Regulatory action will provide a major acceleration for defining material ESG factors, on its own a very positive development. The primary goal of integrating ESG risks into Pillar 3 disclosures is to improve data collection and transparency, starting with climate change. The ECB’s climate stress test is not designed to be a pass or fail exercise but it will feed into the Supervisory Review and Evaluation Process and potentially influence Pillar 2 requirements.

“The lack of readiness among banks for these initiatives could lead to soft regulatory actions,” said Nicolas Hardy, executive director in Scope’s financial institutions team. “Neither the EBA nor the ECB initiatives establish binding financial requirements for banks, such as minimum thresholds. Their main merit is to narrow down nebulous ESG concepts into specific quantitative metrics.”

On the basis of the quantitative metrics included in the ECB climate stress test and expanded Pillar 3 disclosures, some key takeaways have emerged. “Requiring banks to screen their balance-sheets and measure alignment with policy objectives has transformed them into policy tools to transform the economy,” Hardy said.

“Incentivising banks to lend to certain sectors i.e. the green sectors of the economy but limit their exposure to or even exit brown sectors is a form of directed lending, which is usually only seen with institutions with a declared policy role; not privately-owned commercial banks,” Hardy added. “In addition, requiring banks to screen their balance sheets to identify which clients or sectors are poorly aligned with policy objectives could give rise to evasion strategies.”

Reading through the multiplicity of EU initiatives to understand how they complement each other – or by contrast the extent to which they focus on different goals, scopes or involve different stakeholders according to different timelines – is complex.

And finally, there are limitations for credit analysis and peer benchmarking in using the frameworks of the two initiatives. One is the partial risk coverage and in particular the limited scope in terms of banks’ balance-sheet coverage. The focus of Pillar 3 disclosures is mainly on banking books. Sovereign exposures are excluded and it only applies to the largest listed EU banks. Also, the current focus is on climate change, only one of the components of ESG. The use of proxies or the possibility to opt for different approaches to produce risk indicators is another limiting factor. If data is overly aggregated, transparency will be impaired.

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