financial risks posed by climate change:
information gaps and transition plans
Speech by Paolo Angelini
Deputy Governor of the Bank of Italy
Associazione nazionale per lo studio dei problemi del credito
Milan, 15 November 2022
1. Introduction
The consequences of climate change affect the financial system in several ways. The
materialisation of the related risks - physical and transitional - can cause damage to
buildings and companies, and the obsolescence of entire production chains. The
potential negative effects on the stability of individual intermediaries and of the financial
system are the main reason why central banks and supervisory authorities have long
included environmental sustainability in their work programmes.1 Furthermore, ensuring
the adequate management of these risks is instrumental to allocate the resources for the
transition towards a sustainable economy.
Awareness of the importance of climate-related and environmental risks is growing
among the banks in the Single Supervisory Mechanism (SSM); all significant banks have
begun to consider how to integrate these risks into their activities. The progresses of the
works are heterogeneous. While no bank is fully in line with the ECB's expectations on this
matter,2 progress is ongoing on several fronts. Banks have so far mainly worked on data
collection and exercises to assess transition risks. Physical risk management practices
instead are generally less advanced. Only few intermediaries have started to consider
other environmental risks, such as biodiversity loss and pollution. Overall, Italian banks
seem to be moving in step with those of other European countries.3
In my remarks I will briefly survey some key elements of the legal and regulatory
The
framework on ESG practices and risks which have a bearing on intermediaries and
non-financial firms. I will argue that excessive reliance on sectoral sustainability data by
lenders (banks and investors) can lead to incorrect allocation of finance, to the detriment
of the overall transition process. Intermediaries and companies should join forces to
assemble data at the individual company level. This appears particularly necessary and
urgent in Italy, given the comparatively high share of small businesses that will not be
subject to sustainability reporting obligations. I will then focus on transition plans. In
short, a transition plan is a detailed description of actions that a company commits to
implement over a multi-year horizon, in order to comply with a given environmental
objective, for example that of the Paris Agreement. The SSM encourages banks
to adopt transition plans. I will argue that overreliance on the thrust that financial
intermediaries (banks and institutional investors) can give to the transition process
should be avoided, and that transition plans of non-financial corporations should be a
key point of attention. Finally, I will argue that it is essential to clarify the relationship
between the investors' traditional objectives, typically expressed in terms of risk and
return, and the environmental objectives defined in the transition plans. The potential
conflict between the two might become a serious obstacle to the contribution that the
financial system can provide in the fight against climate change.
2. Regulatory initiatives to improve climate risk reporting
The regulation of environmental, social and governance (ESG) risks of financial and
non-financial companies is still in the making. At the European level, this work is at
an advanced stage, especially in comparison with the other main jurisdictions. In what
follows I will focus on some important measures, without claiming to be complete.
The Corporate Sustainability Reporting Directive (CSRD), first published by the European
Commission in April 2021, is due to enter into force on 1st January 2024. Starting on
that date all companies, both financial and non-financial, that fall within the scope of
the directive (essentially large companies and, from 2026, listed SMEs) have to prepare
a non-financial statement (NFS) according to the sustainability standards set by the
European Financial Reporting Advisory Group (EFRAG).4
The CSRD expands significantly the pool of companies subject to regulation and
introduces much more detailed reporting requirements than those prescribed by the
Non-Financial Reporting Directive (NFRD) currently in force. Banks will be affected by
these changes both as users of better information on client companies and, in case they
are also subject to the new directive, as providers of more accurate information on their
own risks.
A second important element is the proposal of the Corporate Sustainability Due
Diligence Directive (CSDDD). This directive will introduce the obligation for large
companies, both financial and non-financial, to identify, prevent, mitigate and account
for the negative externalities they generate in terms of human rights and environmental
impact. In particular, intermediaries should refrain from investing in counterparties that
have adverse impacts on the environment and human rights; alternatively, they should
define (potentially very costly) measures to mitigate and reduce impacts. The directive
would have implications for the entire "value chain" of large companies, e.g. for supplier
companies not belonging to the group, regardless of their size.5 Lastly, the CSDDD should
introduce the obligation for large companies to prepare a transition plan consistent with
the Paris Agreement. For banks, this obligation is also included in the proposed revision
of the CRR3/CRD6 prudential framework, at an advanced stage of negotiation.
Albeit still in an embryonic stage, another important aspect concerns the non-financial
reporting audit framework. The Roadmap for Addressing Climate-Related Financial
Risks by the Financial Stability Board proposes to define such a framework. In Europe
the CSRD will make the certification of non-financial declarations mandatory starting
from 2024; it will be initially set to less stringent criteria, a more stringent approach
is envisioned from 2028. Currently companies subject to NFRD publish audited
sustainability data in some European countries only, among which Italy.
Regarding reporting requirements for banks under the Third pillar, the second Capital
Requirements Regulation for banks (CRR2) provides that large financial institutions6 that
have issued securities listed on a regulated market of any of the Member States must publish
information on ESG risks every six months. The technical document for the implementation
of this legislation prepared by the EBA requires banks to publish more detailed qualitative
and quantitative information than those currently reported under the NFRD.7
As for timing, the EBA has adopted a transitional regime. The banks concerned will be
required to publish a first set of data in the first months of next year, with reference
date end 2022. Based on the current text of the CRR3 proposal, this obligation will be
extended to all banks from 2025, according to criteria of proportionality that are still
being defined.
Regarding transition risks, banks will have to publish, among other things, their exposures
towards the ten high-emissions sectors defined by the European legislation8 and towards
the top twenty most polluting companies worldwide, as well as measures of energy
efficiency of their real estate collateral. Regarding physical risks, banks will have to provide
5
For banks, the "value chain" includes only the companies they lend to. SMEs are also excluded.
6
"Large financial institutions" are defined as those that meet any of the following conditions: (a) they
have been identified as institutions of global or national systemic relevance; (b) they are among the
top three banks nationwide based on total assets; (c) their total individual or consolidated assets are
equal to or greater than 30 billion euros.
7
EBA (2022), "Final draft implementing technical standards on prudential disclosures on ESG risks in
accordance with Article 449a CRR", January.
8
The sectors are as follows: a) agriculture, forestry and fishing; b) mining and quarrying; c) manufacturing;
d) electricity, gas, steam and air conditioning supply; e) water supply; sewerage, waste management
and remediation activities; f) construction; g) wholesale and retail trade; repair of motor vehicles and
motorcycles; h) transportation and storage; i) accommodation and food service activities; l) real estate
activities. Sectors a)-h) and l) are identified by Commission Delegated Regulation EU/2020/1818.
Sector i) was added by the EBA following discussions with experts.
data on exposures to counterparties located in high risk geographical areas (identified
through specialised databases), as well as an estimate of the impacts of climate risks on
regulatory capital, and a description of the risk management methodologies adopted.
From 2024 banks will also need to report indicators of the alignment of their assets
to the European Taxonomy, such as the Green Asset Ratio (GAR)9, the Banking Book
Taxonomy Alignment Ratio (BTAR) and greenhouse gas emissions.10 This will require
granular information on the environmental performance of client firms.
The adoption of this complex body of legislation, and more generally the push given by
the European legislator to the fight against climate change, have many implications for
the financial system. In what follows I will examine two of them, without any claim to
exhaustiveness.
3. The problem of sustainability data
Granular sustainability data are at present insufficient. This helps explain the delay of
most banks in aligning with the expectations of the SSM, and hinders the ability of the
financial system to support the environmental transition.
With the the approval of the CSRD, the number of Italian companies subject to the
obligation to draw up the NFS will significantly increase, from a few hundreds under the
NFRD regime to 4-5.000.11 Once the phase-in is completed, the companies subjected to
the directive will publish the bulk of the data needed by the intermediaries to fulfil their
reporting obligations. However, this leaves out most SMEs, which in Italy account for
about two thirds of value added and about 80 percent of the workforce. Both shares are
more than 10 points higher than the respective European averages. For micro-enterprises
the differential in terms of workforce rises to 15 points.12
The regulation does not neglect SMEs completely. The G20 working group on sustainable
finance recommended the International Financial Reporting Standards (IFRS) Foundation
to consider issuing sustainability reporting guidelines for SMEs, mirroring the IFRS
9
The GAR (requested both in the Third pillar and the NFS) is calculated as the ratio between the credit
or other financial instruments that finance economic activities aligned with the European Taxonomy
and total assets. In the numerator, in the context of loans to businesses, only loans and debt securities
to entities included in the perimeter of the NFRD and in the future CSRD are considered (therefore
excluding SMEs). It seems questionable that there is no indicator that excludes SMEs from the
denominator as well. The BTAR, requested only in the Third pillar, differs from the GAR since the
numerator also includes Taxonomy aligned exposures towards companies that are not subject to the
NFRD (i.e. SMEs).
10
Scope 1 emissions are those generated directly by the production activity of the company through the
direct use of fossil fuels. Scope 2 emissions stem from use of energy produced outside the corporate
perimeter (e.g. by electricity companies). Scope 3 emissions occur throughout the company's value
chain, both downstream and upstream of its production process.
11
See Lavecchia et al. (2022), "Data and methods for the evaluation of climate and environmental risks
in Italy", Banca d'Italia, Occasional papers, n. 732, November.
12
European Commission (2019), "2019 SBA Fact Sheet - Italy".
accounting standards for SMEs.13 In 2024 the EFRAG will publish simplified standards for
listed European SMEs, to be used by unlisted SMEs on a voluntary basis.
However, these developments will take time. In the meantime, as I mentioned above, the
Third pillar regulation mainly leverages information at the sectoral level, requiring banks
to publish their exposures to companies belonging to the ten high-emissions sectors
defined by European legislation. In Italy these sectors contribute 61 percent to GDP,
higher than the EU average of 56 percent. The entire manufacturing sector is classified
as high-emissions.
Such emphasis on highly aggregated sectoral data creates the risk that intermediaries
seeking to reduce their carbon footprint indicators might reduce credit to companies
belonging to high-emissions sectors indiscriminately, treating them all as unsustainable.
A similar risk could also arise with reference to market instruments (shares and bonds),
should sectoral data play an increasing role in the choices of other financial intermediaries.
Excessive reliance on sectoral data in orienting lending and investment choices would not
be justified. First, subsectors with extremely heterogeneous environmental footprints can
coexist within a sector. For example, the "agriculture, forestry and fishing" sector, labelled
as high-emissions, includes both the forestry subsector, which produces negligible
emissions, and that of livestock, notoriously responsible for very high emissions.
Second, even companies producing identical goods can have very different emissions,
depending on the production processes adopted (e.g. reliance on renewables, more
advanced machinery). Companies that have adopted state-of-the-art technologies will
have "incompressible" emissions in the short term, while others will have room to invest.
Should the financial industry help the laggards improve or focus on the best performers?
Finally, even companies that at moment present the same high-emission levels may have
developed very different transition plans; a company seeking funding to carry out an
ambitious and credible decarbonisation plan should be assessed by lenders differently
from one that carries on with ordinary production strategies and policies.
A second risk determined by these complex information problems is that companies not
subject to environmental disclosure requirements might adopt a wait-and-see approach.
This choice, while understandable, might turn out to be short-sighted. Today, companies
at the forefront in the field of sustainability have a strong advantage to make their
choices known to the market and to customers. A policy of poor transparency could be
assimilated to an inadequate sustainability performance, with the negative consequences
described above. Furthermore, scope 1 and 2 emissions of SMEs are included in the
calculation of scope 3 emissions of the large companies they sell intermediate products
to. Large companies will therefore tend to transmit down their value chain the pressure
to adopt more sustainable production models; the CSDDD could contribute to this trend,
for the reasons mentioned in the previous paragraph.
These considerations suggest a few conclusions. First, sectoral data, albeit useful for
many purposes, should be interpreted and used with caution by intermediaries in their
investment and financing choices, and by the Supervisory Authority for its control
activities. This conclusion is supported by microdata-based evidence which confirms that
important heterogeneities exist within sectors and subsectors.14 European regulation
could at least refer to more granular sectoral classifications.15 Second, there is a strong
need for data at the individual company level for the purpose of providing credit and
planning investment. Finally, committing to ambitious sustainability investment and
adopting reporting practices is in the very interest of SMEs, at least the more dynamic
and forward-looking ones.
Various private initiatives have been launched in Europe to set up information platforms
on the environmental sustainability of non-financial companies.16 However, SMEs seem
reluctant to join, due to the high costs for data collection and processing and lack of
standardisation.17
Therefore, actions at national level could be considered. The newly established
Sustainability Coordination Table promoted by the Ministry of Economy and Finance,
which involves the Ministry of Environment and Energy Security as well as the supervisory
authorities (Bank of Italy, Consob, Covip and Ivass) could launch initiatives involving
intermediaries, non-financial companies and their associations, among others. Similar
initiatives have already been launched in other countries.18
14
For example, the experimental database built by Accetturo et al. (2022), "Credit supply and green
investments", mimeo, shows that among companies belonging to the high-emission sectors
according to the EU definition, those that are investing to improve their sustainability performance
are about 10 percent of the total; this share falls to 4 percent among companies in other sectors. This
evidence suggests that among high-emission companies there is a greater awareness and willingness
to tackle environmental issues. Furthermore, there is considerable heterogeneity across the various
high-emission sectors: for example, the aforementioned share is close to 50 percent in the energy
supply sector. Schober and Silberbach (2022), "Modeling effects of carbon taxation on corporate
ratings in the German power market" (2022), mimeo, find that the effect of an increase in carbon
taxation on the probability of default of German electricity generation companies can change sign
depending on the type of technology and fuel used in the production process.
15
The EBA relies on the EU regulatory framework; at the moment, a more granular sectoral breakdown is
not foreseen. Starting from the Third pillar disclosure for 2023, banks will have to add to sectoral data
the amount of exposures that contributes to climate change mitigation and the value of the GAR, thus
providing a measure of the alignment of their portfolio with the taxonomy. However, given the large
share of companies not subject to the CSRD in Italy, this approach is unlikely to change the picture
that will emerge from sectoral data.
16
The European Commission proposes to set up the European Single Access Point (ESAP), aimed at
guaranteeing simple and free access to financial and sustainability information made public by large
or listed European companies. At a later stage, other companies would participate on a voluntary
basis. See article 9 Amendment to Directive 2013/34/EU of the Proposal for a Directive of the
European parliament and of the council amending certain Directives as regards the establishment and
functioning of the European single access point.
17
See Moeslinger, Fazio and Eulaerts (2022), "Data platform support to SMEs for ESG reporting and EU
Taxonomy implementation", Publications Office of the European Union.
18
In Germany, the Green and Sustainable Finance Cluster provides a forum for discussion among
intermediaries, companies, regulators, scientists and academics interested in the strategy for
sustainable finance. A broadly similar role is performed in the Netherlands by the Sustainable Finance
Platform, and by the Observatory for Sustainable Finance in France.
In the realm of data, two types of initiatives could be considered. First, the associations
of intermediaries and those of non-financial companies could cooperate towards the
standardisation and collection of sustainability information. Harmonised templates for
data collection could be developed, extremely simplified for micro-firms, more articulated
for SMEs. This work would not start from scratch, as many banks have already developed
similar templates.
Complementary initiatives could involve public bodies that collect detailed data on gas
and electricity consumption for all Italian households and businesses, or other public
entities that have data on the energy efficiency of buildings at the individual real estate
units' level.19 Some of these databases already cover the totality - or at least a large
portion - of their populations, are systematic and well-organised, but are not accessible
for analysis purposes or to financial intermediaries, mainly because of confidentiality
constraints.
These problems do not seem unsolvable. Confidentiality issues do not arise with
aggregated data. The entities that hold information at granular level could therefore
make themselves available to publish - or to produce for the benefit of other interested
parties - suitably aggregated data.20 Furthermore, confidentiality problems could be
solved if the entities that hold the granular information granted access to intermediaries
with a proxy from their clients. Through this mechanism, intermediaries as well as other
entities (e.g. professional data providers) could have an efficient single point of access
to accurate, detailed and verified information on individual energy consumption,
in compliance with data protection regulations.
The harmonised collection of microeconomic data on sustainability would have several
advantages. Companies borrowing from many banks would avoid having to deal with a
multiplicity of differentiated requests. Banks would reduce or avoid the use of estimated
data provided by professional data vendors. Data comparison would be facilitated.
Greenwashing could be tackled more effectively. The data could also be very useful
for economic policy purposes. Faced with the energy shock, European governments
must balance public finance constraints with the need to provide relief to needy
families and energy-intensive businesses. However, effective targeted policies are hard
to design without adequate information. Looking beyond the current critical phase,
this information would be equally important for designing and evaluating the policies
needed to reach the climate goals that governments are committed to achieving.
4. The transition plans
The topic of transition plans is relatively new. As already mentioned, the European
legislation that should introduce the obligation to draw up plans both for intermediaries
and for non-financial companies (the CSDDD and the CRR3/CRD6 package) is still on the
drawing board.
In spite of this, many of the world's large financial institutions and non-financial companies
have voluntarily committed to reduce their carbon footprint.21 A conceptually similar
approach, which implements the so-called tilting strategies, is common among asset
managers. Such an approach adds new goals, such as reducing the carbon footprint, or
improving the overall ESG score, to the traditional objectives of portfolio management,
which are typically based on the paradigms of risk-return, time horizon, and the liquidity
of the investment. To this end, various providers have developed ad hoc indexes that
-compared to the standard market indices - feature a larger proportion of companies
with relatively low emissions, or relatively high ESG scores. Savers can mandate asset
managers to invest their funds in portfolios replicating these indices.
Following a similar approach, last July the ECB announced a gradual decarbonisation
path for its corporate bond portfolios.22 In parallel, the SSM is encouraging banks to
adopt transition plans consistent with the Paris Agreement and to put pressure on the
financed companies if they do not meet their transition objectives, up to the last resort
of cutting off funding.23
The transition plans of intermediaries, together with the tilting approach adopted by the
asset management industry, can represent a powerful tool for managing and mitigating
climate risks. However, we should be mindful that we are moving our first steps this area.
One issue that needs to be clarified is the consistency between the aforementioned
traditional objectives of an intermediary that manages clients' funds - be it a bank or
an asset manager - and the objectives of sustainability. There is empirical evidence that
good ESG practices are associated with good operational performance of companies, as
they encourage innovation, a long-term orientation, and the efficient use of resources.
Sustainable investing has thus so far produced advantages both for investors, in the form
of higher risk-adjusted returns, and for issuers, in the form of lower external financing
costs.24
This picture will likely change in a more or less distant future. In recent years, the bond
and share prices of sustainable companies may have benefited from the strong growth
in demand from investors increasingly sensitive to environmental issues. However, in
principle, other things equal, a sustainable investment should be relatively less risky,
and therefore less profitable.25 But investors might be reluctant to accept lower yields.
Also, we cannot rule out that sustainability objectives might also eventually conflict
with a risk-adjusted return target.26
In summary, it cannot be excluded that at some stage the traditional investment objectives
conflict with the transition plan and the related decarbonisation objectives adopted by
an intermediary, or a retail investor. Should this turn out to be the case, which goal
should be sacrificed?
At the moment there is neither a theoretical nor an empirical answer to this question.
However, some preliminary considerations seem warranted.
First, there are reasons to doubt that investors would be willing to spontaneously prioritise
sustainability at the expense of profitability. Even if some were, their choices would
likely be insufficient to achieve the desired result. As shown by some recent theoretical
analyses, the efforts of "responsible" investors could be thwarted by the arbitrage
strategies of other investors focused exclusively on the risk-return paradigm, who would
therefore invest in firms not interested in sustainability standards. There is therefore a
risk of "carbon leakage": responsible investors would give up their yield to the benefit
of other investors, with limited effects in terms of progress on the climate front;27 yet
another instance of the "waterbed effect" which mars economic policies in many areas.
This lack of clarity about the potential conflict of objectives may have contributed to
some recent developments. Following a series of controversies over its sustainability
stance, BlackRock has announced plans to allow retail investors to vote on controversial
corporate issues.28 Some large US banks that are members of the Glasgow Financial
Alliance for Net Zero (GFANZ) are reconsidering their decarbonisation targets, due to
concerns about litigation risk29. If not addressed, the conflict of objectives could represent
25
Bolton and Kacperczyk (2020), "Carbon Premium Around the World", CEPR Discussion Papers, n. 14567,
find that firms with higher greenhouse gas emissions are characterised by relatively high equity returns.
26
This could happen, for example, if efforts to combat climate change were to fail, consequently
weakening the demand for sustainable investments.
27
See Pástor, Stambaugh and Taylor (2021), "Sustainable investing in equilibrium", Journal of Financial
Economics, n. 142(2), pp. 550-571; Abiry, Ferdinandusse, Ludwig and Nerlich (2022), "Climate change
mitigation: How effective is green quantitative easing?", CEPR Press Discussion Paper, n. 17324.
28
See Masters (2022), "BlackRock opens door for retail investors to vote in proxy battles", Financial
Times, November 3rd.
29
See Morris, Brian and Walker (2022), "US banks threaten to leave Mark Carney's green alliance over
legal risks", Financial Times, 21 September. For this reason, the signatories of the initiative in the latest
GFANZ progress report will no longer be required to respect the criteria of the Race To Zero Campaign
promoted by the United Nations, which also includes commitments from governments and public
institutions. Until August, the two initiatives will move in a coordinated manner, with the condition for
GFANZ participants to also respect the stringent criteria of Race to zero.
a serious obstacle to the financial system's contribution to the fight against climate
change.
Secondly, a strategy to promote an orderly transition of the economic system towards
the Paris goals should be multi-pronged. While the thrust of the SSM goes in the right
direction, it would be necessary to leverage the entire financial system, including the
asset management and insurance sectors.
Above all, action should also target non-financial companies, at least large ones and
those with high emissions, prompting them to adopt ambitious and credible transition
plans. The investment choices of these companies - such as the producers of electricity,
currently characterised by extremely high emissions - will be the first to determine
the fate of the transition. Banks and other intermediaries could decide to achieve the
decarbonisation objectives of their assets declared in the transition plans by reducing
loans to these companies. However, without huge investments in these sectors it will not
be possible to produce electricity mainly from clean sources and to electrify transport
and heating. It is therefore desirable that lenders might be able to discriminate between
the various companies on the basis of their transition plans, thus allowing companies
that carry out investments aimed at this purpose to find the necessary financial resources
easily and at low cost.
As argued above, European legislation does adopt such a multi-pronged approach.
By introducing mandatory transition plans for all companies, financial and non-financial,
the CSDDD aims to bring about a virtuous convergence of the entire economic system
towards the principles of the Taxonomy and the Paris goals. In this context, the problem
of the conflict of objectives could be assuaged, but might not disappear. Investors
interested only in yield could look outside Europe (the aforementioned carbon leakage
problem). Also, it remains to be seen whether this virtuous convergence will actually take
place. The current energy crisis is resulting in huge profits for energy companies that use
fossil fuels, and government subsidies for the consumption of energy. This reminds us
that today's technology does not allow an accelerated transition to low-carbon energy
sources; that the investments required are enormous; that the demand for energy cannot
be easily reduced without radical changes in consumption habits and lifestyles which the
populations do not seem willing to accept, especially in advanced countries.
In such an uncertain framework intermediaries and non-financial companies should liaise
to align climate change mitigation policies and climate risk management, with a greater
offer of consultancy by intermediaries and greater transparency by companies. Initiatives
regarding transition plans could be promoted by the Sustainability Coordination Table
mentioned in the previous paragraph. In this case as well, the path has been traced by
other countries.30
5. Conclusions
The transition towards a low carbon emissions economy brings risks and opportunities
for the financial sector. Intermediaries must prepare by accounting for physical and
transition risks in their lending and investing processes. To this end, they must improve
the quantity and quality of the information used internally and communicated to the
market. This is required by the European legislation, but it is also in line with sound
business practice.
Sustainability initiatives by authorities and individuals encounter many obstacles.
International standard setters - the ISSB, EFRAG - are still working on non-financial
reporting models, so reliable data are not yet available. While among the most advanced
in the world, the environmental regulation in Europe is still in the making; it will mainly
concern large and listed companies only, leaving the others out of the spotlight. The
very concept of overall emissions is still uncertain due to considerable difficulties in
the definition and measurement of scope 3 (those connected to the entire production
process). Due to the shortcomings in corporate sustainability reporting, intermediaries
make extensive use of data purchased from specialised suppliers. For the same reason, the
latter often obtain data at the firm level through estimates based on sector averages, which
cannot fully reflect the specifics of individual companies. Furthermore, each supplier uses
proprietary and relatively opaque methodologies. As a result, sustainability indicators for
the same company can s