EU Capital Requirements Regime: CRD VI and CRR III: ESG

Background

The European Commission considers that credit institutions have a key role in financing the
transition finance to a more sustainable economy. It has introduced a number of key initiatives
such as the European Green Deal, Sustainable Finance Strategy and Corporate
Sustainability Reporting Directive directly or indirectly impacting banks. The CSRD, for
example, requires in scope entities (including credit institutions meeting certain criteria) to
prepare transition plans documenting how they intend to contribute to and prepare for a transition
to a low greenhouse gas emissions and a climate resilient economy (and to make disclosures in
this regard).

The existing EU Capital Requirements framework dealt in a limited way with sustainable finance.

Article 449a, introduced via CRR II, requires large institutions with securities traded on a
regulated market of any member state to disclose prudential information on ESG risks, including
physical risks and transition risks. Implementing Regulation (EU) 2021/637 contains uniform
disclosure formats and instructions for disclosures required under CRR.

CRR II also introduced the so-called infrastructure supporting factor under article 501a,
applicable under both the standardised approach and internal rating based approach. This
aimed to support private and public investments in infrastructure projects by permitting a 25 per
cent reduction in own fund requirements for certain exposures in corporate/specialised lending
categories.

Key changes

CRR III and CRD VI contain a number of changes in relation to ESG. This includes: new
harmonised definitions of the different types of ESG risks as well as other definitions;
amendments to the infrastructure supporting factor; requirements in relation to transition plans;
disclosure requirements; amendments to the SREP process; and provisions for carbon trading
under the alternative standardised approach.

Requirements

Definitions

New ESG definitions in CRR III are: "ESG risks"; "environmental risk", "transition risk"; "ESG
factors"; "fossil fuel sector entity"; and "exposures subject to impacts from environmental or
social factors."

• ESG risk means "the risk of losses arising from any negative financial impact on the
  institution stemming from the current or prospective impacts of ESG factors on the
  institution's counterparties or invested assets". ESG risks materialise through traditional
  categories of financial risks.
• Environmental risk, which includes both physical risk and transition risk under CRR III,
  is defined as "the risk of losses arising from any negative financial impact on the
  institution stemming from the current or prospective impacts of environmental factors on
  the institution's counterparties or invested assets, including factors related to the
  transition towards certain environmental objectives". These are found in the Taxonomy
  Regulation and include objectives such as climate change mitigation.
• Transition risk is defined as "the risk of losses arising from any negative financial
  impact on the institution stemming from the current or prospective impacts of the
  transition of business activities and sectors to an environmentally sustainable economy
  on the institution's counterparties or invested assets".
• Physical risk is defined as "the risk of losses arising from any negative financial impact
  on the institution stemming from the current or prospective impacts of the physical
  effects of environmental factors on the institution's counterparties or invested assets".
• ESG factors have "a positive or negative impact on the financial performance or
  solvency of an entity, sovereign or individual". The legislation cites greenhouse gas
  emissions, biodiversity; human rights, and labour and workforce considerations as
  common examples.

ESG disclosures

Provisions concerning reporting on prudential matters under article 430 have been amended to
include a requirement to report information in relation to ESG risks. This will need to include
existing and new exposures to fossil fuel sector entities; exposures to physical risks and
transition risks.

Disclosure of ESG risks under article 449a CRR now apply to all institutions, with a distinction to
be made between environmental, social and governance risks, and between physical risks and
transition risks for environmental risks. Information in this regard is to include (but is not limited
to) total amount of exposures to fossil fuel sector entities; and information on how identified ESG
risks are integrated into the business strategy and processes and governance and risks
management. Small and non-complex institutions that are non-listed institutions are to disclose
ESG risks referred to in Article 449a on an annual basis. The respective ITS are to be revised.

Scenarios for stress tests for capital adequacy under Article 177 are to include ESG risk factors,
in particular physical and transition risks arising from climate change.

Capital requirements

CRR III introduces a lower risk weight for the commodity delta risk factor related to carbon
trading emissions (article 383v) via a specific risk category for ETS allowances under the
alternative standardised approach. There is a risk weight of 60 per cent for non-EU ETS carbon
trading and 40 per cent for energy EU ETS carbon trading. This will be welcomed by some trade
associations, such as ISDA who had argued that the design of the ETS and political commitment
in the EU to safeguard the stability in the EU market meant carbon trading in the EU was less
volatile than elsewhere.

CRR III introduces a new article 122a, setting out preferential treatment of 80 per cent risk weight
under standardised approach for "High Quality Finance Project Finance" meeting certain
conditions (the preferential treatment set out in article 122a and in article 501a is not to be used
at the same time so as to prevent double counting).

CRR III limits the scope of the infrastructure supporting factor under article 501a to provide that
(from the date of application of CRR III) assets being financed must contribute positively to
environmental objectives under the Taxonomy Regulation and not significantly harm the other
objectives in the Taxonomy Regulation.

Collateral

Requirements for firms in relation to financial collateral and physical collateral under article
207(4)(d); article 208(3)(b); article 210(g) have been amended to provide that collateral
valuations should consider ESG risks, with an assessment to be carried out on ESG risks that
could lead to a decline in the value of financial or physical collateral (decline materially relative to
general market prices).

Governance

Article 73 and 74 of the CRD have been amended to require that short, medium and long-term
horizons of ESG risks be included in credit institutions' strategies and processes for evaluating
adequate internal governance, as well as internal capital needs. Article 91 of the CRD now
provides that the collective knowledge, skills and experience expected of the management body
will include understanding the entity's impact in the short, medium and long term, taking into
account ESG factors.

Requirements for institutions in relation to internal capital under article 73 have been amended to
include an express requirement to explicitly take into account short, medium and long term
coverage of ESG risks.

Under updated article 76 CRD, management bodies are to develop and monitor the
implementation of transition plans, quantifiable targets and processes to monitor and address
financial risks arising in the short, medium and long-term from ESG factors. Institutions
disclosing information on ESG matters under CRD are to ensure that transition plans are
consistent with transition plans referred to in article 19a/article 29a of the CSRD.

The EBA has already published a consultation paper on the guidelines for the transition plans
(see our briefing here). As explained by the EBA, transition plans under EU ESG legislation look
at the compatibility of business models with the move to 1.5 degree and with the EU's aim to
achieve net zero greenhouse gas emissions. Transition plans under updated CRD are intended
to serve as a risk management tool allowing institutions to demonstrate that they are ready for
the transition towards a sustainable economy. CRD-based transition plans are therefore likely to
have unique aspects in comparison to non-prudential transition plans.

A new article 87a in CRD has been introduced requiring governance arrangements include
robust strategies, policies, processes and systems for identifying, measuring and managing and
monitoring ESG risks over the short, medium and long-term. Competent authorities are also to
ensure that institutions test their resilience to long-term negative impacts of ESG factors under
baseline and adverse scenarios (starting with climate related factors).

Dedicated treatment of prudential exposures

Changes have been made to the existing EBA mandate under Article 501c that required a report
on whether there is a dedicated prudential treatment of exposures related to assets/activities
substantially associated with environmental or social objectives is needed The mandate has
been split into a number of reports, which are to be completed by the end of 2024 and 2025.
Additional areas that the EBA will be looking at include whether ESG risks are appropriately
reflected in the credit risk ratings of counterparties/exposures that institutions have. The
European Commission is to submit a legislative proposal within one year of the publication of the
last report.

EBA Mandates

Mandates for the EBA include:

• guidelines on, minimum standards and reference methodologies for the identification,
  measurement, management and monitoring of ESG risk under article 87a of CRD;
• guidelines on the content of transition plans to be prepared in accordance with Article
  76(2) (to include specific timelines and intermediate quantifiable targets; qualitative and
  quantitative criteria for the assessment of the impact of ESG risks on the risk profile and
  solvency of institutions in the short, medium and long term);
• draft ITS on uniform disclosure formats for ESG risks (the recitals state that the EBA is
  expected to consider whether the disclosures should cover pools of covered bonds and
  whether the revised ITS or the overall regulatory and disclosure framework for covered
  bonds should include information on exposures of pools of loans underlying covered
  bonds (directly issued by institutions or via transfer of loans using an SPV));
• guidelines on scenarios for stress tests for capital adequacy under Article 177 to include
  ESG risk factors; and
• ITS under article 430 in relation to exposures to ESG risk.

Impact

The new regime introduces enhanced requirements for management bodies of banks. Large
banks have been subject to disclosure requirements under article 449a since June 2022 but will
need to prepare for enhanced disclosure requirements and for changes that are expected to be
made to the disclosure templates by the EBA. Banks falling within scope for the first time as a
result of CRR III will need to prepare to ensure that the quantitative and qualitative information
expected to be disclosed can be provided. The assessment of transition plans to be carried out
by competent authorities will include institutions' sustainability related product offering, their
transition finance policies, related loan origination policies, and ESG-related targets.

Changes brought by the CRR III and CRD VI also need to be viewed against other
developments, such as the ECB's revisions to its internal model guide.