Since the 2015 Paris Agreement recognised the role of capital flows in climate change mitigation, EU regulations have sought to harness finance to achieve climate neutrality by 2050. New laws inter alia created a common framework for defining sustainable activities (“Green Taxonomy”) and introduced dedicated treatment of ESG (environment, social, governance) issues qua risks. In this context, physical and transition risks are two channels used by regulators to make banks “see” climate change issues. The latter risk type is puzzlingly broad and encompasses all societal change (policy, consumer preferences, technology) conceivable in the context of transition to climate neutrality. To better understand transition risk, the blog post traces the definitions and uses of the concept across several recent EU legal initiatives, such as the European Commission’s 2021 Banking Package. I show how in EU law “transition risk” blurs the line between public and private transition, making banks internalize the climate neutrality policy objectives. Whereas risk governance is an established banking regulation technique, the concept of transition risk is novel given the transformative role it plays in expanding the time horizon of business decisions and organising uncertainty around the socioeconomic “net zero” transformation.
Defining transition risk in the EU
EU Member States have decided on a number of common goals relating to the future sustainability of European economies. The EU’s 2021 Climate Law makes the objective of climate neutrality binding on EU institutions and Member States. Practically, this requires a series of policy, consumer and technological transformations, collectively referred to as “transition”, “transition to a carbon-neutral economy” or “transition of business activities and sectors to an environmentally sustainable economy”. The all-encompassing concept of “transition” is used across various EU pieces of legislation to clarify how various reforms, relating to energy efficiency or renewable energies for example, serve “fair transition towards a climate-neutral Union by 2050”, “energy transition”, “clean transition” or “green transition.” It is only in the context of EU’s financial regulation, or European Commission’s “Financing the Transition to Sustainable Economy” strategy, that transition is becoming directly relevant for regulatory purposes as “transition risk.”
Transition risk relates to the possible financial impact on the financial institutions’ balance sheets of an array of policy, technological and societal (behavioural) changes materialising in the context of climate change mitigation, and transition to an environmentally sustainable economy more broadly. The 2021 Banking Package, revising EU’s capital requirements rules (so-called CRR3 and CRD6), proposes the following definition: “as part of the overall environmental risk, [transition risk] means the risk of losses arising from any negative financial impact on the institution stemming from the current or prospective impacts of the transition of business activities and sectors to an environmentally sustainable economy on the institution’s counterparties or invested assets” (art. 4(1)(52g) CRR3 proposal).
Though transition risk bears some resemblance to known categories of operational risks (e.g. regulatory or legal risks), there is something quite different about it. Three features make transition risk stand out among other categories of risk already incorporated into the EU’s bank risk governance framework. First, transition risk is anchored in a goal of a “net zero” sustainable future. This means that while it is feasible to envisage viable transition risk mitigation techniques such as diversification of exposures or appropriate reserves, the optimal risk mitigation technique will reside in ensuring timely achievement of the climate neutrality objective. Second, a related feature concerns the “double materiality” aspect of transition risk for financial institutions: in order to properly address transition risk, a bank should take into account how its lending decisions affect the real economy transition (inside-out perspective), not just any specific risk they may be exposed to as a result of climate change (outside-in perspective). Third, while transition risk is contingent on actual policy being implemented, it is ultimately defined by reference to the explicit policy objectives (e.g. climate neutrality), in this way effectively shoring up the credibility of such pledges.
Uses of transition risk in EU law
Incorporating the idea of “transition” into a primarily financial risk-based framework represents an attempt to make financial institutions internalise the long-term public policy goals and, in this way, drive banks’ and the real economy firms’ alignment with a net zero future. EU prudential framework for banks does this in two ways: (a) by introducing transition risk disclosures and a dedicated supervisory treatment and (b) by introducing a requirement that banks manage the long-term risk of misalignment with EU’s transition pathway.
Already the 2019 CRR2 introduced a requirement that banks disclose information on the transition risks they face (art. 449a CRR) with draft Implementing Technical Standards (ITS) published by EBA in January 2022 and due to be adopted by the European Commission. Such transition risk-related bank disclosures include – in EBA’s draft ITS – metrics covering energy efficiency of mortgages, scope 1, 2 and 3 GHG emissions as well as alignment with ‘net zero’ 2050 goals of exposures to highly-polluting sectors. The next step is introducing appropriate assessment of transition risk management by the supervisors as part of the Supervisory Review and Evaluation Process (SREP). The ECB has already assessed how banks should monitor and address transition risks across their portfolios to satisfy supervisory expectations as part of its 2020 Guide on climate-related and environmental risks. Transition risk serves here equally to introduce considerations such as carbon emission footprint of assets or the energy label of mortgage portfolios into the banks’ material risk assessment.
Furthermore, in the 2021 Banking Package, the European Commission proposed to introduce a dedicated prudential transition plan requirement for banks. This builds on the Corporate Sustainability Reporting Directive (CSRD) which will mandate firms to disclose how they intend “to ensure that its business model and strategy are compatible with the transition to a sustainable economy and with the limiting of global warming to 1.5 °C in line with the Paris Agreement” (art. 19a(2)(a)(iii) CSRD) as a way to steer corporate strategies in a sustainable direction “from within”. To ensure such forward-looking plans fall squarely within the remit of prudential supervisors, CRD6 requires that banks actively plan to reduce their misalignment with a transition “towards a sustainable economy in relation to environmental, social and governance factors” (art. 76(2) proposed CRD6). Since transition risk can only be addressed by real economy firms, the bulk of the banks’ work in mitigating this risk will reside in ensuring their real economy counterparties align with the climate neutrality goals.
Transition risk: shoring up enforcement of climate neutrality goals?
While risk governance is at the heart of prudential regulation, the definition and uses of “transition risk” in EU law do something quite novel in terms of making banks internalise the policy, technological and consumer behaviour changes in the service of climate neutrality in a forward-looking and long-term goal way. Transition risk mitigation is as much about steering the strategy of banks – and their counterparties – in a sustainable direction as it is about effectively mitigating financial risk to banks’ balance sheets. Regulatory requirements work here as “connectors” between the different logics and spheres of human life and serve a transformative function. Rather than discounting the future, transition risk brings valid future concerns into the calculations of financial institutions today, requiring decisions having real economy impact in the present.
The use and instrumentalization of the concept of “transition risk” also serves the function of organizing the uncertainty of the economic transformation. This blurring of the private and the public transition perspective – as Avner Offer argues in a recent book – is a necessary function of government. Using regulatory tools to make financial institutions internalize the current and (expected) future trajectory of net zero policies may facilitate the timely implementation of climate policy objectives. The necessary policy guidance on how banks should think about the future, as we argue in a recent paper with Jens van ‘t Klooster, presents however new challenges of legitimacy and democratic credentials of depoliticised and technocratic modes of enforcement of climate policy goals via the banking system.
Financial regulation has over time often been the site of regulatory experimentation. The dynamic nature of the financial system and the (often) destabilising nature of financial innovation, has given rise to a plethora of regulatory concepts: such as different notions of flexible and responsive regulation explored by Cristie Ford or John Armour’s forward-looking compliance. We should therefore not be surprised at the emergence of new regulatory concepts to align the existing market practices with the overarching goal of EU’s socioeconomic transformation toward sustainability. Leveraging the infrastructural centrality of the financial sector through the concept of “transition risk” also appears to be a smart choice in terms of the role it may play in ensuring real economy transformation and – arguably – as a useful back-up option in case sufficiently “transformative” policy decisions are not implemented by Member States. A tall order for a concept originating from the EU’s banking prudential framework. Nevertheless, the transformative potential of transition risk management as an enforcement mechanism for the EU’s Green Deal operating by making firms internalise the relevant public policy goals is certainly a development EU legal scholars should follow.
(Photo: Viktor Forgacs)