The new challenge
Over the last two years, we have observed a material increase in focus from European regulators on the identification, measurement, monitoring and disclosure of climate-related and environmental risks. Published in 2020, the European Central Bank’s (ECB) guide on climate-related and environmental risks has become one of the key regulatory frameworks for the management and integration of climate-related and environmental risks. The guide defines 13 supervisory expectations defining how climate and environmental related risks should be taken into account in the business model and strategy, risk appetite and governance, risk management and disclosures of directly supervised SSM banks.
Following the ECB’s assessment of the ESG risks exposure of major banks, the CSSF has published a new circular CSSF 21/773 setting out its expectation on the management of climate-related and environmental risks. This new Circular is applicable for all Luxembourg based Less Significant Institutions (LSI) and branches of non-EU credit institutions.
Understanding the requirements
Circular CSSF 21/773 has the objective of: (1) raising credit institutions’ awareness on the need to consider and assess climate-related and environmental risks; and (2) increasing awareness of members of the management body and staff about these risks.
By mid-year 2021, financial institutions should have already started reviewing their current business models and operational frameworks to progressively implement needed arrangements that incorporate climate-related and environmental risk factors.
The CSSF expectations cover four main areas:
1. Identification of risks: A regular assessment of materiality and relevance of climate-related and environmental risks must be implemented covering short, medium and long term (more than 5 years) time horizons, considering different sectors, geographical areas and products/services.
2. Business Strategy and risk appetite: Understanding the challenges linked to data availability and quantitative approaches, the CSSF allows the use of qualitative techniques to measure and monitor the exposure to climate-related and environmental risk indicators and limits.
3. Risk Management framework: Climate-related and environmental risks should be treated as risk drivers of existing risks (credit, market, operational and liquidity risks) and be considered in the ICAAP and ILAAP reports.
4. Internal governance: The circular sets out expectations for each of the business lines. Moreover, the institutions that have defined climate-related and environmental objectives should consider their implementation as a remuneration component.
Where to start?
So, what does this circular mean for financial institutions? Regardless of size, financial institutions should start considering these regulatory expectations in a proportionate manner, capturing the complexity and the specificities of their own business model (commercial bank, retail bank, private bank, custodian, etc.).
Last week during The Economist Climate Risk event, David Suetens, former CEO of State Street Luxembourg and Senior Advisor to Avantage Reply, provided some powerful insights on the integration of climate-related and environmental risks in the asset management and banking industries. David promotes the importance of having a clearly defined climate (risk) strategy. Financial institutions should push relevant Committees to design and approve a climate (risk) strategy as part of the bank’s overall business strategy. Rather than simply relying on the sustainability department to define such a strategy; it should be driven by all to make it successful. It is a key element to ensuring that responsibilities around climate risk are addressed early on.
In the next step, the CRO should align the Risk Appetite with this climate (risk) strategy. Once climate (risk) strategy and risk appetite are harmonised, the institution should analyse its lending and investment practices since climate risk cuts across many traditional risk categories. This exercise will allow the bank to not only identify its exposure towards climate risk, but also facilitate the collection of internal data that can be combined with available external data sources to be used for risk quantification.
Dealing with climate-related and environmental risks requires new skills, e.g. deep understanding of new concepts, knowledge of data gathering and manipulation techniques, awareness of climate-related and environmental trends and others. Thus, institutions should invest in their resources to ensure the appropriate technical knowledge and mindset across all business lines.
Bringing new talent and data analytics insight together will not just lead to effective risk management, but also potentially crystallise commercial opportunities per segment (sector, client type, country, etc.) resulting from climate transition. If we want to succeed in making sure that sustainable lending and investments go mainstream, it is not just about excluding uncorrectable brown industries and financing deep green industries – it is also about supporting the transition of brown industries to more sustainable practices.
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