Regulating sustainability initiatives – need of the hour!

Sustainable finance is essentially defined as lending and investment decisions by asset owners that consider the ESG impact of an economic activity.

Banks can lead the change by financing the right projects and empowering firms, society, and people who want to accelerate the green transition. And banks play a pivotal role - without their active participation, the path to a sustainable world and social equality will be more complicated, if not impossible.

Key drivers

• The UN-convened Net-Zero Asset Owner Alliance is an alliance of around 70 financial institutions, including banks, fund management companies, and insurance entities, with more than USD 10 trillion in assets under management. The alliance has committed to transforming its investment portfolio to net-zero green house gas (GHG) emissions by 2050, consistent with what is required to achieve a maximum temperature rise of 1.5°C above pre-industrial levels.
• An exponential growth in the green bond market has occurred since its inception in 2007, and by December 2020 cumulative issuance has surpassed USD 1 trillion. These bonds are created to direct capital flows into projects and economic activities that have positive environmental benefits.
• Banks, other financial institutions, and regulators have started embedding ESG factors into their business as well as operating models. This means enhancing their lending portfolios to include ESG factors as a main component of credit risk measurement and management. This is also leading to strong and positive messaging to corporate customers (both public and private) that are seeking to access capital. The objective is to redirect capital from high-emission sectors to green ones.
• Conscious consumerism is rising, and consumers believe in linking their purchase decisions to a prospective brand's environmentally friendly sourcing, production, packaging, and distribution processes, in addition to ethical values.
• Sustainability incentives, such as tax breaks and awards, as well as punishments, like higher lending rates, are soon expected to become regulatory obligations. 2022 could be an inflection point beyond which financial services firms could feel increasing pressure from regulators to comply with green norms.

Regulatory developments

The commitment of European banks to the Paris Agreement goals has resulted in many green business initiatives. Banks have started to support their customers and employees with green initiatives and to make their underlying collaterals more sustainable:

• Íslandsbanki partnered with Meniga to provide its customers with a precise carbon footprint for each transaction.
• ABN AMRO Bank has developed an energy-savings tool for customers to display their options for lowering energy consumption.
• Bank of the West(part of BNP Paribas) launched a green checking account.
• Rabobank has been facilitating green entrepreneurship via various kinds of sustainable loans, including green loans, impact loans, and innovation loans.
• BBVA launched cards made of recycled plastic, and CaixaBank launched a biodegradable line of gift cards.
• There are several green mortgage products available at leading banks, including Barclays, ING, Nordea, and Société Générale.
• Deutsche Bank launched a green IT initiative that resulted in energy savings of 76% per person, saving 4.5 million kWh of electricity per year, reducing the quantity of paper used by 25%, and increasing energy efficiency in the bank's data centers four-fold.

Initially, European banks offered these green business initiatives primarily as a reaction to growing demand from society. Subsequently, however, an increased number of sustainability-related regulations were introduced by regulatory institutions. By introducing these new regulations, the regulators also emphasized the role of banks as one of the primary actors with a responsibility to help in creating a more sustainable world. This development resulted in a situation that, next to the social pressure from society and to the banks' own intrinsic motivation, requires banks to now focus more on initiating sustainable business initiatives.

It took quite some time for regulators to finalize concrete regulatory requirements related to sustainability. In the previous decade, regulators have been primarily sharing ideas and discussion papers on the topic. Gradually, especially in the last few years, initial ideas have been transformed into more concrete regulations and guidelines that banks must comply with.

Figure 1 shows a timeline with an overview of some of the latest developments regarding sustainability-related regulations, with their corresponding dates.

Many other significant regulations have been created in this time period, some of the more notable ones being:

• The Non-Financial Reporting Directive
• The EU Sustainable Finance Disclosure Regulation
• EU labels for benchmarks (climate, ESG) and benchmarks' ESG disclosures
• The Corporate Sustainable Reporting Directive
• The AIFMD, UCITS and MiFID (Markets in Financial Instruments Directive) ESG measures
• And many others.

Since regulations related to sustainability are relatively new for banks, many regulatory requirements in this area must still be enacted by regulators. We expect that, in the coming years, more concrete regulations will follow the previously mentioned regulations. These regulations should especially relate to:

• Uniform definitions of environmental, social, and governance (ESG) risks, including for physical risks and transition risks.
• The development of appropriate stress testing and scenario analyses for the assessment of the impact of ESG risks on the financial stability of banks.

Challenges for banks

• Banks follow their own individual approaches to embed climate targets in their business, which is becoming a core business process. To align their lending and investment portfolios with the Paris Agreement goals, banks are obligated to, for example, determine the greenhouse gas emissions associated with the economic activities of their customers and the related projects they finance.
• In addition, banks need to compare emissions with science-based benchmarks and set time-bound emissions reduction targets to bring the emissions profiles of their lending and investment portfolios in line with these benchmarks.
• As mentioned before, banks have initiated various green business initiatives to achieve a common goal: to create a more sustainable world. To achieve this goal, banks use a sectoral approach. It entails that each sector has its own transition pathway, or technological roadmap, to contribute to a more sustainable world. For the various sectors, banks have piloted and tested different science-based methods to measure their performance in achieving this goal, and to compare their performances using multiple benchmarks.
• The objective measurement and comparison of banks' performances is one of the many challenges that banks face on this topic. The main drawback of the different performance measures and benchmarks used across banks is that it is hard to compare what the most optimal approach for banks is. The main reason that banks might use different measurement methods and benchmarks is because there is not yet a unique global standard or method available. The main factor that the different performance measurement methods and benchmarks have in common is that they are dependent on each sector, with their own corresponding global climate goals and ambitions.
• Finally, the availability and accuracy of sustainability data is still a challenge for banks. Although this has significantly improved in recent years, it is still a point that requires attention, especially for banks to be able to perform scenario analyses and to monitor and report on the sustainability-related performance of their portfolios and potential (future) climate risks.

How can we help?

Capgemini has an experienced team of domain specialists, with a depth of knowledge, skills, and experience in the field of sustainable finance and risk (SFR).

• Our specialists can assist banks by interpreting existing or new regulations in the field and can also translate these regulations towards policies and practices.
• Furthermore, our experts are ready to help banks by performing gap analyses and by leading or assisting with the necessary implementation processes for relevant regulations.
• Our specialists can develop SFR-related stress tests and scenario analyses, can integrate ESG factors in banks' risk models, and are able to measure the corresponding impacts.
• Financial sustainability and ESG regulations have led to a massive increase in regulatory reporting for banks. This increased burden can be supported by trained specialists from Capgemini.

Interested in our thoughts about the next generation of climate-related stress tests? Have a look at our article on climate stress tests:
https://www.linkedin.com/pulse/getting-ready-climate-stress-test-tej-vakta/?utm_source=LinkedIn

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