By Neil Sandle, Head of Product Management, Alveo
According to the European Commission (EC), “the EU taxonomy is a cornerstone of the EU’s sustainable finance framework and an important market transparency tool. It is a classification system that defines criteria for economic activities that are aligned with a net zero trajectory by 2050 and the broader environmental goals other than climate.”
On one level, the taxonomy presents a framework for a set of business activities deemed to be sustainable, from forestry to certain types of agriculture to solar parks, channelling investments toward the European Green Deal’s objectives. However, European Union (EU)-based banks now face significant challenges due to this regulatory development. Starting in 2024, they must report on the companies and projects they fund, incentivising investments aligned with the EU Taxonomy’s sustainability criteria.
In practical terms, if a bank funds only exploration for new oil or coal, it would inevitably receive a very low score on the EU Taxonomy. However, its EU Taxonomy score would be much higher if it lends significant sums to multiple wind parks or solar farms.
Scoping the challenge
The advent of the EU Taxonomy poses significant challenges to banks. If they lend to large multinationals, the situation is clear. These institutions will have comprehensive environmental, social and governance (ESG) reporting in place, with data gathered and supplied by their investor relations and sustainability departments.
However, the lion’s share, perhaps 95 percent or more of borrowers in banks’ books, are small to medium-sized enterprises (SMEs), primarily non-listed entities with limited ESG-reporting experience that lack essential data for EU Taxonomy compliance. For these businesses, reporting on their environmental performances and ESG credentials may well be a new exercise.
Adding to the complexity is the need for banks, in some cases, to specifically address where funds are applied. This is not always a “black and white” issue. An oil company may invest in wind power through a subsidiary, for example. Some of the money lent to it may be for unspecified general purposes, but some may be in the form of a specific-purpose loan or project finance to the wind-power subsidiary and, therefore, contribute to a higher EU Taxonomy score.
Finding a solution
To address these hurdles, banks must gather data from various sources, including ESG-data providers, rating agencies, chambers of commerce and also directly from companies. They may need data from firms such as Morningstar Sustainalytics, a company that rates the sustainability of listed companies based on their environmental, social and corporate-governance performances, and MSCI (Morgan Stanley Capital International), a leading provider of critical-decision support tools and services for the global investment community with a strong focus on ESG and climate products. Trucost, now part of Standard & Poor’s (S&P) Global, and Truvalue Labs, part of FactSet, also act as data and analytics engines.
In short, numerous businesses today provide banks with sustainability scores, expert estimates and, in some cases, other statistics, such as industry averages, that can be used as proxies. For smaller businesses, though, banks also need to collect data from chambers of commerce or directly.
The benefits for banks include not just accurate reporting; many of these companies will also need funding to complete their green transitions. By adopting a data-driven approach, banks can ensure accurate reporting and cultivate stronger relationships with their clients, potentially offering new loans to support their green-transition initiatives.
If a bank can, for example, build positive engagements with its corporate-banking clients, it can then start dialogues with them on sustainability issues. The bank might, for example, say to a client, “You are operating in fast-moving sectors: consumer goods, energy, agriculture. Say the typical scores for your sector per million euros of revenue are this…when it comes to greenhouse-gas emissions, water usage or pollution. These are the benchmarks. But this, in contrast, is where you sit. Let us help you improve.”
This kind of measurement can become a relationship-building tool for banks today rather than just a regulatory-reporting exercise—and, given the growing importance of ESG measurements to organisations worldwide, an increasingly essential one.
Collaboration among banks may also play a role, with clients’ permission, to share or pool basic data. Various initiatives are occurring in many countries to facilitate data sharing.
All this will inevitably be a long-term project. Many banks will take extended periods to get their reporting in order because their data landscapes may be scattered. Even within a single bank, there may be multiple banking systems, with various systems set up in different countries. On top of this, different loan portfolios for sectors such as agriculture or shipping may have diverse data sources providing the required information. Aggregating all this will be a massive task for corporate banking.
That covers the next few years in a nutshell. Over the longer term, data sharing will become even more prevalent. Individuals will increasingly choose to move their financial businesses from bank to bank. Some corporates will follow suit but also want to control with whom they share information.
Some of the larger corporates will have to report, regardless. Under the terms of the Corporate Sustainability Reporting Directive (CSRD), an increasing number of EU firms will be required to report on their sustainability credentials and make some of their data public. But while many smaller companies will not have to report under this regulation, their banks will likely want to learn more about their sustainability data to decide whether to lend more to them.
Effective and integrated ESG-data management is key.
Effective data-management systems will be critical to navigate this complex ESG environment successfully. For banks aiming to both comply with regulations and leverage sustainable-finance opportunities, robust data-centric approaches are indispensable.
Acquiring, integrating and ensuring the quality of ESG data is an ongoing challenge. Comprehensive ESG-data management should ensure data consistency for various use cases. Although challenges abound, especially concerning data quality, solutions are emerging. Data-management solutions and data-as-a-service (DaaS) offerings are now assisting firms in capturing the ESG data they need, with capabilities for quality checks, data enrichment and seamless integration. What is important is not to create another data silo only for ESG but to integrate the required ESG data into overall market- and reference-data management.
For effective ESG-data management, organisations need approaches that acquire, integrate and validate ESG data seamlessly. They should offer easy data discoverability, efficient integration into user workflows and capabilities such as cross-referencing taxonomies, data derivations and historical-scenario analyses.
The rapid regulatory emphasis on fostering a sustainable economy presents both challenges and opportunities. The immediate focus should be determining an effective operating model, designing a target data system and ensuring a customised implementation approach.
Toward ESG data as a service
In light of the end-to-end support that ESG-data management requires, the data-as-a-service model stands out. While in-house capabilities are beneficial, the complexities of ESG-data collection, validation and integration may necessitate expertise from third-party solution providers.
Adopting data-as-a-service models could be the optimal route, especially given the evolving standards and best practices in the industry. Leveraging third-party expertise and holistic solutions can greatly enhance the efficiency and accuracy of ESG-data management, ensuring banks stay ahead in the sustainable-finance landscape.