ESG lending: what banks need to do in 2024
Are you stuck in a nightmare of acronyms, trying to decipher what’s coming down the road for your bank in the sustainable finance space? Whether it’s ESRS, SDR or GAR we have summarized some of the key implications of ESG regulations for banks operating across Europe in 2024.
You may rightly be asking, how relevant is sustainable finance in the current uncertain economic climate? Well, all of the top 10 lending banks in Europe have a key strategic pillar for ESG or sustainability, which should provide the answer for you. Strategy is of course vital to steer the ship; however, the real challenge is applying and achieving these goals in what is a fast-moving and relatively new area of finance. The guidance around how to handle ESG business has developed just as quickly as the level of demand for sustainable finance – according to Environmental Finance the volumes of sustainable loans exceeded $860 billion for the 12 months to the end of Q1 2023, with more than 80% in a sustainability-linked loan (SLL) format.
Disclosure, reporting & taxonomy changes
Research compiled by ESG Book shows that ESG regulation has increased by 155% over the past decade and 2024 certainly won’t buck that trend.
- ESRS - All large companies in the EU will need to provide sustainability reporting under the European Sustainability Reporting Standards (ESRS) by the end of 2024. This requires companies to provide more detailed, granular data about their business’s impact on sustainability. Key concepts include the double materiality approach (both financial and impact-led) and reporting across a much broader scope with consideration to their entire business value chain. This is all framed within models such as the circular economy to ensure that due regard is given to all elements within the end-to-end business cycle. For most companies to implement this reporting, it will require a significant strategic planning exercise, particularly focusing on the people and the resource requirements they use. The European Central Bank views this reporting change as highly impactful in terms of aiding credit providers with higher quality data to help them manage and identify key risks under their regulatory obligations. The banks that adopt and adapt to use these new data points effectively will see multi-faceted benefits in the long-term, while simultaneously highlighting their commitment to sustainable progress via a multi-stakeholder approach.
- SDR - In the UK, the FCA is introducing a new regime in 2024: Sustainability Disclosure Requirements (SDR). The aim of this regime is clear and refreshingly simple: ‘financial products that are marketed as sustainable should do as they claim and have the evidence to back it up’. The anti-greenwashing rule applies to all FCA-authorised firms who make sustainability-related claims about their products and services. This means it is going to be applicable to the majority of UK banks who offer a varying range of sustainability-related products and services; whether in the corporate or retail space. The anti-greenwashing rule is due to come in to force on 31 May 2024; so, in a similar vein to the ESRS rules, it will be the early adopters who will benefit from this most of all – particularly in nurturing their important working relationships with the FCA. These new rules again point us in the direction of an overriding trend of the industry, which is the high quality and expanding breadth of granular data that is required to evidence the appropriateness of their sustainable marketing claims. UK banks need to be able to accurately define, record and store this data in order to satisfy these requirements. However, this should not just be seen as an appeasement to the latest set of rules, as using this new data effectively is going to be invaluable in the long-run for banks. In practical terms, this means feeding wider data lakes to build up a repository of information that can be used across the bank in areas such as credit risk assessment, pricing and covenant monitoring – I will touch on these topics later in this article.
- Taxonomy - For European banks, it has been imperative to report accurately under taxonomy-aligned objectives since 2022, and the reporting focus is now developing towards the provision of key transparency metrics such as the Green Asset Ratio (GAR) (in essence what proportion of the overall lending balance sheet is taxonomy-aligned). This is due to become mandatory from January 2024 onwards. Regulators and supervisory bodies will scrutinize these KPIs more than ever before, particularly with the expectation that banks are to underpin the transition towards a more sustainable economy. The European Banking Authority (EBA) issued a report in May 2021 estimating an average GAR of below 10% across 29 banks, which perhaps won’t surprise readers given that the concept of sustainable finance is still in its relative infancy compared to traditional banking. According to McKinsey, there is a global annual average spending need of $9.2 trillion on physical assets to aid the transition to Net Zero by 2050. Therefore, it is widely expected that the GAR for banks should increase consistently as the pressure to sustainably transition worldwide ever increases. GAR is the headline act of the new transparency KPIs, but it is just one of many that are being implemented. EU banks will be required to be well-structured to handle this market expansion, from front to back and right across the full end-to-end lending process. Everything is in scope, from risk policies to origination to back-office reporting. Ultimately, these rules cover a number of overlapping concepts from both the ESRS and SDR changes, and with the same end goal – to make the market more transparent and reliable, and encouraging market investment.
What implications does this have for European banks in 2024?
- Data, Data, Data – Underpinning a lot of these new regulations, and as a key trend across the banking industry generally, data is arguably the foremost driver of action. As we’ve seen in every new proposed change for 2024 so far, the onus is now very much on collecting, monitoring and assessing the new data points to drive factual-based decision making within the banks. In the current era where the ‘FAANG’ companies (Facebook – now Meta – Apple, Amazon, Netflix and Google – now part of Alphabet) continue to dominate the US stock market, the future value of data is clearly more cherished by investors than reliable, long-term cashflows. Banks hold vast amounts of data and utilizing it effectively is not only vital for the daily operations of the organization but also as a future store of value that will ensure long-term success.
- Risk frameworks – There is now a clear expectation that European banks will have a well-defined sustainable product and services suite to offer to clients who are looking to invest in their business as part of the transition to a more sustainable economy. The EBA guidelines around credit risk management are especially interesting as they emphasize incorporating climate change risk as a core element of the overall risk profile of customers. This features a wider range of considerations for the businesses that banks are lending to, including physical risks and transition risks. Longer term, it may also include potential future liability risks through customers adding negatively to the climate change problem. There are numerous innovative ideas on how to incorporate this new ESG data into the risk algorithms and, for many European and UK banks, it will be an ongoing challenge to adopt best practice in this new area.
- Customer engagement – Put simply, down to the individual customer level, there needs to be continuous engagement about their sustainability transition plans. At its most rudimentary level, this is an important risk management exercise for both the customer and the bank as the move towards carbon neutrality gathers pace. Relationship managers are always looking for the best way to add value for their clients and perhaps this active engagement and education on a topic that can be incredibly complex is an excellent way to foster these relationships further. As would be expected, the provision of appropriate finance solutions will remain as the cornerstone of the bank-customer relationship and ensuring that the bank’s sustainable product suite is relevant in the current market is critical. Whether this is sustainability-linked-loans, green bonds or sustainable trade finance; as customer demands change, new products will emerge, and the most successful banks will be those that are nimble in their approach to these developments.
- Marketing – The market messaging around sustainable finance is of great importance - if potential customers aren’t aware of the possibilities, then adoption will be further hampered. The UK SDR rules are just the start of making choices clearer for customers and fostering market trust through transparency. The accurate marketing of sustainable and ESG finance products feeds into many of the key themes for 2024, including growing the GAR, and businesses obtaining funding for their new strategic plans following their ESRS reviews. The dissemination of product information needs to be approached with caution, of course. Supplying appropriate and clear material is crucial to avoid the potential reputational risks of being accused of ‘greenwashing’.
- Employee advocacy – In line with customer awareness of sustainable financing, banks also have an obligation to inform and train their employees. If bank staff haven’t been provided with adequate education on the ESG-related options available to their customers, then naturally their ability to provide an appropriate sustainable financing option is hindered. Governance is also a key theme running throughout and this is an area that could be developed with regards to employee pay decisions. Perhaps linking a sustainability or ESG-related objective as part of the ‘balanced scorecard’ approach to measuring employee performance would be one way of highlighting a bank’s commitment to leading the transition.
Finastra places the principles of Environment, Social & Governance (ESG) and our business mantra of ‘doing well by doing good’ at the heart of our OPEN and inclusive culture. Our corporate purpose is to orchestrate the sustainable financial empowerment of every single person on the planet through the collaborative power of our technology, diverse talent and ecosystem.
This strategic approach and vision for ESG was formed at the inception of Finastra through our corporate social responsibility (CSR) strategy, which we launched in 2018. Our dedicated ESG team, which includes many members of our Executive Leadership Team, recognize the role all of our stakeholders play in the pursuit of our objectives to improve the wellbeing of our employees, customers, partners, society and the environment in which we operate.
With our CSR foundations and ESG framework and ambition we have created a platform for positive social and environmental impact through philanthropy, education, job creation, economic growth and innovation.
We would be delighted to discuss your strategic sustainable plans with you in greater detail. Please reach out to your Finastra account representative or contact us.
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