A measured approach to ESG?

You can’t manage what you can’t measure.

We said in our write-up to COP26 that we expected ESG to become part of the DNA of finance. It will sit at the heart of financial risk management. We can see a time in the not-too-distant future when there is a new member of the xVA family – we already have Credit (CVA), Funding (FVA), Capital (KVA) etc. Is it too much to think we will soon have to make way for EVA – ”ESG Valuation Adjustment” – as well?

We’ve teamed-up with Juliette Jestin-Knapp, our Head of Data Strategy, Climate & ESG Capital Markets, who comes from a trading rather than an ESG SME background, to consider some key high-level observations around ESG and data:

  • You can’t manage what you can’t measure – finding quantifiable metrics might be a challenge but you need to find a way to monitor your exposure (which will evolve over time)
  • This is not only a product challenge, but also a process / framework challenge– therefore it should not be deferred purely to the ESG specialists in the firm
  • The industry will have to adopt an iterative approach since we will not have perfect data for some time, therefore the journey will be important vs the perfect answer
  • ESG moving from ideology to economics– the financial risks and opportunities will come from first degree repricing, as well as reg / reporting pressure and reputational burden (we have seen that before)
  • If you focus only on regs and standards, you focus on a subset of the whole, and on a timeline and outcome that may be ‘academically satisfying’, but not necessarily what will be practically relevant for risk management in the nearer term
  • There is a barrier to entry in the form of a plethora of regs and acronyms ... we look to simplify this and help our customers navigate through what is relevant for them

Recent announcements

Of course regs and standards is rather our bread and butter, so it would be remiss of us not to mention a few of the recent announcements which will inevitably have a bearing on the more general observations above. 

We’ve seen some key announcements from the EU in the last few months on ESG measures – and they tend to revolve around what is rapidly becoming the word of the year (at least in ESG circles) ... taxonomy. We warned you last year in Who ate all the PIEs that taxonomy would loom large in discussions on ESG, and so it has.

  • Taxonomy Regulation – in December 2021, the EC published final rules on cross-sectoral disclosure and reporting under the EU Taxonomy Regulation, which came into effect on 1 January 2022.  
  • Pillar 3 – in January 2022, the European Banking Authority (EBA) published the final standard on prudential (Pillar 3) disclosures that will require the ~150 largest banks in the EU to begin reporting on their ESG risks and sustainable finance strategy, mostly starting from 2024.
  • Gas & Nuclear – in February the European Commission published its Delegated Act on the inclusion of nuclear energy and gas in the EU’s Taxonomy.

For now these are all EU-specific announcements, but we expect statements from other jurisdictions in the months to come. The UK is expected to provide more detail on its Green Taxonomy later in the year, and all are watching the US to see how the picture will develop there. Equally within the prudential space it will be interesting to see how different regulators choose to apply pressure via capital requirements on banks. Will the market start to respond to different rules to measuring ESG in different legislative environments? 

Read on for some additional detail on these announcements, and as ever we have more in-depth material we would be happy to walk through on a call with our Sustainable Finance specialists. 

EU Taxonomy regulation

Back in July 2021 the EC adopted the Delegated Act (‘DA’) for Article 8 of the Taxonomy Regulation covering disclosures that would be required for activities to qualify as environmentally sustainable. Since then the DA has undergone scrutiny by the European Parliament and Council leading up to final publication in the Official Journal (‘OJ’) in December and entry into force on 1 January 2022.

In December, alongside final publication in the OJ, the EC together with the EU Platform on Sustainable Finance published supporting documents to help clarify which disclosures would be required when:

Below is a quick snapshot of what and when – the reporting requirements are phased, both moving from ‘eligibility’ to ‘alignment’, and staggered between non-financial and financial entities (and an expanding scope of entities within those groups):

Pillar 3

In January 2022, the EBA published the final standard on prudential (Pillar 3) disclosures that will require the ~150 largest banks in the EU to begin reporting on their ESG risks and sustainable finance strategy, mostly starting from 2024.

The disclosure rules will initially focus on Climate Risk (and would need Quantitative Information) with a view to extending the scope to cover other environmental risks when the EU Green Taxonomy is complete. Qualitative Information is required around Social and Governance risks.

The requirements set out by the EBA for bank disclosures dovetail into those above for the Taxonomy Regulation, and more generally the recommendations made by the Task Force on Climate-Related Financial Disclosures (TCFD). But they also go further in asking institutions to identify exposures that highly contribute to climate change. Per the technical standards, disclosures will include:

  • Qualitative disclosures on ESG risks
  • Quantitative disclosures on climate change transition risk
  • Quantitative disclosures on climate change physical risk 
  • Quantitative information on KPIs including green asset ratio (GAR) and banking book taxonomy alignment (BTAR)

In terms of when, some level of disclosure under Pillar 3 will come into play in 2023 (for period 2022) but the bulk of disclosures will apply from 2024 (by which time banks in theory will have a year’s worth of taxonomy-alignment data from non-financial corporates).

There is clearly risk here – banks will be expected to present quite granular data on the ESG risks associated with the exposures they hold, but that data will be highly dependent upon the quality of data a very wide range of counterparties will be supplying to them. In the absence of such data, banks may need to consider reasonable proxies by sector or geography, with the legal and reputational risks that might entail. 

Nuclear and gas

The most recent row on the Taxonomy front came in the form of the disagreement within the EU (and wider) on whether gas and nuclear should be included within the EU Taxonomy. In February, the EC announced that certain nuclear and gas activities would be added to the taxonomy of transitional activities, albeit with additional disclosure requirements (subject to scrutiny and final approval by European Council & Parliament).

There is some concern that a ‘two tier taxonomy’ may be developing, with some activities considered greener than others. This could further complicate an already complex picture. And this is just the EU – other jurisdictions are yet to announce greater detail on their own green taxonomies, and one can envisage those lists being influenced by local political as well as broader environmental considerations.

So how does this all come together?

It is clear that regulators will continue to ‘up the ante’ in terms of what disclosures are required for ESG – whether that is through taxonomy-based ESG reporting, or the capital reporting banks are required to undertake. And so much of this ESG reporting eco-system is interdependent – financial entities will not be able to make full disclosures if the corporates they have loan exposure to do not in turn make their disclosures.

And even if everyone reported just as they should (required by respective legislation), that would not be sufficient for effective risk management. There is a big change in infrastructure, data gathering and most of all mindset required to truly bring ESG into the mainstream of financial management. 

Additional contributors

Juliette Jestin-Knapp, Head of Data Strategy, Climate & ESG Capital Markets

Tonia Plakhotniuk, Climate & ESG Capital Markets

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