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

So, what will be expected of insurers?

In general terms, insurers are expected to:

• Integrate climate change risks in their system of governance, risk management system and ORSA
• Assess climate change risk in ORSA in the short and long term
• Disclose climate-related information

But what does this mean in practice? We will further explained this per topic.

Integrating climate change risks

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:

• Risk Management
  For all the relevant risk management areas – covering both the asset and the liability side of the balance sheet, and including liquidity, concentration and operational risk – climate change risks need to be identified, measured, monitored, managed and reported on.
• ORSA
  The ORSA is a mandatory part of the required system of governance for insurers and will therefore also have to take climate risks into account. In order to properly assess the potential impact of climate change risks and the resilience of the insurers’ business model, these climate change risks need to be analyzed over a longer horizon. EIOPA has therefore advised to include climate change scenarios in the ORSA. This will be discussed in more detail in the next section of this article.
• Internal Control and Internal Audit
  Changes in the system of governance, risk management and ORSA to incorporate climate change risk also requires extension of the internal control system and the scope of internal audit.
• Actuarial Function
  The actuarial function will be responsible for the appropriateness of assumptions, methodologies and models used to assess the impact of climate change risks in underwriting. Especially in the context of ORSA and the assessment of the influence climate risk has on future reserving and capital needs. In addition, the actuarial function will be responsible for the sufficiency and quality of the data used within these calculations.

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.

Assess climate change risk in ORSA in the short and long term

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:

• Transition risks
  These are defined as follows: ‘Risks that arise from the transition to a low-carbon and climate-resilient economy’. This includes the following aspects: Policy, Legal, Technology, Market sentiment and Reputational risks.
• Physical risks
  These are defined as: ‘risks that arise from the physical effects of climate change’ and are subdivided in acute and chronic physical risks.

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:

• Global temperature increase remains below 2◦C, preferably no more than 1.5◦C, in line with Paris Agreement;
• Global temperature increase exceeds 2◦C.

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:

• Assessment of transition and physical risk impacts
  Materialization of transition and physical risks will have to be translated to impact on assets and liabilities. In a discussion paper, EIOPA provides examples of different methodologies for the assessment of transition impacts on assets, that have already been developed by academics, research institutes and regulators⁴. In general, these methodologies use carbon-sensitivities of financial instruments to assess the impact of climate change risk scenarios.
  The basis for the determination of physical risks is the change in temperature over time. This change needs to be translated into impact on frequency and severity of acute natural disasters (e.g. storms, floods, fires or heatwaves) and chronic effects (e.g. rising sea levels, reduced water availability, biodiversity loss and changes in land and soil productivity). The next step is to translate these effects into impact on assets and liabilities. The translation into financial impact on companies in which insurers invest can especially be challenging. Larger companies often have a greater diversity of activities and are more spread out geographically. In addition, companies will not only be hindered by the materialization of physical risks in their own activities, but their supply chain can also be affected. However, some scoring models already exist in which companies are ranked based on their sensitivity to physical risks.⁵
• Long-term multi-period modeling
  Incorporation of the climate change risk scenarios in ORSA aims to assess the viability of current business models and strategies and the adequacy of the insurers’ solvency. For longer horizons, insurers may use a lower precision for balance sheet projections and conduct assessment at a lower frequency than short-term risk assessments.
  The lower precision allows for simplifications as long as the long-term character of the climate change scenarios is preserved. Simplifications may include projecting simple ratios instead of full balance sheets, or assessment of climate change impact on assets and technical provisions in isolation. However, projection of the full balance sheet ensures internal consistency and may provide much more information, especially when assessing the impact of potential management actions to mitigate the impact of climate change risks.

Disclose climate-related information

Insurers are expected to provide explanation on the short- and long-term climate change risk analysis in the ORSA report. This should include:

• An overview of all material risks, how materiality is assessed and an explanation for each risk that is considered immaterial.
• The methods and assumptions used by the insurer in both the materiality assessment of the climate change risks and in ORSA.
• The outcomes and conclusions of the scenario analysis, both quantitative and qualitative.

In addition, climate change risk related disclosures should be consistent with the Non-Financial Reporting Directive (NFRD).⁶

How can Zanders help?

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:

• Identification of climate change risk exposures and materiality assessment
• Integration of climate change risks in your system of governance and risk management system
• Incorporate climate change risk into your ORSA, including
  • Mapping climate change risks to traditional prudential risk categories
  • Development of climate change risk scenarios
  • Climate change risk modeling
• Support in setting up or adjusting disclosures

Sources

_{[1] Previous EIOPA publications related to climate change risk:}

• _{Opinion on Sustainability within Solvency II, 30 September 2019}
• _{draft Opinion on the supervision of the use of climate change risk scenarios in ORSA, 5 October 2020}

_{[2] Opinion on the supervision of the use of climate change risk scenarios in ORSA, 19 April 2021}

_{[3] See:}

• _{DNB>Insurers>Prudential supervision> Q&A Climate-related risks and insurers (February 2021)}
• _{PRA: Supervisory Statement 3/19 – Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change (April 2019)}

_{[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}

As the financial sector is key for the transition towards a low-carbon and more circular economy, financial institutions have to deal with climate-related and environmental financial risks (C&E risks). At the same time, the increased importance of these C&E risks also presents new business opportunities for the financial sector. Therefore, to support banks in their self-assessment and action plans, Zanders developed a Scan & Plan Solution on C&E risks.

According to the 2021 World Economic Forum Global Risk Report¹, extreme weather, climate action failure, human environmental damage and biodiversity loss are ranked as four of the top five global risks by highest likelihood and four of the six global risks with the largest impact. It is not surprising that over the past years, numerous articles on C&E risks have been published and many initiatives have been taken to identify, measure and manage these risks. The Paris Agreement², the United Nations 2030 Agenda for Sustainable Development³ and more recently the European Green Deal⁴ are the main examples of international governmental responses to address C&E risks.

The financial sector is considered key for the transition towards a low-carbon and more circular economy. This is illustrated by the fact that the European Central Bank (ECB) has identified climate-related risks as a key risk driver for the euro area banking system in their Single Supervisory Mechanism Risk Map⁵. At the same time, the increased importance of C&E risks also presents new business opportunities for the financial sector, such as providing sustainable financing solutions and offering new financial instruments that facilitate C&E risk management. To illustrate, the UN’s Intergovernmental Panel on Climate Change⁶ (IPCC) estimates that the required investment for alignment with the Paris Agreement would be at least $3.5tn per year until 2050 for the energy sector alone.

To address C&E risks, the ECB published a Guide on climate-related and environmental risks⁷ for banks that describes the ECB’s supervisory expectations related to risk management and disclosure. Banks are required by the ECB to perform a self-assessment with respect to the supervisory expectations and to draft an action plan in 2021. The self-assessments and plans will subsequently be reviewed and challenged by the ECB as part of the supervisory dialogue. In 2022, the ECB will conduct a full supervisory review of bank’s practices related to C&E risks.

The Zanders Scan & Plan Solution provides clear insights into gaps with the ECB expectations and proposes practical actions that are tailored to a bank’s nature, scale and complexity. This article provides a brief explanation of C&E risks, outlines a few specific ECB supervisory expectations and elaborates on the Solution.

Definition of C&E risk

Financial risks from climate and environmental change arise from two primary risk categories:

• Physical risks. The first risk category concerns physical risks caused by acute (direct events) or chronic (longer-term events which cause gradual deterioration) C&E events. Examples of acute events are floods, wildfires and heatwaves, whereas chronic events relate to the likes of rising sea levels, acidity and biodiversity losses, for example.
• Transition risks. The second risk category comprises transition risks resulting from the process of moving towards a low-carbon economy. Changes in policy, regulation, technology, market sentiment and consumer sentiment could destabilize markets, tighten financial conditions and lead to procyclicality of losses.

These two risk categories are distinct from other risk categories in the following aspects: 1) they have a correlated and non-linear impact on all business lines, sectors and geographies, 2) they have a long-term nature and 3) the future impact is largely dependent on short-term actions. The risk categories are, among others, drivers of credit, market and operational risk, as shown in Figure 1.

Figure 1: Examples of the impact of physical risks and transition risks on traditional risk types from the ECB Guide on climate-related and environmental risks.

ECB Supervisory Expectations

In the Guide on climate-related and environmental risks⁷, published in November 2020, the ECB explains that banks are expected to reflect C&E risks as drivers of existing risk categories (e.g., credit risk, market risk, operational risk) rather than as a separate risk type. This indicates that not only efforts should be made by banks to develop risk management practices related to C&E risks but that these practices should also be integrated in existing risk management frameworks, models and policies.

The ECB Guide covers four main areas. First, in relation to ‘business models and strategy’, the ECB expects banks to understand the impact of C&E risks on their business environment and integrate C&E risks in their business strategy. Secondly, the guide addresses ‘governance and risk appetite’. The ECB expects a bank’s management to include C&E risks in the risk appetite framework, assign responsibilities related to C&E risks to the three lines of defense and establish internal reporting. Thirdly, in relation to ‘risk management’, the ECB expects that banks integrate C&E risks into their existing risk management framework. Finally, regarding ‘disclosures’, the ECB expects banks to disclose meaningful information and metrics on C&E risks. The four above-mentioned areas are covered in 13 expectations, which are in turn further divided in 46 sub-expectations. Banks are required by the ECB to perform a self-assessment with respect to the supervisory expectations and to draft an action plan in 2021. The self-assessments and plans will subsequently be reviewed and challenged by the ECB as part of the supervisory dialogue. The ECB recommends National Competent Authorities, in their supervision of less significant institutions, to apply these expectations proportionate to the nature, scale and complexity of the bank’s activities.

Zanders has thoroughly analyzed all (sub)-expectations and has highlighted a few specific expectations including possible actions below.

Expectation 4.2: Institutions are expected to develop appropriate key risk indicators (KRI) and set appropriate limits for effectively managing climate-related and environmental risks in line with their regular monitoring and escalation arrangements.

Here, the ECB expects institutions to monitor and report their exposures to C&E risks based on current data and forward-looking estimations. In addition, institutions are expected to assign quantitative metrics to C&E risks. It is however acknowledged that, since definitions, taxonomies and methodologies are still under development, qualitative metric or proxy data can be used as long as specific quantitative metrics are not yet available. The ECB deems that the metrics should reflect the long-term nature of climate change, and explicitly consider different paths for temperature and greenhouse gas emissions. Finally, the ECB expects institutions to define limits on the metrics based on the risk appetite regarding C&E risks.

This expectation has various elements to it, and Zanders has defined as the most important and first step to identify the internal and external data availability related to C&E risks. If the data availability allows it, an institution should set up quantitative metrics and limits on these metrics that reflect C&E risks. A first step to achieve this would be to define several firmwide KRIs, for example by limiting the carbon emission of the whole portfolio in line with the Paris Agreement² or other (inter)national climate agreements. These KRIs can then be cascaded down to business lines and/or portfolios, such as limiting the exposure to specific sectors with large carbon footprints or substantial use of water. If the current data availability does not allow for quantitative metrics, the bank should identify which data is still lacking and assess ways to collect this data from internal data sources or external data providers in the course of time. In the meantime, qualitative metrics or proxies could be developed such as a qualitative score for the sophistication of the climate strategy of large corporates in the portfolio.

Should a bank already have some metrics in place, Zanders advises to evaluate if these metrics sufficiently cover all material physical and transition C&E risks that the bank is expected to face and if there are ways to increase the sophistication of these metrics, for example by including forward-looking estimations. Finally, Zanders advises banks to create a monitoring procedure to ensure that these metrics and their limits are evaluated regularly.

Expectation 8.1: Climate-related and environmental risks are expected to be included in all relevant stages of the credit-granting process and credit processing.

In this expectation, the ECB underlines that banks should identify and assess material factors that affect the default risk of loan exposures. The quality of the client’s own management of C&E risks may be taken into account in this case. In addition, banks are expected to consider changes in the credit risk profiles based on sectors and geographical areas.

The way to address this expectation is highly dependent on the nature of the bank, on the existing credit granting process and on the availability of data. Some examples of including C&E risk in the credit granting process in a qualitative way, which Zanders has observed in the market, are the development of shadow PD models that trigger mitigating actions in case of large discrepancies with the regular PDs, or the introduction of a scorecard based on quantitative as well as qualitative aspects.

It should be noted that these and other solutions are not mutually exclusive and that multiple approaches can be adopted for different parts of the portfolio. Also, the efforts for several individual expectations can be combined. For example, taking C&E risks into account in the credit granting process could also be linked to the qualitative and quantitative metrics set as part of expectation 4.2 (see above). The quality of the client’s own management of C&E risks can for instance be measured based on the qualitative score for the climate strategy sophistication of large corporates mentioned above.

Expectation 11: Institutions with material climate-related and environmental risks are expected to evaluate the appropriateness of their stress testing, with a view to incorporating them into their baseline and adverse scenarios.

This expectation indicates that banks should evaluate the appropriateness of their stress testing in relation to C&E risks. In this evaluation, the bank should take into account the following considerations: i) how will the bank be affected by physical and transition risks, ii) how will C&E risks evolve under various scenarios (thereby taking into account that these risks may not fully be reflected in historical data), and iii) how may C&E risks materialize in the short-, medium- and long-term. Based on these considerations and on scientific climate change pathways as well as on assumptions that fit with their risk profile and individual specification, banks should incorporate C&E risks in their baseline and adverse scenarios.

To address this recommendation, Zanders advises banks to first identify C&E risks scenarios with different severities based on the materiality of C&E risks for the bank. Examples of this include early or late transition to a low-carbon economy (transition risk), introduction of a carbon tax (transition risk) or staying below or above a 2°C temperature increase (physical risk). These scenarios could be based on scientific scenarios from the IPCC⁸ or the International Energy Agency⁹. The next step is to translate these scenarios into macro-economic variables, such as GDP, inflation and loan valuations, over a range of relevant sectors and geographies. Since there is not yet a single methodology to do this, banks need to be creative and combine new qualitative and quantitative approaches with existing modeling methodologies.

Zanders Scan & Plan Solution

To manage C&E risks, to seize new business opportunities and to meet the regulatory expectations related to C&E risks, it is crucial for banks to have transparency about their exposure to these risks. To support banks with this, the Zanders Scan & Plan Solution is available. The Scan assesses the gaps between the bank’s current practices and each of the expectations in the ECB guide. These gaps are scored based on a pre-defined scoring system and are shown in a heatmap that is easy to interpret. Subsequently, the Plan proposes possible actions to close the identified gaps. These possible actions will be tailored to the nature, scale, and complexity of the bank and to the level of sophistication of the bank in the field of C&E risks. The Scan & Plan will be provided in the form of a detailed report.

Zanders has previously supported clients on topics related to climate change, published market insights and supported research. In addition, Zanders has broad experience in supporting clients in each of the areas of the ECB guide: business models and strategy, governance and risk appetite, risk management and disclosure. Hence, Zanders is in an excellent position to also support banks with the implementation of the proposed actions from the Scan & Plan or with shaping new business activities related to C&E risks.

To learn more about the Zanders Scan & Plan solution and how Zanders can support your institution with managing C&E risks, please contact Petra van Meel, Marije Wiersma or Pieter Klaassen.

References
1) http://www3.weforum.org/docs/WEF_The_Global_Risks_Report_2021.pdf
2) https://unfccc.int/sites/default/files/english_paris_agreement.pdf
3) https://sdgs.un.org/2030agenda
4) https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en
5) https://www.bankingsupervision.europa.eu/ecb/pub/ra/html/ssm.ra2021~edbbea1f8f.en.html#toc1
6) https://www.ipcc.ch/site/assets/uploads/sites/2/2019/02/SR15_Chapter4_Low_Res.pdf
7) https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideonclimate-relatedandenvironmentalrisks~58213f6564.en.pdf
8) https://www.ipcc.ch/report/emissions-scenarios/
9) https://www.iea.org/reports/world-energy-model/sustainable-development-scenario

One of the key subjects in this re-assessment is the implementation of tangible and transparent Environment, Social, and Governance (ESG) factors into the business.

Treasury can drive sustainability throughout the company from two perspectives, namely through initiatives within the Treasury function and initiatives promoted by external stakeholders, such as banks, investors, or its clients. When considering sustainability, many treasurers first port of call is to investigate realizing sustainable financing framework. This is driven by the high supply of money earmarked for sustainable goals. However, besides this external focus, Treasury can strive to make its own operations more sustainable and, as a result, actively contribute to company-wide ESG objectives.

Figure 1: ESG initiatives in scope for Treasury

Treasury holds a unique position within the company because of the cooperation it has with business areas and the interaction with external stakeholders. Treasury can leverage this position to drive ESG developments throughout the company, stay informed of latest updates and adhere to regulatory standards. This article shows how Treasury can become a sustainable support function in its own right, highlights various initiatives within and outside the Treasury department and marks the benefits for Treasury – on top of realising ESG targets.

Internal initiatives

Automation and digitalization drive certain environmental initiatives within the Treasury department. Full digitalized records and bank statement management and the digitalization of form processes reduce the adverse environmental impact of the Treasury department. Besides reducing Treasury’s environmental footprint, digitalization improves efficiency of the Treasury team. By reducing the number of manual, cumbersome operational activities, time can be spent on value-adding activities rather than operational tasks.

Another great example of how Treasury can contribute to the ESG goals of the company, is to incorporate ESG elements in the capital allocation process. This can be done by adding ESG related risk factors to the weighted average cost of capital (WACC) or hurdle investment rates. By having an ESG linked WACC, one can evaluate projects by measuring the real impact of ESG on the required return on equity (ROE). By adjusting the WACC to, for example, the level of CO2 that is emitted by a project, the capital allocation process favours projects with low CO2 emissions.

An additional internal initiative is the design of a mobility policy with the objective to lower CO2 emissions. On one hand, this relates to decreasing the amount of business trips made by the Treasury department itself. On the other hand, it relates to the reduction of business travel by stakeholders of treasury such as bankers, advisors and system vendors. A framework that offsets the added value of a real-life meeting against the CO2 emission is an example of a measure that supports CO2 reduction on both sides. Such a framework supports determination whether the meeting takes place online or in person.

Furthermore, embedding ESG requirements into bank selection, system selection and maintenance processes is a valuable way of encouraging new and existing partners to undertake ESG related measures.

When it comes to social contributions, the focus could be on the diversity and inclusion of the Treasury department, which includes well-being, gender equality and inclusivity of the employees. Pursuing these policies can increase the attractiveness of the organization when hiring talent and make it easier to retain talent within the company, which is also beneficial to the Treasury function.

The development of a structured model that defines the building blocks for Treasury to support the achievement of companywide ESG objectives is a governance initiative that Treasury could undertake. An example of such a model is the Zanders Treasury and Risk Maturity Model, which can be integrated in any organization. This framework supports Treasury in keeping track of its ESG footprint and its contribution to company-wide sustainable objectives. In addition, the Zanders sustainability dashboard provides information on metrics and benchmarks that can be applied to track the progress of several ESG related goals for Treasury. Some examples of these are provided in our ‘Integration of ESG in treasury’ article.

External initiatives

Besides actions taken within the Treasury department, Treasury can boost company-wide ESG performance by leveraging their collaboration with external stakeholders. One of these external initiatives is sustainability linked financing, which is a great tool to encourage the setting of ambitious, company-wide ESG targets and link these to financing arrangements. Examples of sustainability linked financing products include green loans and bonds, sustainability-linked loans, and social bonds. To structure sustainability-linked financing products, corporates often benefit from the guidance of external parties when setting KPIs and ambitious targets and linking these to the existing sustainability strategy. Besides Treasury’s strong relationships with banks, retaining good relationships with (ESG) rating agencies and financial institutions is critical to stay abreast of the latest updates and adhere to regulatory standards. Additionally, investing excess cash in a sustainable manner, using green money market funds or assessing the ESG rating of counterparties, is an effective way of supporting sustainability.

Apart from financing instruments, Treasury can drive the ESG strategy throughout the organization in other ways. Treasury can seek collaborations with business partners to comply with ESG targets, which is another effective manner to achieve ESG related goals throughout the supply chain. An increasing number of corporates is looking to reduce the carbon footprint of their supply chain, for which collaboration is essential. Treasury can support this initiative by linking supplier onboarding on its supply chain finance program to the sustainability performance of suppliers.

To conclude

As developments in ESG are rapidly unfold9ing, Zanders has started an initiative to continuously update our clients to stay ahead of the latest trends. Through the knowledge and network that we have built over the years, we will regularly inform our clients on ESG trends via articles on the news page on our website. The first article will be devoted to the revision of the Sustainability Linked Loan Principles (SLLP) by the Loan Market Association (LMA) and its American and Asian equivalents.

We are keen to hear which topics you would like to see covered. Feel free to reach out to Joris van den Beld or Sander van Tol if you have any questions or want to address ESG topics that are on your agenda.

The Bank of England is even of the opinion that climate change represents the tragedy of the horizon: “by the time it is clear that climate change is creating risks that we want to reduce, it may already be too late to act” [1]. This article provides a summary of the type of financial risks resulting from climate change, various initiatives within the financial industry relating to the shift towards a low-carbon economy, and an outlook for the assessment of climate change risks in the future.

At the December 2015 Paris Agreement conference, strict measures to limit the rise in global temperatures were agreed upon. By signing the Paris Agreement, governments from all over the world committed themselves to paving a more sustainable path for the planet and the economy. If no action is taken and the emission of greenhouse gasses is not reduced, research finds that per 2100, the temperature will have increased by 3°C to 5°C².. Climate change affects the availability of resources, the supply and demand for products and services and the performance of physical assets. Worldwide economic costs from natural disasters already exceeded the 30-year average of USD 140 billion per annum in seven out of the last ten years. Extreme weather circumstances influence health and damage infrastructure and private properties, thereby reducing wealth and limiting productivity. According to Frank Elderson, Executive Director at the DNB, this can disrupt economic activity and trade, lead to resource shortages and shift capital from more productive uses to reconstruction and replacement³.

According to the Bank of England, financial risks from climate change come down to two primary risk factors⁴:

Increasing concerns about climate change has led to a shift in the perception of climate risk among companies and investors. Where in the past analysis of climate-related issues was limited to sectors directly linked to fossil fuels and carbon emissions, it is currently being recognized that climate-related risk exposures concern all sectors, including financials. Banks are particularly vulnerable to climate-related risks as they are tied to every market sector through their lending practices.

Financial risks

• Physical risks. The first risk factor concerns physical risks caused by climate and weather-related events such as droughts and a sea level rise. Potential consequences are large financial losses due to damage to property, land and infrastructure. This could lead to impairment of asset values and borrowers’ creditworthiness. For example, as of January 2019, Dutch financial institutions have EUR 97 billion invested in companies active in areas with water scarcity⁵. These institutions can face distress if the water scarcity turns into water shortages. Another consequence of extreme climate and weather-related events is the increase in insurance claims: in the US alone, the insurance industry paid out USD 135 billion from natural catastrophes in 2017, almost three times higher than the annual average of USD 49 billion.
• Transition risks. The second risk factor comprises transition risks resulting from the process of moving towards a low-carbon economy. Revaluation of assets because of changes in policy, technology and sentiment could destabilize markets, tighten financial conditions and lead to procyclicality of losses. The impact of the transition is not limited to energy companies: transportation, agriculture, real estate and infrastructure companies are also affected. An example of transition risk is a decrease in financial return from stocks of energy companies if the energy transition undermines the value of oil stocks. Another example is a decrease in the value of real estate due to higher sustainability requirements.

These two climate-related risk factors increase credit risk, market risk and operational risk and have distinctive elements from other risk factors that lead to a number of unique challenges. Firstly, financial risks from physical and transition risk factors may be more far-reaching in breadth and magnitude than other types of risks as they are relevant to virtually all business lines, sectors and geographies, and little diversification is present. Secondly, there is uncertainty in timing of when financial risks may be realized. The possibility exists that the risk impact falls outside of current business planning horizons. Thirdly, despite the uncertainty surrounding the exact impact of climate change risks, combinations of physical and transition risk factors do lead to financial risk. Finally, the magnitude of the future impact is largely dependent on short-term actions.

Initiatives

Many parties in the financial sector acknowledge that although the main responsibility for ensuring the success of the Paris Agreement and limiting climate change lies with governments, central banks and supervisors also have responsibilities. Consequently, climate change and the inherent financial risks are increasingly receiving attention, which is evidenced by the various recent initiatives related to this topic.

Banks and regulators

The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) is an international cooperation between central banks and regulators⁶. NGFS aims to increase the financial sector’s efforts to achieve the Paris climate goals, for example by raising capital for green and low-carbon investments. NGFS additionally maps out what is needed for climate risk management. DNB and central banks and regulators of China, Germany, France, Mexico, Singapore, UK and Sweden were involved from the start of NGFS in 2017. The ECB, EBA, EIB and EIOPA are currently also part of the network. In the first progress report of October 2018, NGFS acknowledged that regulators and central banks increased their efforts to understand and estimate the extent of climate and environmental risks. They also noted, however, that there is still a long way to go.

In their first comprehensive report of April 2019, NGFS drafted the following six recommendations for central banks, supervisors, policymakers and financial institutions, which reflect best practices to support the Paris Agreement⁷:

1. Integrating climate-related risks into financial stability monitoring and micro-supervision;
2. Integrating sustainability factors into own-portfolio management;
3. Bridging the data gaps by public authorities by making relevant data to Climate Risk Assessment (CRA) publicly available in a data repository;
4. Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing;
5. Achieving robust and internationally consistent climate and environment-related disclosure;
6. Supporting the development of a taxonomy of economic activities.

All these recommendations require the joint action of central banks and supervisors. They aim to integrate and implement earlier identified needs and best practices to ensure a smooth transition towards a greener financial system and a low-carbon economy. Recommendations 1 and 5, which are two of the main recommendations, require further substantiation.

• The first recommendation consists of two parts. Firstly, it entails investigating climate-related financial risks in the financial system. This can be achieved by (i) mapping physical and transition risk channels to key risk indicators, (ii) performing scenario analysis of multiple plausible future scenarios to quantify the risks across the financial system and provide insight in the extent of disruption to current business models in multiple sectors and (iii) assessing how to include the consequences of climate change in macroeconomic forecasting and stability monitoring. Secondly, it underlines the need to integrate climate-related risks into prudential supervision, including engaging with financial firms and setting supervisory expectations to guide financial firms.
• The fifth recommendation stresses the importance of a robust and internationally consistent climate and environmental disclosure framework. NGFS supports the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD⁸) and urges financial institutions and companies that issue public debt or equity to align their disclosures with these recommendations. To encourage this, NGFS emphasizes the need for policymakers and supervisors to take actions in order to achieve a broader application of the TCFD recommendations and the growth of an internationally consistent environmental disclosure framework.

Future deliverables of NGFS consist of drafting a handbook on climate and environmental risk management, voluntary guidelines on scenario-based climate change risk analysis and best practices for including sustainability criteria into central banks’ portfolio management.

Asset managers

To achieve the climate goals of the Paris Agreement, €180 billion is required on an annual basis⁵. It is not possible to acquire such a large amount from the public sector alone and currently only a fraction of investor capital is being invested sustainably. Research from Morningstar shows that 11.6% of investor capital in the stock market and 5.6% in the bond market is invested sustainably⁹. Figure 1 shows that even though the percentage of capital invested in sustainable investment funds (stocks and bonds) is growing in recent years, it is still worryingly low.

Figure 1: Percentage of invested capital in Europe in traditional and sustainable investment funds (shares and bonds). Source: Morningstar [9].

The current levels of investment are not enough to support an environmentally and socially sustainable economic system. As a result, the European Commission (EC) has raised four initiatives through the Technical Expert Group on sustainable finance (TEG) that are designed to increase sustainable financing¹⁰. The first initiative is the issuance of two kinds of green (low-carbon) benchmarks. Offering funds or trackers on these indices would lead to an increase in cash flows towards sustainable companies. Secondly, an EU taxonomy for climate change mitigation and climate change adaptation has been developed. Thirdly, to enable investors to determine to what extent each investment is aligned with the climate goals, a list of economic activities that contribute to the execution of the Paris Agreement has been drafted. Finally, new disclosure requirements should enhance visibility of how investment firms integrated sustainability into their investment policy and create awareness of the climate risks the investors are exposed to.

Insurance firms

Within the insurance sector, the Prudential Regulation Authority (PRA) requires insurers to follow a strategic approach to manage the financial risks from climate change. To support this, in July 2018, the Bank of England (BoE) formed a joint working group focusing on providing practical assistance on the assessment of financial risks resulting from climate changes. In May 2019, the working group issued a six-stage framework that helps insurers in assessing, managing and reporting physical climate risk exposure due to extreme weather events¹¹. Practical guidance is provided in the form of several case studies, illustrating how considering the financial impacts can better inform risk management decisions.

Authorities

Another initiative is the Climate Financial Risk Forum (CFRF), a joint initiative of the PRA and the Financial Conduct Authority (FCA)¹². The forum consists of senior representatives of the UK financial sector from banks, insurers and asset managers. CFRF aims to build capacity and share best practices across financial regulators and the industry to enhance responses to the financial climate change risks. The forum set up four working groups focusing on risk management, scenario analysis, disclosure and innovation. The purpose of these working groups, which consist of CFRF members as well as other experts such as academia, is to provide practical guidance on each of the four focus areas.

Current status and outlook

On 5 June 2019, the TCFD published a Status Report assessing a disclosure review on the extent to which 1,100 companies included information aligned with these TCFD recommendations in their 2018 reports. The report also assessed a survey on companies’ efforts to live up to TCFD recommendations and users’ opinion on the usefulness of climate-related disclosures for decision-making¹³. Based on the disclosure review and the survey, TCFD concluded that, while some of the results were encouraging, not enough companies are disclosing climate change-linked financial information that is useful for decision-making. More specifically, it was found that:

• “Disclosure of climate-related financial information has increased, but is still insufficient for investors;
• More clarity is needed on the potential financial impact of climate-related issues on companies;
• Of companies using scenarios, the majority do not disclose information on the resilience of their strategies;
• Mainstreaming climate-related issues requires the involvement of multiple functions.”

Further, the BoE finds that despite the progress, there is still a long way to go: while many banks are incorporating the most immediate physical risks to their business models and assess exposures to transition risks, many of them are not there yet in their identification and measurement of the financial risks. They stress that governments, financial firms, central banks and supervisors should work together internationally and domestically, private sector and public sector, to achieve a smooth transition to a low-carbon economy. Mark Carney, Governor of the BoE, is optimistic and argues that, conditional on the amount of effort, it should possible to manage the financial climate risks in an orderly, effective and productive manner⁴.

With respect to the future, Frank Elderson made the following claim: “Now that European banking supervision has entered a more mature phase, we need to retain a forward-looking strategy and develop a long-term vision. Focusing on greening the financial system must be a part of this.”³.

References

¹ https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/avoiding-the-storm-climate-change-and-the-financial-system-speech-by-sarah-breeden.pdf
² https://public.wmo.int/en/media/press-release/wmo-climate-statement-past-4-years-warmest-record
³ https://www.bankingsupervision.europa.eu/press/interviews/date/2019/html/ssm.in190515~d1ab906d59.en.html
⁴ https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/report/transition-in-thinking-the-impact-of-climate-change-on-the-uk-banking-sector.pdf
⁵ https://fd.nl/achtergrond/1294617/beleggers-moeten-met-de-billen-bloot-over-klimaatrisico-s
⁶ https://www.dnb.nl/over-dnb/samenwerking/network-greening-financial-system/index.jsp
⁷ https://www.banque-france.fr/sites/default/files/media/2019/04/17/ngfs_first_comprehensive_report_-_17042019_0.pdf
⁸ https://www.fsb-tcfd.org/publications/final-recommendations-report/
⁹ http://www.morningstar.nl/nl/
¹⁰ https://ec.europa.eu/info/publications/sustainable-finance-technical-expert-group_en
¹¹ https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/publication/2019/a-framework-for-assessing-financial-impacts-of-physical-climate-change.pdf
¹² https://www.bankofengland.co.uk/news/2019/march/first-meeting-of-the-pra-and-fca-joint-climate-financial-risk-forum
¹³ https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-2017-TCFD-Report-11052018.pdf

The new EU directive regulating alternative investment funds management (AIFMD) meant that asset manager ACTIAM had to make substantial changes to its risk management, a major operation that had to be carried out in a short period of time.

ACTIAM was founded on 1 July 2014 after a merger between SNS Asset Management (SNS AM) and SNS Beleggingsfondsen Beheer (SBB, Investment funds management). The company now has more than EUR 50 billion assets under management for insurers, banks and pension funds. Among them are Reaal, Zwitserleven, ASN Bank and SNS Bank. “Responsible asset management is our specialism,” says Rob Verheul, COO at ACTIAM. “We manage all our investment categories in a responsible fashion. We have made doing business in a responsible way core to our investment process. It is in our DNA and we are proud of it. “ACTIAM originates from the Hollandse Koopmansbank (Dutch Merchant Bank) and has more than earned its reputation as a responsible asset manager. It has managed the ASN equity fund for more than 20 years. In 2013, this fund was awarded the Golden Bull for the best investment fund, and in 2015 was deemed the best equity fund in the world. Verheul says: “We do not invest in companies who do not trade in a sustainable way and we let people know through our website which companies we exclude. The universe in which we invest is therefore not as big as that of many other players, but we have already proved that social and financial returns go hand in hand.”

According to Bart Harmsen, head of risk management at ACTIAM, it is not a question of just excluding the insufficiently sustainable companies. “We try to encourage these companies to become more sustainable. We keep many lines of contact open in order to bring about improvements in that area.”

Growth ambition

As a part of VIVAT Insurance, ACTIAM considers Zwitserleven and Reaal (also part of VIVAT Insurances) just as much a client as ASN Bank and SNS Bank, says Verheul. “We have also close commercial contracts with them, just as with our other external clients. We have seen that the combination of professionalism, flexibility and sustainability has created a lot of interest for our funds from institutional investors. The legislator gives us a helping hand here, since pension funds are required to use part of their capital for sustainable investments.”
As administrator of institutional investment funds, ACTIAM’s name is well-known in this market segment. Our ambition is to grow in the retail market as well, says Verheul. “We are investigating whether funds for institutional investors could also be made suitable for retail investors. Our name recognition among a larger audience will then grow as a matter of course.”

Tougher demands

Under VIVAT Insurances, ACTIAM operates independently, with its own license, policy and statutory board. “Even though SNS AM and SBB have worked together for years, with this merger we are creating one expertise centre for our clients,” Verheul explains. “By doing this, we are creating even more commercial and operational strength and we can more easily comply with legislation and regulations.” Tougher demands on fund management as a result of new legislation and regulations in the AIFMD (Alternative Investment Fund Managers Directive) were important reasons for the merger. This legislation requires that a fund manager may not outsource both its portfolio management and its risk management. Verheul explains: “The fund manager (SBB) would therefore have to go to great lengths to rig up its risk management. Asset management was already outsourced to ACTIAM (at the time SNS AM). If we had not integrated SBB and SNS AM, the cost to the client would have been much higher than it is now. The costs of the merger are small by comparison. We are trying to absorb these by working more efficiently.”

Gap analysis

The AIFMD legislation sets out best practices in the area of risk and liquidity management, among others. As far as ACTIAM was concerned, this guideline had an impact on many different levels. “Most of them were under control,” says Verheul, “but we were not able to make the changes for the risk management part on our own. We could see that the scale of changes necessary within risk management was too great for our own staff to contend with. We had discussions with a number of contenders, but Zanders was selected fairly quickly. During the very first meeting they showed their pragmatic, down to earth approach. No standard consultant-talk, but serious people who gave the impression they would get on with it and deliver something of real useful value.”

Time was of the essence: ACTIAM had to be AIFMD compliant by 22 July 2014 and have its risk policy implemented, otherwise obtaining the license would be under threat. So, article for article, a speedy start was made on analyzing the legal texts; what was written down exactly, and what is the impact of them for ACTIAM? And as far as the risk management parts were concerned, where were the gaps as far as the guidelines went? And that’s how the risk management and risk methodology were assessed, a process during which hundreds of pages were read and analyzed. Zanders consultant Mark van Maaren says: “Early on we involved the front office, as well as others, in the development of risk policies, risk methodology and risk reporting. They made a valuable contribution and their involvement facilitated the acceptance of the risk framework.” During the whole process the strategy was developed gradually and the levels of risk became clearer. Beforehand, Verheul expressed progress in terms of a target figure: “We wanted to achieve 6.5 on reaching compliance, then we wanted to take our time in order to make it an 8.” In that way the inaccuracies in some reports, which were a result of tight deadlines, were corrected, while the reporting process itself was speeded up.

With constant to-ing and fro-ing, i.e. by involving front office, a large number of issues were solved.

Jasper van Eijk, Partner at Zanders

This way most of the interest rate sensitivities on fixed interest instruments could be calculated, but a number of rates differed to what front office saw. By constantly going back to departments involved, the results were fine-tuned.

Internal involvement

In a short time frame a lot had to happen on both sides, but the interaction was ideal, Verheul thinks. “And what is so good is that we have improved the whole ACTIAM risk management framework. We are much more aware of the whole spectrum since it had much more impact than just the AIFMD part.” Harmsen nods in agreement: “The risk policy was also immediately adopted by the business and, as a result, the quality of thinking in terms of risk in the organization was given an enormous boost.” Van Maaren adds: “ACTIAM’s board’s strong commitment was an important factor in the success of the project. All directors gave up a lot of time to review and discuss the risk strategy, the preparation of risk reports and the development of risk methodology. Quick decisions were also made where there were issues within the project.” Van Eijk also felt the interaction within the organization was a success factor. “This was at all levels within the organization. The formulated policy had to take form by setting up models, methods and systems. But due to the limited timeframe we had to do this in parallel. This demands good co-ordination to get all cross-references tied in. Thanks to a pragmatic approach and the broad internal involvement, this was achieved.” The deadline was reached; ACTIAM was AIFMD compliant as of 22 July 2014.

Stick to the plan

For monitoring risk, ACTIAM used the existing risk management system, Dimension, from supplier Simcorp, of which Zanders implemented the new risk module. Verheul says: “We want the whole organization to use this system and the starting point was to include the whole risk reporting process in this system. Zanders firstly evaluated the suitability of this module for implementation of risk reporting together with ACTIAM and Simcorp before starting the implementation process.”
It symbolizes the secret of success of the whole journey, Verheul thinks: “Make considered choices and then stick to the plan. Don’t fall into the trap of implementing another system just because a report is easier to print for example, as this always leads to different problems. In retrospect, it all went very well, but there was a lot of pressure on everyone involved. All in all we are very pleased with the whole project. If we had to do it again then we would do it the same way.”

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