The attention of financial regulators on environmental, social and governance factors is significantly and rapidly increasing. A proper integration of ESG features in the business model of financial and non-financial entities and institutions is crucial for a sustainable economic growth in light of the existing environmental challenges.
The Bank of Italy, in line with the EBA, ESMA and EIB recommendations and in accordance with the EU regulatory rules on integration of ESG factors within corporate governance, has introduced certain specific non-financial and ESG-related disclosure requirements for investment firms and credit institutions.
Environmental, Social and Governance Factors
Environmental, Social and Governance are the three main pillars of sustainability as core value and business trend. According to the European Banking Authority (EBA), "ESG factors are environmental, social or governance characteristics that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual".
The rise of this new trend and the subsequent initiatives adopted at the international level, expose the entire financial sector to new risks (and opportunities), as ESG factors could impact financial institutions' performances and solvency ratios by affecting them directly or indirectly through their counterparties.
In this context, non-financial disclosure is steadily representing a key source of information for different categories of stakeholders, such as investors and market participants, who intend to redirect capital to more sustainable investments and need to understand the relevant risks, opportunities and impacts of their investment on people and the environment.
As far as banks and financial institutions are concerned, disclosure of ESG factors is a vital tool for market discipline allowing stakeholders to assess banks' and financial institutions' environmental risks and their sustainable finance strategy. Many stakeholders have a legitimate interest in the physical risks (i.e. risks related to the physical impacts of climate change) and transition risks (i.e. risks related to the transition to a lower-carbon economy) that banks are exposed to from climate change. They also want to understand a bank's strategy in financing the transition to a zero carbon economy.
EBA and ESMA recommendations on integration of ESG factors in the supervisory process
In June 2021, EBA published its Report on management and supervision of ESG risks for credit institutions and investment firms (the "Report"), whereby the EBA provides common definitions of ESG risks and their transmission channels and identifies evaluation methods that are needed for effective risk management. In such Report, EBA recommends credit institutions and investment firms on how to integrate ESG risks into business strategies, governance and risk management. EBA's recommendations focus also on how to manage ESG risks as drivers of financial risks in the internal capital allocation process of financial institutions Such risks shall indeed be integrated in their plans and objectives as well as in their governance structures. The Report is also focused on methodologies and techniques to evaluate institutions' long-term resilience to ESG factors and risks, reinforcing once more the increasing interest of institutions to such new field.
The Report suggests a phase-in approach, substantially starting from including climate-related and environmental factors and risks in the supervisory business model and internal governance analysis, on one side, whilst collecting data and developing new tools for a deeper analysis in the supervisory activity of ESG factors and risks, on the other side.
In July 2022, the European Securities and Markets Authority (ESMA) published the so-called Guidelines on common procedures and methodologies for the supervisory review and evaluation process ("SREP") under the Investment Firms Directive ("IFD"), which includes a description of the process and criteria for the assessment of the main SREP elements such as business model, governance arrangements and firm-wide controls, risks to capital and capital adequacy as well as liquidity risk and adequacy.
In this context, in October 2022, EBA published the Report on the integration of ESG risks in the supervision of investment firms (the "2022 Report"). The 2022 Report provides an initial assessment of how ESG factors and ESG risks could be included and harmonised in the supervisory assessment of investment firms. This 2022 Report sets out the key terms for integrating ESG risks-related considerations in the supervisory process of investment firms and covers the main SREP elements including: (i) business model analysis, (ii) assessment of internal governance and risk management, and (iii) assessment of risks (risk to capital and liquidity risk).
A key term of the 2022 Report is "Proportionality", a term which emphasizes the need to implement ESG considerations in a proportionate manner when the ESG elements and hazards potentially affect the risk profile of an investment firm.
EBA recommends that the integration of ESG factors in the supervisory process could take a gradual approach, prioritizing the recognition of ESG risks in investment firms' strategies, governance arrangements and internal processes, and incorporating such risks at a later stage in the assessments of risks to capital and liquidity. While this approach proves the current limitations related to data and methodologies of ESG risks assessment, it also suggests a stricter focus (and support) of relevant authorities on future developments in the data and methodology that will allow investment businesses to analyse and manage ESG risks more precisely.
On April 12, 2023, further to the request by the EU Commission for the European Supervisory Authorities (the "ESAs", i.e., EBA, EIOPA and ESMA) to review the indicators in the Sustainable Finance Disclosure Regulation ("SFDR") for principal adverse impact (PAI) and financial product disclosures, the ESAs published a consultation paper in which they announced a series of proposed amendments aimed at extending and simplifying the SFDR scope. Proposals include:
- adding information disclosure on the decarbonization targets of financial products, including intermediate targets, the level of ambition and how the target will be achieved;
- extending the list of universal social indicators for the disclosure of the principal adverse impacts of investment decisions on the environment and society, such as earnings from non-cooperative tax jurisdictions or interference in the formation of trade unions;
- refining the content of other indicators for adverse impacts and their respective definitions, applicable methodologies and calculations as well as the presentation of the share of information derived directly from investee companies, sovereigns, supranationals or real estate assets;
- including a dashboard providing information about products' sustainable and taxonomy-aligned investments and improving disclosure on how sustainable investments "do not significantly harm" the environment and society;
- simplifying pre-contractual and periodic disclosure templates for financial products; and
- making other technical adjustments concerning, among others, the treatment of derivatives, the definition of equivalent information and provisions for financial products with underlying investment options.
The ESAs have opened a consultation period - which will last until July 4, 2023 - during which individuals, financial institutions, regulated markets, consultants and other interest persons may submit comments on the new proposals and, also to this end, ESAs will organize a joint public hearing and targeted consumer testing. At the end of the consultation period, and after considering the comments received, the ESAs will submit the final report to the European Commission.
The Bank of Italy initiatives on ESG disclosure and supervision
The Bank of Italy has provided a significant contribution to global ESG disclosure initiatives. In 2021, it took part in the Financial Stability Board's working group to create a worldwide minimum standard for disclosures on financial risks related to climate change in partnership with the Minister of Economy and Finance. This was part of a larger initiative promoted by the Bank of Italy to put sustainable finance at the forefront of the global agenda, which also included re-establishing and upgrading the Sustainable Finance Study Group to a working group within the G20 Finance Track.
In April 2022, the Bank of Italy published the so called "Supervisory Expectations on Climate and Environmental Risks". These "expectations" are not legally binding and are merely guidelines on how the Bank of Italy expects banking and financial institutions to handle climate and environmental risks in their risk management framework.
In particular, the financial institutions should integrate climate and environmental risks in their corporate strategies, governance and control systems, risk management frameworks, and disclosure obligations on supervised banking and financial intermediaries. The Bank of Italy reserved the right to supplement and develop the set of expectations to take into account the best practices and the evolution of the regulatory framework, possibly extending it to social and governance issues.
Depending on the type, size, and complexity of its organization, each institution is asked to conduct its own evaluation and implement the solutions that are most suitable with their exposure to climate risk.
The Bank of Italy is encouraging a dialogue within the Italian financial industry as part of a larger initiative to support the financial sector to move toward sustainable finance. This dialogue will help monitoring and assessing how prepared the system is for upcoming regulatory requirements on ESG disclosure and, more broadly, how well it aligns with the supervisory expectations that were released in April 2022. Even if there are still a wide range of differences among banks, the Italian Less Significant Institutions (LSIs)1 have made a significant effort to effectively implement new disclosure standards, which may help in the context of the standardisation process of information disclosure.
In the context of a sample analysis conducted by the Bank of Italy on certain LSIs, certain institutions have been requested to carry out evaluations on the relevance of ESG factors for the purpose of their business and, consequently, to provide possible solutions which should be consistent with the relevant level of exposure to such risks.
Such analysis shows that, on the one hand, there was historically a poor alignment among institutions in managing and dealing with such risks, whilst pointing out, on the other hand, that the institutions are becoming more aware of the sustainability importance in their business. Again, as outlined above, the availability of data and information systems capable of managing and processing information efficiently remains one of the main issues to date.
In this respect, the current status can be briefly summarised in (i) the absence of reliable quantitative methods for assessing climate risks; and (ii) the poor organisation of risk management procedures, noting that the quantitative indicators (such as key risk indicators (KRIs) and key performance indicators (KPIs)) are still not frequently applied.
As a consequence, the main challenge for improving the ESG risks management by banks and financial institutions should be: (i) improving the ESG disclosure and relevant information to be provided; (ii) strengthening the resilience of banking sector; and (iii) a proper assessment and analysis on how ESG factors may affect banking activities.
To this end, and in the context of a wider policy aimed at integrating ESG factors in its supervision activity, the Bank of Italy changed its governance rules last year, providing for the first time a minimum quota for the presence of the least represented gender in the bank's board. In the same context, the Bank of Italy has informed the European Banking Authority (EBA) of its intention to comply with the EBA Guidelines 2022/06, 2022/07, and 2022/08 on the collection and processing of information on remuneration systems of banks and investment firms. By doing so, the Bank of Italy has committed to gathering information on high earners in banks and firms, conducting a survey for benchmarking purposes on remuneration trends and practices and to disclose the gender pay gap on said sample of banks.
Which opportunities are next for the Italian financial system
Where the benefit for a bank resulting from the initial setting of a financing transaction as "sustainable" was intended to be primarily reputational, as of today the inclusion of a green or sustainability-related credit in its portfolio is no longer to be considered in merely reputational terms, but also takes on its own value from a risk assessment (and, possibly, capital allocation) and supervisory reporting perspectives.
Thus, banks will play an essential role in facilitating the reallocation of financial resources needed to support the transition to more sustainable economies. Intermediaries that are quickest to properly integrate ESG factors into their investment processes, lending decisions, and dialogue with customers will be able to accrue a competitive advantage in seizing the opportunities offered by the transition in terms of growth in high-quality lending, expansion of customer services, and effective management of ESG risk factors. Conversely, those that will fall behind, in addition to being penalized in their market positioning, may find it difficult to govern the evolution of their portfolio quality, ultimately finding themselves more exposed to ESG risks.
1 According to the definition provided by the European Central Bank, the LSIs are small and medium-sized banks that are directly supervised by their national competent authorities, under the oversight of the ECB. In particular, supervised entities become significant – and therefore fall under the ECB's direct supervision – only if they fulfil at least one of the criteria set out in the Single Supervisory Mechanism (SSM) Regulation, otherwise they are considered as being LSIs. The significance criteria relate to, among other things, a bank’s size, its importance to the economy of its home country or the EU as a whole, and the significance of its cross-border activities. Most LSIs are smaller banks whose assets do not exceed €30 billion.
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