Introduction
The increasing emphasis on environmental preservation and sustainability has led regulators globally to enforce a range of rules impacting financial and non-financial institutions. This paper explores the European Banking Authority’s (EBA) Pillar 3 framework, a regulatory initiative aimed at enhancing environmental, social, and governance (ESG) reporting by large credit institutions within regulated European Economic Area (EEA) markets. The discussion highlights alignments and divergences between the Pillar 3 framework and the EU Taxonomy, emphasizing technical and functional challenges faced by financial institutions.
Pillar 3: A Comprehensive ESG Reporting Framework
Pillar 3 consists of 10 templates designed to address transitional and physical risks associated with climate change. These templates serve dual purposes: identifying ESG-related vulnerabilities and embedding sustainability considerations into traditional risk management frameworks (e.g., credit, market, and operational risks). The transparency provided by these templates aims to benefit investors and stakeholders.
Key features include:
- Assessment of exposures financing taxonomy-aligned activities.
- Merging mitigative risk-management strategies with promotive ESG goals.
Comparative Analysis of Pillar 3 and EU Taxonomy
NACE Classification
Both frameworks utilize the Nomenclature of Economic Activities (NACE) system to categorize sustainable activities. However, while the EU Taxonomy focuses on granular classification at NACE level-4, Pillar 3 limits this requirement to levels 1 or 2, simplifying the identification of climate-risk exposures.
Green Asset Ratio (GAR) Calculation
Both frameworks mandate the disclosure of GAR, representing the proportion of an institution’s assets deemed sustainable under the EU Taxonomy’s Technical Screening Criteria (TSC). However, the methodologies differ:
| Aspect | EU Taxonomy | Pillar 3 |
|---|---|---|
| Data Source | Counterparty-reported data only | Allows use of estimated data |
| Calculation Basis | Counterparty turnover and capital expenditure | Counterparty turnover exclusively |
Additionally, Pillar 3 introduces the Banking Book Taxonomy Alignment Ratio (BTAR), extending disclosures to counterparties exempt from the Non-Financial Reporting Directive (NFRD).
Collateral Assessment
Pillar 3 applies distinct rules for loans with multiple collaterals, limiting assessments to immovable assets. In contrast, the EU Taxonomy prioritizes the loan’s intrinsic value over collateral type.
Key Functional and Technical Aspects of Pillar 3
Pillar 3 mandates both qualitative and quantitative disclosures, including:
- Qualitative Aspects: Background narratives supporting sustainability initiatives.
- Quantitative Metrics:
- Greenhouse gas (GHG) emissions based on Partnership for Carbon Accounting Financials (PCAF) guidelines.
- Counterparty exposures linked to high carbon intensity and energy efficiency.
Templates assess transition risks (e.g., sectoral climate contributions) and physical risks (e.g., exposure to climate-sensitive geographies). Actions to mitigate risks, along with sustainability integration in risk management, are also documented.
Challenges in Pillar 3 Implementation
Data Collection and Credibility
The specificity and novelty of data required under Pillar 3 pose significant challenges. Institutions must ensure data credibility, not only for compliance but also to advance internal sustainability objectives. A unified ESG reporting solution encompassing both Pillar 3 and EU Taxonomy requirements is recommended.
Adapting to Evolving Regulations
The dynamic regulatory landscape, including upcoming requirements from the International Sustainability Standards Board (ISSB), necessitates a proactive and flexible ESG reporting approach. For example, Brazil’s Social, Environmental, and Climate Risks Document (DRSAC) shares synergies with Pillar 3 disclosures, highlighting global alignment opportunities.
Reconciling ESG and Financial Reporting
While there are overlaps between ESG Pillar 3 and financial reporting, discrepancies in data granularity complicate reconciliation. For instance, Pillar 3’s gross carrying amount differs from financial reporting’s carrying amount.
Technical Implications for Future Compliance
Pillar 3 requires institutions to address the following:
- XBRL Reporting: The integration of EBA’s XBRL Taxonomy framework necessitates robust technical capabilities for accurate data submission.
- Scope 1, 2, and 3 Emissions: Financed emissions calculations, guided by PCAF, demand sophisticated methodologies and extensive data collection.
Conclusion
The alignment of Pillar 3 with the EU Taxonomy presents both opportunities and challenges for financial institutions. While shared data attributes facilitate compliance, significant differences in methodologies underscore the need for adaptable, data-driven ESG reporting systems. By embracing a holistic approach, institutions can enhance sustainability integration, navigate regulatory complexities, and contribute to the transition toward climate-neutral economies.
