Green Mortgages, EU Taxonomy and Environment Risk Weighted Assets: A Key Link for the Transition

Most houses are bought with a mortgage, making these financial instruments strategically important for the construction and renovation of energy-efficient buildings. Although evidence shows a significant reduction in default risk associated with energy efficiency, progress towards integrating environmental external costs into mortgage risk management remains limited and slow.

This original and timely paper fills this gap by introducing an environment risk weighted assets (ERWA) tool that financial regulators could use almost immediately to help banks green their portfolios and reduce their risks while at the same time helping households reduce their energy use and emissions. Drawing on EU taxonomy technical screening criteria and available building energy performance data, the tool connects environmental costs to financial risks to calculate prudential capital requirements for mortgages.

It begins with an introduction to EU sustainable finance initiatives and regulations, followed by a literature review covering the integration of environmental issues into financial risk in the building sector. Seeking a path to quickly expand green mortgage lending, the authors critique the assumptions underlying current models of integrating environmental risk. “All these aspects suggest that the only possibility to have an effective and rapidly enforceable rule is that it is as simple and assumption-neutral as possible,” they conclude, before outlining their ERWA solution.

The proposed tool involves a double weighting of the bank’s asset, introducing a pollution coefficient assigned to that asset. It integrates EU Taxonomy technical screening criteria with data from building energy performance certificates to connect environmental external costs to financial risks. The tool is able to intervene in every specific case connected to the credit for the housing sector,” say the authors. “To our knowledge, it is still the only proposal of a banking regulation tool ready for application at the micro-prudential level.”

The paper then offers an example, outlining how the ERWAs proposal for green mortgages can become operational using available data on the energy consumption performance of buildings in Lombardy, Italy. It offers methodological steps for the estimation of the specific annual external costs related to the energy consumption classes, producing an environmental risk weight for the asset.

“The point is to pass from the general discussions on a green regulatory environment to change the rules of the game,” the paper concludes. “The main policy implication of our work is that there is a quick and effective way to incentivise banks to fund the green transition.”