Explore how Zanders’ scoring methodology quantifies biodiversity risks, enabling financial institutions to safeguard portfolios from environmental and transition impacts.
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.
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:
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.
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).
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).
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).
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.
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.
On Thursday 15 June 2023, Zanders hosted a roundtable on ‘Climate Scenario Design & Stress Testing’. This article discusses our view on the topic and highlights key insights from the roundtable.
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.
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:
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:
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.
In March 2021, the European Banking Authority (EBA) was mandated through Article 501c of the Capital Requirements Regulation (CRR) to “assess […] whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified”.
After briefly presenting the DP, this article reviews the current Pillar 1 Capital (P1C) requirements. We limit ourselves to the P1C requirements for credit risk as this is by far the largest risk type for banks. Furthermore, we only discuss the interaction of the P1C with climate change risks (as opposed to broader environmental and/or social risk types). After establishing the extent to which the prudential framework takes climate change risks into account, possible amendments to the framework will be considered.
Key take-aways of this article:
In the introduction of the DP, the EBA mentions the increasing environmental risks – and their interaction with the traditional risk types – as the trigger for the review of the prudential framework. One of the main concerns is whether the current framework is sufficiently capturing the impact of transition risks and the more frequent and severe physical risks expected in the coming decades. In this context, they stress the special characteristics of environmental risks: compared to the traditional risk types, environmental risks tend to have a “multidimensional, non-linear, uncertain and forward-looking nature.”
The EBA also explains that the P1C requirements are not intended to cover all risks a financial institution is exposed to. The P1C represents a baseline capital requirement that is complemented by the Pillar 2 Capital requirement, which is more reflective of a financial institution’s specific business model and risks. Still, it is warranted to assess whether environmental risks are appropriately reflected in the P1C requirements, especially if these lead to systemic risks.
Even though the DP raises more questions than it provides answers, some starting points for the discussion are introduced. One is that the EBA takes a risk-based approach. Their standpoint is that changes to the prudential framework should reflect actual risk differentials compared to other risk types and that it should not be a tool to (unjustly) incentivize the transition to a sustainable economy. The latter lies “in the remit of political authorities.”
The DP also discusses some challenges related to environmental risks. One example is the lack of high-quality, granular historical data, which is needed to support the calibration of the prudential framework. The EBA also mentions the mismatch in the time horizon for the prudential framework (i.e., a business cycle) and the time horizon over which the environmental risks will unfold (i.e., several decades). They wonder whether “the business cycle concepts and assumptions that are used in estimating risk weights and capital requirements are sufficient to capture the emergence of these risks.”
Finally, the EBA does not favor supporting and/or penalizing factors, i.e., the introduction of adjustments to the existing risk weights based on a (green) taxonomy-based classification of the exposures1. They are right to argue that there is no direct relationship between an exposure’s sustainability profile and its credit risk. In addition, there is a risk of double counting if environmental risk drivers have already been reflected in the current prudential framework. Consequently, the EBA concludes that targeted amendments to the framework may be more appropriate. An example would be to ensure that environmental risks are properly included in external credit ratings and the credit risk models of financial institutions. We explain this in more detail in the following paragraphs.
The assessment to what extent climate change risks are properly captured in the current prudential framework requires at least a high-level understanding of the framework. Figure 1 presents a schematic overview of the P1C requirements.
The P1C (at the top of Figure 1) depends on the total amount of Risk-Weighted Assets (RWAs; on the row below)2. RWAs are determined separately for each (traditional) risk type. As mentioned, we only focus on credit risk in this article. The RWAs for credit risk are approximately 80% of the average bank’s total RWAs3. Financial institutions can choose between two methodologies for determining their credit risk RWAs: the Standardized Approach (SA)4 and the internal ratings-based (IRB) approach5 . In Europe, on average 40% of the total RWAs for credit risk are based on the SA, while the rest is based on the IRB approach6 :
Figure 1 – Schematic overview of the P1C requirements and the interaction with climate change risks
In the SA, risk weights (RWs) are assigned to individual exposures, depending on their exposure class. About 50% of the RWAs for credit risk in the SA stem from the Corporates exposure class7. Generally speaking, there are three possible RW drivers: the RWAs depend on the external credit rating for the exposure, a fixed RW applies, or the RW depends on the Loan-to-Value8 (LtV) of the (real estate) exposure. The RW for an exposure to a sovereign bond for example, is either equal to 100% if no external credit rating is available (a fixed RW) or it ranges between 0% (for an AAA to AA-rated bond) and 150% (for a below B-rated bond).
Within the IRB approach, a distinction is made between Foundation IRB (F-IRB) and Advanced IRB (A-IRB). In both cases, a financial institution is allowed to use its internal models to determine the Probability of Default (PD) for the exposure. In the A-IRB approach, the financial institution in addition is allowed to use internal models to determine the Loss Given Default (LGD), Exposure at Default (EAD), and the Effective Maturity (M).
The overview of the P1C requirements introduced in the previous section allows us to investigate the interaction between climate change risks and the P1C requirement. This is done separately for the SA and the IRB approach.
In the SA, there are two elements that allow for interaction between climate change risks and the resulting P1C. Climate change risks could be reflected in the P1C if the RW depends on an external credit rating, and this rating in turn properly accounts for climate change risks in the assessment of the counterparty’s creditworthiness (see 1 in Figure 1). The same holds if the RW depends on the LtV and in turn, the collateral valuation properly accounts for climate change risks (see 2 in Figure 1). This raises several concerns:
First, it can be questioned whether external credit ratings are properly capturing all climate change risks. In a report from the Network for Greening the Financial System (NGFS) [3], which was published at the same time as EBA’s DP, it is stated that credit rating agencies (CRAs) have so far not attempted to determine the credit impact of environmental risk factors (through back-testing for example). Also, the lack of high-quality historical data is mentioned as an explanation that statistical relationships between environmental risks and credit ratings have not been quantified. Further, a paper published by the ECB [4] concludes that, given the current level of disclosures, it is impossible for users of credit ratings to establish the magnitude of adjustments to the credit rating stemming from ESG-related risks. Nevertheless, they state that credit rating agencies “have made significant progress with their disclosures and methodologies around ESG in recent years.” The need for this is supported by academic research. An example is a study [5] from 2021 in which a correlation between credit default swap (CDS) spreads and ESG performance was demonstrated, and a study from 2020 [6] which demonstrated that high emitting companies have a shorter distance-to-default.
Secondly, the EBA has reported in the DP that less than 10% of the SA’s total RWAs is derived based on external credit ratings. This implies that a large share of the total RWAs is assigned a fixed RW. Obviously, in those cases there is no link between the P1C and the climate change risks involved in those exposures.
Finally, climate change risks only impact the P1C maintained for real estate exposures to the extent that these risks have been reflected in collateral valuations. Although climate change risks are priced in financial markets according to academic literature, many papers and institutions indicate that these risks are not (yet) fully reflected. In a survey held by Stroebel and Wurgler in 2021 [7], it is shown that a large majority of the respondents (consisting of finance academics, professionals and public sector regulators, among others) is of the opinion that climate change risks have insufficiently been priced in financial markets. A nice overview of this and related literature is presented in a publication from the Bank for International Settlements (BIS) [8]. The EBA DP itself lists some research papers in chapter 5.1 that indicate a relationship between a home’s sales price and its energy efficiency, or with the occurrence of physical risk events. It is unclear though if climate change risks are fully captured in the collateral valuations. For example, research is presented that information on flood risk is not priced into residential property prices. Recent research by ABN AMRO [9] also shows this.
In the IRB approach, financial institutions have more flexibility to include climate change risks in their internal models (see 3 in Figure 1). In the F-IRB approach this is limited to PD models, but in the A-IRB approach also LGD models can be adjusted.
A complicating factor is the forward-looking nature of climate change risks. In recent years, the competent authorities have pressured financial institutions to use historical data as much as possible in their model calibration and to back-test the performance of their models. As climate change risks will unfold over the next couple of decades, these are not (yet) reflected in historical data. To incorporate climate change risk, expert judgement would therefore be required. This has been discouraged over the past years (e.g., through the ECB’s Targeted Review of Internal Models (TRIM)) and it will probably trigger a discussion with the competent authorities. A possible deterioration of model performance (due to higher estimated risks compared to historically observations) is just one example that may attract attention.
Another complicating factor is that under the IRB approach, the PD of an obligor is estimated based on long-run average one-year default rates. While this may be an appropriate approach if there are no clear indications that the overall risk level will change, this does not hold if climate change risks increase in the future, and possibly increase systemic risks. By continuing to base a PD model on historical data only, especially for exposures with a time to maturity beyond a couple of years, the credit risk may be understated.
We have explained that there are several mechanisms in the prudential framework that allow environmental risks to be included in the P1C: the use of external credit ratings, the valuation of collateral, and the PD and LGD models used in the IRB approach. We have also seen, however, that it is questionable whether these mechanisms are fully effective. External credit ratings may not properly reflect all environmental risks and these risks may not be fully priced in on capital markets, leading to incorrect collateral values. Finally, a large share of the RWAs for credit risk depends on fixed RWs that are not (environmentally) risk-sensitive.
Consequently, it can be argued that amendments or enhancements to the prudential framework are needed. One must be careful, however, as the risk of double counting is just around the corner. Therefore, the following amendments or actions should be considered:
Based on the schematic overview of the P1C requirements and the (potential) interaction with climate change risks, we conclude that several mechanisms in the prudential framework allow for climate change risks to be incorporated into the P1C. At the same time, we conclude that this interaction is limited to specific parts of the portfolio, and that in those cases it remains to be seen to what extent this is properly accounted for. To remedy this, amendments to the prudential framework could be considered. It is important, however, to avoid double counting issues and to be mindful of time horizon differences.
It is expected that the EBA will publish a final report on the prudential treatment of environmental risks in the first half of this year. However, especially financial institutions that are using the IRB approach should not take a wait-and-see approach. Given the complexity of modeling climate change risks, it is prudent to start incorporating climate change risks into PD and LGD models sooner rather than later.
With Zanders’ extensive experience covering both credit risk modeling and climate change risk, we are well suited to support with this process. If you are looking for support, please reach out to us.
In March 2021, the European Banking Authority (EBA) was mandated through Article 501c of the Capital Requirements Regulation (CRR) to “assess […] whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified”.
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.
In total, twelve bank-focused principles are presented and grouped in eight categories. Each of the eight categories is briefly discussed below:
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.
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.
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.
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.
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.
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.
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.
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.
In March 2021, the European Banking Authority (EBA) was mandated through Article 501c of the Capital Requirements Regulation (CRR) to “assess […] whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified”.
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.
Financial institutions (FIs) play an important role in the transition towards a more sustainable economy in which Environmental, Social and Governance (ESG) factors are properly addressed.
But to seize the opportunities ESG must become an integrated part of a bank’s strategy, risk management and disclosure regimes. High-quality data is instrumental to identify and measure ESG risks, but it can be lacking. FIs need to improve their internal data and use of external private and public vendors like Moody’s or the IMF, while developing a framework that plugs any data gaps.
The lack of appropriate ESG data is considered one of the main challenges for many FIs, but proxies, such as using a building’s energy rating to work out its carbon emissions, can be used.
FIs need climate change-related data that isn’t always available if you don’t know where to look. This article will give you an overview of the most relevant data vendors and provide suggestions on how to treat missing data gaps in order to get a comprehensive ESG framework for the green future where carbon measurement, assessment, reporting and trading will be vital
In May 2021, the Network for Greening the Financial System (NGFS) published a ‘Progress report on bridging data gaps’. In this report, the NGFS writes that meeting climate-related data needs is a challenge that can be described along the following three dimensions:
A further breakdown of the challenges related to these dimensions can be found in Figure 1.
Figure 1: The dimensions of the climate-related data challenge.
Source: Graphic adapted by Zanders from a NGFS report entitled: ‘Progress report on bridging data gaps’ (2021).
The NGFS writes that a mix of policy interventions is necessary to ensure climate-related data is based on three building blocks:
Several initiatives have started to ignite these needed policy interventions. For example, the EU Taxonomy, introduced by the European Commission (EC), is a classification system for environmentally sustainable activities. In addition, the recently approved Corporate Sustainability Reporting Directive (CSRD) provides ESG reporting rules for large listed and non-listed companies in the EU, including several FIs. The aim of the CSRD is to prevent greenwashing and to provide the basis for global sustainability reporting standards. Another example of a disclosure standard is the binding standards on Pillar 3 disclosures on ESG risks developed by the European Banking Authority (EBA).
Even though policy, law and regulation makers have a big part to play in the data challenge, there are also steps that individual institutions could and should take to improve their own ESG data gaps. Regulatory bodies such as the EBA and the European Central Bank (ECB) have shared their expectations and recommendations on the management of ESG data with FIs.
To illustrate, the EBA recommends FIs “[identify] the gaps they are facing in terms of data and methodologies and take remedial action” and the ECB expects institutions to “assess their data needs in order to inform their strategy-setting and risk management, to identify the gaps compared with current data and to devise a plan to overcome these gaps and tackle any insufficiencies”
Collecting ESG data is a challenging exercise. A distinction can be made between collecting data for large market cap companies, and small cap companies and retail clients. Although large cap companies tend to be more transparent, the data often is dispersed over multiple reports – for example, corporate sustainability reports, annual reports, emissions disclosures, company websites, and so on.
For small cap companies and retail clients, the data is more difficult to acquire. Data that is not publicly available could be gathered bilaterally from clients. For example, one European bank has developed an annual client questionnaire to collect data from its clients.
Gathering data from various reports or bilaterally from clients might not always be the best option, however, because it is time consuming or because the data is not available, reliable, or comparable. Two alternatives are:
This could be forward-looking external data on macro-economic expectations, international climate scenarios, financial market data or sectoral climate developments. Below we discuss some sources for external ESG and climate change-related data.
Some of Zanders’ clients resort to vendor solutions for acquiring their ESG data. The most commonly observed solutions, in random order, are:
All the solutions above provide an aid to determine if climate related performance data is lacking, or can assist in reporting comparable and reliable data. They all apply a similar process of collecting the data and determining ESG scores, which is illustrated in Figure 2.
Figure 2: Data collection process for ESG data solutions (Source: Zanders).
Additionally, public and non-commercial data and solution providers are available, such as:
Given the data challenges, it is nearly impossible to create a complete data set. Until that is possible, there are several (temporary) methods to deal with missing data:
The increased attention to integrating ESG risks into existing risk frameworks has led to a need for FIs to collect and disclose meaningful data on ESG factors. However, there is still a lack of data availability, reliability, and comparability.
Several regulatory and political efforts are ongoing to tackle this data challenge, such as the EU taxonomy. More policy interventions, however, are required. Examples are additional mandatory disclosure requirements, an audit and validation framework for ESG data, and social and governance taxonomies that classify economic activities that contribute to social and governance goals.
In the meantime, FIs have to find ways to produce meaningful insights and comply with regulatory requirements related to ESG risks. Zanders has experienced that there is no one-size-fits-all solution for defining, selecting, implementing, and disclosing relevant data and metrics. It is dependent on the composition of the asset and loan portfolio, the use of the data, and the data that is (already) available. Regardless of how the lack of data is solved, it is important that FIs are transparent about their choices and methodologies, and that the related metrics and scorings are explainable and intuitive.
Sources:
https://www.ngfs.net/sites/default/files/medias/documents/progress_report_on_bridging_data_gaps.pdf
https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en
https://www.europarl.europa.eu/news/en/press-room/20220620IPR33413/new-social-and-environmental-reporting-rules-for-large-companies
https://zandersgroup.com/en/insights/blog/ebas-binding-standards-on-pillar-3-disclosures-on-esg-risks
https://www.eba.europa.eu/sites/default/documents/files/document_library/Publications/Reports/2021/1015656/EBA%20Report%20on%20ESG%20risks%20management%20and%20supervision.pdf
https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideonclimate-relatedandenvironmentalrisks~58213f6564.en.pdf
https://2degrees-investing.org/resource/pacta/
Financial institutions (FIs) play an important role in the transition towards a more sustainable economy in which Environmental, Social and Governance (ESG) factors are properly addressed.
The Working Group II contribution to the IPCC’s Sixth Assessment Report states that “climate change is a grave and mounting threat to our wellbeing and a healthy planet”. It is a formidable, global challenge to transition to a sustainable economy before time is running out. Banks have an important role to play in this transition. By stepping up to this role now, banks will be better prepared for the future, and reap the benefits along the way.
In the Paris Agreement (or COP21), adopted in December 2015, 196 parties agreed to limit global warming to well below 2.0°C, and preferably to no more than 1.5°C. To prevent irreversible impacts to our climate, the IPCC stresses that the increase in global temperature (relative to the pre-industrial era) needs to remain below 1.5°C. To achieve this target, a rapid and unprecedented decrease in the emission of greenhouse gasses (GHG) is required. With CO2 emissions still on the rise, as depicted in Figure 1, the challenge at hand has increased considerably in the past decade.
Figure 1 – Annual CO2 emissions from fossil fuels.
To further illustrate this, Figure 2 depicts for several starting years a possible pathway in CO2 reductions to ensure global warming does not exceed 2.0°C. Even under the assumption that CO2 emissions have already peaked, it becomes clear that the required speed of CO2 reductions is rapidly increasing with every year of inaction. We are a long way from limiting global warming to 2.0°C. This even holds under the assumption that all countries’ pledges to reduce GHG emissions will be achieved, as can be observed in Figure 3.
To quote the IPCC Working Group II co-chair Hans-Otto Pörtner: “Any further delay in concerted anticipatory global action on adaptation and mitigation will miss a brief and rapidly closing window of opportunity to secure a livable and sustainable future for all.”
Figure 2 – CO2 reduction need to limit global warming.
Figure 3 – Global GHG emissions and warming scenario’s.
Historically, banks have been instrumental to the proper functioning of the economy. In their role as financial intermediaries, they bring together savers and borrowers, support investment, and play an important role in facilitating payments and transactions. Now, banks have the opportunity to become instrumental to the proper functioning of the planet. By allocating their available capital to ‘green’ loans and investments at the expense of their ‘brown’ counterparts, banks can play a pivotal role in the transition to a sustainable economy. Banks are in the extraordinary position to make a fundamentally positive contribution to society. And even better, it comes with new opportunities.
The transition to a sustainable economy requires huge investments. It ranges from investments in climate change adaption to investments in GHG emission reductions: this covers for example investments in flood risk warning systems and financing a radical change in our energy mix from fossil-fuel based sources (like coal and natural gas) to clean energy sources (like solar and wind power). According to the Net Zero by 2050 Report from the International Energy Agency (IEA)2, the annual investments in the energy sector alone will increase from the current USD 2.3 trillion to USD 5.0 trillion by 2030. Hence, across sectors, the increase in annual investments could easily be USD 3.0 to 4.0 trillion. As much as 70% of this investment may need to be financed by the private sector (including banks and other financial institutions)3. To put this in perspective, the total outstanding credit to non-financial corporates currently stands at USD 86.3 trillion4. Assuming an average loan maturity of 5 years, this would translate to a 12-16% increase in loans and investments by banks on a global level. Hence, the transition to a sustainable economy will open up a large market for banks through direct investments and financing provided to corporates and households.
The transition to a sustainable economy is also triggering product development. The Climate Bonds Initiative (CBI) for example reports that the combined issuance of Environmental, Social, and Governance (ESG) bonds, sustainability-linked bonds and transition debt reached almost USD 500 billion in 2021H1, representing a 59% year-on-year growth rate. Other initiatives include the introduction of ‘green’ exchange-traded funds (ETFs) and sustainability-linked derivatives. The latter first appeared in 2019 and they provide an incentive for companies to achieve sustainable performance targets. If targets are met, a company is for example eligible for a more attractive interest coupon. Again, this is creating an interesting market for banks.
By embracing the transition, with all the opportunities that it offers, banks are also bracing themselves for the future. Banks that adopt climate change-resilient business models and integrate climate risk management into their risk frameworks will be much better positioned than banks that do not. They will be less exposed to climate-related risks, ranging from physical and transition risks to risks stemming from a reputational perspective or litigation, also justifying lower capital requirements. The early adaptors of today will be the leaders of tomorrow.
How should a bank approach this transition? As depicted in Figure 4, we identify four important steps: target setting, measurement and reporting, strategy and risk framework, and engaging with clients.
Figure 4 – The roadmap supporting the transition to a sustainable economy.
Target setting
The starting point for each transition is to set GHG emission targets in alignment with emission pathways that have been established by climate science. One important initiative that can support banks in setting these targets is the Science Based Targets initiative (SBTi). This organization supports companies to set targets in line with the goals of the Paris Agreement. Unlike many other companies, the majority of a bank’s GHG emissions are outside their direct control. They can influence, however, their so-called financed emissions, which are the GHG emissions coming from their lending and investment portfolios. The SBTi has developed a framework for banks that reflects this. It encourages banks to use the Absolute Contraction approach that requires a 2.5% (for a well-below 2.0°C target) or 4.2% (for a 1.5°C target) annual reduction in GHG emissions. A clear emission pathway guides banks in the subsequent steps of the transition process.
Measurement and reporting
With targets in place, the next important step for a bank is to determine their level of GHG emissions: both for scope 1 and 2 (the GHG emissions they control) and for scope 3 (the financed emissions). Important initiatives for the quantification of the financed emissions are the Paris Agreement Capital Transition Assessment (PACTA) and the Platform Carbon Accounting Financials (PCAF). PCAF is a Dutch initiative to deliver a global, standardized GHG accounting and reporting approach for financial institutions (building on the GHG Protocol). PACTA enables banks to measure the alignment of financial portfolios with climate scenarios.
By keeping track of the level of GHG emissions on an annual basis, banks can assess whether they are following their selected emission pathway. Reporting, in line with the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), will contribute to a greater understanding of climate risks with their investors and other stakeholders.
Strategy and risk framework
Setting targets and measuring the current level of GHG emissions are necessary but not sufficient conditions to achieve a successful transition. Climate change risk needs to be fully integrated into a bank’s strategy and its risk framework. To assess the climate change-resilience of a bank’s strategy, a logical first step is to understand which climate change risks are material to the organization (e.g., by composing a materiality matrix). Subsequently, studying the transmission channels of these risks using scenario analysis and/or stress testing creates an understanding of what parts of the business model and lending portfolio are most exposed. This could lead to general changes in a bank’s positioning, but these risks should also be factored into the bank’s existing risk framework. Examples are the loan origination process, capital calculations, and risk reporting.
Engaging with clients
A fourth step in the game plan to successfully support the transition is for a bank to actively engage with its clients. A dialogue is required to align the bank’s GHG emission targets with those of its clients. This extends to discussing changes in the operations and/or business model of a client to align with a sustainable economy. This also may include timely announcing that certain economic activities will no longer be financed, and by financing client’s initiatives to mitigate or adapt to climate change: e.g., financing wind turbines for clients with energy- or carbon-intensive production processes (like cement or aluminium) or financing the move of production locations to less flood-prone areas.
Banks are uniquely positioned to play a pivotal role in the transition to a sustainable economy. The transition is already providing a wide range of opportunities for banks, from large financing needs to the introduction of green bonds and sustainability-linked derivatives. At the same time, it is of paramount importance for banks to adopt a climate change-resilient strategy and to integrate climate change risk into their risk frameworks. With our extensive track record in financial and non-financial risk management at financial institutions, Zanders stands ready to support you with this ambitious, yet rewarding challenge.
Zanders is currently supporting several clients with the identification, measurement, and management of ESG risks. For a start, we are supporting a large Dutch bank with the identification of ESG risk factors that have a material impact on the credit risk profile of its portfolio of corporate loans. The material risk factors are then integrated in the bank’s existing credit risk framework to ensure a proper management of this new risk type.
We are supporting other banking clients with the quantification of climate change risk. In one case, we are determining climate change risk-adjusted Probabilities of Default (PDs). Using expected future emissions and carbon prices based on the climate change scenarios of the Network for Greening the Financial System (NGFS), company specific shocks based on carbon prices and country specific shocks on GDP level are determined. These shocked levels are then used to determine the impact on the forecasted PDs. In another case, we are investigating the potential impact of floods and droughts on the collateral value of a portfolio of residential mortgage loans.
We also gained experience with the data challenges involved in the typical ESG project: e.g., we are supporting an asset manager with integrating and harmonizing ESG data from a range of vendors, which is underlying their internally developed ESG scores. We also support them with embedding these scores in the investment process.
With our extensive track record in financial and non-financial risk management at financial institutions in general, and our more recent ESG experience, Zanders stands ready to support you with the ambitious, yet rewarding challenge to adopt a climate change-resilient strategy and to integrate climate change risk in your existing risk frameworks.
Foot notes:
1 The IPCC Working Group II contribution: Climate Change 2022: Impacts, Adaptation and Vulnerability.
2 The IEA report, Net Zero by 2050.
3 See the Net Zero Financing roadmaps from the UN, ‘Race to Zero’ and the ‘Glasgow Financial Alliance for Net Zero’ (GFANZ).
4 Based on the statistics of the Bank for International Settlements (BIS) per 2021-Q3.
5 The Climate Bonds Initiative’s Sustainable Debt Highlights H1 2021.
In March 2021, the European Banking Authority (EBA) was mandated through Article 501c of the Capital Requirements Regulation (CRR) to “assess […] whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified”.
Since the first sustainability-linked derivative was executed in 2019, market participants have entered into a variety of ESG-related derivatives and products. In this article we provide you with an overview of the different ESG derivatives. We will touch upon the regulatory and valuation implications of this relatively new derivative class in a subsequent article, which will be published later this year.
Driven by regulatory pressure and public scrutiny, corporates have been increasingly looking for ways to manage their sustainability footprint. As a result of a blooming ESG funding market, the role of derivatives to help meet sustainability goals has grown. ESG-related derivatives cover a broad spectrum of derivative products such as forwards, futures and swaps. Five types (see figure 1) of derivatives related to ESG can be identified; of which three are currently deemed most relevant from an ESG perspective.
The first category consists of traditional derivatives such as interest rate swaps or cross currency swaps that are linked to a sustainable funding instrument. The derivative as such does not contain a sustainability element.
Sustainability-linked derivatives are agreements between two counterparties (let’s assume a bank and a corporate) which contain a commitment of the corporate counterparty to achieve specific sustainability performance targets. When the sustainability performance targets are met by the corporate during the lifetime of the derivative, a discount is applied by the bank to the hedging instrument. When the targets are not met, a premium is added. Usually, banks invest the premium they receive in sustainable projects or investments. Sustainability-linked derivative transactions are highly customizable and use tailor-made KPIs to determine sustainability goals. Sustainability-linked derivatives provide market participants with a financial incentive to improve their ESG performance. An example is Enel’s sustainability-linked cross currency swap, which was executed in July 2021 to hedge their USD/EUR exchange rate and interest rate exposures.
Other ESG-related derivatives support meeting sustainable business models and consist of trading carbon offsets, emission trading derivatives, and renewable energy and renewable fuels derivatives, amongst others. Contrary to sustainability-linked derivatives, the use of proceeds of ESG-related derivatives are allocated to specific ESG-related purposes. For example, emissions trading is a market-based approach to reduce pollution by setting a (geographical) limit on the amount of greenhouse gases that can be emitted. It consists of a limit or cap on pollution and tradable instruments that authorize holders to emit a specific quantity of the respective greenhouse gas. Market participants can trade derivatives based on emission allowances on exchanges or OTC markets as spots, forwards, futures and option contracts. The market consists of mandatory compliance schemes and voluntary emission reduction programs.
Another type of ESG-related derivatives are renewable energy and renewable fuel hedging transactions, which are a valuable tool for market participants to hedge risks associated with fluctuations in renewable energy production. These ESG-related credit derivatives encourage more capital to be contributed to renewable energy projects. Examples are Power Purchase Agreements (PPAs), Renewable Energy Certificate (REC) futures, wind index futures and low carbon fuel standard futures.
ESG-related CDS products can be used to manage the credit risk of a counterparty when financial results may be impacted by climate change or, more indirectly, if results are affected due to substitution of a specific product/service. An example of this could be in the airline industry where short-haul flights may be replaced by train travel. Popularity of ESG-related CDS products will probably increase with the rising perception that companies with high ESG ratings exhibit low credit risk.
Catastrophe and weather derivatives are insurance-like products as well. Both markets have existed for several decades and are used to hedge exposures to weather or natural disasters. Catastrophe derivatives are financial instruments that allow for transferral of natural disaster risk between market participants. These derivatives are traded on OTC markets and enable protection from enormous potential losses following from natural disasters such as earthquakes to be obtained. The World Bank has designed catastrophe swaps that support the transfer of risks related to natural disasters by emerging countries to capital markets. An example if this is the swap issued for the Philippines in 2017. Weather derivatives are financial instruments that derive their value from weather-related factors such as temperature and wind. There derivatives are used to mitigate risks associated with adverse or unexpected weather conditions and are most commonly used in the food and agriculture industry.
ESG-related credit derivatives would be best applied by organizations with credit exposures to certain industries and financial institutions. Despite the link to an environmental element, we do not consider catastrophe bonds and weather derivatives as a sustainability-linked derivative. Neither is it an innovative, new product that is applicable to corporates in various sectors.
Truly innovative products are sustainability-linked derivatives, voluntary emissions trading and renewable energy and fuel derivatives. These products strengthen a corporate’s commitment to meet sustainability targets or support investments in sustainable initiatives. A lack of sustainability regulation for derivatives raises the question to what extent these innovative products are sustainable on their own? An explicit incentive for financial institutions to execute ESG-related derivatives, such as a capital relief, is currently absent. This implies that any price advantage will be driven by supply and demand.
Corporate Treasury should ensure they consider the implications of using ESG-related derivatives that affect the cashflows of derivatives transactions. Examples of possible regulatory obligations consist of valuation requirements, dispute resolution and reporting requirements. Since ESG-related derivatives and products are here to stay, Zanders recommends that corporate treasurers closely monitor the added value of specific instruments, as well as the regulatory, tax and accounting implications. Part II of this series, later in the year, will focus on the regulatory and valuation implications of this relatively new derivative class.
For more information on ESG issues, please contact Sander van Tol.
Financial institutions (FIs) play an important role in the transition towards a more sustainable economy in which Environmental, Social and Governance (ESG) factors are properly addressed.
Climate change risks are relatively newly identified risks that insurers are facing. These risks can negatively impact both assets and liabilities of insurers. Already in 2018, the European Commission requested the European Insurance and Occupational Pensions Authority (EIOPA) to investigate how climate change risk could be integrated into the Solvency II Framework.
After various previous publications1 of (draft) opinions, the investigation resulted in EIOPA’s opinion to include climate change risk scenarios in Own Risk and Solvency Assessment (ORSA)2. It basically points out that forward-looking management of climate change risks is essential, and that EIOPA expects insurers to integrate climate change risk scenarios in their ORSA. EIOPA indicates it will start monitoring the application of this opinion two years after publication, i.e. as of April 2023. However, some National Competent Authorities already require insurers to take climate change risks into account.3
In general terms, insurers are expected to:
But what does this mean in practice? We will further explained this per topic.
The integration requirement ensures that climate change risk becomes an integral part of the day-to-day business and the risk management framework. The EIOPA opinion does not provide much detail on what this entails. Draft amendments to the delegated regulation, published by the European Commission, provide more insight into what insurers can expect.
The draft amendments relate especially to the implementing measures of the system of governance laid out in the Solvency II Directive. This means that responsibilities regarding climate change risk need to be clearly allocated towards the key functions within the organization, and appropriately segregated to ensure an effective system of governance.
This means climate change risk should be included in the following functions/processes:
Consequently, written policies regarding risk management, internal control, internal audit, outsourcing (where relevant) and contingency plans need to be updated to include everything outlined above with regards to climate change risk.
Insurers will be required to assess climate change risk in ORSA by analyzing at least two climate scenarios. For the implementation we suggest a four-step approach, largely based on the guidance provided by EIOPA.
Step 1 – Risk identification
EIOPA expects insurers to take a broad view of climate change risks and include all risks stemming from trends or events caused by climate change. EIOPA provides a list of these risks, which distinguishes between:
Materialization of these risks for insurers will translate into impact on traditional risk categories, such as underwriting risk, market risk, credit and counterparty risk, operational risk, reputational risk and strategic risk. To help insurers get started with the implementation of climate change risks in ORSA, EIOPA has provided examples of a mapping in the annex of their opinion.
Step 2 – Materiality assessment
Insurers will be required to include all material climate change risks in ORSA. Under Solvency II, risks are considered material if ignoring the risk could lead to different decision making. This means that insurers are required to assess the materiality of each risk to determine whether these need to be included. If an insurer concludes that a certain climate change risk is immaterial, the insurer must be able to explain how that conclusion was reached.
The materiality assessment should be a combination of a qualitative and a quantitative analysis. The qualitative analysis is to provide insight in the relevance of the climate change risk drivers and the way they impact the traditional prudential risks (underwriting risk, market risk etc.). The quantitative analysis will be used to determine the extent to which assets and liabilities are exposed to transition and physical risks.
Step 3 – Defining scenarios
The inclusion of the forward-looking, risk-based approach to ORSA requires insurers to define a set of climate change risk scenarios. EIOPA expects insurers to assess material climate change risks utilizing ‘a sufficiently wide range of stress tests or scenario analysis, including the material short- and long-term risks associated with climate change’. The goal of these scenarios is to assess the resilience and robustness of the insurer’s business strategies, including the impact of risk mitigating measures.
EIOPA states that insurers may develop their own climate scenarios or build on existing ones and provides a number of sources of publicly available scenarios containing pathways for physical and transition risks. The decision for internal scenario development versus building on publicly available may depend on many factors like expected materiality or company size. For example, the underwriting risk for a life insurer is probably less exposed to transition risk than the underwriting risk for a non-life insurer, and a smaller insurer may not have sufficient expertise and resources.
The scenarios must project a multitude of external factors to properly capture the effects of climate change risks. Factors such as demographics (e.g. in case of natural disasters), economic development (e.g. as a result of technological breakthrough) and government policies to reduce carbon emissions, just to name a few. The climate change scenario set should contain at least two long-term climate scenarios:
In addition, a reference scenario is needed to be able to determine the impact of the stress scenarios.
The assessment is to be performed for several time horizons. Given the nature of climate change risks, horizons need to be in the order of decades. EIOPA provides examples for length of time horizons, ranging from instantaneous (‘current climate change’) to projected views of climate change for the next 80 years (‘long-term climate change’).
Step 4 – Climate change risk modeling
Modeling climate change risks in ORSA introduces two challenges:
Insurers are expected to provide explanation on the short- and long-term climate change risk analysis in the ORSA report. This should include:
In addition, climate change risk related disclosures should be consistent with the Non-Financial Reporting Directive (NFRD).6
As mentioned in the introduction, climate change risks are relatively new to the insurance sector. The same holds for other financial industries like the banking sector and asset management sector. As a consultancy firm for the financial industry, we support various types of financial institutions with the implementation of ESG and climate-related strategies and regulations. In doing so, we can benefit from our experience gained in the insurance, banking and asset management sectors.
We can assist with the implementation of climate change risk management, including:
Sources
[1] Previous EIOPA publications related to climate change risk:
[2] Opinion on the supervision of the use of climate change risk scenarios in ORSA, 19 April 2021
[3] See:
[4] Second Discussion Paper on Methodological principles of insurance stress testing, 24 June 2020
[5] See footnote 4
[6] Guidelines on non-financial reporting: Supplement on reporting climate-related information, 17 June 2019
Sulzer realigns its corporate treasury to support business expansion.
Sulzer is a Swiss company specializing in reliable, sustainable solutions for performance-critical applications, focusing on industrial machinery, surface technology, and rotating equipment maintenance. Active in key markets like oil and gas, power, water, and transportation, Sulzer enhances customer competitiveness through innovation. The company operates over 170 locations worldwide.
Expansion into new markets brings challenges on many levels, not least of all financially. When Sulzer, a leading provider of products and solutions in markets such as oil and gas, power, water, and transportation, decided that it needed best-practice treasury and cash management processes to support the developing business operations, the two-pronged treasury project required some external help. Zanders was able to advise on and facilitate a European cash concentration structure and a TMS implementation project.
Sustainable value creation and profitable growth are the ultimate strategic priorities of the company and the financial side of Sulzer’s organization has to be flexible to keep up with the changing patterns of cash flows, revenue streams, investments, and new risk exposures. Treasury needs to move with the challenging cash management environments in new markets, often in developing countries around the world, and it was decided that treasury processes and structures needed to be updated. In 2008, Sulzer’s treasury team embarked on a dual project to implement a new treasury management system (TMS) as well as a new European cash concentration structure.
Jean-Daniel Millasson (Corporate Treasurer at Sulzer)
Jean-Daniel Millasson, the corporate treasurer at Sulzer, explains that the company has grown organically but also considerably through acquisitions. Today, it has a production and service network of over 170 locations around the world, while back in 2008 it had about 120. He says: “We have legal entities in many countries and each has its own set of bank accounts, banking relationships, and manages its payments and cash management independently of the treasury center in Switzerland, although we give clear directions and guidelines for their treasury activities. We feel it’s very important to further develop in the area of cash and risk management, hence centralizing business support functions such as treasury is a vital way to achieve higher efficiencies, greater transparency and access to real-time information across a broad geographic area.”
With this in mind, one clear goal of this treasury project was to improve cash management and visibility by implementing a Europe-wide zero-balancing cash pool. Equally important was the selection and implementation of a new TMS. Millasson says: “It was clear for me that we needed external support to realize two projects of this magnitude since we are a small treasury team. We therefore decided to conduct a request for proposals (RFP), after which Zanders was selected.”
The cash pool implementation involved intense interviewing and liaising with Sulzer’s European subsidiaries. Eric Schwarz, head of the corporate treasury center at Sulzer, explains that this data-collection phase of the project was time-consuming. Zanders consultant Bart Timmerman carried out many of these visits and fact-finding missions with Sulzer or on the company’s behalf.
Schwarz says: “During the cash concentration project, Zanders contributed to the success by taking care of that part of the project that we just didn’t have the resources for. They were able to collect and collate data and meet our subsidiaries. Although we at Sulzer didn’t lack the expertise to go ahead and implement the kind of Europe-wide cash concentration structure that we had in mind, Zanders was able to alleviate an important part of the hard work where we needed support.”
The objectives of the cash concentration project were to increase the centralization of cash, to improve visibility of cash balances and flows in Europe, to improve efficiency of cash management, and to later leverage the platform across the organization in a broad geographical sense covering different time zones. The cash concentration project also included an analysis and redesign of the company’s European banking infrastructure and was successfully concluded in 2009.
The second phase of Sulzer’s treasury transformation was initiated at the same time as the cash concentration project. In fact, the TMS implementation was partially triggered by the need for a best practice system to manage the transaction data generated by the European cash concentration project.
Millasson explains that the previous TMS was not operating in line with best practice and there were still manual processes involved that prevented automated processing of data: “Having a zero-balancing cash pool created a high number of transactions for us – which meant more work for the back office. With the new TMS in place, we’re able to handle this workload. Previously, we didn’t have straight-through processing (STP) or electronic bank statements through our front or back offices,” he says.
Expert advice was invaluable during the selection of a new TMS provider. Sulzer first of all consulted Judith van Paassen, partner at Zanders, and then worked closely with Zanders consultant Bart Timmerman. Millasson adds: “For the TMS project, Zanders’ expertise was crucial. We were looking for professional support on the evaluation of different systems and also on the implementation at a later stage. Even for an experienced treasury department it is difficult to make a decision on an individual system. It was therefore invaluable to work with experts who have in-depth knowledge of the systems.”
Eventually IT2 was chosen but it couldn’t become fully functional until the cash concentration structure was in place, because of the need to have a clear view of the new bank reporting infrastructure. Although IT2 went live with FX deals and reporting in 2009, the full implementation was completed in 2010. Bart Timmerman worked closely with the Sulzer treasury team on the TMS implementation but was also present for much of the European cash pool project. He says: “The two projects were complementary. It was an opportunity for the company to make better use of its idle cash. However, implementing a cash pool without a TMS would have been impossible.”
Millasson adds: “The benefit of the TMS was also that it enabled us to carry out compliance and reporting. It has made a big difference in terms of improving our processes. Of course, data quality is crucial for risk management, too.”
While the new TMS has introduced best practice treasury processes, there are still some areas that could be improved, according to Sulzer’s Millasson. He says: “We try to be in a position to best monitor our entities but what we can monitor is limited. We don’t have a common ERP system in the group, which given our business model is not essential, but makes it more difficult for us to access detailed transaction data. At the moment we have to rely on data sent to us by subsidiaries and their analysis. In an ideal world we would be able to monitor all the subsidiaries’ transaction data by having access to a data warehouse.”
In 2011, the new IT2 accountancy module was added for the company’s new cash pool in Australia. Millasson says: “Thanks to Zanders’ knowledge of TMS, this was a short and smooth project, which was nonetheless very important for us.” Currently, Timmerman and his colleague Tobias Schaad are upgrading IT2 to the latest release, while looking at possible enhancements and extended functionality simultaneously with the treasury staff of Sulzer.
Jean-Daniel Millasson (Corporate Treasurer at Sulzer)
As Sulzer continues to develop and grow, both geographically and in terms of its markets and technology innovation, Millasson and Schwarz now feel it is well supported by treasury. Millasson says: “We still want our business to grow, so you need to finance it. These projects support internal and external growth by concentrating processes and increasing efficiency – these contribute to growth.”
And like the operational side of the company, Sulzer’s treasury team is not likely to let the grass grow under its feet. Rather, they are constantly looking for improvements to their financial processes. Millasson says: “The immediate projects and priorities are still efficient, to make better future use of the TMS in certain areas, to make processes even leaner, which means having electronic dealing and electronic data submissions from legal entities through the TMS. We also want to roll out our cash concentration strategy to more countries such as Singapore and China.”
Treasury is also considering doing some work to establish meaningful and effective key performance indicators (KPIs) for the business. Millasson explains: “The benefits of KPIs are twofold: a means for continuous improvement and illustrating Treasury’s contribution to the business’s financial performance, and a prerequisite for being able to benchmark against other treasuries. Furthermore, we continuously assess opportunities to expand our in-house bank activities, for instance, by considering how payment factory solutions in certain regions could add value to Sulzer.”
Timmerman summarizes the overall feeling about Sulzer’s treasury project: “What was interesting was that there was dedication at Sulzer and there was a really strong drive to lift the treasury practice one level higher. As clients, they were open about shortfalls in their processes and supporting systems, and this really contributed to the quality and progress of the project. Taking on both projects together was a real challenge and, ultimately, it went very well.”
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The CSP helps reinforce the controls protecting participants from cyberattack and ensures their effectivity and that they adhere to the current Swift security requirements. *Swift does not
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As a result of the growing importance of this transformative technology and its applications, various regulatory initiatives and frameworks have emerged, such as Markets in Crypto-Assets
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Over the past decades, banks significantly increased their efforts to implement adequate frameworks for managing interest rate risk in the banking book (IRRBB). These efforts typically focus
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This article is intended for finance, risk, and compliance professionals with business and system integration knowledge of SAP, but also includes contextual guidance for broader audiences. 1.
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Our team at Zanders has been at the forefront of implementing BACS AUDDIS (Automated Direct Debit Instruction Service) with SAP S/4HANA, helping clients to streamline their direct debit
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Thailand's e-Withholding Tax (e-WHT) system officially launched on October 27, 2020, in collaboration with 11 banks, marking a significant digital transformation with far-reaching benefits for
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In today’s rapidly evolving financial landscape, fortifying the Financial Risk Management (FRM) function remains a top priority for CFOs. Zanders has identified a growing trend among
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Emergence of Artificial Intelligence and Machine Learning The rise of ChatGPT has brought generative artificial intelligence (GenAI) into the mainstream, accelerating adoption across
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Introduction In December 2024, FINMA published a new circular on nature-related financial (NRF) risks. Our main take-aways: NRF risks not only comprise climate-related risks,
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As mid-sized corporations expand, enhancing their Treasury function becomes essential. International growth, exposure to multiple currencies, evolving regulatory requirements, and increased
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Industry surveys show that FRTB may lead to a 60% increase in regulatory market risk capital requirements, placing significant pressure on banks. As regulatory market risk capital requirements
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First, these regions were analyzed independently such that common trends and differences could be noted within. These results were aggregated for each region such that these regions could be
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The EU instant payments regulation1 comes into force on the 5th October this year. Importantly from a corporate perspective, it includes a VoP (verification of payee) regulation that requires
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Human activities such as deforestation, pollution, and resource over-extraction have caused a dramatic decline in biodiversity, with approximately 1 million species at risk of extinction,
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We have developed a machine learning model for a leading Dutch bank with over EUR 300 billion in assets to detect potential money laundering activities within its high-net-worth client
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The evolution of the payments industry over the past 20 years has been significant, both in terms of the number of available settlement methods and how transactions can now be made. At a
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In the ongoing efforts to enhance tax transparency for multinational corporations, tax authorities have progressively increased scrutiny on intercompany financial transactions. While the
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With recent volatility in financial markets, firms need increasingly faster pre-trade and risk calculations to react swiftly to changing markets. Traditional computing methods for these
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After a prolonged period of stable low (and at points even negative) interest rates, 2022 saw the return of rising rates, prompting Dutch digital bank, Knab, to appoint Zanders to
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The implementation update covers observations, recommendations and supervisory tools to enhance the assessment of IRRBB risks for institutions and supervisors.1 Main topics include
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Over the past year, the interest rates on intercompany financial transactions have come under closer examination by tax authorities. This intensified scrutiny stems from a mix of
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At Zanders, we are proud to announce the promotion of Tobias Westermaier as our newest partner. With a rich background in Corporate Finance and Treasury, he brings a wealth of experience and a
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Introduction: Faster, smarter, and future-proof In the fast-paced financial industry , speed and accuracy are paramount. Banks are tasked with the complex calculation of XVAs
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In a continued effort to ensure we offer our customers the very best in knowledge and skills, Zanders has acquired Fintegral.
In a continued effort to ensure we offer our customers the very best in knowledge and skills, Zanders has acquired RiskQuest.
In a continued effort to ensure we offer our customers the very best in knowledge and skills, Zanders has acquired Optimum Prime.
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