Guide to managing climate and environmental risks 2023 PDF

Guide to managing climate and environmental risks March 2023  Contents Contents Legislative framework Introduction and applicability Climate and Focal points for managing environmental risks r...

Guide to managing climate and environmental risks March 2023  Contents Contents Legislative framework Introduction and applicability Climate and Focal points for managing environmental risks risks  Introduction Introduction Climate change and environmental degradation can pose risks to Dutch financial In this Guide, we provide tools to manage climate and environmental risks. The Guide builds on institutions. DNB expects financial institutions to understand all material risks and previous policy statements on the management of these risks which have been published in recent to manage them appropriately. This also applies to climate and environmental years for specific sectors and components of the management framework.5 We are thus following the risks. In this Guide, we provide tools to manage these risks. recommendation of the Network for Greening the Financial System (NGFS) to draw up “supervisory expectations”.6 Financial institutions can use these tools proportionately by adopting a risk-based Climate change and environmental degradation can pose risks to Dutch financial institutions. 1 approach. The Guide should be viewed in conjunction with applicable laws and regulations. These risks may result from physical damage due to climate change and environmental degradation or from financial institutions having to adapt to stricter climate and environmental policies, new This Guide relates to prudential supervision and will be updated periodically. The tools it contains technology and/or changing market and consumer sentiment.2 are intended for insurers, pension funds, premium pension institutions, investment firms and institutions, and electronic money and payment institutions. In the case of investment firms and DNB expects financial institutions to understand and manage all material risks, including climate institutions, only the sector-specific tabs apply. These incorporate the Good Practice published in and environmental risks. Institutions must have sound and ethical operational management.3 DNB 2021.7 The tools in this Guide have been aligned where possible with the European Central Bank’s research4 shows that financial institutions are aware of climate and environmental risks but are still supervisory expectations for the banking sector. 8 In the light of legislative and regulatory taking only limited account of them in their core processes. We also announced that, in 2022, we developments and new insights into the proper management of climate and environmental risks, would further define how we expect financial institutions to manage sustainability risks and consult additional explanatory notes and practical examples will be added to this Guide periodically. For the financial sector on this, thereby meeting a need felt throughout the sector. example, we are currently working on good practices for payment and securities institutions for managing climate and environmental risks. Introduction Reader’s guide The Guide consists of a cross-sectoral section and sector-specific explanations and good practices (accessible via the sector buttons at the end of each section). The next tab, “Legislative framework and applicability”, outlines the legislative and regulatory framework for the management of climate and environmental risks and its application in supervisory activities. The associated sector tabs outline additional sector-specific legislation. This is followed by a more detailed explanation of climate and environmental risks (“Climate and environmental risks” tab), with the sector- specific tabs providing examples of the potential impact by sector. The “Focal points for managing risks” tab then outlines focal points for integrated climate and environmental risk management. These cover the areas of business model and strategy, governance, risk management and information provision. The sector-specific tabs contain good practices for the relevant sector. These are practical examples that, in our view, are good examples of integrated climate and environmental risk management. They are intended as a source of inspiration on how institutions can give substance to the cross-sectoral focal points. For now, these tabs only include good practices for pension funds and insurers. Good practices for electronic money and payment institutions will be added in a future edition of the Guide. Good practices vary by sector, making it worthwhile to consult the sector-specific tabs of other sectors for additional inspiration. Good practice for investment firms and institutions Legislative framework and applicability Legislative framework the European Sustainability Reporting Standards (ESRS). The European Supervisory Authorities (ESAs) Under Section 3:17 of the Financial Supervision Act (Wet op het financieel toezicht – Wft) and Section 143 are also increasingly embedding sustainability in their laws and regulations.11 of the Pensions Act (Pensioenwet – Pw), Dutch financial undertakings and pension funds respectively are obliged to have sound and ethical operational management. In addition, more detailed specific Application in supervision regulations are in force for various sectors with regard to the management of prudential risks. This Guide provides tools to enable the sector to embed climate and environmental risks in core These can be found in the sector-specific tabs. processes. The tools include cross-sectoral focal points for integrated climate and environmental risk management in the areas of business model and strategy, governance, risk management and information Institutions are thus expected to manage material risks. Since climate and environmental risks can be provision. These focal points have been further detailed in sector-specific good practices: practical a source of financial and non-financial risks, supervised institutions are required to manage material examples that in our view can effectively fulfil the obligations in the laws and regulations. These may be climate and environmental risks. (anonymised) practical examples that we have observed at institutions or stylised examples. At the European level there is a growing body of legislation and regulation in the field of Good practices are indicative and institutions are free to take a different approach as long as they sustainability.9 For example, the European Commission has drawn up the Action Plan for Financing comply otherwise with the laws and regulations.12 The good practices in the Guide are thus not Sustainable Growth to make sustainability an integral part of risk management and encourage binding, but serve as input in the supervisory dialogue between the institution and DNB on climate transparency and long-term thinking. This package includes: the EU taxonomy, a classification system and environmental risk management. An institution can use these examples and apply them for sustainable economic activities; the Sustainable Finance Disclosure Regulation (SFDR), containing proportionately according to its nature, size and complexity and the materiality of the risks. sustainability disclosure requirements for financial market participants; and the Corporate Sustainability Reporting Directive (CSRD), with reporting requirements for listed and large companies on ESG aspects.10 At the request of the European Commission, the European Financial Reporting Advisory Group (EFRAG) is developing the CSRD into standards for sustainability reporting: Whether climate and environmental risks are material to an institution depends on the characteristics of its business model, operating environment and risk profile. As a minimum, we expect an institution to analyse the extent to which climate and environmental risks are material to the institution (see the “Focal points for managing risks” tab, Box 1 for further information and focal points for the materiality analysis). An institution must accordingly identify these risks and assess their materiality. The institution must then manage the material risks identified. An institution adopts a proportionate and risk-based approach to managing climate and environmental risks that is geared to the size of the institution and the materiality of its exposure to climate and environmental risks. For example, a qualitative and less granular approach may suffice for a small institution with low material exposures, whereas larger institutions or institutions with material exposures will adopt a more sophisticated approach. We recognise that climate and environmental risks have particular characteristics and that a gradual entry path may be necessary to raise the management to the desired maturity level over time. Insurers Climate and environmental risks market sentiment. This Guide covers climate and environmental risks. These are the financial and non-financial risks13 that may arise from financial institutions’ exposure to the effects of climate change and environmental Physical and transition risk factors are interrelated. The longer policy action and hence the transition to degradation. Climate change can lead to extreme droughts, floods and storms, among other events. a lower-carbon and environmentally friendlier economy is delayed, the greater will be the (actual or Examples of environmental degradation include water or air pollution, desertification, deforestation expected) physical consequences. This may require more drastic policy measures. At the same time, far- and loss of biodiversity and ecosystem services14. reaching policy measures are a transition risk factor. Physical and transition risks can also lead to systemic risks, which are risks that arise from the breakdown of the entire system, rather than from Climate and environmental risks may be driven by physical and transition risk factors: ▪ Physical risk factors are related to the physical impacts of climate change and environmental the failure of individual parts.15 For example, if an ecosystem collapses due to the accumulation of degradation. These can be both acute and chronic. Acute physical risk factors result from extreme physical risks, if multiple sectors are affected by physical and transition risks, and/or if the financial climate and environmental events, such as drought, floods or environmental disasters leading to problems of one or more companies or financial institutions spill over to the entire system. soil, air or water pollution. Chronic physical risk factors result from long-term climate and environmental events, leading, for example, to sea level rise and biodiversity loss. Physical and transition risk factors can lead to financial or non-financial risks for financial institutions, ▪ Transition risk factors are related to the transition to a lower-carbon and environmentally friendlier such as market and reputational risk, through so-called transmission channels (see Figure 1), as these economy, such as changes in climate and environmental policies, technology or consumer and factors can have an impact on the economy and thus feed through to the financial system. Figure 1: Climate and environmental risks as a source of prudential risks16 Physical risk factors (examples) Economics Transmission channels Financial system Capital destruction Impairment of assets and Market risk (losses on shares, bonds, etc.) collateral Credit risk (losses on loans) More volatile commodity prices Liquidity risk (refinancing risk) Disruption to production processes and value chains Operational risk (liability claims, reputational damage, legal costs, business continuity) Relocation and adjustment of activities Underwriting risk (higher claim costs) Technology Electric cars, renewable energy Pricing of externalities Strategic/business model risk (earning power under pressure) Consumer Aversion to polluting and market activities/products/etc. Stranded assets Interest rate risk (interest rate shock) sentiment Macroeconomic deterioration leads to increasing risks to the financial system; and (negative) financial consequences lead to macroeconomic deterioration Climate change, for example, will make extreme weather events more frequent, potentially causing developments and/or changes in consumer preferences could also potentially reduce the market value capital destruction and increasing the unforeseen claims burden for non-life insurers, as well as their underwriting risk. It can also damage the premises, data centres and services of financial institutions, disrupting production processes and jeopardising business continuity. New climate policies, technical of certain investments and even result in stranded assets 17. In the case of financial institutions, this may imply increased market risk. Climate change and environmental degradation do not only affect financial institutions; financial institutions themselves also have an impact on the climate and environment through their activities. This is also known as double materiality18. The ESRS defines double materiality as impact materiality Biodiversity loss and climate change and financial materiality. Impact materiality is about the institution’s impact on people and the Biodiversity loss poses a major risk to our society and the global economy. It accelerates climate environment, whereas financial materiality refers to the impact of people and the environment on an change and threatens the health of ecosystems that support the economy. This also affects the institution’s financial performance. The impact on people and the environment (impact materiality) financial sector. Financing companies that depend on ecosystems exposes financial institutions to also entails risks. For example, financial institutions that invest in companies that have a large -physical- biodiversity risks. Investments in companies that negatively impact biodiversity can negative environmental impact may face increased reputational and legal risks. Financing and lead to transition risks if governments start banning or pricing these impacts. Research19 shows investments with an actual or intended positive impact on the climate or the environment entail that Dutch financial institutions have hundreds of billions of euros in outstanding exposures that possible reputational risks if, for example, greenwashing is involved or if expectations are not met. are at potential risk from biodiversity loss. This may be because ecosystem services disappear, Institutions may then face claims that lead to higher operational risks. because of changes in legislation to protect the environment and nature, or because of environmental controversies. The stakes are thus high for the financial sector, and it is vital that The extent to which climate and environmental risk factors permeate or interact with the institution financial institutions identify these risks. may differ from sector to sector and also depend on the institution’s business model. The sector- It is also important to consider climate-related and biodiversity risks in relation to each other. specific tabs contain a table with examples of how these risk factors feed through into existing Biodiversity loss amplifies climate change through deforestation and CO2 released in the process, financial and non-financial risks. In addition to these direct impacts, financial institutions may face for example, while climate change in turn is one of the main drivers of biodiversity loss. indirect or second-order effects. The (negative) impact on the financial system may in turn worsen the Conversely, good forest management can actually help prevent further climate change. macroeconomic conditions. The feedback arrows between the economy and the financial system in Read more: Figure 1 illustrate these second-order effects. Study by DNB and PBL Indebted to nature – Exploring biodiversity risks for the Dutch financial sector DNB-OMFIF biodiversity conference: three takeaways Biodiversity Working Group Characteristics of climate and environmental risks Climate and environmental risks have specific characteristics that are important in the integrated management of these risks. Climate and environmental risks are systemic in nature and have a non-linear impact. Historical data is therefore often of limited value in assessing the risks. In addition, they are characterised by the enormous scope and scale of the impacts, uncertain timing ranging from the short to long (or very long) term and dependence on short-term action and policy measures. Finally, climate and environmental risks are relatively new in the financial sphere and new developments and insights are emerging in rapid succession. Insurers Focal points for the management of climate and environmental risks In this Guide, we highlight four focal areas of possible relevance to financial management across sectors. We also provide institutions with good practices as institutions in achieving integrated management of climate and environmental examples of effective application of the focal points. These can be found on the risks. The focal areas are (1) business model and strategy, (2) governance, (3) risk sector-specific tabs. When applying these it is important to keep in mind the management and (4) information provision. For each focal area we have proportionality and materiality of the risks to the institution. identified focal points that are applicable to climate and environmental risk Box 1: Focal points for materiality analysis 3. Different time horizons Financial institutions should manage material risks appropriately. The same applies to material Here a distinction can be made between the short (0-5 years), medium (5-10 years) and long (>10 climate and environmental risks. Whether climate and environmental risks are material to the years) term. institution can be determined by means of a materiality analysis. 4. Ǫualitative and quantitative analysis methods When conducting a materiality analysis, the institution can take the following focal points into Examples of quantitative methods include exposure and/or concentration analysis, scenario account: analysis, sensitivity analysis, portfolio alignment assessment and ratings or climate scores from external data providers. Qualitative methods include a heat map and qualitative scenario analysis. 1. Difference between physical and transition risk factors Examples of physical risk factors include drought, floods, biodiversity loss and water stress. 5. Materiality assessment Transition risk factors include policy, technology and market sentiment. Materiality can be assessed by combining information on probability and impact for different time horizons. This assessment is institution-specific and depends on the institution’s business model, 2. Impact on the various prudential risk areas operational environment and risk profile. It is important that institutions record the results of this This involves identifying how the physical and transition risk factors may impact the risk domains analysis. This will enable the institution to provide an explanation if climate and environmental used by the institution, such as credit, market, liquidity, operational/reputational, business model risks turn out to be non-material. and strategic risk (see the “Climate and environmental risks” tab for an explanation of how climate and environmental risks impact prudential risk categories). Focal area 1: Business model and strategy Mapping the potential impact of climate and environmental risks on the business environment Establishing performance indicators and business model To implement and monitor the strategic goals regarding climate and environmental risks, an Institutions should consider all material risks to which the business model may be exposed. These risks institution can establish performance and risk indicators. The indicators allow the institution to make may arise from developments in the business environment, among other things. Climate change and adjustments to the implementation of its strategy and take action. Depending on the activities and environmental degradation can affect this environment and pose risks to the business model. materiality, specific indicators can be drawn up for relevant parts of the institution and portfolios. For instance, increased flood risk can make a region’s business climate less attractive. An institution These could include indicators such as the organisation’s carbon footprint or the share of sustainable that is dependent on income from this region may have lower earning power in the long run. At the assets in the strategic investment policy. same time, climate change and environmental degradation can provide opportunities for the institution to maintain its earning power. Using a materiality analysis, the institution can determine which risks from the environmental analysis constitute a material risk (see Box 1 for focal points for the materiality analysis). Adopting a granular and long-term perspective when identifying risks (and opportunities) A good way to identify risks (or opportunities) for the business model is to identify them at the level of sectors, geographical areas and services in which the institution operates or wishes to operate. In doing so, the institution can indicate the timeframe within which these risks are likely to materialise. Some climate and environmental risks may occur within the regular planning cycle, such as reputational effects or extreme weather events. Other risks, such as technological breakthroughs, may come into play and affect the business model in the longer term. Including climate and environmental risks in strategy formulation and implementation Material climate and environmental risks may impact the effectiveness of the existing and future strategy. To investigate this, the institution can use forward-looking tools, such as stress tests and scenario analyses. Material risks arising from the analyses are taken into account when formulating or updating the strategy. Focal area 2: Governance Policymakers20 Ensuring sufficient fitness with regard to climate and environmental risks It is important that policymakers have sufficient knowledge, experience and skills in climate and Embedding climate and environmental risks in governance and policy frameworks environmental risks to be able to assess the institution’s exposure to these risks and make balanced It is important that policymakers, making up the senior level of the institution, embed climate and decisions about them. We also pay particular attention to this when assessing the suitability of environmental risks in the governance, strategy, risk appetite and risk management framework. policymakers and other officers for whom we conduct fit and proper assessments (see Box 2 for As these risks can affect the institution in multiple ways, it is important to do this on an integrated additional information on these assessments). 21 As these risks are relatively new, complex and diverse, basis to ensure that these risks receive sufficient attention within the organisation and are adequately building fitness and propriety is particularly important. Since developments are fast-moving in this addressed. In doing so, they also promote a culture of values, standards and behaviour that contributes area, for example around new legislation, it is advisable to pay constant attention to this. to conscious consideration of climate and environmental risks. Policymakers also engage in a dialogue with relevant stakeholders so that their interests and views are included in the considerations. Box 2: Climate and environmental risks as part of fit and proper assessments Assigning responsibilities for climate and environmental risks within the institution’s own In fit and proper assessments at banks, insurers and pension funds, climate and environmental policymaking bodies risks are taken into account when assessing fitness. Among other things, we expect prospective Assigning tasks and responsibilities for climate and environmental risks in the institution’s own members of the management board, supervisory board, supervisory authority or other sole or policymaking bodies stresses the importance of this theme and demonstrates a commitment to joint policymakers to have knowledge of these risks, the relevant laws and regulations and to climate and environmental risks from “the top”. To ensure that climate and environmental risks are know how these risks may affect the institution. We also assess whether they have sufficient properly embedded, it is possible to examine which structure, working method and/or mutual division competences to properly assess these risks and include them in decision-making, such as a of tasks is appropriate within the institution’s own bodies. Various options are possible, including setting helicopter view, environmental sensitivity and strategic guidance. We apply this expectation up a specific management or supervisory board committee for climate and environmental risks. proportionately, taking into account the specific position, the institution’s nature, size, complexity and risk profile and the composition and performance of the body as whole. See: Climate-related risks are now a part of fit and proper assessments Organisation Allocating responsibilities and resources for climate and environmental risk management within the organisational structure By explicitly assigning roles and responsibilities and distributing them in a balanced way across functions, it is possible to take well-informed decisions on climate and environmental risks. The nature of these risks requires institutions to take account of major uncertainties surrounding the timing and impact of climate change and environmental degradation in decision-making. This makes it particularly important to include input from the relevant functions involved in the management of climate and environmental risks. Sufficient financial and human resources, including the required knowledge and skills, are important for the adequate performance of the functions. As developments are occurring rapidly in this area, it is advisable that the adequacy of resources, expertise and skills to manage climate and environmental risks is assessed on a regular basis. Aligning remuneration policies and practices with the climate and environmental risk strategy and management By aligning remuneration policies and practices with the institution’s strategy, goals, long-term targets and risk appetite, it is possible to encourage behaviour that can help achieve the institution’s climate and environmental targets. This could involve, for example, compliance with the institution’s own climate or footprint targets. Achieving such targets generally requires a gradual entry or exit path of several years. Focal area 3: Risk management Explicitly including climate and environmental risks in the existing risk appetite Figure 2: Risk management cycle The risk appetite is the starting point for the structure of the risk management cycle. By including in this risk appetite all material and other risks to which the institution is exposed, both now and in the future, an institution can indicate which climate and environmental risks it accepts in order to attain its strategic goals, and which it does not. As input for integrating climate and environmental risks in Risk Risk the risk appetite, the institution can investigate which risk categories are affected by climate and identification environmental risks and to what extent. Using a materiality analysis, the institution can determine which risks from the environmental analysis constitute a material risk (see Box 1 for focal points for the materiality analysis). For risks it considers material, the institution formulates a risk appetite and takes targeted measures. These could include a risk tolerance for market risk caused by asset impairment due to stricter climate policies. It is sensible to review this risk appetite regularly, particularly in view of the new and dynamic nature of climate and environmental risks and the related regulations. Integrating climate and environmental risks in the existing risk management cycle Risk Risk monitoring mitigation Including climate and environmental risks in the existing management cycle (see Figure 2) ensures ongoing attention for these risks. In this cycle, the institution identifies, assesses, mitigates, monitors Building a comprehensive picture of climate and environmental risks in the identification phase and evaluates its exposure to the relevant risks in the light of the established risk appetite. In its policy, In the identification phase, it is useful for the institution to build a comprehensive picture of the management information and risk reports, the institution can provide a written demonstration of the climate and environmental risks that affect the aforementioned business model and strategy and that way it manages risk through these steps in the management cycle. The identification and assessment generally arise in the medium to long term, but also how these risks will affect the current balance builds on financial institutions’ legally required risk assessments.22 sheet and organisation in the short term. This identification enables the institution to understand the climate and environmental risks to which it is exposed. Looking from different perspectives and considering interactions between risks helps to build a comprehensive pictur Using scenario analyses and stress tests to estimate exposure to climate and environmental risks Scenario analyses and stress tests can be useful tools given the uncertainties and complexities Box 3: Fo cal points fo r preparing and conducting scenario analyses associated with both short-term and long-term climate and environmental risks. For the shorter regular planning period, these tools can be used to identify the impact of these risks on capital (and Stage Action Explanatory notes required capital). Business impact analyses and continuity tests can also be used to test the resilience 1 Define goal Understanding long-term risks to the business model or of critical operational processes to climate and environmental risks. Longer-term scenario analyses are short-term financial risks. useful particularly to test the resilience of the business model. Examples are scenarios of temperature Input for risk management or strategic policy discussions. rises of 1.5 versus 3 or more degrees Celsius, or a scenario involving a disorderly transition to a 2 Choose scenarios Type (dependent on purpose): qualitative or quantitative, trend, exploratory or stress. sustainable economy. These can also be analyses of a qualitative nature that can provide input for Number: 2 or more, including 1.5 degree temperature rise. strategic planning and decision-making. See also box 3 for additional information on scenario analyses. 3 Assumptions, Assumptions: internal or aligned with recognised third parties measure and (NGFS, KNMI, et al.). Establishing appropriate risk tolerances and indicators for measuring and assessing climate and parameters Measure: choice of emissions, temperature rise. Parameters: type of transition (orderly and timely, disorderly or environmental risks no transition). For example, given the risk appetite, tolerances can be set on exposures to sectors or geographical Make prudent assumptions in a stress scenario. areas that are highly sensitive to climate and environmental risks and thus a source of market or 4 Time horizon Short (up to 5 years) and medium (5 to 10 years) horizon for financial risks and impact on soundness of the institution. counterparty risks. Clearly defined tolerances and, where possible, measurable indicators are Long horizon (>10 years) for qualitative estimates for impact on important for monitoring the risk appetite. To form a complete picture of the risks, it may be business environment and business model. necessary to formulate multiple indicators for a single risk. For example, these could be indicators 5 Method and Method: calculation model or storyline behind the scenarios. derived from certain concentration risks on investments and loans or indicators reflecting the procedure Procedure: include stakeholder engagement, workshops with experts. potential impact of physical risks on outsourcing. Where there is no quantitative data, it is possible to use qualitative indicators based on expert judgement. For each risk indicator, it is possible to use probability and impact analyses to assess whether the identified risk level falls within the risk tolerance and hence the risk appetite. Managing climate and environmental risks outside the risk tolerance If the potential impact of climate and environmental risks falls outside the established risk tolerance, it is important to indicate how these risks will be mitigated within a set timeframe. For example, an institution can reduce its carbon footprint or opt for investing in companies that invest in renewable energy. It is useful to evaluate the effectiveness of the mitigation tools used, to make this measurable where possible and to monitor it. Where measures are unlikely to be sufficient to align the risk profile with the risk appetite, appropriate follow-up steps are defined. Monitoring and periodically reporting exposure to climate and environmental risks By monitoring climate and environmental risks using the established risk indicators, these risks and their development can be tracked. For institutions that have committed themselves to certain climate targets or alliances, it is important to monitor the progress of these commitments to remain credible and avoid reputational risk. Risk reporting helps the policymaking body to take informed decisions on the management of material climate and environmental risks. Frequently evaluating the climate and environmental risk management cycle Developments in climate and environmental risks are occurring rapidly. There is increasing knowledge and understanding of the risks and their modelling, data coverage is growing and legislation is increasing. It is therefore important that an institution frequently evaluates its climate and environmental risk management cycle. In this evaluation, questions may arise such as: Is the list of identified risks still complete? Is the materiality estimate of the risks still correct? Is the impact of the risks being properly measured? Are the mitigation measures effective? By setting a target maturity level, the institution can identify what future steps are still needed to improve the risk management cycle.