The Benchmark for Banks to Demonstrate Their Sustainability Credentials: The Green Asset Ratio

The growing climate crisis has accelerated efforts on sustainable economy and sustainable finance worldwide. Particularly, the European Union's (“EU”) sustainability endeavors under the European Green Deal [1] are centered on creating a sustainable economy through greener financial instruments.

What Were the Key Steps Leading up to the Green Asset Ratio Regulation in the EU?

The EU Taxonomy is considered one of the most important steps taken towards transforming the EU economy into a sustainable structure. The EU Taxonomy Regulation[2] entered into force in 2020 and set a framework for companies to determine which economic activities can be considered environmentally sustainable, and therefore, be labelled as “green”. This framework intends to prevent the misuse of “being green and environmentally sustainable” by means of “greenwashing”, which will become even more important in the decision-making processes of both consumers and investors in the very near future.

Banks and other financial institutions have a unique, key role to play, not only in adapting to the regulations in order to become more sustainably organized themselves but also to push economic actors towards more environmentally sustainable and green economic activities. The EU Commission's regulations require the financial services sector to disclose sustainability-related economic activities in its reporting. [3] Pursuant to these regulatory frameworks, the European Banking Authority has determined sectoral performance indicators for financial services. This is where the Green Asset Ratio becomes relevant, providing a benchmark for the environmental sustainability of banks’ portfolios. Therefore, the green asset ratio is expected to be an important metric in the financial sector.

How will it be Regulated in Türkiye? How to Calculate it?

As in the EU, banks are the primary source for financing companies in Türkiye; in fact, as disclosed by the Banking Regulatory and Supervisory Authority (“BRSA”), the banking sector accounts for approximately 90% of Türkiye's financial markets. [4] Accordingly, Turkish regulators are working on implementing the necessary measures and regulations to increase the financial markets’ contribution to a more sustainable economy in line with the principles adopted in the EU.

The calculation of the green asset ratio and public disclosure regarding green banks' portfolios is expected to encourage financial institutions to allocate a portion of their assets to environmentally friendly and socially responsible projects in the future, and thus, promote sustainability in Türkiye and contribute to Türkiye’s promises to meet its sustainability undertakings under the Paris Agreement. [5] Therefore, the green asset ratio represents a strategic goal that matches the EU's sustainability agenda.

In this context, the BRSA introduced the Draft Communiqué on the Green Asset Ratio (“Draft Communiqué”), setting forth the guidelines for calculating and disclosing banks’ contributions to sustainable economic activities in the finance sector. Pursuant to the Draft Communiqué, banks will be required to periodically report their green asset ratio to the BRSA. In line with the EU regulations, the Draft Communiqué sets the green asset ratio as the primary key performance indicator for determining banks’ contribution to environmental sustainability. The green asset ratio is to be calculated by dividing compliant assets in banks’ unconsolidated balance sheets by the bank’s eligible assets. Consequently, the green asset ratio will require banks to develop a clear understanding of the concepts of “compliant assets” and “eligible assets” and implement the necessary internal systems to this end.

Compliant Assets

Compliant assets are calculated by summing up the gross amount of on-balance sheet financial assets measured at amortized costs arising from economic activities that meet all of the following criteria simultaneously.

Significant contributions to one or more of the environmental objectives

For a financial asset to be considered a compliant asset, it must significantly contribute to one or more of the environmental objectives set out under the EU Taxonomy. Please refer to the chart below for the aforementioned objectives included in the EU Taxonomy.

(https://ec.europa.eu/sustainable-finance-taxonomy/assets/img/objectives.png?v=2.1)

Provisional Article 1 of the Draft Communiqué initially foresees the goals concerning (i) the “climate change mitigation” and (ii) “adaptation to climate change” to be used in calculating the green asset ratio. The BRSA is expected to adopt the remaining criteria in the Draft Communiqué in a staggered manner.

No significant harm to other environmental objectives

These compliant assets should, in principle, not cause significant harm to any of the other environmental objectives listed above. Annex 2 to the Draft Communiqué sets out five evaluation criteria in order to decide whether an activity causes significant harm to the environment, which are as follows:

- Any violation of the principle to avoid causing significant harm to the environment;

- Climate risk vulnerability assessment;

- Sustainable use and conservation of water and marine resources;

- Pollution prevention and control related to the use and presence of chemicals; and

- Biodiversity and ecosystem restoration and protection.

Providing minimum social security measures

Finally, these activities and associated parties must adhere to minimum social security measures, avoid violations related to human and labor rights, corruption, tax, and competition laws, comply with recognized international guidelines and principles such as the OECD Guidelines for Multinational Enterprises, and follow the eight fundamental conventions defined in the International Labor Organization's Declaration on Fundamental Principles and Rights at Work, the UN Guiding Principles on Business and Human Rights, and the International Bill of Human Rights. Assessing compliance involves evaluating the criteria regarding respect for human, labor, and consumer rights, anti-corruption measures, compliance with tax regulations, and fair competition in alignment with outlined standards.

Annex 1 of the Draft Communiqué lists various types of economic activities (such as the agriculture, energy, cement, iron, and steel industries) and states that loans provided for activities that meet the abovementioned criteria will qualify as compliant assets. In line with the EU Taxonomy technical screening criteria, different sectors are specified with NACE codes, certain certifications demonstrating compliance with environmental objectives are sought from borrowers, and various environmental thresholds are introduced for sectors with significant negative impacts on the environment.

The Draft Communiqué also foresees a threshold excluding loans under a certain amount, which will be disregarded in the calculation of compliant assets. The amount of such threshold is yet to be determined in the current form of the Draft Communiqué.

Eligible Assets

Eligible assets are calculated by totaling the gross amount of the on-balance sheet financial assets measured at amortized costs arising from all economic activities specified in the EU Taxonomy under the technical screening criteria. This calculation is irrespective of whether these activities fulfil the technical screening criteria outlined in Annex 1 of the Draft Communiqué.

Additional Key Performance Indicators

As per the Draft Communiqué, there are other additional key performance indicators that will determine Turkish banks’ contribution to environmental sustainability. These are the ratio of “compliant assets/gross assets” and “eligible assets/gross assets”. The calculation for gross assets involves totaling the gross amounts measured at amortized costs for the remaining on-balance sheet assets, excluding receivables from central governments, central banks, multilateral investment banks, development institutions, and assets designated for trading from the total financial assets.

How Will this Affect Banks?

The enactment of the Draft Communiqué will have various impacts on banks. These include, among others, adjustments in lending practices favoring eco-friendly projects, heightened risk management to address misclassification risks, and the development of new financial products tailored for sustainability. Additional authorities will be vested in the BRSA to take any necessary measures, including imposing additional capital requirements vis-à-vis banks that do not comply with the limits set by the green asset ratio.

Banks will be subject to increased reporting costs due to compliance requirements, but compliance could bolster their reputation with environmentally conscious stakeholders. Primarily, the green asset ratio enhances data accuracy, transparency, and comparability for both banks and financial entities, reducing the risks associated with greenwashing and reputational damage tied to environmental litigation. This unified evaluation method encourages increased private investment towards sustainable and innovative projects within the environmental facet of the ESG criteria.

Overall, the Draft Communiqué will require banks to implement strategic adaptations, affirming commitment to responsible banking practices and catering to the rising demand for sustainable financial options.

Because the green asset ratio has a limited scope and non-financial undertakings are yet to be adequately prepared, it is anticipated that banks’ green asset ratio scores will be initially low. In the inaugural EU-wide pilot exercise[6] on climate risk conducted in May 2021, the European Banking Authority approximated an average GAR of 7.9% across a sample of 29 EU banks. Consequently, the significance of comparing green asset ratio scores among banks will be limited initially, with greater relevance expected as more undertakings are included in the assessment scope.

What Are the Expected Challenges under the Draft Communiqué?

Banks will be required to make systemic developments to identify “compatible assets” and “eligible assets” based on the criteria of each loan type. The need to verify the criteria set out to determine an activity financed by banks as a “compatible asset” by an independent third party or by other methods may arise. As the BRSA will determine a lower limit for the loans provided, any projects or financings that fall below this limit will not be included in the calculation of compliant assets. Accordingly, loans to large corporate entities and large-scale financing projects will predominantly fall within this scope. Even if loans provided to smaller companies exceed the lower limit, the ability to obtain data from these companies will pose an obstacle for banks due to the limited sustainability reporting obligations in Türkiye. In this regard, the Public Oversight Accounting and Auditing Standards Authority is currently working on implementing sustainability reporting.

Taking into consideration that there are several items to sort out in determining the categories and criteria thereto, an increased workload and higher operational costs for banks will be inevitable. Besides the formation of new tasks, changes in internal workflows, projected operational burdens, and system investment requirements, all of these regulations are expected to introduce a fundamental change in culture rather than a simple change in practice.

Therefore, banks should make their business plans now to be prepared and take the necessary actions (such as establishing corporate governance structures and increasing their management capacities for climate-related risks) to avoid possible measures by the BRSA, including additional capital requirements in the future.

[1] European Commission, the European Green Deal. COM (2019) 640 final.

[2] Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088, Official Journal of the European Union L 198/13. EU Taxonomy Regulation officially entered into force on 12 July 2020.

[3] Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector.

[4] Preamble of the Draft Communiqué. Access link: https://www.bddk.gov.tr/Mevzuat/DokumanGetir/1195

[5] The Paris Agreement, adopted in 2015, creates a global structure to combat climate change by urging nations to engage in reducing emissions and adapting to climate impacts, targeting both limiting global warming and transitioning to a low-carbon economy and Türkiye became a party to the Agreement on 10 November 2021.

[6] European Banking Authority, Mapping Climate Risk - Main findings from the EU-wide pilot exercise on climate risk (2021).