Extending ‘environment-risk weighted assets’: EU taxonomy and banking supervision

The world is becoming aware of how quickly and radically the economy must change to meet the goals posed by the Paris Agreement and of the importance that the financial system is aligned to this end. This debate also involves a reconsideration of aims and tools of banking regulation although, for now, the discussion is still not very operational. Building on a previous work were we introduced the “environment-risk weighted assets” to internalize the pollution risk of the borrower, we expand this tool with three aims. The first is to complete its empirical application to estimate both direct and indirect environment external costs of economic sectors, in order to make a calculation of the “external costs footprint” of Italian corporate lending and to discuss the pros and cons of the two methods. The second is to confirm that the proposal is aligned to the European Union taxonomy on environmentally sustainable activities, part of the wide regulatory efforts by European institutions to tackle climate change. Thirdly, we propose how to widen the scope of our tool to cover virtually every part of banks’ business, so that its application can be the most business model-neutral possible. We show that this framework can help to put on a working track the discussion on banking regulation for sustainable finance.