Under the draft Capital Requirements Directive VI (the Draft), European credit institutions will be required to prepare and update annually ‘carbon transition plans’. Although the Draft mandates the European Banking Authority (EBA) to flesh out their content in guidelines, we have attempted in this post to identify their main expected features ahead of further information from the regulator.

Conceptually, banks will be required to define, on a consolidated basis, their targets for the carbon intensity of their activities in a manner that is at least aligned to the targets under the 2015 Paris Agreement. These targets will be complemented by the actions that banks will be expected to implement to achieve them, and by the policies, procedures and infrastructure required to gather and manage the large amount of data that is required for the calculation of each target. The plans are expected to be risk-based, and therefore, banks will need to test their targets against different scenarios, including where decarbonisation needs may become more acute. The plans will be reviewed by banks national prudential authorities who may provide feedback to the bank and may integrate the assessment of the soundness of the carbon transition plans into their regular supervisory assessment.

We are aware that the Draft is still at a very nascent stage, but there are already some questions that should be addressed and clarified as soon as possible. We would like to open the discussion on at least three: (i) target setting, (ii) data availability, and (iii) the role in the broader supervisory framework.

Target setting

A pertinent question is: what key issues should inform a bank’s decision when determining its targets for carbon reduction? A domestic bank may have a bank-neutral strategy in line with the National Determined Contributions (NDCs, as set out under the Paris Agreement) as they apply to the jurisdiction in which it is situated and, therefore, may be using the carbon targets, including intermediate ones, to inform its own decarbonisation targets. Nonetheless, a bank may be more ambitious than its country, and, therefore, may want to build up its carbon net neutrality (or even negative contribution) in an accelerated way. Should this be acceptable? Banks with more ambitious carbon transition plans will undoubtedly accelerate the ‘greening’ of their borrowers’ activities but may also increase transition risks for the rest of the economy. This would be particularly the case if this muted appetite for transition risks becomes commonplace across the banking sector. What should prevail?

Target-setting is also likely to be challenging for other reasons. First, how the setting of targets is to be carried out. Consistently with the time horizon of climate change, banks will be required to set decarbonisation targets for the short, but especially the medium and long, term (but, as it is a well-known, the longer the projection period, the less accurate the targets become). Second, how banks should approach the target setting is not completely clear. Even when the targets follow a top-down approach, their credibility will force banks to cascade those targets down to specific portfolios and industries, and ultimately, to the customer level. Third, banks should break down their targets on a country-by-country basis if they engage in cross-border banking activities, as the level of ambition can significantly vary across countries. Fourth, , setting targets by scope, at least at the first stage, can help address data availability problems regarding scope 3 emissions (those for which entities are indirectly, rather than directly, responsible).

Data availability

Looking at this further, one of the biggest problems is the lack of sufficient data to support the credibility of the targets and the actions arising from them. It is well known that current data is still quite limited. Among other aspects, not all companies are required to disclose their own emissions data. Second, banks are progressively migrating from emissions data based on financial indicators (financial proxies) to such data based on physical activities (and these two approaches may not result in fully comparable results). Third, data on the scope 3 emissions of banks’ clients is increasingly being retrieved, affecting the calculations of banks. In addition, banks operating in different jurisdictions can face additional difficulties, given less data is available in non-EU countries. Finally, the use of different proxy mechanisms is likely to result in the low comparability of emissions information across the banking sector.

One key part of the carbon transition should be the decarbonisation measures and actions  that banks intend to adopt to achieve their targets. The changes to banks’ credit underwriting standards and credit risk appetites should ensure that the carbon intensity of their loan portfolios is gradually reduced. But decarbonisation measures will also affect the carbon intensity of banks’ own economic activities (for example, improvements in the energy efficiency of their own buildings, business travel, migration towards less carbon-intensive data-processing capabilities). Last but not least, banks may also engage in transactions that can capture carbon emissions, either by financing the acquisition of new technologies that facilitate carbon capture or by using available carbon sinks (for example, tree-planting).

Role of the broader supervisory framework

A final question concerns the role of national regulatory supervisors when assessing banks’ carbon transition plans. A truly risk-based approach should focus on assessing how banks manage their transition risks stemming from climate change. In particular, this may involve ascertaining the risk management actions taken by banks. Moreover, as these plans should flesh out the targets and actions to mitigate transition risks, they may become a key input for regulators to understand banks’ exposure to, and management of, climate risks.