New climate and environmental risk management guide for the financial sector

Sustainability is a strategic priority for DNB And now, in consultation with the sector, we have published a Guide to managing climate and environmental risks with dozens of concrete examples of ways in which insurers, pension funds and other institutions can identify and manage risks. The Guide also outlines how we approach climate and environmental risks in our supervisory practice. We spoke with Cindy van Oorschot, Sustainability Programme Director, and Marloes van Schaik, Sustainable Finance Officer, about the Guide.

Why this Guide?
“Being prepared for risks is not a voluntary matter. Financial institutions are required by law to manage the risks they may face, including Environmental, Social and Governance (ESG) risks. It is very important that the sector gets to grips with this, as financial institutions’ lending and investments are increasingly exposed to the direct physical risks of climate change and environmental degradation, as well as the risks associated with the transition to a climate-neutral society. The focal points in this Guide provide institutions with guidance. We also provide concrete examples of how institutions can manage risks. Currently, the Guide only contains examples for climate and environmental risks, but in a future edition we will include examples of social risks. We also use the Guide in our supervisory practice.”

Where does the sector currently stand on managing climate and environmental risks compared to a few years ago? Has there been sufficient progress given the risks?
“Two years ago, we concluded that banks, insurers and pension funds were taking insufficient account of sustainability risks. A survey of 127 Dutch financial institutions at the time showed that a majority did not yet adequately embed sustainability risks in their risk management and that financial institutions found it difficult to measure and report on sustainability risks due to limited availability of consistent and reliable data. See for example our study of last November Banks at risk due to slow pace of climate transition by companies (dnb.nl)”.

“In our most recent surveys, we find that financial institutions have started integrating climate and environmental risks into their risk management, but they still have plenty of work to do. We have published this Guide to assist the sector along the way. The European Central Bank (ECB) had previously published a guide for banks, and our Guide is now available for other institutions.”

Are there risks that are already generally well managed, or risks that are still being overlooked?
“The sector has evolved. In the earliest stages, the main focus was on transition risks, climate risks that can be measured based on carbon footprint. A higher carbon footprint usually means exposure to fossil sectors. And these are the sectors most likely to face stricter climate policies. This is indeed the focus of the financial sector’s Climate Commitment. But we are seeing a broadening of perspectives to include physical climate risks and biodiversity loss. Take the biodiversity summit in Montreal last year, where international agreements were reached on nature conservation. And more recently, we see social risks such as human rights, diversity and inclusion receiving greater emphasis. This is a relatively new development and is still in its infancy.”

Can you shed some light on the climate and environmental risks that institutions themselves face?
“Climate change and environmental degradation can lead to both financial and non-financial risks. These include more frequent extreme weather events that could cause destruction of capital or increase the unforeseen claims burden for non-life insurers. And biodiversity loss can threaten ecosystem services such as animal pollination on which economic activities depend. If an institution finances these economic activities, it runs risks because environmental degradation can affect their earnings generating capacity. The Guide also contains an example of a financial institution whose data centre is located in an area at risk of flooding. Once the institution had identified that risk, it changed its IT policy to provide for data redundancy in another location. Down the road, they intend to relocate the data centre to a safer location.”

Climate and environmental risks are not only related to extreme weather, but can also arise as a result of new policies or changing market preferences. Can you give some examples?
“Yes, you could think of pension funds investing in fossil fuels. Suppose the government introduces a carbon tax. The funds would then be facing a financial risk. The market value of certain investments could fall, and some assets could even become stranded. Stranded assets are assets that have suffered unexpected or premature depreciation or write-downs as a result of new climate and environmental regulations, for instance. Another example: if investors put money into projects that turn out to be harmful to the environment, they may suffer reputational damage. The same applies to institutions that sign a sustainability commitment but do not adhere to it. For more examples, see the Guide.”

Now that you have published the Guide, what happens next?
“Everyone can learn from the Guide. We expect institutions to work with it and take meaningful steps. In April 2023, we will survey a select group of institutions to gain insight into the current state of ESG risk management. We will then incorporate those insights into our supervisory approach. The survey results will also hopefully provide us with new practical examples that we can include in a new edition of the Guide, which we plan to have ready in about a year's time. We are integrating these ESG risks more and more frequently in our regular supervision. That means these risks will soon be part of the risk assessment. While the Guide is not prescriptive, this does not affect the need for institutions to manage their material ESG risks today.”

When will DNB start including ESG risks in its supervision?
“We expect to include ESG risks in the annual surveys we require financial institutions to submit starting in 2024. However, if our surveys, supervisory meetings with institutions or on-site inspections reveal climate and environmental risks that are not being adequately managed, we will of course include these in the risk assessment straight away.”

This Guide is not the only sustainability initiative in the financial sector. What else is going on?
“Financial institutions are demonstrating increasing awareness of the importance of sustainability and the role they play in this area. That is good news because these institutions can be instrumental in the energy transition and building a more climate-neutral economy by pursuing sustainable investment policies. After all, financial institutions have large investment portfolios that are sometimes worth billions of euros. We also see financial institutions voluntarily signing sustainability commitments or covenants, such as the Climate Commitment, which indicates their resolve to be part of the transition. Institutions do need to put their money where their mouth is, as it were, and deliver on their commitments. Because if they fail to adhere to them, they could run reputational or legal risks, which is why we also emphasise these aspects in our supervision of these institutions.”

Not a dull field of work, it would seem...
“It is very dynamic indeed, and things are moving fast. Laws and regulations are in flux, meaning companies and institutions must constantly make new trade-offs. And the data and methods available for measuring and managing ESG risks are also improving. We will also include these developments in the new edition of the Guide.”