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Sustainability risks, ESG risks and climate-related and environmental risks: are you still keeping score?
Date:August 24, 2021
Level 2 of the Sustainable Finance Disclosure Regulation (SFDR) describes the regulatory technical standards for the content, methods and presentation of disclosures for financial market participants. We have been exploring specific topics related to this on a monthly basis and have, for example, already discussed the “do no significant harm” principle, principal adverse impacts on sustainability factors, website requirements and pre-contractual disclosure.
It will not have escaped your attention that level-2 texts have been postponed and will take effect on 1 January 2023 (instead of 1 January 2022). A consolidated version of the level-2 SFDR and the associated taxonomy related disclosures will be published before that date. We will then pick up the thread with the next level-2 chapter, namely the periodic reporting requirements.
Although the level-2 SFDR has been postponed, a slew of other ESG documents were released over the summer, several of which are highlighted below.
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In June 2021, the European Banking Authority (EBA) published its Report on management and supervision of ESG risks for credit institutions and investment firms. This was followed in July 2021 with the Dutch Central Bank (DNB) publishing its consultation version: Good Practice – Integrating climate-related and environmental risks into the risk management of investment firms and managers of collective investment schemes. And on 2 August 2021, following the SFDR, delegated regulations/directives for MiFID II, IDD/SOLV, AIMFD and UCITS were published in the Official Journal of the European Commission.
As an investment firm, you will probably soon need to pay attention to all of these publications and how to implement them, whether partially or not. For example, how do you integrate SFDR sustainability risks, ESG risks, climate-related risks and environmental risks within your organisation?
The legislator does not appear to be offering much help here, however. For instance, new concepts are introduced that appear or prove to mean almost the same — or the exact opposite — as already existing definitions.
An investment firm’s ESG risks vs sustainability risks
According to the EBA, ESG risks are defined as the risksof any negative financial impact on the institution stemming from the current or prospective impacts of ESG factors on its counterparties or invested assets. For the SDFR, a sustainability risk is an ESG event or circumstance that may have an adverse impact on the value of the investment.
For both ESG risks defined in the EBA report and sustainability risks based on the SFDR, investment firms are required to incorporate risk-related considerations into their business strategies, governance structures and risk management.
As stated above, the EBA’s definition of an ESG risk is formulated differently from the SDFR’s definition of a sustainability risk. The definition of an ESG risk is focused on the financial impact on the institution, while the sustainability risk is concerned with the negative financial impact on the end investor. On balance, the effect of this on investment firms that do not engage in proprietary trading appears to be the same.
ESG risks for investment firms that do not engage in proprietary trading relate to the possible negative impact on the investment firm’s financial position — because your client’s investment value can decline due to an ESG factor. This reduction can then lead to lower fees, liability claims or reputational damage, which may be reflected on your balance sheet. This is termed the “second order” effect.
It is justifiable that a sustainability risk can likewise be included here. After all, the Delegated Regulation MiFID II will soon require that you integrate sustainability risks from the SDFR in your risk management. Sustainability risks can also present themselves as second-order effects; if the investments you have made for your clients decrease in value because of an ESG event, this can indirectly affect your financial position.
The SFDR sustainability risk has likely been incorporated in your (sustainable) investment and selection policies. For the same reason as mentioned above, we find it justifiable to also include ESG risks.
ESG factors, ESG events and sustainability factors
If you re-read both definitions, you will notice that the definition of an ESG risk speaks of “ESG factors” and the SDFR sustainability risk refers to an “ESG event”.
While an ESG event is not defined in the SFDR, ESG factors are described in the EBA. Specifically, ESG factors are defined as ESG matters that may have a positive or negative impact on the financial performance or solvency of an entity or individual.
The definition of ESG factors agrees partly with another concept/requirement from the SFDR; the SFDR requires you to indicate to what extent you weigh principal adverse impacts (PAI) on sustainability factors in your investment decisions and to disclose this, for example through the “Consideration” or “No consideration” statement.
In the SFDR, the sustainability risk is limited to a possible decline in investment value due to an ESG event for the end investor — and not to the possible negative impact of the investment on society. For that, the SFDR has the PAI. Because of these ESG factors, EBA risks seem to envision both applications.
In the explanation of ESG risk, the emphasis is placed on the possible negative impact on your balance sheet. Based on the SFDR, you are not required — provided your organisation has no more than 500 employees — to consider adverse impacts of your investment decisions on society. Therefore, we find it justifiable that you interpret the definition of ESG factors to mean only the potentially negative impact on the investment and/or your balance sheet.
DNB Good Practice
In its consultation version of the Good Practice, the DNB provides information about “climate-related and environmental risks”.
The consultation’s explanation of the stated risks for investment firms appears to be limited to investment firms that do not engage in proprietary trading, and the DNB’s explanation agrees with the definition of ESG risks issued by the EBA.
The question remains why the DNB would publish a Good Practice on a specific part of ESG — namely, the ‘E’ component or parts thereof — while the entire spectrum has already been explained in the EBA report referenced above. Should this Good Practice be published unchanged, then investment firms, in our opinion, do not need to perform any supplementary work provided they have demonstrably implemented the SFDR and the findings of the EBA report.
Common goal but no common language
The discussion above shows that laws and regulations regarding sustainability may have a common goal, but they do not (yet) speak a common language.
To maintain an overview, we advise you to separately state the above-mentioned concepts, such as ESG risk and sustainability risk, in your business strategies, governance structures and risk management. Indicate where (and why) you have interpreted these concepts equally and how you have ultimately implemented them. In our experience, this approach is — in the end — more accurate than the forced separate implementation of the stated concepts.
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