In recent years, the global community has grown increasingly aware of the imperative for
sustainable finance, driven by the escalating concerns surrounding environmental, social, and
governance (ESG) factors. Governments and organizations alike are ambitiously striving to attain
sustainable development goals, but they face a multifaceted landscape defined by regulations,
reporting standards, and the intricacies of handling ESG-related data challenges. Most importantly,
the financial sector plays a pivotal role in driving positive change and addressing global challenges
like climate change, inequality and resource depletion. Incorporating sustainable finance ensures
that investments, loans and other financial activities aim to promote positive environmental and
social outcomes while ensuring long-term financial stability. Read in the following sections which
sustainable finance related regulations banks need to comply with, how banks are implementing the
regulations, the related (data) challenges arising during the implementation and how we as VB Risk
Advisory can help your organization.
Defining ESG
ESG, an abbreviation for Environmental, Social, and Governance, comprises a set of criteria used to
evaluate the sustainability and ethical impact of companies and investments. This framework is
progressively gaining recognition among investors, businesses, and stakeholders, who aim to create
enduring value while addressing pressing environmental and social issues.
The evolution of ESG
ESG has undergone a transformation over time: it evolved from the concept of “socially responsible
investing” in the 1990s to “environmental, social, and governance” (ESG) investing. This progression
further accelerated from the 2000s to the 2010s with asset managers and institutional investors
increasingly integrating ESG factors into their investment strategies. The focus transitioned from
mere exclusionary screens to actively seeking companies with robust ESG performance.
Subsequently, governments across the globe, during the 2010s, started introducing rules and
guidelines for ESG disclosure and reporting. This included significant initiatives such as the European
Union’s Non-Financial Reporting Directive and a host of national-level reporting requirements.
Presently, ESG considerations have become mainstream in investment decision-making, with
numerous large institutional investors, corporations, and asset managers recognizing ESG factors as
essential indicators for assessing long-term performance and risk management.
Unpacking ESG categories
- Environmental (E): This aspect evaluates a company’s environmental impact, covering areas such
as carbon emissions and energy efficiency. - Social (S): The social category delves into a company’s social responsibility, with a particular
emphasis on its treatment of employees, customers, suppliers, and the communities in which it
operates. Key factors within this domain encompass labor practices, diversity, and inclusion. - Governance (G): Governance pertains to the internal structures of a company, including the
quality of its board of directors, executive compensation, shareholder rights, and transparency in
financial reporting.
Understanding sustainable finance regulations
Sustainable finance regulations are closely intertwined with ESG principles. These regulations, often
aimed at promoting the integration of ESG factors into financial decision-making and disclosures,
provide a comprehensive framework for fostering responsible investment practices and addressing
environmental and social challenges. These regulations particularly apply to institutions falling under
the ambit of the Non-Financial Reporting Directive (NFRD). Such institutions include companies or
entities with more than 500 employees and/or qualify as public interest entities, such as insurance
companies and banks.
The EU taxonomy
Among the pivotal regulations in this landscape, the EU Taxonomy, released by the European
Commission in July 2020, stands out prominently. It serves as a guiding framework for directing
investment decisions toward environmentally sustainable activities. The EU Taxonomy
predominantly focuses on the environmental components within ESG, aiming to establish a common
classification system for environmentally sustainable projects and industries. This alignment with the
EU’s climate and environmental objectives, including the Paris Agreement’s objective of achieving
net-zero emissions by 2050, is integral to the EU Taxonomy. Additionally, the EU Taxonomy serves as
a vital tool to counteract greenwashing, the deceptive practice of falsely marketing products as
sustainable when they lack genuine sustainability.
The EU Taxonomy necessitates specific data concerning the activity being financed by a loan. For
instance, if a bank grants a loan to a consumer who wants to finance a vehicle, the bank is required
to evaluate whether the vehicle is “Taxonomy-Aligned,” meaning it contributes to climate change
mitigation and/or adaptation. In the case of an electric vehicle with no CO2 emissions, it would meet
the requirements.
The key deliverable from the EU Taxonomy is the disclosure of the Green-Asset-Ratio (GAR). While
the EU Taxonomy clarifies that the GAR is not an indicator of a bank’s overall sustainability
performance, it logically becomes a crucial Key Performance Indicator (KPI) for banks that prioritise
sustainability. It quantifies the proportion of Taxonomy-Aligned activities within a portfolio,
providing a measurable gauge of alignment with sustainable activities.
The reporting requirements of the EU Taxonomy are progressively increasing between 2021 and
2023, with full disclosure mandated for the financial year 2023. As companies start reporting the
GAR for the first time in the upcoming year, the true value of this metric remains to be fully
understood. It’s a reasonable assumption that stakeholders would favor companies with higher GAR,
but the correlation between investment behavior and consumer preferences remains uncertain. As a
likely consequence of reporting the GAR, companies may seek to minimize non-sustainable activities
within their portfolios. This raises the intriguing question: Could we witness a future where banks
refuse to finance energy-inefficient vehicles?
The ECB guide on climate and environmental risks (CER) and EBA LOM ESG
A more comprehensive and holistic approach to sustainability legislation is presented in the ECB
Guide on Climate and Environmental Risks. Published in November 2020 by the European Central
Bank (ECB), this guide outlines 13 expectations that banks must fulfill to effectively manage climate
and environmental risks. The first expectation places an emphasis on institutions comprehending the
impact of climate-related and environmental risks on their business environment. Additionally, the
European Banking Authority’s (EBA) Loan Origination & Monitoring (LOM) on ESG emphasizes the
need for banks to integrate ESG risks into their organizational framework.
To better comprehend this aspect, it’s essential to distinguish between two critical types of risks:
physical risk and transition risk. Physical risk refers to the financial risk stemming from the actual
impact of climate change and other environmental factors on businesses and their assets. The
escalating frequency and severity of climate-related events, such as extreme weather occurrences,
rising temperatures, floods, hurricanes, wildfires, and sea-level rise, contribute to these risks.
Transition risk, on the other hand, constitutes the financial risks arising from the process of
transitioning to a low-carbon and more sustainable economy. For instance, policy shifts by
governments can significantly affect the carbon-related activities that businesses engage in.
In the context of a mortgage portfolio or any real estate collateralized product, the inclusion of
physical and transition risks in the risk monitor dashboard becomes a crucial element. Given that
real estate is exposed to various forms of physical risk, such as increasing sea levels, the value of
these properties can be profoundly affected. This prompts the question of whether it is prudent to
finance real estate in regions known for their vulnerability to physical risk. For instance, the
devastating floods in Limburg in the summer of 2021, which ranked as the second most expensive
natural disaster worldwide (involving the Netherlands, Belgium, and Germany) with costs amounting
to 38 billion euros, underscore the importance of such considerations. Another example involves
real estate financing in areas like Amsterdam or Zaanstad, renowned for their wooden foundations
susceptible to pole rot caused by a wet underground.
One of the foremost challenges in integrating ESG risks into business operations is the availability of
adequate data. This challenge encompasses both internal and external data sources. While banks
are increasingly required to disclose ESG risks, not all processes are aligned or ready to fulfill this
mandate. Banks must assess clients based on ESG criteria by implementing additional data fields,
such as those in the loan origination process. The strategic decisions involved can be complicated,
particularly considering that the benefits of reporting metrics like the GAR or other ESG-related
indicators are not yet fully realized, and the implementation of new data fields can incur significant
costs.
Transition risk is equally significant. Policies pertaining to the energy efficiency of real estate can
necessitate specific energy labels. In the Netherlands, commercial real estate must possess an energy
label C by 2023. Failure to comply with this regulation can result in the property being classified as
stranded assets. Moreover, collateralized products, investments, or loans within carbon intensive
sectors are prone to ESG risk, particularly transition risks. Banks disclose their exposure to these
sectors based on consumer preferences. An organization’s strategic sustainability goals should outline
a detailed plan for gradually disinvesting in such sectors, with a focus on achieving objectives like
carbon neutrality by 2050.
Data: A pervading challenge
One of the foremost challenges in integrating ESG risks into business operations is the availability of
adequate data. This challenge encompasses both internal and external data sources. While banks
are increasingly required to disclose ESG risks, not all processes are aligned or ready to fulfill this
mandate. Banks must assess clients based on ESG criteria by implementing additional data fields,
such as those in the loan origination process. The strategic decisions involved can be complicated,
particularly considering that the benefits of reporting metrics like the GAR or other ESG-related
indicators are not yet fully realized, and the implementation of new data fields can incur significant
costs.
External data providers are emerging as essential supplements to banks in assessing ESG risks.
Notable among these providers are Moody’s, which assesses physical risk in specific areas, and
Sustainalytics, which rates publicly listed companies based on their ESG score. Numerous other
providers, such as KCAF (data on building foundations) , PCAF (GHG emissions methodology and
database), and EP-online (energy efficiency database of buildings in the Netherlands), operate in this
space. However, not all of these providers exhibit the same level of quality, and harmonization is
currently lacking. This absence of harmonization complicates the comparability of financial
statements from different banks. This lack of comparability can lead to additional costs, and the
methodologies of different providers are difficult to compare (often referred to as a “black box”).
Integrating external data necessitates testing, integration, and scripting into databases, requiring
considerable expertise, often found in data-driven companies like VB Risk Advisory.
The significance of data integration and analysis is underscored by the role of ESG data in credit risk
models. This integration demands sophisticated data management techniques and a robust
assessment of a client’s creditworthiness based on ESG factors.
Current and future data requirements
At present, hundreds of new data attributes must be gathered to comply with current regulations on
risk monitoring and reporting requirements. As we find ourselves in the early stages of Sustainable
Finance Regulations, it is evident that an even more extensive array of data attributes will be
necessary in the future. The existing Non-Financial Reporting Directive (NFRD) will be replaced by
the Corporate Sustainability Reporting Directive (CSRD), expanding the scope dramatically. While the
NFRD covers 11,600 companies obligated to disclose sustainability-related information, the CSRD’s
scope will encompass around 50,000 companies, underscoring the growing importance of
sustainability reporting.
The future of sustainable finance
Banks currently find themselves in the nascent stages of implementing ESG-related initiatives,
grappling with a host of associated challenges. Contact us today to learn more about how our
quantitative consultancy services can assist your organization in not only embracing the tenets of
sustainable finance but also effectively addressing the intricate data-related hurdles that lie ahead.
Our expertise can be instrumental in guiding your institution through this transformative journey.
Together, we can navigate the complex landscape of sustainable finance, ensuring a responsible and
impactful approach to the future of finance.
If you want to learn more about ESG, or our consulting services, let us contact you, or please feel free to contact the author of this article:
Jordi Kenswil | j.kenswil@vbadvisory.nl
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