Over the last few years, Europe has become a global leader in Sustainable Banking. The European financial industry, led by the European Union (EU), is at the forefront in integrating sustainability into its investments, operations and regulatory frameworks, with a growing emphasis on Environmental, Social and Governance (ESG).

The EU believes that sustainable finance has a key role to play in achieving internal policy objectives by channeling investment towards the transition to a low-carbon, more resource-efficient and sustainable economy, within the framework of the European Green Deal, as well as the EU’s international sustainability commitments.

Sustainable finance (or Green Finance) – process of taking environmental, social and governance (ESG) considerations into account when making investment decisions in the financial sector, leading to more long-term investments in sustainable economic activities and projects (European Commission, 2021).

The European Green Deal and Sustainable Finance Initiatives

In December of 2019, the European Commission presented The European Green Deal, which represents a comprehensive strategy aimed at transforming the European economy into a sustainable, climate-neutral model by 2050, addressing climate change, biodiversity loss, and pollution, while promoting economic growth and a just transition for every EU region and citizen.

To finance The European Green Deal, the EU Commission has announced a total of €1 trillion to be invested in the green transformation of the European economy, mainly generated under the 2021-2027 Multiannual Financial Framework (MFF) and NextGenerationEU fund. However, public backing will not be sufficient to attain the ambitious goals proposed by the Green Deal. A substantial amount remains to be financed primarily by the private sector, for which adequate legal framework conditions and incentives are required to further stimulate ESG investments. As a result, the EU is gradually promoting regulatory changes and initiatives to foster those type of investments.

Throughout this year, the European Green Deal strategy has given rise to several initiatives aligned with its fundamental goals. On the 24th of October of 2023, the Council adopted the Commission’s proposal for European Green Bond Regulation, agreed with the Parliament in February, which will set a high-quality standard for green bonds (EUGBS). To be applied 12 months after approval, the regulation demands that at least 85% of the money raised through these bonds adhere to the Taxonomy Regulation, making it simpler for investors to trust in the long-term viability of their investments and lowering greenwashing risk. In addition, to reduce administrative constraints, the Commission will provide standardized templates for providing information on the Taxonomy alignment of green bonds.

Moreover, in June of 2023, the European Commission introduced the EU Sustainable Finance Package compiling measures to strengthen the EU’s sustainable finance framework, focusing on encouraging private investment in transition projects, and enhancing transparency in sustainable investments. This package includes:

The European Commission has preliminarily approved a set of criteria for the EU Taxonomy, expanding coverage to more environmental objectives. Following recommendations from the Platform on Sustainable Finance, the goal is to make the EU Taxonomy more comprehensive and usable for scaling up sustainable investments in the EU. The Acts will be transmitted to the European Parliament and the Council for scrutiny, with the expectation to be applied from January 2024.

The Commission has proposed a regulation to enhance transparency and reliability in the ESG ratings market, addressing conflicts of interest and ensuring integrity. ESG rating providers offering services in the EU will need to be authorized and supervised by the European Securities and Markets Authority (ESMA) to protect investors and market integrity.

The Commission is focusing on improving the usability of the EU Taxonomy by developing measures and initiatives, including a user guide for non-experts. These efforts aim to support stakeholders in implementing the EU Taxonomy and the sustainable finance framework effectively.

The package emphasizes the use of the EU legal framework to facilitate transition finance, providing guidance and practical examples for companies and the financial sector to channel investments into the transition and manage climate and environmental risks. It recognizes the specific challenges faced by small and medium-sized enterprises.

How are European Banks and Supervisors Incorporating ESG Criteria?

Despite increased efforts by EU banks and supervisors, ESG integration continues to be at an early stage, and the pace of implementation to achieve effective integration within bank’s risk management, business strategies and investment policies, as well as prudential supervision needs to be accelerated.

In recent years, banks have made efforts to enhance governance structures, establishing central sustainability teams to drive group wide ESG integration. Nevertheless, the integration of ESG factors within banks’ risk management practices still faces a major challenge regarding the lack of a common and detailed definition of ESG risks across banks. Despite clearer progress in assessing climate-related risks, it remains unclear how various ESG factors contribute to different types of financial risks. Most banks view these risks from the perspective of reputational or strategic risk and are generally considered transversal rather than principal risk types.

This limited integration extends to business strategies and investment decisions. Despite some banks already offering ESG-related products and services, such as green project finance and energy-efficient mortgages, the integration of ESG factors across their full range of products and services, including off-balance sheet exposures, is a work in progress. Portfolio analysis of ESG lending and investment activity is often limited to specific sectors and product types, primarily for high-risk sectors, with a focus on renewables and green bonds. Although many banks have intentions to integrate ESG factors into their lending activities as part of broader ESG strategies, they often lack adequate monitoring and specific targets. Moreover, ESG risk integration into risk models and stress testing is in the preliminary stage, with further development needed to refine quantitative approaches and to recognize ESG risks as material in the context of longer time horizons.

Along the same lines, the effective integration of ESG risks into prudential supervision among EU supervisors still faces a long process ahead. While the majority acknowledge the importance of considering the environmental and social impact of banking activities, debates persist regarding whether ESG risks should be viewed as a principal risk type or as drivers of existing risk categories. As result, ESG pillars and specific risks are often assessed separately, rather than holistically. In addition, quantitative indicators for measuring ESG risks are yet to be fully defined, with a focus on qualitative elements related to risk processes within banks.

Notwithstanding, many supervisors have issued guidance on ESG integration, covering areas like risk definition, governance, strategy, risk management, and disclosure, with common guidance seen as beneficial for harmonizing practices and increasing ESG risk awareness among supervised institutions.

Regulatory Environment

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.

The Way Forward

In essence, sustainable banking in Europe is no longer a niche trend but a fundamental shift in the financial industry. With an undoubtedly improved regulatory framework and a commitment to responsible banking, Europe is paving the way for a more environmentally and socially conscious financial sector, shaping the future of finance, both in Europe and beyond.

Nevertheless, given the urgent need to accelerate the execution of The European Green Deal, it is worthwhile to investigate further financial incentives to promote green investments, such as tax incentives for green investments or “Green Branding”, not only green bonds but also to other financial products such as stocks, loans, or asset-backed securities.