies will also have an impact on borrowers and issuers. We can anticipate that financiers will require them to provide relevant data regarding ESG activities or to achieve certain key performance indicators, in order to meet their own regulatory requirements related to ESG matters.
More changes on the horizon
More regulatory changes impacting both financial institutions and their counterparties are looming. To name just a few, the technical classification of environmentally sustainable activities under Regulation 2020/852 (the Taxonomy Regulation) has been established only for two of the six EU climate-related environmental goals– climate change mitigation and climate change adaptation. On 13 June the European Commission enacted the second delegated act to the Taxonomy, which sets out technical screening criteria for the remaining four goals related to climate (sustainable use and protection of water, transition to a circular economy, pollution prevention and control and protection and restoration of biodiversity and ecosystems). This means that a wider array of activities will be available for assessment in the context of Taxonomy and that the entities required to report about their Taxonomy alignment – under the NFRD or, for banks, also under the CRR – will have more work to do.
On the horizon, there is also the so-called CSDD (corporate social due diligence) Directive which is very close to being officially enacted. This directive will require large corporates, both financial and non-financial ones, to carefully consider ESG issues within their due diligence policies and to identify, prevent and remove negative effects which they may have on ESG factors. These requirements consider not only a particular company’s own activities but also its value chain. The addressees of the directive will also have to implement complaint procedures through which their stakeholders should be able to lodge complaints if they think that the company is causing harm to environment or other ESG factors (such as rights of the local communities). CSDD Directive will also have a mandatory reporting element. In general, its addressees will most likely have to strengthen their due diligence procedures in respect of ESG. This is again especially important in the context of financial institutions – even if a particular company does not find itself within the scope of CSDD, its bank or insurer probably will – and its due diligence requirements will affect its counterparties.
Borrowers should prepare
All of the already implemented and proposed changes described above are just the beginning. The key takeaway for borrowers and other participants of the financial market is that even if my own company is not subject to any new ESG-related requirements directly, it may be affected indirectly – in particular through its financiers. Due to various new regulatory requirements, financial institutions will scrutinise their portfolios more diligently with regard to ESG considerations in the coming years. In order to meet these requirements, work will have to be done by the portfolio companies – for example in the area of data collection and measurement of various ESG risks and impact on ESG factors.
