Addressing biodiversity (loss) is not only relevant from an impact perspective; it is also quickly becoming a necessity for financial institutions to safeguard their portfolios against financial risks stemming from habitat destruction, deforestation, invasive species and/or diseases. 

In a previous article, published in November 2023, Zanders introduced the concept of biodiversity risks, explained how it can pose a risk for financial institutions, and discussed the expectations from regulators.¹ In addition, we touched upon our initial ideas to introduce biodiversity risks in the risk management framework. One of the suggestions was for financial institutions to start assessing the materiality of biodiversity risk, for example by classifying exposures based on sector or location. In this article, we describe Zanders’ approach for classifying biodiversity risks in more detail. More specifically, we explore the concepts behind the assessment of biodiversity risks, and we present key insights into methodologies for classifying the impact of biodiversity risks; including a use case. 

Understanding biodiversity risks 

Biodiversity risks can be related to physical risk and/or transition risk events. Biodiversity physical risks results from environmental decay, either event-driven or resulting from longer-term patterns. Biodiversity transition risks results from developments aimed at preventing or restoring damage to nature. These risks are driven by impacts and dependencies that an undertaking has on natural resources and ecosystem services. The definition of impacts and dependencies and its relation to physical and transitional risks is explained below:

• Companies impact natural assets through their business operations and output. For example, the production process of an oil company in a biodiversity sensitive area could lead to biodiversity loss. Impacts are mainly related to transition risk as sectors and economic activities that have a strong negative impact on environmental factors are likely to be the first affected by a change in policies, legal charges, or market changes related to preventing or restoring damage to nature. 
• On the other hand, companies are dependent on certain ecosystem services. For example, agricultural companies are dependent on ecosystem services such as water and pollination. Dependencies are mainly related to physical risk as companies with a high dependency will take the biggest hit from a disruption or decay of the ecosystem service caused by e.g. an oil spill or pests. 

For banks, the impacts and dependencies of their own operations and of their counterparties can impact traditional financial (credit, liquidity, and market) and non-financial (operational and business) risks. In our biodiversity classification methodology, we assess both impacts and dependencies as indicators for physical and transition risk. This is further described in the next section.

Zanders’ biodiversity classification methodology

An important starting point for climate-related and environmental (C&E) risk management is the risk identification and materiality assessment. For C&E risks, and biodiversity in particular, obtaining data is a challenge. A quantitative assessment of materiality is therefore difficult to achieve. To address this, Zanders has developed a data driven classification methodology. By classifying the biodiversity impact and dependencies of exposures based on the sector and location of the counterparty, scores that quantify the portfolio’s physical and transition risks related to biodiversity are calculated. These scores are based on the databases of Exploring Natural Capital Opportunities, Risks and Exposure (ENCORE) and the World Wide Fund for Nature (WWF). 

Sector classification 

The sector classification methodology is developed based on the ENCORE database. ENCORE is a public database that is recognized by global initiatives such as Taskforce on Nature-related Financial Disclosures (TNFD) and Partnership for Biodiversity Accounting Financials (PBAF). ENCORE is a key tool for the “Evaluate” phase of the TNFD LEAP approach (Locate, Evaluate, Assess and Prepare).  

ENCORE was developed specifically for financial institutions with the goal to assist them in performing a high-level but data-driven scan of their exposures’ impacts and dependencies. The scanning is made across multiple dimensions of the ecosystem, including biodiversity-related environmental drivers. ENCORE evaluates the potential reliance on ecosystem services² and the changes of impacts drivers³ on natural capital assets⁴. It does so by assigning scores to different levels of a sector classification (sector, subindustry and production process). These scores are assigned for 11 impact drivers and 21 ecosystem services. ENCORE provides a score ranging from Very Low to Very High for a broad range of production processes, sub-sectors and sectors. 

To compute the sector scores, ENCORE does not offer a methodology for aggregating scores for impacts drivers and ecosystem services. Therefore, ENCORE does not provide an overall dependency and impact per sector, sub-industry, or production process. However, Zanders has created a methodology to calculate a final aggregated impact and dependency score. The result of this aggregation is a single impact and a single dependency score for each ENCORE sector, sub-industry or production process. In addition, an overall impacts and dependencies scores are computed for the portfolio, based on its sector distribution. In both cases, scores range from 0 (no impact/dependency) to 5 (very high impact or dependency).

Location classification

The location scoring methodology is developed based on the WWF Biodiversity Risk Filter (hereafter called WWF BRF).⁵ The WWF BRF is a public tool that supports a location-specific analysis of physical- and transition-related biodiversity risks. 

The WWF BRF consists of a set of 33 biodiversity indicators: 20 related to physical risks and 13 related to reputational risks, which are provided at country, but also on a more granular regional level. These indicators are aggregated by the tool itself, which ultimately provides one single scape physical risk and scape reputational risk per location.

To compute overall location scores, the WWF BRF does not offer a methodology for aggregating scores for countries and determine the overall transition risk (based on the scape reputational risk scores) and physical risk (based on the scape physical risk scores). However, Zanders has created a methodology to calculate a final aggregated transition and physical risk score for the portfolio, based on its geographical distribution. The result of this aggregation is a single transition and physical risk score for the portfolio, ranging from 0 (no risk) to 5 (very high risk). 

Use case: RI&MA for biodiversity risks in a bank portfolio 

In this section, we present a use case of classifying biodiversity risks for the portfolio of a fictional financial institution, using the sector and location scoring methodologies developed by Zanders. 

The exposures of this financial institution are concentrated in four sectors: Real estate, Oil & Gas, Soft commodities and Luxury goods. Moreover, the operations of these sectors are located across four different countries: the Netherlands, Switzerland, Morocco and China. The following matrix shows the percentage of exposures of the financial institution for each combination of sector and country: 

ENCORE provides scores for 11 ecosystem services and 21 impacts drivers. Those related to biodiversity risks are transformed to a range from 0 to 5. After that, biodiversity ecosystem services and biodiversity impacts drivers are aggregated into an overall biodiversity impacts and dependencies scores, respectively. The following table shows the mapping between the sectors in the portfolio and the corresponding sub-industry in the ENCORE database, including the aggregated biodiversity impacts and dependencies scores computed for those sub-industries. The mapping is done at sub-industry level, since it is the level of granularity of the ENCORE sector classification that better fits the sectors defined in the fictional portfolio. In addition, the overall impacts and dependencies scores are computed, by taking the weighted average sized by the sector distribution of the portfolio. This leads to scores of 3.8 and 2.4 for the impacts and dependencies scores, respectively. 

The WWF BRF provides biodiversity indicators at country level. It already provides an aggregated score for physical risk (namely, scape physical score) and for transition risk (namely, scape reputational risk score), so no further aggregation is needed. Therefore, the corresponding scores for the four countries within the bank portfolio are selected. As the last step, the location scores are transformed to a range similar to the sector scores, i.e., from 0 (no physical/transition risk) to 5 (very high physical/transition risk). The results are shown in the following table. In addition, the overall impacts and dependencies scores are computed, by taking the weighted average sized by the geographical distribution of the portfolio. This leads to scores of 3.9 and 3.3 for the physical and transition risk scores, respectively. 

Results of the sector and location scores can be displayed for a better understanding and to enable comparison between sectors and countries. Bubble charts, such as the ones show below, present the sectors and location scores together with the size of the exposures in the portfolio (by the size of each bubble). 

Combined with the size of the exposures, the results suggest that biodiversity-related physical and transition risks could result in financial risks for Soft commodities and Oil & Gas. This is due to high impacts and dependencies and their relevant size in the portfolio. Moreover, despite a low dependencies score, biodiversity risks could also impact the Real estate sector due to a combination of its high impact score and the high sector concentration (45% of the portfolio). From a location perspective, exposures located in China could face high biodiversity transition risks, while exposures located in Morocco are the most vulnerable to biodiversity physical risks. In addition, relatively high scores for both physical and transition risk scores for Netherlands, combined with the large size of these exposures in the portfolio, could also lead to additional financial risk.’ 

These results, combined with other information such as loan maturities, identified transmission channels, or expert inputs, can be used to inform the materiality of biodiversity risks. 

Conclusion 

Assessing the materiality of biodiversity risks is crucial for financial institutions in order to understand the risks and opportunities in their loan portfolios. In this article, Zanders has presented its approach for an initial quantification of biodiversity risks. Curious to learn how Zanders can support your financial institutions with the identification and quantification of biodiversity risks and the integration into the risk frameworks? Please reach out to Marije Wiersma, Iryna Fedenko or Miguel Manzanares.

In recent years, consumers’ and investors’ interest in sustainability has been growing. Since 2015, assets under management in ESG funds have nearly tripled, the outstanding value of green bonds issued by residents of the euro area has surged eightfold, and emission-related derivatives have seen a more than sevenfold increase¹. 

The global push for sustainable and environmentally responsible practices has led to an increased focus on the role of financial institutions in supporting green initiatives. One of the ways financial institutions use to incentivise sustainable investments, is by designing new products, such as blue bonds to protect marine areas and other sustainability-linked bonds², or by transitioning to funding sectors with positive sustainability impact.

However, amidst the growing wave of environmental consciousness, the credibility of "green" claims made by some financial institutions is a point of concern. This phenomenon, known as greenwashing, is gaining attention, not only within financial institutions, but also with regulators. Financial regulators, including the European Supervisory Authorities (ESAs) and UK’s Financial Conduct Authority (FCA) have taken action against potentially misleading green statements made by institutions. Despite these regulatory interventions, the persistent risk of greenwashing persists, primarily due to the absence of consistent standards governing sustainability claims and disclosures. The lack of uniform criteria poses an ongoing challenge to effectively combatting greenwashing practices within the financial landscape.

Defining Greenwashing

The ESAs describe greenwashing as “a practice where sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. This practice may be misleading to consumers, investors, or other market participants” ³.

Financial institutions, as key players in the global economy, play a crucial role in fostering sustainability. However, some have been accused of using deceptive practices to push their green image without making substantial changes. This practice may be misleading to consumers, investors, and other market participants.

In practice, greenwashing can take different forms depending on the institution. For insurance companies, the European Insurance and Occupational Pensions Authority (EIOPA) found in their Advise to the European Commission on Greenwashing⁴ various examples where insurers misleadingly claimed to be transitioning their underwriting activities to net zero by 2050 without any credible plans to do so. Other examples include insurance companies falsely claiming to plant trees for each life insurance policy sold but failing to fulfil this promise, or products being marketed as sustainable merely because of a positive "ESG rating," despite the rating not taking into account any actual sustainability factors and focusing solely on financial risks.

Withing the banking sector, the EBA reported⁵ that the most common misleading claims relate to the current approach to integrating sustainability into the business strategy, claims on the sustainability results and the real-world impact, and claims on future commitments on medium and long-term plans.

Finally, for investment companies and pension funds, the European Securities and Markets Authority (ESMA) reported⁶ that most the common greenwashing practices result from exaggerated claims without any proven link between and ESG metric and the real-world impact.

Key Indicators of Greenwashing:

1. Vague and Ambiguous Language: Financial institutions engaging in greenwashing often use vague terms and ambiguous language in their marketing materials. This lack of clarity makes it challenging for consumers to discern the actual environmental impact of their investments.
2. Lack of Transparency: Genuine commitment to sustainability involves transparency about investment choices and the environmental impact of financial products. Institutions that are less forthcoming about their practices may be concealing less-than-green investments.
3. Inconsistent Policies: Greenwashing is also evident when there is a misalignment between a financial institution's sustainability claims and its actual policies and practices. Actions, or lack thereof, can speak louder than words.

The Role of Regulatory Bodies

Greenwashing poses potential reputational and financial risks for the institutions involved. Addressing greenwashing might not only improve consumer’s trust in the products and services offered by financial institutions, but also will allow customers to make informed decisions that are align with their sustainability preferences and increase the capital into products that genuinely represent a more sustainable choice and drive a positive change. Tackling greenwashing should therefore be a priority for regulatory supervisors.

The introduction of the EU’s Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFDR) addresses the initial concerns of greenwashing within the financial sector. The Taxonomy determines which economic activities are environmentally sustainable and addresses greenwashing by enabling market participants to identify and invest in sustainable assets with more confidence. SFDR promotes openness and transparency in sustainable finance transactions and requires Financial Market Participants to share the environmental and social impact of their transactions with stakeholders. In May 2023, the ESA published their progress report on greenwashing monitoring and supervision⁷. The report aims to provide insights into an understanding of greenwashing and identify the specific forms it can take within banking. It also evaluates greenwashing risk within the EU banking sector and determines the extend to which it might be and issue from a regulatory perspective.

In the UK, the FCA published in November 2023 a guidance consultation on the Anti-Greenwashing Rule⁸. The anti-greenwashing rule is one part of a package of measures introduced through the Sustainability Disclosure Requirements (SDR). The anti-greenwashing rule requires FCA-authorised firms to ensure that any claims they make to the sustainability characteristics of their financial products and services are consistent with the actual sustainability characteristics of the product or service and are fair, clear and not misleading, and have evidence to back them up. The propose rule will come into force on 31 May 2024.

While the existing and planned regulation contributes to addressing aspects of greenwashing, several measures have not yet fully entered into application, making the impact of the frameworks not visible yet. Beyond disclosures, regulators should also focus on tightening requirements on sustainability data and ratings, and creating mandates to prevent misleading statements and unfair commercial practices.

Going forward, as regulators gain more experience to comprehensively address greenwashing, financial institutions should expect increased supervision and enforcement of sustainable finance policies aimed at preventing misleading sustainability claims.

Actions to mitigate greenwashing risk

One of the biggest challenges financial institutions faced in relation to sustainability is that scientific progress, policy development and social values are in constant evolution. What was a well-supported green initiative two years ago can potentially be considered as greenwashing today.

In the meantime that stricter regulations and guidance is in place, financial institutions should take a broad view on how to develop and communicate sustainability strategies to mitigate greenwashing risk.

Here are three ways on how to prevent greenwashing:

1. Promote disclosure: financial institutions should publish comprehensive sustainability reports and disclose ESG information as part of their financial reports.
2. Commit to transparency: claims about environmental aspects or performance of their products should be justified with science-based and verifiable methods. Financial institutions should be transparent about their ambitions, status, and be open about any shortcomings they identified.
3. Align business practices with purpose:  financial institutions should determine which climate-related and environmental risks impact business strategy in the short, medium and long term. They should reflect climate-related and environmental risks in business strategies and its implementation. In addition, they should balance sustainability ambitions with the reality of real transformation.

Zanders’ approach to managing reputational risk

Avoiding greenwashing should always be a priority for institutions. If a risk arises in this area, reputational risk management can help to limit negative effects. Due to the interdependencies between ESG, reputational, business and liquidity risk, the supervisory authorities are also increasingly focusing on this area.

In the context of reputational risk management, we recommend a holistic approach that includes both existing and new business in the analysis. In addition to identifying critical transactions from a reputational perspective, the focus is also on active stakeholder management. This requires cross-departmental cooperation between various units within the institution. In many cases, the establishment of a reputation risk management committee is key to manage that topic properly within the institution.

Conclusion

While many financial institutions genuinely strive for sustainability, the rise of greenwashing highlights the need for increased vigilance and scrutiny. Consumers, regulators, and industry stakeholders must work together to ensure that financial institutions align their actions with their environmental claims, fostering a truly sustainable and responsible financial sector.

Curious to learn more? Please contact: Elena Paniagua-Avila or Martin Ruf

In October 2023, the European Banking Authority (EBA) published a report[1] with recommendations for enhancements to the Pillar 1 prudential framework to reflect environmental and social (E&S) risks, distinguishing between actions to be taken in the short term and in the medium to long term. The short-term actions are to be taken into account over the next three years as part of the implementation of the revised Capital Requirements Regulation and Capital Requirements Directive (CRR3/CRD6).

The EBA report follows a discussion paper on the same topic from May 2022[2], on which it solicited input from the financial industry. In this note, we provide an overview of the recommended actions by the EBA that relate to the prudential framework for banks. The EBA report also contains recommended actions for the prudential framework applying to investment firms, but these are not addressed here.

If the EBA’s recommendations are implemented in the prudential framework, in our view the most immediate implications for banks would be:

• When using external ratings to determine own fund requirements for credit risk under the standardized approach (SA) of Pillar 1, ensure that E&S risks are explicitly considered when evaluating the appropriateness of the external ratings as part of the due diligence requirements.
• When calculating own fund requirements for credit risk under the internal-ratings-based (IRB) approach, embed E&S risks in the rating assignment, risk quantification (for example through a margin of conservatism or the downturn component) and/or expert judgment and overrides.
• To assess E&S risks at a borrower level, establish a process to obtain and update material E&S-related information on the borrowers’ financial condition and credit facility characteristics, as part of due diligence during onboarding and ongoing monitoring of the borrowers’ risk profile.
• For IRB banks, embed E&S risks in the credit risk stress testing programs.
• Ensure that E&S risks are considered in the valuation of collateral, specifically for financial and real estate collateral.
• For market risk, embed environmental risks in trading book risk appetite, internal trading limits and the new product approval process. Furthermore, for banks aiming to use the internal model approach (IMA) of the Fundamental Review of the Trading Book (FRTB) regulation, environmental risks need to be considered in their stress testing program.
• For operational risk, identify whether E&S risks constitute triggers of operational risk losses.

We note that many of these implications align with the ECB’s expectations in the ECB Guide on climate-related and environmental risks[3].

Background

The EBA report considers both environmental and social risks, which the EBA characterizes as follows:

• As drivers of environmental risks, EBA distinguishes physical and transition (climate) risks. It does not explicitly refer in the report to other environmental risks, such as a loss of biodiversity or pollution, but in an earlier report the EBA considered these as part of chronic physical risks[4].
• EBA considers social factors to be related to the rights, well-being and interests of people and communities, including factors such as decent work, adequate living standards, inclusive and sustainable communities and societies, and human rights. As drivers of social risks, EBA distinguishes environmental factors (as materialization of physical and transition risks may change living standards and the labor market and increase social tensions, for example) as well as changes in policies and market sentiment. These may in part be driven by actions taken to meet the United Nation’s sustainable development goals (SDGs) in 2030.

In line with the ECB Guide on climate-related and environmental risks[5], the EBA does not view E&S risks as stand-alone risks, but as drivers of traditional banking risks. This is depicted in Figure 1. The report considers the impact on credit, market, operational, liquidity and concentration risks and reviews to what extent E&S risks can be reflected in capital buffers and the macro-prudential framework. It does not explicitly consider the securitization framework, although this will be implicitly affected by impacts on credit risk. The EBA does not see an impact of E&S risks on the (risk-insensitive) leverage ratio, and therefore does not consider it in the report.

Figure 1: Examples of transmission channels for environmental and social risks (source: EBA).

The EBA notes that the Pillar 1 framework has been designed to capture the possible financial impact of cyclical economic fluctuations, but not to capture the manifestation of long-term environmental risks. It is therefore important to keep the main principles that form the basis of the prudential framework in mind when contemplating adjustments to reflect E&S risks in the prudential framework. The main principles as highlighted by the EBA are summarized below.

Main principles of the prudential framework and the relation to the horizon for E&S risks  

With repect to the framework in general:

• Own fund requirements are intended to cover potential unexpected losses. In contrast, expected losses are directly deducted from own funds, and are generally captured in the accounting rules through provisions, impairments, write-downs and appropriate valuation of assets.
• The purpose of own fund requirements is to ensure resilience of an institution to unexpected adverse circumstances, before appropriate mitigating actions and strategy adjustments can be implemented. Therefore, environmental factors that can affect institutions in the short to medium term are expected to be reflected in the prudential framework. However, for those with an impact in the longer term, institutions are expected to take appropriate mitigating actions in their strategy.
• The high confidence level used in the Pillar 1 framework to protect institutions from risks over the short to medium horizon may no longer be achievable and appropriate if longer horizons would be considered.
• To the extent that institutions are exposed to E&S risks in relation to their specific strategy and business model, coverage of these risks in the Pillar 2 own-fund requirements instead of Pillar 1 could be appropriate. In addition, reflection of these risks in the Pillar 2 guidance for stress testing may be considered.

With respect to the internal-ratings-based (IRB) approach for credit risk:

• The Probability of Default (PD) represents a one-year default probability, which is required to be calibrated based on long-run average (‘through-the-cycle’) default rates. As such, longer-term risk characteristics of the obligor may be taken into account.
• The Credit Conversion Factor (CCF) as an estimate of potential additional drawdowns before default naturally relates to the one-year time horizon for the PD, but is expected to reflect the situation of an economic downturn.
• The time horizon for the Loss Given Default (LGD) extends to the full maturity of the exposure and/or the collection process and its calibration is also expected to reflect the situation of an economic downturn.  

In the following sections we summarize the EBA recommendations by risk type.

Credit risk

The recommendations of the EBA largely put the burden on financial institutions to take E&S risks into account in the inputs for the existing Pillar 1 framework and/or to apply conservatism or overrides to the outputs. It does not recommend to include explicit E&S risk-related elements in the determination of risk weights for rated and unrated exposures in the SA or in the risk-weight formulas of the IRB. The main reasons for not doing so are that it is not clear what common and objective E&S-related factors should be used as input, what the proper functional form would be, a lack of evidence on which the size of an adjustment could be based so that it results in proper risk differentiation, and the risk of double counting with the reflection of E&S risks in the inputs to the existing own funds calculations under Pillar 1 (external ratings in the SA and PD, LGD and CCF in the case of IRB). However, the EBA will continue to evaluate this possibility in the medium to long term. The EBA also does not recommend introducing an environment-related adjustment factor to the risk weights resulting from the existing Pillar 1 framework[6].

Recommended actions for credit risk

Short term

• SA) The EBA encourages rating agencies to integrate environmental and social factors as drivers in the external credit risk assessments and to provide enhanced disclosures and transparency about the rating methodologies.
• (SA) Financial institutions to explicitly consider environmental factors in the due diligence that they are required to perform when using external credit risk assessments.
• (IRB) Financial institutions to reflect E&S risks in the rating assignment, risk quantification (for example through a margin of conservatism or the downturn component) and/or expert judgment and overrides, without affecting the overall performance of the rating system. In this context:
  • Quantification of risks must be based on sufficient and reliable observations;
  • Overrides should be for specific, individual cases where the institution believes there is material exposure to E&S risks but it has insufficient information to quantify it. Such overrides need to be regularly assessed and challenged;
  • If an institution derives PDs for internal rating grades by a mapping to a scale from a credit rating institution, it needs to consider whether the default rates associated with the external scale reflect material E&S risks.
• To assess E&S risks at a borrower level, institutions need to have a process to obtain and update material E&S-related information on the borrowers’ financial condition and on credit facility characteristics, as part of the due diligence during onboarding and ongoing monitoring of borrowers’ risk profile.
• (IRB) Financial institutions to consider E&S risks in their stress testing programs.
• (SA, IRB) Financial institutions to ensure prudent valuation of immovable property collateral, considering climate-related physical and transition risks as well as other environmental risks. The prudent valuation should be considered at origination, re-valuation and during monitoring.

Medium to long term

• (SA) Financial institutions to monitor that environmental factors are reflected in financial collateral valuations through market values under Pillar 1 and valuation methodologies under Pillar 2.
• (SA) The EBA to consider whether benefits from the Infrastructure Supporting Factor (ISF) should only be applied to high-quality specialized lending corporate exposures that meet strong environmental standards.
• (SA) The EBA to consider adjusting risk weights, both in general and specifically for those assigned to real estate exposures.
• (IRB) As E&S risks materialize in defaults and loss rates over time, institutions need to redevelop or recalibrate their PD and LGD estimates.

(SA = standardized approach; IRB = Internal-rating-based approach)

Market risk

Within market risk, the EBA sees the main interaction of E&S risks with the equity, credit spread and commodity markets, in which E&S risks may cause additional volatility. In line with the existing regulatory guidance, the EBA expects E&S risks not to be treated as separate risk factors but as drivers of existing risk factors, with the exception of products for which cash flows depend specifically on ESG factors (‘ESG-linked products’).

The EBA does not recommend changes at this point to the standardized approach (SA) and the internal model approach (IMA) under the FRTB regulation, which will come into effect in the EU in 2025. The primary reason is the lack of sufficient evidence on the impact of E&S risks to enable a data driven approach, which forms the basis of the FRTB.

When calculating the expected shortfall (ES) measure under the IMA based on last 12 months' market data, the materialization of E&S risks will automatically be reflected in the market data that is used. When using market data from a stress period, either to calculate ES in the IMA or to calibrate risk factor shocks for the sensitivity-based measure (SbM) at a risk class level in the SA, the reflection of E&S risks will depend on the choice of stress period. To include E&S risks fully in the IMA but avoid overlap with the (partial) presence of E&S risks in historical data, the EBA views the consideration of E&S risks in a separate ‘risk not in the model engine’ (RNIME) add-on as most promising option for the medium to long term, leveraging the framework described in the ECB Guide to internal models[7].

Recommended actions for market risk

Short term

• (SA, IMA) Financial institutions to consider environmental risks in relation to their trading book risk appetite, internal trading limits and new product approval.
• (IMA) Financial institutions to consider environmental risk as part of their stress testing program that is required to get internal model approval.

Medium to long term

• (SA, IMA) Competent authorities to consider how to treat ESG-linked products for the residual risk add-on in the SA and in the IMA.(SA) The EBA to consider including a dimension for ESG risks in the existing equity and credit spread risk classes, or including a separate environmental risk class.
• (IMA) Financial institutions to consider ESG risks when monitoring risks that are not included in the model, for which the ECB’s RNIME framework could be used as a basis.

(SA = standardized approach; IRB = Internal-rating-based approach)

Operational risk

The EBA notes that various types of operational risks can increase as a result of E&S risks, including damage to physical assets, disruption of business processes and litigation. However, the new standardized approach (SA) for operational risk in the Basel III framework, which will come into effect in the EU in 2025, does not have a forward-looking component – it only considers historical loss experience (besides business indicators). Historical losses are unlikely to fully reflect the potential future impact of E&S risks, but there is as of yet insufficient evidence and data to quantify and consider this in an amendment of the SA.

Recommended actions for operational risk

Short term

• Financial institutions to identify whether E&S risks constitute triggers of operational risk losses.

Medium to long term

• Following evidence of E&S risk factors to trigger operational risk losses, the EBA to consider whether revisions to the BCBS SA methodology are warranted.

Liquidity risk

The EBA report describes three ways in which E&S risks may affect the liquidity coverage ratio (LCR) calculation. First, liquid assets that are specifically exposed to E&S risks may become less liquid and/or decrease in value. As a consequence, they may no longer satisfy the eligibility criteria for liquid assets. If they still do, then the decrease in market value would reflect the lower liquidity and reduce the LCR. Second, contingent liabilities arising from environmentally harmful investments would need to be included as outflows in the LCR calculation, thereby lowering the LCR. Third, a decrease in credit quality of receivables that are particularly exposed to E&S risks will decrease the inflows that can be taken into account in the LCR calculation. The EBA concludes that the existing LCR framework can capture the impact of E&S risks on the definition of liquid assets, outflows and inflows, so that no amendments are needed.

Regarding the existing framework for the net stable funding ratio (NSFR), the EBA notes that a reduction in the creditworthiness and/or liquidity of loans and securities exposed to E&S risks would lead to a higher requirement for stable funding and thereby negatively impact the NSFR. In this way, the existing NSFR framework can capture the impact of E&S risks on the definition of stable assets.

In summary, the EBA does not propose changes to the LCR and NSFR frameworks in relation to E&S risks. In case of excessive exposure to E&S risks for individual institutions, it notes that supervisors can set specific liquidity or funding requirements as part of the Pillar 2 framework for LCR and NSFR.

Concentration risk

The SA and IRB of the Pillar 1 framework for credit risk assume that a bank’s loan portfolio has full diversification of name-specific (idiosyncratic) risk and is well diversified across sectors and geographies. Because of these assumptions, the framework is not able to capture concentration risks, including those arising from E&S risks. In the current framework, single-name concentration risk is separately captured in Pillar 1 using the large exposure regime. Sector and geographic concentrations are considered in the SREP process under Pillar 2.

Recommended actions for concentration risk

Short term

• The EBA to develop a definition of environment-related concentration risk as well as exposure-based metrics for its quantification (e.g., ratio of exposures sensitive to a given environmental risk driver in a specific geographical area or in a specific industry sector over total exposures, total capital or RWA). These metrics will be part of supervisory reporting and, when relevant, external disclosure. In addition, they should be considered as part of Pillar 2 under SREP and/or supplement Pillar 3 disclosures on ESG risks.The EBA does not recommend to change the existing large exposure regime.

Medium to long term

• Based on the experience obtained with initial environment-related concentration risk metrics and quantification, the EBA may consider enhanced metrics and the appropriateness to introduce it in the Pillar 1 framework.
  • This would entail the design and calibration of possible limits and thresholds, add-ons or buffers, as well as the specification of possible consequences if there are breaches.

Capital buffers and macroprudential framework

An alternative to amending the calculation of capital requirements to capture E&S risks in the prudential framework would be to increase the minimum required level of capital and/or to implement ‘borrower-based measures’ (BMM). Such BMMs aim to prevent a build-up of risk concentrations, for example by setting upper bounds on loan-to-value or loan-to-income for mortgage lending. Of the various possibilities, the EBA deems the use of a systemic risk capital buffer as the most suitable, although a double counting with the inclusion of E&S risks in the calculation of capital requirements under Pillar 1 and 2 needs to be avoided.

Recommended actions for capital buffers and macroprudential framework

Short term

• The EBA to asses changes to the guidelines on the appropriate subsets of sectoral exposures to which a systematic risk buffer may be applied.

Medium to long term

• The EBA to coordinate with other ongoing initiatives and assess the most appropriate adjustments.

Conclusion

The EBA considers E&S risks as a new source of systemic risk, which may not be adequately captured in the existing prudential framework. At the same time, the EBA recognizes the challenges in assessing the impact of these risks on regulatory metrics. The challenges range from a lack of granular and comparable data, varying definitions of what is environmentally and socially sustainable, historic data not being representative of what can be expected in the future, to the high uncertainty about the probability of future materialization of E&S risks. Moreover, the time horizon considered in the existing Pillar 1 framework is much shorter than the long horizon over which environmental risks are likely to fully materialize, with an exception of short-term acute physical and transition risks.

Against this background, the EBA does not recommend concrete quantitative adjustments to the existing Pillar 1 framework at this point. Nonetheless, it does expect financial institutions to take E&S risks into account in the inputs to the existing Pillar 1 framework or to apply overrides based on expert judgment. The EBA further proposes actions that should provide more clarity over time about the drivers and materiality of E&S risks. In due time, this can provide the basis for quantitative amendments to the Pillar 1 framework.

If you are interested to discuss this topic in more detail or would like support to embed E&S risks in your organization, please contact Pieter Klaassen at p.klaassen@zandersgroup.com or +41 78 652 5505.

[1]EBA (2023), Report on the role of environmental and social risks in the prudential framework (link), October.

[2] EBA (2022), Discussion paper on the role of environmental risks in the prudential framework (link), May. For a summary, see the article (link) on the Zanders website.

[3] ECB (2020), Guide on climate-related and environmental risks (link), November.

[4] See section 2.3.2 in EBA (2021), Report on management and supervision of ESG risks for credit institutions and investment firms (link), June.

[5] ECB (2020), Guide on climate-related and environmental risks (link), November.

[6] In the current EU Pillar 1 framework, adjustments are included that result in lower risk weights for small- and medium-sized enterprises (SME) and infrastructure lending. As the EBA notes, these adjustments are not risk-based but have been included in the EU to support lending to SMEs and for infrastructure projects.

[7] See ECB (2019), ECB Guide to internal models (link).

In this report, biodiversity loss ranks as the fourth most pressing concern after climate change adaptation, mitigation failure, and natural disasters. For financial institutions (FIs), it is therefore a relevant risk that should be taken into account. So, how should FIs implement biodiversity risk in their risk management framework?

Despite an increasing awareness of the importance of biodiversity, human activities continue to significantly alter the ecosystems we depend on. The present rate of species going extinct is 10 to 100 times higher than the average observed over the past 10 million years, according to Partnership for Biodiversity Accounting Financials[i]. The Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES) reports that 75% of ecosystems have been modified by human actions, with 20% of terrestrial biomass lost, 25% under threat, and a projection of 1 million species facing extinction unless immediate action is taken. Resilience theory and planetary boundaries state that once a certain critical threshold is surpassed, the rate of change enters an exponential trajectory, leading to irreversible changes, and, as noted in a report by the Nederlandsche Bank (DNB), we are already close to that threshold[ii].

We will now explain biodiversity as a concept, why it is a significant risk for financial institutions (FIs), and how to start thinking about implementing biodiversity risk in a financial institutions’ risk management framework.

What is biodiversity?

The Convention on Biological Diversity (CBD) defines biodiversity as “the variability among living organisms from all sources including, i.a., terrestrial, marine and other aquatic ecosystems and the ecological complexes of which they are part.”[iii] Humans rely on ecosystems directly and indirectly as they provide us with resources, protection and services such as cleaning our air and water.

Biodiversity both affects and is affected by climate change. For example, ecosystems such as tropical forests and peatlands consist of a diverse wildlife and act as carbon sinks that reduce the pace of climate change. At the same time, ecosystems are threatened by the accelerating change caused by human-induced global warming. The IPBES and Intergovernmental Panel on Climate Change (IPCC), in their first-ever collaboration, state that “biodiversity loss and climate change are both driven by human economic activities and mutually reinforce each other. Neither will be successfully resolved unless both are tackled together.”[iv]

Why is it relevant for financial institutions?

While financial institutions’ own operations do not materially impact biodiversity, they do have impact on biodiversity through their financing. ASN Bank, for instance, calculated that the net biodiversity impact of its financed exposure is equivalent to around 516 square kilometres of lost biodiversity – which is roughly equal to the size of the isle of Ibiza in Spain[v]. The FIs’ impact on biodiversity also leads to opportunities. The Institute Financing Nature (IFN) report estimates that the financing gap for biodiversity is close to $700 billion annually[vi]. This emphasizes the importance of directing substantial financial resources towards biodiversity-positive initiatives.

At the same time, biodiversity loss also poses risks to financial institutions.

The global economy highly depends on biodiversity as a result of the increasedglobalization and interconnectedness of the financial system. Due to these factors, the effects of biodiversity losses are magnified and exacerbated through the financial system, which can result in significant financial losses. For example, approximately USD 44 trillion of the global GDP is highly or moderately dependent on nature (World Economic Forum, 2020). Specifically for financial institutions, the DNB estimated that Dutch FIs alone have EUR 510 billionof exposure to companies that are highly or very highly dependent on one or more ecosystems services[vii]. Furthermore, in the 2010 World Economic Forum report worldwide economic damage from biodiversity loss is estimated to be around USD 2 to 4.5 trillion annually. This is remarkably high when compared to the negative global financial damage of USD 1.7 trillion per year from greenhouse gas emissions (based on 2008 data), which demonstrates that institutions should not focus their attention solely on the effects of climate change when assessing climate & environmental risks[viii].

Examples of financial impact

Similarly to climate risk, biodiversity risk is expected to materialize through the traditional risk types a financial institution faces. To illustrate how biodiversity loss can affect individual financial institutions, we provide an example of the potential impact of physical biodiversity risk on, respectively, the credit risk and market risk of an institution:

Credit risk:

Failing ecosystem services can lead to disruptions of production, reducing the profits of counterparties. As a result, there is an increase in credit risk of these counterparties. For example, these disruptions can materialize in the following ways:

• A total of 75% of the global food crop rely on animals for their pollination. For the agricultural sector, deterioration or loss of pollinating species may result in significant crop yield reduction.
• Marine ecosystems are a natural defence against natural hazards. Wetlands prevented USD 650 million worth of damages during the 2012 Superstorm Sandy [OECD, 2019), while the material damage of hurricane Katrina would have been USD 150 billion less if the wetlands had not been lost.

Market risk:

The market value of investments of a financial institution can suffer from the interconnectedness of the global economy and concentration of production when a climate event happens. For example:

• A 2011 flood in Thailand impacted an area where most of the world's hard drives are manufactured. This led to a 20%-40% rise in global prices of the product[ix]. The impact of the local ecosystems for these type of products expose the dependency for investors as well as society as a whole.

Core part of the European Green Deal

The examples above are physical biodiversity risk examples. In addition to physical risk, biodiversity loss can also lead to transition risk – changes in the regulatory environment could imply less viable business models and an increase in costs, which will potentially affect the profitability and risk profile of financial institutions. While physical risk can be argued to materialize in a more distant future, transition risk is a more pressing concern as new measures have been released, for example by the European Commission, to transition to more sustainable and biodiversity friendly practices. These measures are included in the EU biodiversity strategy for 2030 and the EU’s Nature restoration law.

The EU’s biodiversity strategy for 2030 is a core part of European Green Deal. It is a comprehensive, ambitious, and long-term plan that focuses on protecting valuable or vulnerable ecosystems, restoring damaged ecosystems, financing transformation projects, and introducing accountability for nature-damaging activities. The strategy aims to put Europe's biodiversity on a path to recovery by 2030, and contains specific actions and commitments. The EU biodiversity strategy covers various aspects such as:

• Legal protection of an additional 4% of land area (up to a total of 7%) and 19% of sea area (up to a total of 30%)
• Strict protection of 9% of sea and 7% of land area (up to a total of 10% for both)
• Reduction of fertilizer use by at least 20%
• Setting measures for sustainable harvesting of marine resources

A major step forwards towards enforcement of the strategy is the approval of the Nature restoration law by the EU in July 2023, which will become the first continent-wide comprehensive law on biodiversity and ecosystems. The law is likely to impact the agricultural sector, as the bill allows for 30% of all former peatlands that are currently exploited for agriculture to be restored or partially shifted to other uses by 2030. By 2050, this should be at least 70%. These regulatory actions are expected to have a positive impact on biodiversity in the EU. However, a swift implementation may increase transition risk for companies that are affected by the regulation.

The ECB Guide on climate-related and environmental risks explicitly states that biodiversity loss is one of the risk drivers for financial institutions[x]. Furthermore, the ECB Guide requires financial institutions to asses both physical and transition risks stemming from biodiversity loss. In addition, the EBA Report on the Management and Supervision of ESG Risk for Credit Institutions and Investment Firms repeatedly refers to biodiversity when discussing physical and transition risks[xi].

Moreover, the topic ‘biodiversity and ecosystems’ is also covered by the Corporate Sustainability Reporting Directive (CSRD), which requires companies within its scope to disclose on several sustainability related matters using a double materiality perspective.[1] Biodiversity and ecosystems is one of five environmental sustainability matters covered by CSRD. At a minimum, financial institutions in scope of CSRD must perform a materiality assessment of impacts, risks and opportunities stemming from biodiversity and ecosystems. Furthermore, when biodiversity is assessed to be material, either from financial or impact materiality perspective, the institution is subject to granular biodiversity-related disclosure requirements covering, among others, topics such as business strategy, policies, actions, targets, and metrics.

Where to start?

In line with regulatory requirements, financial institutions should already be integrating biodiversity into their risk management practices. Zanders recognizes the challenges associated with biodiversity-related risk management, such as data availability and multidimensionality. Therefore, Zanders suggests to initiate this process by starting with the following two steps. The complexity of the methodologies can increase over time as the institution’s, the regulator’s and the market’s knowledge on biodiversity-related risks becomes more mature.  

1. Perform materiality assessment using the double materiality concept. This means that financial institutions should measure and analyze biodiversity-related financial materiality through the identification of risks and opportunities. Institutions should also assess their impacts on biodiversity, for example, through calculation of their biodiversity footprint. This can start with classifying exposures’ impact and dependency on biodiversity based on a sector-level analysis.
2. Integrate biodiversity-related risks considerations into their business strategy and risk management frameworks. From a business perspective, if material, financial institutions are expected to integrate biodiversity in their business strategy, and set policies and targets to manage the risks. Such actions could be engagement with clients to promote their sustainability practices, allocation of financing to ‘biodiversity-friendly’ projects, and/or development of biodiversity specific products. Moreover, institutions are expected to adjust their risk appetites to account for biodiversity-related risks and opportunities, establish KRIs along with limits and thresholds. Embedding material ESG risks in the risk appetite frameworks should include a description on how risk indicators and limits are allocated within the banking group, business lines and branches.

Considering the potential impact of biodiversity loss on financial institutions, it is crucial for them to extend their focus beyond climate change and also start assessing and managing biodiversity risks. Zanders can support financial institutions in measuring biodiversity-related risks and taking first steps in integrating these risks into risk frameworks. Curious to hear more on this? Please reach out to Marije Wiersma, Iryna Fedenko, or Jaap Gerrits.

[1] CSRD applies to large EU companies, including banks and insurance firms. The first companies subject to CSRD must disclose according to the requirements in the European Sustainability Reporting Standards (ESRS) from 2025 (over financial year 2024), and by the reporting year 2029, the majority of European companies will be subject to publishing the CSRD reports. The sustainability report should be a publicly available statement with information on the sustainability-matters that the company considers material. This statement needs to be audited with limited assurance.

[i] PBAF. (2023). Dependencies - Pertnership for Biodiversity Acccounting Financials (PBAF)

[ii] De Nederlandche Bank. (2020). Indepted to nature - Exploring biodiversity risks for the Dutch Financial Sector.

[iii] CBD. (2005). Handbook of the convention on biological diversity

[iv] IPBES. (2021). Tackling Biodiversity & Climate Crises Together & Their Combined Social Impacts

[v] ASN Bank (2022). ASN Bank Biodiversity Footprint

[vi] Paulson Institute. (2021). Financing nature: Closing the Global Biodiversity

[vii] De Nederlandche Bank. (2020). Indepted to nature - Exploring biodiversity risks for the Dutch Financial Sector

[viii] PwC for World Economic Forum. (2010). Biodiversity and business risk

[ix] All the examples related to credit and market risk are presented in the report by De Nederlandsche Bank. (2020). Biodiversity Opportunities and Risks for the Financial Sector

[x] ECB. (2020). Guide on climate-related and environmental risks.

[xi] EBA. (2021). EBA Report on Management and Supervision of ESG Risk for Credit Institutions and Investment Firms

Carbon offset processes are currently dominated by private actors providing legitimacy for the market. The two largest of these, Verra and Gold Standard, provide auditing services, carbon registries and a marketplace to sell carbon offsets, making them ubiquitous in the whole process. Due to this opacity and centralisation, the business models of the existing companies was criticised regarding its validity and the actual benefit for climate action. By buying an offset in the traditional manner, the buyer must place trust in these players and their business models. Alternative solutions that would enhance the transparency of the process as well as provide decentralised marketplaces are thus called for.

The conventional process

Carbon offsets are certificates or credits that represent a reduction or removal of greenhouse gas emissions from the atmosphere. Offset markets work by having companies and organizations voluntarily pay for carbon offsetting projects. Reasons for partaking in voluntary carbon markets vary from increased awareness of corporate responsibility to a belief that emissions legislation is inevitable, and it is thus better to partake earlier.

Some industries also suffer prohibitively expensive barriers for lowering their emissions, or simply can’t reduce them because of the nature of their business. These industries can instead benefit from carbon offsets, as they manage to lower overall carbon emissions while still staying in business. Environmental organisations run climate-friendly projects and offer certificate-based investments for companies or individuals who therefore can reduce their own carbon footprint. By purchasing such certificates, they invest in these projects and their actual or future reduction of emissions. However, on a global scale, it is not enough to simply lower our carbon footprint to negate the effects of climate change. Emissions would in practice have to be negative, so that even a target of 1,5-degree Celsius warming could be met. This is also remedied by carbon credits, as they offer us a chance of removing carbon from the atmosphere. In the current process, companies looking to take part in the offsetting market will at some point run into the aforementioned behemoths and therefore an opaque form of purchasing carbon offsets.

The blockchain approach

A blockchain is a secure and decentralised database or ledger which is shared among the nodes of a computer network. Therefore, this technology can offer a valid contribution addressing the opacity and centralisation of the traditional procedure. The intention of the first blockchain approaches were the distribution of digital information in a shared ledger that is agreed on jointly and updated in a transparent manner. The information is recorded in blocks and added to the chain irreversibly, thus preventing the alteration, deletion and irregular inclusion of data.

In the recent years, tokenization of (physical) assets and the creation of a digital version that is stored on the blockchain gained more interest. By utilizing blockchain technology, asset ownership can be tokenized, which enables fractional ownership, reduces intermediaries, and provides a secure and transparent ledger. This not only increases liquidity but also expands access to previously illiquid assets (like carbon offsets). The blockchain ledger allows for real-time settlement of transactions, increasing efficiency and reducing the risk of fraud. Additionally, tokens can be programmed to include certain rules and restrictions, such as limiting the number of tokens that can be issued or specifying how they can be traded, which can provide greater transparency and control over the asset.

Blockchain-based carbon offset process

The tokenisation process for carbon credits begins with the identification of a project that either captures or helps to avoid carbon creation. In this example, the focus is on carbon avoidance through solar panels. The generation of solar electricity is considered an offset, as alternative energy use would emit carbon dioxide, whereas solar power does not.

The solar panels provide information regarding their electricity generation, from which a figure is derived that represents the amount of carbon avoided and fed into a smart contract. A smart contract is a self-executing application that exist on the blockchain and performs actions based on its underlying code. In the blockchain-based carbon offset process, smart contracts convert the different tokens and send them to the owner’s wallet. The tokens used within the process are compliant with the ERC-721 Non-Fungible Token (NFT) standard, which represents a unique token that is distinguishable from others and cannot be exchanged for other units of the same asset. A practical example is a work of art that, even if replicated, is always slightly different.

In the first stage of the process, the owner claims a carbon receipt, based on the amount of carbon avoided by the solar panel. Thereby the aggregated amount of carbon avoided (also stored in a database just for replication purposes) is sent to the smart contract, which issues a carbon receipt of the corresponding figure to the owner. Carbon receipts can further be exchanged for a uniform amount of carbon credits (e.g. 5 kg, 10 kg, 15 kg) by interacting with the second smart contract. Carbon credits are designed to be traded on the decentralised marketplace, where the price is determined by the supply and demand of its participants. Ultimately, carbon credits can be exchanged for carbon certificates indicating the certificate owner and the amount of carbon offset. Comparable with a university diploma, carbon certificates are tied to the address of the owner that initiated the exchange and are therefore non-tradable. Figure 1 illustrates the process of the described blockchain-based carbon offset solution:

Figure 1: Process flow of a blockchain-based carbon offset solution

Conclusion

The outlined blockchain-based carbon offset process was developed by Zanders’ blockchain team in a proof of concept. It was designed as an approach to reduce dependence on central players and a transparent method of issuing carbon credits. The smart contracts that the platform interacts with are implemented on the Mumbai test network of the public Polygon blockchain, which allows for fast transaction processing and minimal fees. The PoC is up and running, tokenizing the carbon savings generated by one of our colleagues photovoltaic system, and can be showcased in a demo. However, there are some clear optimisations to the process that should be considered for a larger scale (commercial) setup.

If you're interested in exploring the concept and benefits of a blockchain-based carbon offset process involving decentralised issuance and exchange of digital assets, or if you would like to see a demo, you can contact Robert Richter or Justus Schleicher.

On Thursday 15 June 2023, Zanders hosted a roundtable on ‘Climate Scenario Design & Stress Testing’. In our head office in Utrecht, we welcomed risk managers from several Dutch banks. This article discusses our view on the topic and highlights key insights from the roundtable. 

In recent years, many banks took their first steps in the integration of climate and environmental (C&E) risks into their risk management frameworks. The initial work on climate-related risk modeling often took the form of scenario analysis and stress testing. For example, as part of the Internal Capital Adequacy Assessment Process (ICAAP) or by participating in the 2022 Climate Stress Test by the European Central Bank (ECB). To comply with the ECB’s expectations on C&E risks, banks are actively exploring methodologies and data sources for adequate climate scenario design and stress testing. The ECB requires that banks will meet their expectations on this topic by 31 December 2024. 

Our view

We believe that banks should start early with climate stress testing, but in a manageable and pragmatic way. Banks can then improve their methodologies and extend their scope over time. This allows for a gradual development of knowledge, data and methodologies within all relevant Risk teams. Zanders has identified the following steps in the process of climate scenario design and stress testing: 

• Step 1: Scenario selection 
  A bank has to select appropriate (climate) scenarios based on the bank’s climate risk materiality assessment. Important to consider in this phase is the purpose for which the scenarios will be used, whether the scenarios are in line with scientific pathways, and whether they account for different policy outcomes (like an early or late transition to a sustainable economy). 

• Step 2: Scope and variable definition 
  An appropriate scope must then be selected and appropriate variables defined. For example, banks need to determine which portfolios to take in scope, which time horizons to include, select the granularity of the output, the right level of stress, and which climate- and macro-economic variables to consider. 

• Step 3: Methodology 
  Then, the bank needs to develop methodologies to calculate the impact of the scenarios. There are no one-size-fits-all approaches and often a combination of different qualitative and quantitative methodologies is needed. We recommend that the climate stress test approach be initially simple and to focus on material exposures. 

• Step 4: Results 
  It is important to use the results of the scenario analysis in the relevant risk and business processes. The results can be used for the bank’s risk appetite and strategy. The results can also help to create awareness and understanding among internal stakeholders, and support external disclosures and compliance. 

• Step 5: Stress testing framework 
  Finally, banks should establish minimum standards for climate scenario design and stress testing. This framework should include, amongst others, policies and processes for data collection from different sources, how adequate knowledge and resources are ensured, and how the scenarios are kept up-to-date with the latest market developments. 

Key insights 

Prior to the roundtable, participants filled in a survey related to the progress, scope and challenges on climate risk stress testing. The key insights presented below are based on the results of this survey, together with the outcomes of the discussion thereafter. 

The financial sector has advanced with several aspects around integrating climate risks in risk management over the past year. This was recognized by all participants, as they had all performed some form of climate risk stress testing. The scope of the stress testing, however, was relatively limited in some cases. For example, all participants considered credit risk in their climate risk scenario with many also including market risk. Only a limited number of participants took other risk types into account. 

Furthermore, all participants assessed the short-term impact (up to 3 years) of the climate scenarios, whereas only around 40% and 10% assessed the impact on the medium term (3 to 10 years) and long term (>10 years), respectively. This is probably related to the fact that all participants used climate scenarios in their ICAAP, which typically covers a three-year horizon. The second most mentioned use for the climate scenarios, after the ICAAP, was the risk identification & materiality analysis. A smaller percentage of participants also used the climate scenarios for business strategy setting, ILAAP and portfolio management. 

The two topics that were unanimously mentioned as the main challenges in climate risk stress testing are data selection and gathering, and the quantification of climate risks into financial impacts, as shown in the graph below: 

• Insight 1: Assessing impact of climate risk beyond the short-term very much increases the complexity and uncertainty of the exercise 
  The participants indicated that climate stress testing beyond the short-term horizon (beyond 3 to 5 years) is very difficult. Beyond that horizon, the complexity of the (climate) scenarios increases materially due to uncertainties of clients’ transition plans, the bank’s own transition plan and climate strategy (e.g., related to pricing and client acceptance policies), and climate policies and actions from governments and regulators. Taking the transition plans of clients into account on a granular level is especially difficult when there is a large number of counterparties. There are no clear solutions to this. Some ideas that take longer-term effects into account were floated, such as adjusting the current valuation of various assets by translating future climate impact on assets into a net present value of impact or by taking climate impacts into account in the long-term macro-economic scenarios of IFRS9 models. 

• Insight 2: Whether to use a top-down or bottom-up approach depends on the circumstances 
  It was discussed whether a bottom-up stress test for climate scenarios is preferable to a top-down stress test. The consensus was that this depends on the circumstances, for example: 
  • Physical risks are asset- and location-specific; one street may flood but not the next. So, in that case a bottom-up assessment may be necessary for a more granular approach. On the other hand, for transition risks, less granularity might be sufficient as transition policies are defined on national or even supranational level, and trends and developments often materialize on sector-level. In those cases, a top-down type of analysis could be sufficient. 
  • If the climate stress test is used to get a general overview of where risks are concentrated, a top-down analysis may be appropriate. However, if it is used to steer clients, a more granular, bottom-up approach may be needed. 
  • A bottom-up approach could also be more suitable for longer-term scenarios as it allows to include counterparty-specific transition plans. For more short-term scenarios, a sector average may be sufficient, considering that there will be less transition during this period.

• Insight 3: Translating the results of climate risk stress testing into concrete actions is challenging 
  The results of the stress test can be used to further integrate climate risk into risk management processes such as materiality assessment, risk appetite, pricing, and client acceptance. Most participants, however, were still hesitant to link any binding actions to the results, such as setting risk limits (e.g., limiting exposures to a certain sector), adjusting client acceptance, or amending pricing policies. However, the ECB does require banks to consider climate impacts in these processes. The most mentioned uses of the climate risk stress testing results were risk identification & materiality assessments and risk monitoring.  

Conclusion 

Most banks have taken first steps in relation to climate scenario design and stress testing. However, many challenges still remain, for example around data selection and quantification methodologies. Efforts by banks, regulators and the market in general are required to overcome these challenges. 

Zanders has already supported several banks with climate scenario design and stress testing. This includes the creation of a climate scenario design framework, the definition of climate scenarios, and by quantifying climate risk impacts for the ICAAP. Next to that, we have performed research on modeling approaches that can be used to quantify the impact of transition and physical risks. If you are interested to know how we can help your organization with this, please reach out to Marije Wiersma.

More simply put, the EBA was asked to investigate whether the current prudential framework properly captures environmental and social risks. In response, the EBA published a Discussion Paper (DP) [1] in May 2022 to collect input from stakeholders such as academia and banking professionals.

These risks stem from the transition towards a low carbon economy and from the physical risks of damages due to extreme weather events. To address climate-related financial risks within the banking sector, the Basel Committee on Banking Supervision (BCBS) established a high-level Task Force on Climate-related Financial Risks in 2020. It contributes to the BCBS’s mandate to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

Both the BCBS’s Core principles for effective banking supervision¹ and the Supervisory Review and Evaluation Process (SREP) within the existing Basel Framework are considered sufficiently broad and flexible to accommodate additional supervisory responses to climate-related financial risks. It was felt, however, that supervisors and banks could benefit from the publication of the Principles for the effective management and supervision of climate-related financial risks². Through this publication, the BCBS seeks to promote a principles-based approach to improving risk management and supervisory practices regarding climate-related financial risks. The document contains principles directed to banks and principles directed to supervisory authorities. In this article, we present an overview of the principles directed to banks.

The BCBS published a draft of their Principles in November 2021. During the consultation phase, which lasted until February 2022, banks and supervisors could provide feedback. The BCBS incorporated their feedback in the final version of the Principles that were published in June 2022.

Principles for the management of climate-related financial risks

In total, twelve bank-focused principles are presented and grouped in eight categories. Each of the eight categories is briefly discussed below:

Corporate governance – Principles 1 to 3

The principles related to corporate governance state that banks first need to understand and assess the potential impact of climate risks on all fields they operate in. Subsequently, appropriate policies, procedures and controls need to be implemented to ensure effective management of the identified risks. Furthermore, roles and responsibilities need to be clearly defined and assigned throughout the bank. To successfully manage climate-related risks, banks should ensure an adequate understanding of climate-related financial risks and as well as adequate resources and skills at all relevant functions and business units within the bank. Finally, the board and senior management should ensure that all climate-related strategies are consistent with the bank’s stated goals and objectives.

Internal control framework – Principle 4

The fourth principle within the internal control framework subcategory requires banks to include clear definitions and assignment of climate-related responsibilities and reporting lines across all three lines of defense. Further requirements are then presented for each line of defense.

Capital and liquidity adequacy – Principle 5

After the identification and quantification of the climate-related financial risks, these risks need to be incorporated into banks’ Internal Capital (and Liquidity) Adequacy Assessment Process (ICLAAP). Banks should provide insights in which climate-related financial risks affect their capital and liquidity position. In addition, physical and transition risks relevant to a bank’s business model assessed as material over relevant time horizons, should be incorporated into their stress testing programs in order to evaluate the bank’s financial position under severe but plausible scenarios. Furthermore, the described incorporation in the ICLAAP to handle such financial risks, should be done iteratively and progressively, as the methodologies and data used to analyze these risks continue to mature over time.

Risk management process – Principle 6

The sixth principle connects to the previous one, as it states that a bank needs to identify, monitor and manage all climate-related financial risks that could materially impair their financial condition, including their capital resources and liquidity positions. The bank’s risk management framework should be comprehensive with respect to the (material) climate-related financial risks they are exposed to. Clear definitions and thresholds should be set for materiality. These need to be monitored closely and adjusted, if necessary, as climate-related risks are evolving.

Management monitoring and reporting – Principle 7

After ensuring that the risk framework is comprehensive, banks need to implement the monitoring and reporting of climate-related financial risks in a timely manner to facilitate effective decision-making. To achieve such reporting, a good data infrastructure should be in place at the bank. This allows it to identify, collect, cleanse, and centralize the data necessary to assess material climate-related financial risks. Furthermore, banks should actively collect additional data from clients and counterparties in order to develop a better understanding of their client’s transition strategies and risk profiles.

Management of credit, market, liquidity, operational risk – Principles 8 to 11

Banks should understand the impact of climate-related risk drivers on their credit risk profiles, market positions, liquidity risk profiles and operational risks. Clearly articulated credit policies and processes to identify, measure, evaluate, monitor, report and control or mitigate the impacts of material climate-related risk drivers on banks’ credit risk exposures should be in place. From a market risk perspective, banks should consider the potential losses in their portfolios due to climate-related risks. On the business operation and strategy side of banking activities, the impact of climate-related risks also plays a large role. For example, physical risks have to be taken into account when drafting business continuity plans. After understanding the different risks and their impacts, a range of risk mitigation options to control or mitigate climate-related financial risks need to be considered.

Scenario analysis – Principle 12

The final principle states that banks need to use scenario analysis to assess the resilience of their business models and strategies to a range of plausible climate-related pathways, and to determine the impact of climate-related risk drivers on their overall risk profile. Scenario analysis should reflect the overall relevant climate-related financial risks for banks, including both physical and transition risks. This analysis should be performed for different time horizons, both short- and long-term, and should be highly dynamic.

Changes to the BCBS risk framework draft and related publications

The final Principles have not changed much compared to the November 2021 consultation document. The most important changes are that the first principle, concerning corporate governance of banks, and the fifth principle, concerning capital and liquidity adequacy, have been extended. The corporate governance principle, for example, now also includes that banks should ensure that their internal strategies and risk appetite statements are consistent with any publicly communicated climate-related strategies and commitments. The capital and liquidity adequacy principle now includes a section requiring banks to incorporate material climate-related financial risks in their stress testing programs.

These twelve bank-focused principles, providing banks guidance on effective risk management of climate-related financial risks, can also be linked to the initiatives of other regulators such as the ECB. In November 2020, for example, the ECB provided a guide that describes how it expects institutions to consider climate-related and environmental risks, when formulating and implementing their business strategy, governance and risk management frameworks (the ECB expectations). These ECB expectations are in line with the BCBS Principles (and often more elaborate).

Zanders has gained relevant experience in implementing the ECB expectations at several Dutch banks. This experience ranges from risk identification and materiality assessments to the quantification of climate-related risks, ESG data frameworks, model validations, and scenario analysis. Please reach out to us if your bank is seeking support in implementing the BCBS Principles.

References
1) Basel Committee on Banking Supervision (2012). Core Principles for Effective Banking Supervision.
2) Basel Committee on Banking Supervision (2022). Principles for the effective management and supervision of climate-related financial risks.

In the below overview, we present an overview of the main ESG-related publications from the European Commission (EC), the European Central Bank (ECB), and the European Banking Authority (EBA).

This is complemented by the most important timelines that are stipulated in these regulations and guidelines. Additional regulations and guidelines that are expected for the next couple of years are also highlighted.

If you want to discuss any of them, don’t hesitate to reach out to our subject matter experts.

The most popular financial instruments in this regard are sustainability-linked loans and bonds. But more recently, corporates also started to focus on ESG-related derivatives. In short, these derivatives provide corporates with a financial incentive to improve their ESG performance, for instance by linking it to a sustainable KPI. This article aims to provide some guidance on the impact of regulation around ESG-related derivatives.

As covered in our first ESG-related derivatives article, a broad spectrum of instruments is included in this asset class, the most innovative ones being emission trading derivatives, renewable energy and fuel derivatives, and sustainability-linked derivatives (SLDs).

Currently, market participants and regulatory bodies are assessing if, and how new types of derivatives fit into existing derivatives regulation. In this regard, European and UK regulators are at the forefront of the regulatory review to foster activity and ensure safety of financial markets. Since it’s especially challenging for market participants to comprehend the impact of these regulations and the valuation implications of SLDs, we aim to provide guidance to corporates on these matters, with a special focus on the implications for corporate treasury.

Categorization & classification

When issuing an SLD, it’s important to understand which category the respective SLD falls in. That is, whether the SLD incorporates KPIs and the impact of cashflows in the derivatives instrument (category 1), or if the KPIs and related cashflows are stated in a separate agreement, in which the underlying derivatives transaction is mentioned for setting the reference amount to compute the KPI-linked cashflow (category 2). This categorization makes it easier to understand the regulations applying to the SLD, and the implications of those regulations.

In general, a category 1 SLD will be classified as derivative under European and UK regulations, and swap under US regulations, if the underlying financial contract is already classified as such. The addition of KPI elements to the underlying financial instrument is unlikely to change that classification.

Whether a category 2 SLD is classified as a derivative or swap is somewhat more complicated. In Europe, this type of SLD is classified as a derivative if it falls within the MIFID II catch-all provision, which must be determined on a case-by-case basis.

Overall, instruments that are classified as derivatives in Europe will also be classified as such in the UK. But to elaborate, a category 2 SLD will classified as a derivative in the UK if the payments of the financial instrument vary based on fluctuations in the KPIs.

When a category 2 SLD is issued in the US, it will only be classified as a swap if KPI-linked payments within the financial agreement go in two directions. Even if that is the case, the SLD may still be eligible for the status as commercial agreement outside of swaps regulation, but that is specific to facts and circumstances.

Apart from the classification as derivative or swap, it is also helpful to determine whether an SLD could be considered a hedging contract, so that it is eligible for hedging exemptions. The requirements for this are similar in Europe, the UK, and the US. Generally, category 1 SLDs are considered hedging contracts if the underlying instruments still follow the purpose of hedging commercial risks, after the KPI is incorporated. Category 2 SLDs are normally issued to meet sustainability goals, instead of hedging purposes. Therefore, it is unlikely that this category of SLDs will be classified as hedging contracts.

Regulation & valuation implications

When issuing an SLD that is classified as a derivative or swap, there are several regulatory and valuation implications relevant to treasury. These implications can be split up in six types which we will now explain in more detail. The six types (risk management, reporting, disclosure, benchmark-related considerations, prudential requirements, and valuation) are similar for corporates across Europe, the UK, and the US, unless otherwise mentioned.

Risk management

As is the case for other derivatives and swaps, corporate treasuries must meet confirmation requirements, undertake portfolio reconciliation, and perform portfolio compression for SLDs. Additionally, regulated companies are required to construct effective risk procedures for risk management, which includes documenting all risks associated with KPI-linked cashflows. While these points might be business as usual, it must also be determined if and how KPI-linked cashflows should be modeled for valuation obligations that apply to derivatives and swaps. For instance, initial margin models might need to be adjusted for SLDs, so they capture KPI-linked risks accurately.

Reporting

Corporate treasuries must report SLDs to trade repositories in Europe and the UK, and to swap data repositories in the US. Since these repositories require companies to report in line with prescriptive frameworks that do not specifically cover SLDs, it should be considered how to report KPI-linked features. As this is currently not clearly defined, issuers of SLDs are advised to discuss the establishment of clear reporting guidelines for this financial instrument with regulators and repositories. A good starting point for this could be the mark-to-market or mark-to-model valuation part of the EMIR reporting regulations.

Disclosure

Only Treasuries of European financial entities will be involved in meeting disclosure requirements of SLDs, as the legislation in the UK and US is behind on Europe in this respect, and non-financial market participants are not as strictly regulated. From January 2023, the second phase of the Sustainable Finance Disclosure Regulation (SFDR) will be in place, which requires financial companies to report periodically, and provide pre-contractual disclosures on SLDs. Treasuries of investment firms and portfolio managers are ought to contribute to this by reporting on sustainability-related impact of the SLDs compared to the impact of reference index and broad market index with sustainability indicators. In addition, they could leverage their knowledge of financial instruments to evaluate the probable impacts of sustainability risks on the returns of the SLDs.

Benchmark-related implications

In case the KPI of an SLD references or includes an index, it could be defined as a benchmark under European and UK legislation. In such cases, treasuries are advised to follow the same policy they have in place for benchmarks incorporated in other brown derivatives. Specific benchmark regulations in the US are currently non-existent, however, many US benchmark administrators maintain policies in compliance with the same principles as where the European and UK benchmark legislation is built on.
Prudential requirements

Since treasury departments of corporates around the world are required to calculate risk-weighted exposures for derivatives transactions as well as non-derivatives transactions, this is not different for SLDs. While there is currently little guidance on this for SLDs explicitly, that may change in the near future, as US prudential regulators are assessing the nature of the risk that is being assumed with in-scope market participants.

Valuation

The SLD market is still in its infancy, with SLD contracts being drawn up are often specific to the company issuing it, and therefore tailor made. The trading volume must go up, trade datasets are to be accurately maintained, and documentation should be standardized on a global scale for the market to reach transparency and efficiency. This will lead to the possibility of accurate pricing and reliable cashflow management of this financial instrument and increases the ability to hedge the ESG component.

To conclude

As aforementioned, the ESG-related derivatives market and the SLD market within it are still in the development phase. Therefore, regulations and their implications will evolve swiftly. However, the key points to consider for corporate treasury when issuing an SLD presented in this article can prove to be a good starting point for meeting regulatory requirements as well as developing accurate valuation methodology. This is important, since these derivatives transactions will be crucial for facilitating the lending, investment and debt issuance required to meet the ESG ambitions of Europe, the UK, and the US.

For more information on ESG issues, please contact Joris van den Beld or Sander van Tol.