Sustainable finance and EU taxonomy – what is in store for banks?

The European Commission’s European Green Deal envisages Europe becoming the first climate-neutral continent by 2050. It is an ambitious goal that goes hand in hand with a comprehensive action plan and implies a number of legislative initiatives within the framework of financial market regulation for banks and financial service providers: legally binding regulations and reporting obligations mean that financial service providers should contribute to developing the economy in an ecological and sustainable way, as well as usher in the new era of sustainable finance. A common classification system – the EU taxonomy – is designed to offer investors incentives for making sustainable investments and support the shift towards a sustainable economy. Coupled with national legislation, this has led to changes in the frameworks that means there is a new age in store for banks. In this blog post, I will briefly describe what this actually means and what needs to be taken into account.

Regulation as a driver in the financial world – change is constant

Regulation has been a major driver of profound changes and adjustments in the financial industry in recent years. This will not change in the context of sustainable finance and the reason why is clear: two of the things the structural shift towards a sustainable economy requires are high levels of investment and access to the capital market so as to provide the necessary infrastructure and financial resources for the transition to the sustainable era. The EU Council estimates the amount needed to be around €180 billion annually. This is an astronomical figure that will require an appropriate set of control mechanisms – once it has found its way into the free economy through the capital market. The European legislative initiatives use regulations to put the onus on the financial sector to make the transition to the sustainable era. After all, who is better suited to ensure the supply of money to the economy, adequately assess sustainability risks and drive the flow of capital if not financial intermediaries?

Of course, regulations cannot impose an obligation on banks to invest in sustainability projects or even facilitate sustainable investments. This is most certainly not the aim of the EU taxonomy. However, it can support the control, governance and transparency of ecological, climate-friendly and social financial transactions and thus promote structural transition. It can also provide a reliable, uniform framework and help to provide guidance and security. Sustainability risk assessments also imply general economic and system risks. A uniform classification also allows banks to ensure that these are mapped transparently.

The EU taxonomy – the regulation

The Taxonomy Regulation (EU taxonomy) is a regulatory classification system that defines the technical assessment levels of sustainable economic activities to ensure the control and management of capital flows. It comprises six distinct environmental objectives which, based on technical assessment criteria, ensure the regulation is mapped transparently and implemented in the following areas:

• 1. Climate protection
• 2. Climate change adaptation
• 3. The sustainable use and protection of water and marine resources
• 4. The transition to a circular economy
• 5. The prevention and reduction of environmental pollution
• 6. The protection and restoration of biodiversity and ecosystems

This set of criteria serves to clearly define the economic activities that are considered sustainable. It combines the rules for greater uniformity with increasing transparency and reporting requirements and provides for targeted implementation measures. In this way, it defines which economic activities are considered sustainable and which are not, and eliminates the risk of ‘greenwashing’ through guidelines and benchmarks. This increases transparency for investors and visibility for sustainable investments. The regulation has been in force since July 2020. The initial set of requirements laid out in the EU taxonomy has been in force since 1 January 2022 and will be implemented gradually through further mandatory measures.

The German sustainable finance strategy – on its way to setting the bar

Germany is also striving to create its own national financial market sustainability policy by supplementing the EU taxonomy with national provisions. These provisions are designed to help Germany become a leading sustainable financial hub by focusing on clearly defined objectives. These objectives are:

• Objective 1: Advance sustainable finance around the world and in Europe
• Objective 2: Seize opportunities, finance transformation, anchor the impact of sustainability
• Objective 3: Systematically improve risk management in the financial industry and ensure financial market stability
• Objective 4: Strengthen Germany as a financial hub and expand expertise
• Objective 5: Establish the country as a role model for sustainable finance in the financial system

By setting these objectives, the German government has defined financial market stability to be an ‘inherent and central objective’ that is closely linked to fiscal, environmental, human rights and development policy. The German government thus considers it its obligation to support regulatory frameworks in environmental and climate protection or social sustainability requirements (human rights, poverty reduction, diversity) and to strengthen its contribution through subsidies or tax measures.

In turn, this agenda helps to strengthen Germany’s international attractiveness and competitiveness as a business hub by promoting the sustainable transformation of the economy and redefining the course for future viability. This is because shaping the economy with a sustainable blueprint not only promotes the rational handling and sensible allocation of the existing scarce resources, but also represents a competitive advantage that will increasingly become a unique selling point in the future. The sustainable finance strategy is the German government’s recognition of the supporting role that the financial sector plays and establishes the corresponding rules.

What do banks need to be prepared for? Corporate culture, business models and banking value creation put to the test

Structural changes trigger long-term changes and adjustments. The European and national regulations create a number of adjustment mechanisms, reporting and disclosure obligations and technical challenges for banks and financial service providers. Successfully implementing them requires a pragmatic and solution-oriented approach, as well as adequate consideration being given to the following challenges:

1. Banks need a clear and transparent sustainability strategy

Sustainability comes in many forms and exerts its influence at different levels of the banking value creation process. Getting a clear picture of how different aspects of sustainability affect a bank’s corporate culture and strategic orientation requires transparency and operationalisability. A defined picture creates the framework for implementing the necessary measures and meeting challenges, establishes an identity for employees and creates transparency for customers. A tailored sustainability roadmap provides the basis for long-term change and guidance in dealing with complex challenges.

Checkpoints

• Is sustainability an integral part of the bank’s strategy and corporate culture?
• Which sustainability trends have a direct impact on the future viability of the bank (customer expectations, sales, business model and so on)?
• What action is required as a result and how urgently does it need to be implemented (regulation, adaptation of processes, communication with customers and employees and so on)?
• What measures and resources does the bank have (projects, measures and so on)?
• What can be done to make employees identify and participate?

2. Banks need to integrate sustainability criteria into risk management and lending processes

The EU regulation and the related national legislative proposals aim to normalise ESG aspects in all areas of banking value creation and to integrate them into the investment and consultancy process. Complying with uniform requirements helps to identify environmentally sustainable economic activities that are developed and operationalised through delegated acts that also set out the technical evaluation criteria. Banks must therefore ensure that the requirements are applied when making lending and investment decisions. The legislator places different demands on risk management in this regard, implying a range of definitions, stress testing procedures, ESG risk assessments, the impacts of ESG risks on lending and so on.

Checkpoints:

• What adjustments need to be made in risk management for ESG compliance?
• Which sub-areas are responsible for implementation?
• Which measures and preparations are relevant for the implementation?
• How must processes, systems and employees be prepared?
• How will the technical implementation be carried out?

3. Banks have a reporting and disclosure obligation to the supervisory authority, which places extremely high demands on data quality and availability

The Taxonomy Regulation stipulates that credit institutions must report a number of new key figures as part of the transparency and disclosure requirements. These requirements are binding and will have a serious impact on the reporting to the supervisory authority. However, one challenge of the EU Disclosure Regulation lies in the complexity of its implementation – undefined legal terms as well as how they can be interpreted can cause difficulties for financial institutions in practice. It is therefore essential to derive clear, specific actions in line with the regulations. Preparing the data budget and ensuring data quality are the key conditions that need to be met. The technical adjustments to the reporting systems that ensure the Taxonomy Regulation is implemented correctly by the deadline must be made. The timeline below should provide a clear illustration of the reporting obligations to the supervisory authority.

Checkpoints:

• What adjustments and challenges will internal departments face (controlling, internal audit, reporting, compliance and so on)?
• How are the systems secured and the departments coordinated to ensure the reporting process goes smoothly?
• What data, information and systems need to be provided?
• What technological infrastructure is required for data quality, evaluation and reporting?

4. Banks must ensure that dynamic and increasing sustainability requirements are taken into account in the long term

In addition to the current ‘must haves’, banks must ensure that they are flexible enough to meet the dynamic requirements of the regulation and the market. It is obvious that the demands on banks will increase not only from the regulatory side, but from the customer and employee perspective, too. This requires an adaptable and flexible corporate culture that factors in the increasing aspects of the megatrend of sustainability as an integral part of its corporate decision-making and provides the frameworks to implement it. This ability requires dealing with different challenges:

• Ensuring the smooth, technical implementation of the EU taxonomy in the banks’ existing IT landscape
• Determining the individual contributions that a bank’s internal systems, processes and technical infrastructure make to sustainability (CO2 footprint) and making these transparent (audits, screenings and so on)
• Optimising the value contribution to sustainability in the entire bank value chain (service provision, processes, workplace design, resource efficiency, corporate culture and so on)
• Offering and providing sustainable financial products and investment opportunities as an integral part of product management
• Dynamically mapping sustainability requirements into the existing corporate culture

The issue of sustainability has a number of different aspects to it. As well as regulatory challenges, ecological goals and changing market and customer needs, it also implies a number of social elements that we in banking will also have to deal with. I will continue to discuss this topic in future blog posts.

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