Transcript provided by Kensho.



Lindsey Hall: Hi. I'm Lindsey Hall, Head of Thought Leadership at S&P Global Sustainable One. 

Esther Whieldon: And I'm Esther Whieldon, a senior writer on the Sustainable1 thought leadership team.

Lindsey Hall: Welcome to ESG Insider, a podcast hosted by S&P Global where we explore environmental, social and governance issues that are shaping investor activity and company strategy. 

Regulation is playing an increasing role in shaping the direction of the rapidly growing ESG movement. We're seeing investors demanding more consistent disclosure and reporting, and it can be difficult to digest the current alphabet soup of different standards that are out there. As we've talked about quite a bit on this podcast, regulators are paying heed to climate-related risks at corporations really across sectors, and we're expecting to see more regulatory action in the future. The Intergovernmental Panel on Climate Change just came out with a mitigation report on April 4 that said regulatory and economic instruments have slowed emissions, but more needs to be done. 

Now today, we're talking specifically about banks. Banks are going to be key to achieving net zero goals because they lend to vast swaths of the economy. But that position also puts them at risk from exposure to climate change. And as a result, we're seeing regulators take steps to ensure that lenders are adapting their businesses to address those risks. 

Esther Whieldon: One regulator that is taking action is the European Banking Authority, which regulates EU banks. Earlier this year, the EBA announced new ESG disclosure requirements for banks, which will be phased in starting in 2023. For this episode, we turn to Jennifer Laidlaw, a Senior Writer on the thought leadership team at S&P Global Sustainable One. She's going to help us understand what the move means for ESG and the financial sector. 

So Jen, what should our listeners understand about the EBA requirements? 

Jennifer Laidlaw: Lenders will have to disclose their exposure to fossil fuel companies and any assets they hold that could be at risk from increased wildfires, floods or hurricanes because of climate change. It's really a way of measuring how much of their financing is climate friendly and to what extent they may face losses on loans, for example, due to a changing climate.

I spoke to Pilar Gutierrez, Head of Reporting and Transparency at the EBA to find out more. In our interview, you'll hear us talk about the green taxonomy. That's a list of sustainable activities compiled by the EU. We also talk about some other EU regulations, such as the nonfinancial reporting directive, the NFRD, and Pillar 3, which is international regulation requiring banks to disclose risks. I asked Pilar how the new ESG disclosure standards will work and what will be the impact on banks.

Pilar Gutierrez: The Pillar 3 standards include a quantitative disclosures that rely on the classification system as specified in the European taxonomy regulation, including information on 2 KPIs: the green asset ratio and the banking book taxonomy alignment ratio, the GAR and the BTAR. The purpose of these 2 KPIs is to provide information on the level of alignment of institutions' banking book exposures with the taxonomy regulation based on the taxonomy alignment of the investments and activities that the banks are financing. That is, they allow to understand to what extent banks' investment exposures are green based on the extent to which the activities that they are financing are green.

These KPIs also helped to understand to what extent institutions are mitigating climate-related risks by supporting their counterparties in their transition and adaptation path and helping them to mitigate their own risks. Institutions are required to assess the loans, bonds and equity holdings in their banking book based on the underlying activity that is being financed or on the level of a taxonomy alignment of the turnover of the counterparty.

While the GAR, the green asset ratio, provides information on large corporates and retail exposures, including retail real estate loans and car loans, the BTAR extends and complements the GAR with information on taxonomy alignment of exposures towards smaller corporates, including SMEs.

On the question on how this will impact on banks, through the disclosure of these KPIs, banks will be subject to public scrutiny on their sustainability performance. They are targets and transitioning plans, and they will have an impact because stakeholders will be able to understand this information before making, for example, investment decisions. 

Jennifer Laidlaw: Okay. And you mentioned the EU taxonomy. Obviously, that's something that's been very important in the ESG world in Europe and in other regions of the world. And I just wondered what has been the role of the taxonomy in creating these ratios?

Pilar Gutierrez: Well, I mean the role of the taxonomy has been key in creating these ratios. These ratios are calculated around the taxonomy. The taxonomy provides a common classification criteria for the identification of green activities, of those activities that highly contribute to the sustainability objectives of climate change mitigation and climate change adaptation.

The green asset ratio on the banking book taxonomy alignment ratio identify the investments in the banking book of the banks that are sustainable through the application of the taxonomy criteria. Banks have to classify their exposure, their loans, their debits, their bond and equity holdings in the banking book against the criteria provided by the taxonomy. And then relying on a common classification system for the definition of these KPIs, the common classification system provided by the taxonomy will make it possible that banks disclose ratios that are fully comparable across the sector. 

Jennifer Laidlaw: Okay. Yes, I think that's something that's quite important, this comparability that people have been looking for. There's a lot of disclosure standards and rules out there. We have the TCFD; and in the EU there's NFRD. What differences do you think there might be with your own disclosure standards and how will they fit in with the other standards that already exist in the market?

Pilar Gutierrez: You are right, there is a proliferation of disclosure standards both at EU and international level. And at the EU level, the commission Action Plan on Sustainable Finance published in 2018 triggered several initiatives on disclosures. What we have done in particular in relation is how our Pillar 3 ESG disclosure standards interact in particular with the TCFD and the NFRD that you mentioned. When developing our Pillar 3 ESG disclosure standards, we have built notably on the recommendations provided by the Financial Stability Board's Task Force On Climate-related Financial Disclosures, the TCFD recommendations. They provide a very good set of recommendations, very valuable, including climate change, including bank sector-specific recommendations. 

But we have gone one step beyond. Many corporates of banks are already providing disclosure reports - - nonfinancial information according to the TCFD recommendations. But when assessing these reports, we still observe room for improvement in terms mainly of consistency and comparability of the disclosures. The Pillar 3 ESG package should help to address these shortcomings at EU level by setting mandatory, consistent disclosure requirements with the definition of granular templates and tables and associated instructions. And we hope that it also will also push for better disclosures at international level by establishing best practices. 

In the interaction with the Non-Financial Reporting Directive, the NFRD, we are liaising with the relevant bodies to ensure consistency in the development on any future sectoral disclosure standards under this directive. Pillar 3 standards and NFRD standards should complement each other. 

Jennifer Laidlaw: Okay. You've been mentioning risks. I'm just wondering what would you see the biggest risks that you'll be focusing on with your own disclosure standards for the banking sector.

Pilar Gutierrez: Well, the intention is to eventually cover the full scope of environmental, social and governance risks. But our initial focus has been on climate change-related risks. This priority reflects the urgency of the topic. The commission, on the one hand, has set very ambitious policy objectives on climate as soon as 2030. And these policy objectives may translate into transitional risk for banks. On the other hand, there is an increase in frequency of extreme weather events, which may translate into physical risks for banks' investments and exposures. 

But this is also in line with the developments taking place both at the EU level. In the case, for example, of the EU taxonomy regulation whose initial scope is climate change, sustainability objectives, but also at the international level. We have the example of the Basel Committee, they have created a task force on climate-related risks; or of the IFRS Foundation, they are creating an International Sustainability Standards Board that will first work on climate-related disclosures. 

In developing the Pillar 3 framework for ESG risks, we are following a sequential approach. And as explained before, the first set of standards have a main focus on climate change, and we will gradually extend the technical standards in subsequent steps in order to fully cover other environmental risks, including biodiversity, social and governance risks. 

Jennifer Laidlaw: Okay. So it's climate first, and then you'll be looking at different things like you said biodiversity and then there'll be other like social and governance issues. Do you have any idea what that time line is going to be? 

Pilar Gutierrez: We have just published the first set of standards. We have been -- very challenging for us and will be challenging for banks to implement it. So now we are waiting a bit to see the challenges that banks are facing. And also, we are waiting also for the developments outside the EBA. We are waiting for the taxonomy to see how it evolves. We are waiting also for the IFRS Foundation. We still don't have a proper timeline, although we cannot wait either too much, particularly on the part on environmental risks. But the timeline will depend also on the evolution of events outside the EBA.

Jennifer Laidlaw: Yes, sure. And I guess, like this year, we're going to hear more about the social taxonomy we have to have more information before you can actually go ahead with any other additions, right?

Pilar Gutierrez: Yes, precisely, precisely the taxonomy, the evolution of the taxonomy, the social taxonomy would be very important also for our work. 

Jennifer Laidlaw: Okay. Interesting. And just obviously, as the European Banking Authority, you're focusing on banks. With these ESG disclosure standards, how do you expect banks to measure their fossil fuel exposure and financed emissions? 

Pilar Gutierrez : Well, so the Pillar 3 standards require quantitative information on climate-related risks covering information of exposures in the banking book that can be impacted by both transition and physical risk. Information on fossil fuel exposures and financed emissions is captured in the transition risk disclosures. We have several templates in the standards that focus on transition risk.

First, banks are required to inform on their exposures towards sectors that may highly contribute to climate change, notably carbon intensive and fossil-fuel sectors. They will have to indicate the gross carrying amount of loans, bonds and equity holdings in their banking book that are towards corporates in these sectors. 

But second, in the same template, banks will have to indicate the part of those exposures towards sectors that may highly contribute to climate change that are towards corporates that will be excluded from being traded in Paris-aligned benchmarks in the EU. This means companies that derive a certain amount of their revenues from activities related to hard coal and lignite, oil fuels, gaseous fuels or electricity generation with certain greenhouse gas emissions intensity.

These are the main requirements that better reflect what you are asking, right, which is the information on fossil fuel exposures and financed emissions. But in addition, when informing about these exposures, banks will need to report their credit quality and their average residual maturity because we know that the climate change risks are risks that may materialize in the longer term. And it is important that the stakeholders may understand what part of these loans, these bonds are shorter term or longer term. 

And finally, for all these exposures towards carbon-related sectors and corporates that will be excluded from being traded in Paris-aligned benchmarks, banks will need to inform the amount of -- the measures of these counterparties. The volume of financed greenhouse gas emissions coming from this counterparties. That is to what extent the bank is financing Scope 1, Scope 2 and Scope 3 emission through these exposures.

But. in addition, we also ask banks to disclose other relevant information on transition risk. We know that the banks' real estate assets are causing a big, huge part of the CO2 emissions in -- well, in the EU and worldwide, right? And we are asking in our Pillar 3 standards for banks to publicly report the breakdown of their real estate portfolio by energy performance and energy consumption of the underlying real estate assets.

And finally, we are asking banks also to provide information on exposures towards 20 top polluting corporates in the world. There are several analyses in the market that indicate that the top polluting companies of the world are responsible for a very big part of the global emissions. So we thought that it was also important that banks are transparent in their exposure towards these corporates that can be very much impacted by climate-related risks, transition risk. 

Jennifer Laidlaw: Okay. Interesting. Because, yes, I mean, you mentioned real estate, which has a huge carbon footprint. Are there any other sectors specifically that you're looking at apart from real estate and these large polluting companies? 

Pilar Gutierrez : Sure. Of course, we are looking at energy sectors. We are also looking at mining sectors. We are looking also at fossil fuel, oil and gas sectors, but we are also asking banks to provide information on sectors like agriculture. For the identification of sectors that are relevant for this type of disclosures, we are relying on other EU regulations.

For example, I mentioned before the Paris-aligned benchmark regulation. So in the EU, there are already a regulation for Paris-aligned benchmark and transitional benchmarks, and these benchmarks are asked to disclose the volumes that they are trading in those sectors that may highly contribute to climate change, and they provide a classification of these sectors, the most relevant sectors. And we are taking the same classification that is required under the climate benchmark regulations in order to be consistent across the different pieces of regulations. But notably, it is utilities, oil and gas, mining, manufacturing. 

Jennifer Laidlaw: And you mentioned bonds at one point. I just wondered in terms of things like market and underwriting exposure. To what extent are you going to be looking at that?

Pilar Gutierrez: So for the moment, we are focusing on the banking book. I mean as part of the sequential approach that I mentioned before, in next steps, we plan to extend the ITS to cover the full scope of environmental, social and governance risks. But it is also that in this first set of disclosures, we decided to focus on the banking book. In our consultation paper, we try to -- we proposed a template to capture information on market values and rating exposures on the trading book, but we were not very sure about the way we have built this template. We asked for feedback. We received feedback, and we decided that it was better to keep working on this template and postpone it to a later version of the technical standard.

So for the moment, we are focusing on the banking book, gross carrying amount of loans, bonds in the banking book, equity holdings in the banking book, also information on impairments and provisions so that banks explain if they are taking into account climate-related risks and factors in their impairments policy and their provisioning policy, also information on the status, NPL, information on nonperforming loans in order to understand whether the banks are also taking into consideration climate-related factors when considering their policy to classify loans as nonperforming. The initial focus is, as said, gross carrying amount and the impairments in the banking book for these exposures. 

Jennifer Laidlaw: In what ways will the new standards really encourage banks to put in measures that will reduce their carbon footprint? 

Pilar Gutierrez : Our Pillar 3 standard also requests banks to disclose forward-looking information. They have to measure the financed greenhouse gas emissions, Scope 1, Scope 2 and Scope 3 measures of their counterparties. And then they have to provide relative metrics by sectors and compare them with the value that those metrics should have in a net zero emissions scenario. We are asking banks to take the net zero scenario published by the International Energy Agency and to compare their current greenhouse gas emissions per sector relative metrics with the alignment metrics that the International Energy Agency scenario provides.

The IEA provides alignment metrics that banks would comply with if we want to get to the net zero scenario, where the bank would have a net zero emissions. So banks have to disclose the values of this metric as of today, how they compare to the IEA metrics as of 2030. We have put an intermediate year. We don't go directly to 2050. For 2030, we have already very ambitious policy objectives. And then we ask banks to explain how they are planning to evolve towards those metrics.  

Jennifer Laidlaw: Amassing ESG data has been a major challenge, particularly with forward-looking data. How much do you see this being a problem when it comes to calculating the green asset ratio or the banking book taxonomy alignment ratio? 

Pilar Gutierrez: Well, we acknowledge that there are -- at the beginning, there will be big challenges for banks. In terms of the green asset ratio, the taxonomy regulation requires corporates to disclose information to what extent their turnover is generated by activities that are taxonomy aligned, that are green, that meet the strict criteria envisaging the taxonomy.

Nonfinancial corporates will have to start disclosing this information as of end 2022. So for banks to be able to collect this information that corporates that will have to provide this information, which will be corporates that are under the scope of the nonfinancial reporting directive of the NFRD to give banks time to collect this information that will be publicly available from the end of 2022, the Pillar 3 considers a 1-year lag for banks to disclose this information. Banks will have to disclose information on the green asset ratio starting on December 2023. So one year after nonfinancial corporates under the scope of the NFRD will have to start informing about the information that banks need.

So in terms of this, we hope that this will help to address the data challenges. Then we have the information on, for example. On the retail exposure, small and on exposure on medium enterprises and smaller companies, these counterparties are still a very important part of the bank's banking book, and they are not required to disclose, right. But banks will have to collect information, they will have to go to their retail counterparties and ask information on the energy performance of their houses in the case of the real estate portfolio or when they are buying a car and they are asking for a loan to buy the car, they will -- banks will have to ask their retail counterparties the energy performance certificate of the car.

Similarly, in the case of the SMEs, they will have to liaise bilaterally with them in the context of the loan origination and monitoring process in order to understand to -- what extent the activities of the SME are taxonomy aligned. Here, we say that banks should follow a simplified approach and focus on the main activities of the counterparty. We understand that in the case of a small and medium enterprise, I mean, banks do not need to assess the whole scope of activities including the taxonomy, but identify the main activity of the counterparty and assess together in bilateral dialogue what is the level of taxonomy alignment. So for this type of counterparties, the bilateral contact, that the bilateral information will be very important.

There are several sources of information that we propose banks to use, including the use of estimates. We propose phase-in periods. In the case of the green asset ratio, banks will have to start disclosing it as of, into 2023. In the case of the BTAR, the banking book taxonomy alignment ratio, we give 6 extra months until June 2024. And we acknowledge that the first set of disclosures will be in some cases on a best effort basis. But the important thing is that banks start gathering this information and making it publicly available. And so we don't expect the perfect set of disclosures from the beginning, but still information which is on a best effort basis or estimates is better than nothing. And this will push banks to gather all this information that they also need for their risk management purposes. 

Esther Whieldon: The EBA is creating the standards at a time when more central banks are undertaking climate stress tests to assess lender exposure to climate change. So Jen, did Pilar have anything to say about that? 

Jennifer Laidlaw : Yes. She said she hopes the EBA's work will provide valuable information for informing climate stress tests conducted by central banks, such as the European Central Bank. But she also said the EBA could adjust its disclosure rules depending on the outcome of climate stress tests. 

Lindsey Hall : Thanks, Jen, and we look forward on this podcast to hearing more about developing ESG rules and how those impact the way financial institutions are managing their climate risks. Please stay tuned as we track how companies and investors tackle these major challenges and capture the opportunities associated with the low carbon transition.

Now these are topics we're going to be digging into in an upcoming series of events. We're taking the ESG Insider podcast on the road in May to bring you interviews and key highlights from the upcoming S&P Global Sustainable One Summit. That summit will be held in Paris on May 10, in New York on May 17 and in Sydney on June 9, and we'll include a link in our show notes in case you want to sign up to attend any of those events in person. We'll be digging into topics like net zero and nature positive, advancing social equity and measuring progress. So I hope to see you there.

Thanks so much for listening to this episode of ESG Insider and a special thanks to our producer, Kyle Cangialosi. Please be sure to subscribe to our podcast and sign up for our weekly newsletter, ESG Insider. See you next time

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