Housing the green transition in the EU with the right banking regulation tools

The building and real estate sector is not only an important part of advanced economies – it is also a large part of banks’ lending and the environmental emissions of lending-related activities. Therefore, a tool able to speed up the greening of this sector would be paramount to the energy transition. This goal can be pursued with different measures, such as public investment and fiscal incentives. It can also be achieved through banking regulations.

Banks have to meet capital requirements based on the risks embedded in their books through a risk weighting of the assets (RWA) coming from international (Basel 3 and soon Basel 4) and national rules. The more capital an asset absorbs, the less inviting it is for a bank. Of course, the weighting relies on the asset-specific riskiness. Banking regulators cannot simply modify RWA in order to push a given product or sector.

Empirical studies show that a particular component of the banking book is less risky (for instance, thanks to diversification, in the case of lending to small and medium-sized enterprises, or to the role of collateral in the case of residential mortgages), and hence rules and riskiness work accordingly to favour the development of these businesses.

In the case of green mortgages, the scientific literature is in its initial stage, although early data suggest that default risk is inversely associated with buildings’ energy efficiency. This is because green homes have lower operating costs and therefore home bill payers suffer less from an increase in energy prices. Moreover, the real estate market provides a “green price premium” to houses with lower energy needs, as also seems to happen in the green bond market.

This issue is particularly important in Europe. In fact, not only do buildings account for 40% of the EU’s final energy consumptions and 36% of its CO2 emissions, but the stock of buildings in the EU is relatively old, with more than 40% of them built before 1960 and 90% before 1990 – older buildings typically use much more energy. Therefore, financing greener houses seems a sensible idea.As we are dealing with the European situation, a tool to help banks finance the transition must take into account the new framework introduced by the EU taxonomy. To make our idea work, we can leverage the energy performance certificate (EPC) introduced by the EU in 2002, which is also considered as a reference for the taxonomy’s technical screening criteria for buildings.

For information on how this regulatory standard is calculated, please see this article (in Italian).

To reach a practical conclusion, we took a sample of around 85,000 EPCs for residential properties in Lombardy, the most populated region in Italy. We discovered that the most common energy class is the worst (G) with around 31% of occurrences, followed by F with 24%.

We calculated the emissions of the three main greenhouse gases (carbon dioxide, nitrous oxide and methane) and five of the major air pollutants (PM2.5, sulphur dioxide, nitrogen oxides, ammonia and non-methane volatile organic compounds) related to the extraction, production, distribution and combustion processes of the two main energy vectors (electricity and natural gas) needed to provide the building’s annual energy services, as certified by the EPC.

Then, for each EPC energy class we evaluated the external (health and environmental) costs related to these lifecycle emissions by applying the damage cost values for greenhouse gases and air emissions recommended by the relevant European Commission Handbook.

With this method, we obtained environmental risk estimates related to energy efficiency classes, discovering that, for example, houses of the worst energy efficiency class (F) are responsible for an environmental cost per square metre that is 62% higher than the sample average.

This measurement of the environmental risk related to financial assets, which is based on official data and methodologies which can be easily replicated, is the key to calibrating banking rules able to favour the transition. For instance, in the case of renovating an existing building, the tool is calibrated to provide a “neutral” prudential requirement for a residential mortgage to energy saving renovations not achieving the taxonomy criteria (at least a 30% reduction in terms of primary energy use). Moreover, the tool provides a discount on banks’ capital absorption related to mortgages financing taxonomy compliant renovations and, in reverse, a penalty on capital requirement for renovations that unsuccessfully increase the building’s primary energy use.

The suggested prudential mechanism is conceived to trigger deep energy renovation projects with the “window of opportunity” provided by the house purchase: when the borrower receives a mortgage that covers the cost of the renovation project as well, the bank can apply the post-restructuring EPC class to the loan, receiving a discount on its capital requirement. Hence, banks are incentivized to fund renovation projects when extending a residential mortgage.

To explain how our tool works in practice, we can provide an example. We assume the purchase of a house in class G costs €100,000 with a loan of €80,000. The Basel 3 risk weight of the loan in this case is 30%; therefore, the RWA would be €24,000. With our proposal, a mortgage for purchasing class G building without renovation yields 150% weighting, hence the bank’s RWA would jump to €36,000.

If the borrower decides to combine the purchase with a renovation project achieving energy class E (an increase of two classes), supported by an increased loan of €90,000, the environmental risk weight of this mortgage would reduce to 73% and the final RWA would amount to €26,280. The capital requirement would be much lower than the “only purchase” case (with the current Basel 3 rules, 40% in this case, the RWA would be of €36,000).

We should also take into account that the energy requalified house would increase its market price, thus giving the bank more valuable collateral and increasing the investment value for the borrower. The mechanism pushes banks and borrowers to develop deep-energy renovation projects.

We think that, in the European context and also elsewhere, it is important to develop prudential tools that, as in our proposal, are able to rely on established regulatory mechanisms, allowing financial operators to become leaders of the transition towards an environmentally sustainable economy.

The views expressed are those of the authors and reflect those of the Bank of Italy or Ricerca sul Sistema Energetico. This article constitutes an excerpt from the paper Green Mortgages, EU Taxonomy and Environment Risk Weighted Assets: A Key Link for the Transition, Sustainability 2022, 14, 1633, which has been supported by the Research Fund for the Italian Electrical System in compliance with the Decree of 16 April 2018. 

This article was first published by the Green Finance Platform for the Aligning Finance Policies project, which seeks to advance dialogue and collaboration towards international consensus on best practices to green the financial system.