Managing risks related to the environment and climate change is a priority for the entire financial sector.
Consequently, authorities – primarily European – and the industry have long been working in different areas, such as the definition of capital requirements to cover potential losses in bank balance sheets arising from environmental disasters (physical risks) or as a consequence of the impact that certain public policies could have on the payment capacity of banking clients (transition risks); or the establishment of new supervisory reporting, public disclosure, or entity governance requirements.
This regulatory package, which has come to be known in Europe as ‘sustainable finance’, is characterized by the ambition of the reforms to be carried out. To date, the main focus has been on public disclosure obligations.
In the coming weeks, European banks of a certain size, including a large number of Spanish credit institutions, will publish for the first time the Green Asset Ratio (GAR), which expresses the percentage of banking assets that are ‘green’ in nature, i.e., the ratio of their assets considered green according to the European taxonomy divided by the total assets of the consolidated balance sheet.
Any public disclosure initiative related to the efforts made by the financial sector to ensure an orderly transition to a more sustainable economy is welcome for the transparency it provides. However, there is a consensus among many stakeholders in the financial system that the GAR does not accurately represent the efforts made by banks in terms of sustainability and has certain methodological limitations. This leads to the recommendation that it be used with some caution and not as the sole indicator of entities’ progress in this area, among other reasons, for the following:
Firstly, this metric will only show a small part of entities’ efforts to finance the transition to a more environmentally friendly economy, as this ratio only refers to activities covered by the European taxonomy, excluding other activities that have not been considered by the framework but are not necessarily harmful to the environment. That is, it does not allow for reflecting the efforts dedicated to financing the transition of some sectors, even if these are projects focused on sustainability.
Therefore, a bank may be making significant progress by helping its clients in highly polluting sectors reduce their negative environmental impact, and in most cases, this financing will not be reflected in the GAR because these activities are not yet completely green. This is acknowledged by the authorities themselves, such as the European Banking Authority (EBA), which explains that the taxonomy criteria are very strict and do not consider a large volume of activities that contribute to the economy’s transition.
It is important that the banking sector not only finances activities that can already be considered aligned with the EU taxonomy but also – and very importantly – finances activities that can support the transition of companies.
Secondly, there are structural flaws in the ratio, mainly materializing in the asymmetry of numerator and denominator criteria, which makes it difficult to compare across entities.
This problem primarily, though not exclusively, focuses on financing for companies outside the EU, SMEs (which do not report on how ‘green’ their activities are), and activities not covered by the taxonomy, which do not count in the numerator but do in the denominator. Consequently, entities with business models focused on financing these activities will predictably have a lower ratio and, therefore, will be penalized. This means that the GAR value will vary depending on the business model, balance sheet composition, client base, and geographical location.
Finally, there is a lack of taxonomy alignment criteria that would ensure homogeneous implementation among banks and facilitate comparability between entities’ GARs.
Given all the above, it is to be expected that, in addition to the percentages provided by banks not being comparable, they will be low, as they will be largely conditioned by these limitations.
Any analysis that exclusively considers this type of metric, without considering deeper analyses of additional metrics, could lead to erroneous conclusions about the efforts made by banks in their credit portfolio decarbonization processes.
Given the methodological limitations of the GAR and the practical problems of its use, the European Commission’s planned review of this ratio in 2024 is welcome, and the banking sector will actively contribute to the debate to improve the ratio’s usefulness, in order to ensure the transparency of the active role that entities are playing in financing the economy’s transition towards decarbonized models. Because, without a doubt, the economy’s transition must be at the forefront of the political agenda.
Pedro Cadarso, Advisor to the Spanish Banking Association
