Banking regulators are paying increasing attention to defining regulations governing banks’ activities in the fields of environmental protection and combating climate change. In this regard, the European banking regulatory body has defined an indicator that EU banks will have to present in their reports from next year. What represents the Green Asset Ratio?
As part of the aspiration to implement the European Green Deal and achieve climate goals in the coming period, the European Union is working on the implementation of the so-called Taxonomy for sustainable activities (for more details on taxonomy see the second part of the article). Related to this, earlier this month, the European Banking Authority (EBA) published a proposal on how banks in the EU should report the share of “green” assets in their balance sheets.
How far do banks move away from financing activities related to the use of fossil fuels
The EU Regulation on taxonomy for sustainable activities in Article 8 requires that all entities subject to the obligations of Directive 2014/95/EU on non-financial reporting, in their non-financial reports, present information on how and to what extent their business operations can be classified as environmentally sustainable activities. In this regard, the European Commission sent a request to the EBA last September to advise on the application of this rule in the EU banking sector.
Based on this request, the EBA proposed a new indicator called the Green Asset Ratio (GAR). The GAR should show in which financial activities in banks’ balance sheets are related to activities that are in line with the Taxonomy Regulation, the objectives of the Paris Climate Agreement and the European Green Deal. Specifically, the GAR is designed to be a major indicator of how far banks are moving away from financing activities related to the use of fossil fuels, and how quickly, on the other hand, they are moving towards greater investments in environmentally friendly energy sources and green technologies.
According to the EBA, GAR should include bank loans to small and medium-sized enterprises, then credit exposures to private individuals (housing loans, loans for renovation, as well as car loans), as well as those to municipalities (related to housing finance). The indicator refers to loans, securities, capital investments and repossessed colateral. Exposures to Governments and central banks are excluded from this proposal due to the current lack of an applicable reporting methodology for these institutions.
In addition to reporting on the structure of these assets, banks will also need to report on the amount of fees and similar income they generate through cooperation with activities that are considered sustainable according to the taxonomy. In addition, for off-balance assets (bank guarantees), the EBA proposes that banks report GAR in proportion to the amount of guarantees for credit exposures associated with sustainable activities according to the taxonomy. Finally, for the part of banks’ assets related to trading, the EBA proposes that banks present information on general sustainability, structure, trend and limits, as well as investment policy. For banks that have a significant amount of these instruments in their total operations, it is necessary to show the share of transactions related to “green” economic activities.
For creditors who have branches outside the territory of the EU, it is recommended that, in accordance with the relevance of the portfolio, they make an effort to assess the volume of assets that can be classified according to the EU taxonomy as “green”.
The Green Asset Ratio will have to be presented in the reports as early as 2022 on the basis of data as of December 31, 2021. So already this year, banks have to prepare a lot for collecting and monitoring the required data.
Environmental and climate risks – “new” significant risks in the world of banking and business
One of the reasons for defining new indicators is the growing risk of negative effects of nature degradation and climate change. Climate change and intense nature degradation are having an increasing impact on many business activities. This negative impact spills over to the financial sector.
In order to better understand environmental and climate risks, it is necessary to point out that they consist of two main types of risks:
Physical risks – refer to those risks that can be manifested through property damage, reduced productivity, or through jeopardizing supply chains. These risks are caused by occasional weather conditions and gradual long-term changes in the climate. Also, physical risks are affected by environmental degradation, excessive use of water resources, loss of biodiversity, deforestation, environmental incidents.
Example: A flood can destroy property pledged as collateral with a bank, jeopardizing the company's operations and the ability to pay loans, leaving the bank without the ability to collect through the sale of a given pledged property to a client.
Transition risks – refer to the potential financial losses that a company (and bank) may have in the process of adjusting to a low-carbon and sustainable economy. These risks may be manifested in the implementation of new policies and regulations, new technology or changes in customer attitudes towards certain products in a market.
Example: New energy efficiency regulations may require significant costs to adapt to, which further affects profitability and creditworthiness.
EU taxonomy for sustainable financing
In order to encourage investment in green projects under the precisely defined term “sustainable”, the European Union has defined a taxonomy for sustainable financing. The EU taxonomy is a tool by which this group of countries strives to implement the European Green Deal and to achieve the set energy and climate goals by 2030. In particular, the taxonomy has the following objectives:
- climate change mitigation,
- adaptation to climate change,
- sustainable use and protection of water and marine resources,
- transition to a circular economy,
- pollution prevention and control and
- protection and restoration of biodiversity and ecosystems.
The EU taxonomy practically enables companies, investors and policy makers to learn about those activities that are environmentally sustainable. On the one hand, precise definitions and criteria avoid greenwashing, and on the other hand, environmentally sustainable investments enable future resilience to the physical and transitional risks of climate change.
European Central Bank, Guideline on climate-related and environmental risks – supervisory expectations relating to risk management and disclosure, Frankfurt, 2020.