bubble@ (Adds reaction)
LONDON, Jan 31 (Reuters) - Cutting capital requirements at banks to encourage more lending to environmentally-friendly projects could create a "green bubble", a panel convened by the European Union's executive said on Wednesday.
The High-Level Expert Group on Sustainable Finance published its final recommendations on creating a financial system that can fund more projects to improve the environment and deliver social benefits over the long term.
The European Commission wants such investments to help expand the EU capital market as it faces the departure of Britain, its biggest financial centre.
The report aims to recommend tweaks to the bloc's regulatory and financial policy rules to encourage sustainable finance.
The Commission said in December it could lower capital requirements for banks on environmentally-friendly investments to help counter climate change.
But the expert group struck a cautious note, saying several steps were needed before determining whether capital requirements should be cut to below the level of economic risk of a "green" project.
"If capital requirements were reduced below that, lending could become concentrated in less prudent lenders," the expert group's report said.
"To avoid any 'green bubble' and undercapitalisation coming from market distortions, there should be a cap on lower capital requirements on green assets. That cap could evolve over time."
The EU should consider the impact of additional global bank capital standards approved in December on financing sustainable projects before putting them into law, the expert group said.
"This report is just the beginning," European Commission Vice Presidents Valdis Dombrovskis and Jyrki Katainen said in the report's introduction.
"As part of our work to build a true Capital Markets Union, we will come forward in March of this year with a broad Action Plan on sustainable finance, building on the recommendations in this report," they wrote.
The European Banking Federation (EBF), which represents the region's main banks, said tweaking capital rules must not contribute to "unbalancing risks" in the financial system.
"It is extraordinarily difficult to create proper definitions that are not at odds with the need for accuracy and purity in risk weights in banking," the EBF said.
Markus Ferber, a German centre-right member of the European Parliament, said the expert group was plotting a "dangerous shift" by replacing containment of risks in banking with a push for sustainable finance.
"This will lay the groundwork for the next bubble and the next crisis. This is even more so as the High Level Group fails to clearly define what sustainability in finance actually is," Ferber said.
The expert group also said Brussels should encourage markets to focus on long-term goals not short-term gain.
The bloc should also introduce an official EU Green Bond standard to help the market develop more fully, the group said.
Green funds had around 145 billion euros of assets under management in 2016, against 3.1 trillion invested in European bonds and 3.4 trillion in equity funds, the group said in an earlier report.
The EU aims to cut carbon emissions by 40 percent by 2030, for which it estimates about 180 billion euros ($212 billion) in additional low-carbon investments are needed per year.
Brussels plans to introduce a legal obligation for asset managers to consider environmental risks when investing client funds. (Reporting by Huw Jones; Editing by Edmund Blair and Mark Potter)