Despite the early stage, the regulatory framework is currently being enriched by policymakers who are diligently pursuing the goal of fostering a more sustainable economic system, wherein financial institutions play a pivotal role. This commitment to sustainability is evidenced by a growing set of European regulatory requirements centered on ESG considerations, which are significantly reshaping the entire risk landscape across the banking value chain.
The ECB published, in 2020, the guide on climate-related and environmental risk that outlines comprehensive supervisory expectations with respect to financial institutions’ strategy, forward looking and approach to environmental risks. Banks were then requested in early 2021 to conduct self-assessments based on the ECB’s guide and create action plans to be later reviewed. In 2022, the ECB launched a comprehensive review of banks’ strategies, governance and risk management frameworks, with follow-up actions if deemed necessary, and provided a set of good practices from a wide range of institutions to meet the supervisory expectations set out in the guide.
In 2022, the ECB has carried out industry-wide Climate Risk Stress Test (CST) as part of a broader set of activities to assess a bank’s level of preparedness regarding climate risk management. The CST includes a structured questionnaire, an assessment of banks’ transition risk exposure, and a bottom-up stress test to comprehensively assess how banks have incorporated these risks into their strategy, governance and risk management frameworks, and the extent to which banks are aligned with the ECB’s supervisory expectations on climate-related risks.
Also in 2022, EBA published a final draft on implementing technical standards (ITS) on Pillar 3 disclosures related to ESG risks. Applied to large institutions with securities traded on a regulated market, the ITS is a set of qualitative and quantitative disclosure standards related to the management, exposure and mitigation of ESG risks. EBA is adopting a sequential approach, initially focusing on climate change-related risks due to their urgency and the data challenges involved. The main goal is to enhance transparency and comparability of ESG risk disclosures in line with best practices at both EU and international levels.
The EU Non-Financial Reporting Directive (NFRD), introduced in 2016, essentially composed by principle-based requirements for large public-interest entities (more than 500 employees) to publish non-financial information regarding environment and social matters, is being replaced by the Corporate Sustainability Reporting Directive (CSRD), which came into force in January of 2023. The CSRD, in opposition to its predecessor, strengthens the reporting on social and environmental information by expanding the scope of compliance companies and by including a wider and more detailed disclosure requirements, in accordance with mandatory EU Sustainability Reporting Standards (ESRS), adopted in July of 2023. These standards consider technical advice from the European Financial Reporting Advisory Group (EFRAG) and are aligned with the requirements set out in the Taxonomy Regulation and the SFDR. The CSRD goal is to provide stakeholders with essential information to assess companies’ social and environmental impact and to evaluate financial risks and opportunities related to sustainability. The new rules will be applied for the first time in the 2024 financial year, with reports published in 2025.
The EU taxonomy, implemented in July of 2020, also plays a pivotal role on the EU’s sustainable finance framework by unifying the definition of the business activities that are considered environmentally sustainable, aligned with disclosure requirements applicable to NFRD companies. The EU taxonomy established technical screening criteria for each environmental objective through delegated and implementing acts, such as the Delegated Act for economic activities launched in June of 2023, outlining the four overarching conditions that an economic activity must meet to qualify as environmentally sustainable. The unified definition provides guidance for investments toward activities essential for the transition, while protecting against greenwashing and market fragmentation.
In addition, the EU introduced the Sustainable Finance Disclosure Regulation (SFDR) in 2021 as a framework that required financial market participants to disclose sustainability and ESG-related information, enabling investors to support companies and projects that promote sustainability and properly assess sustainability risks. The SFDR also extends its scope beyond environmental sustainability, encompassing social objectives as part of the EU’s broader sustainable finance agenda.
Furthermore, the Commission reviewed MiFID II, effective since 2018, publishing the proposal amending Directive 2014/65/EU on markets in financial instruments, in 2021. Aimed to embed sustainability into the EU financial system, these adjustments extended beyond SFDR’s scope and required MiFID institutions to integrate specific ESG considerations into their product governance arrangements. In August 2023, ESMA published the new Guidelines on MiFID II product governance requirements, that include the specification of any sustainability-related objectives a product is compatible with.
