The German Federal Government (Federal Government) states that climate change is a major global challenge and makes clear that Germany has a special responsibility in this area. In the Paris Climate Agreement of 2015 it was agreed that global warming should be kept below 2°C and furthermore a target of limiting the increase in temperature to 1.5°C was set. In order to achieve this goal in the future, the participation of all sectors, including the financial sector, is required. The financial sector was identified as being able to help allocate resources in a climate-positive manner and allocate monies to industries and market participants willing to enter into a transition.
In February 2019, the Federal Government declared its ambitions to make Germany a leading location for sustainable finance. As a consequence, the Climate Action Program 2030 was adopted, setting out a number of actions to achieve the reductions set out in the German Climate Action Plan 2050 (becoming greenhouse gas neutral by that date).
Guidance notice on dealing with sustainability risks
In light of the above, the Federal Financial Supervisory Authority (BaFin) published a guidance notice in December 2019 on dealing with sustainability risks, directed in particular to supervised entities such as credit institutions, investment firms, insurance undertakings, fund management companies and pension funds. According to BaFin, the notice shall be seen as non-binding guidance and good practice principles. However, the guidance gives a clear view as to BaFin’s view on the appropriate management of risks, corporate governance structure and responsibilities, business organization, outsourcing, group issues and the use of ratings.
Sustainability risks are defined in the guidance notice and, accordingly, not only environmental but also governmental and social risks (ESG risks) are covered, which could have substantial negative impacts on the supervised entities. Furthermore, ESG risks are not classified as a separate risk type; they are seen as factors affecting existing risk types, such as credit, market, liquidity, operational, insurance, strategic and reputational risks. It is therefore important for entities to develop a comprehensive understanding of ESG risks, as they can have a significant impact on reputation, assets, and financial and earnings.
The guidance notice asks supervised entities to develop appropriate strategies regarding ESG risks or to improve already established strategies. As each entity is confronted with different kinds of risks, they can choose to develop or adapt their strategies according to their own risk profile with regards to the principle of proportionality. These strategies should be adaptable to changing circumstances, as there are many uncertainties – specifically, about the development of the climate and political adjustments. The strategies should also be apparent in internal guidelines and principles and include measurements to ensure compliance. BaFin suggests the entities review their business strategies, identify and evaluate potential ESG risks and review their risk strategies to ensure that ESG risks are taken into account. Entities may use so-called risk analysis and classification procedures to identify potential risks. Furthermore, ESG risks should be integrated in outsourcing agreements and organizational guidelines for central outsourcing management. Communication regarding the measures being taken should take place in explicit terms towards managers, employees, clients, and investors to ensure transparency and trust.
Responsibility for handling and communication of ESG risks should be assumed by the management board as the role model for the entity, whereby they may receive the support of experts. If group structures exist, the guidelines and rules for ESG risks should be implemented in a consistent manner on all group levels. Sustainability risks have to be reflected in all outsourcing scenarios, including centralized outsourcing management and every outsourcing agreement.
Overall, the guidance notice provides a framework for the strategic handling of sustainability risks. BaFin therewith anticipates the upcoming EU regulation with respect to risk management (especially amendments to the Capital Requirements Regulation and Solvency II Directive). BaFin has announced that sustainable finance will be one of its supervisory priorities in 2020 and it wants to develop a strategy to substantiate the regulatory requirements for managing sustainability risks. From 2021 on, these risks are to be systematically addressed and measured by BaFin. On the basis of the development and the ambitions regarding climate change in Germany and in the EU, the importance of this topic will most likely continue to increase and binding rules regarding sustainability risks are expected in the future. Consequently, the financial sector should be aware of the challenges and consider making respective efforts regarding ESG risks. The guidance notice may be seen as an early indication of how sustainability risks may be embedded in the existing risk structures of supervised entities.
Webinar - ESG in asset management
Developments concerning ESG risks and developments in the EU, and in particular in the UK, the Netherlands and Germany, were presented in a webinar ‘ESG in asset management’ from February 6, 2020.