Sustainability issues as part of financial market participants’ risk management and disclosure obligations
Phenomena brought about by climate change cause physical and transitional risks to the financial sector, which must be taken into consideration by market participants. It is also important to have adequate and consistent information on sustainability factors, as investors have a growing preference for sustainable investments. Sustainability factors are considered in the regulation and supervision of the financial sector on the one hand from the perspective of risk management and on the other hand from the perspective of disclosure obligations.
ESG (Environmental, Social, Governance) regulations have been developed rapidly: although some companies have communicated on their sustainability efforts for a long time and investors have been interested in sustainable investments, supporting regulations did not exist until a few years ago.
In 2021, the Sustainable Finance Disclosure Regulation entered into force, sustainability factors were added to regulations on insurers, and the ECB guide on climate-related and environmental risks, published in the previous year, was applied in bank supervision. The supervisor has participated in preparing these regulations and continues to do so. It has also incorporated obligations and recommendations that are already in force into its supervision.
In risk management, banks and insurance companies must consider both physical and transition risks. Direct risks include, for example, the immediate impacts of floods and storms resulting from climate change on the operating preconditions of the institutions themselves or parties financed by them. For example, a storm may destroy an institution's data centres or infrastructures used as collateral for credit. Transition risks, in turn, include adjustment costs arising as companies increasingly invest in low-carbon solutions or energy efficiency, or losses caused by sudden changes in valuations.
Banks made self-assessments and action plans on consideration of sustainability risks
In banks’ activities, sustainability risks may take various forms. When providing finance to companies, a key consideration is how the companies being financed consider sustainability risks in their activities – for example, it is important to consider the long-term risks involved in financing a company in a carbon-intensive sector. In the future, when providing finance to households, the energy efficiency of the property used as collateral may have an indirect impact on the price of credit.
For banks, credit risks are the most important risk area, but climate and environmental risks must be considered in the same vein in the management of operational, market and liquidity risks. Have a bank’s own infrastructures been protected from the impacts of natural phenomena, and have potential valuation changes caused in the markets by sustainability factors been taken into account?
In November 2020, the European Central Bank published a guide on the management of climate-related and environmental risks. The guide lays out, in particular, how significant banks under the ECB's direct supervision must consider sustainability risks in their activities. In the future, the purpose is to apply the guide also in the supervision of small domestic banks. Based on the guide, in 2021, significant banks conducted a self-assessment and an action plan on the management of environmental and climate risks.
The EBA Guidelines on loan origination and monitoring entered into force on 30 June 2021. They instruct banks to consider ESG risks in granting credit from the perspective of both client credit risk and environmentally sustainable lending.
In 2021, the ECB prepared a stress test with a particular focus on climate risks. The stress test was rolled out at the beginning of 2022.
The FIN-FSA has also taken climate and environmental risks into consideration in its supervisory review and evaluation processes as well as in supervision meetings with banks.
In Finland, sustainability risks impact insurance companies particularly through transition risks
In Finland, physical risks to insured property are limited by global standards, but regulatory changes, technologies and consumption behaviour also have an impact on insurance companies’ business models. Some of the current insurance activities will change or vanish in the future: some European insurance companies are already withdrawing from insuring the coal industry. At the same time, the insuring of new technologies, such as electric cars and clean energy, introduces new risks. A Finnish insurance company must also consider, in particular, the impact of transition risks on investment activities.
Further details have been added to Solvency II regulations, which are binding on insurance companies, about how to take sustainability factors into account in risk management, the risk management function, the actuarial function, remuneration policy and application of the prudence principle. Sustainability factors have not been specifically mentioned in Solvency II regulations before, but insurance companies have already been obliged to map and consider all material risks to their operations, which also include sustainability risks.
The European Insurance and Occupational Pensions Authority (EIOPA) has issued an opinion on sustainability in the context of supervision of insurance companies. Insurance companies’ own risk and solvency assessment (ORSA) also covers material risks beyond the scope of solvency regulations, such as changes in investment and insurance activities stemming from sustainability factors. The FIN-FSA has recommended that insurance companies also adopt at least a qualitative assessment methodology at a fast pace for climate scenarios.
The FIN-FSA already monitors sustainability risks in accordance with the application paper of the International Association of Insurance Supervisors (IAIS) and the guidelines and policies adopted by EIOPA. This supervision covers insurance companies’ corporate governance, risk management, investment operations and reporting.
Adequate and standardised information to support investment decisions
The Sustainable Finance Disclosure Regulation, which applies to information both at the company level and financial product level, entered into force in 2021. Banks, life insurance companies as well as some occupational pension foundations and funds, fund managers and investment firms must provide information on their sustainability risk policies on their website.
When selling financial products that take sustainability risks into account, promote characteristics related to the environment or society, or invest sustainably, additional information on these factors and objectives must be given to the customer in connection with other information provided before concluding the agreement. Management companies must update their old prospectuses to cover this information on sustainability risks and factors. Furthermore, possibilities for funds to use terms associated with sustainability in their names has been limited.
The FIN-FSA has reviewed fund prospectuses with a particular focus on this viewpoint in 2021. It appears that the tightened regulation is steering the markets in the right direction, to the effect that financial products are not promoted too lightly as sustainable, since this gives rise to an additional disclosure obligation.
At the moment, the manner of presentation of sustainability information is not regulated in detail. There are technical standards under preparation, however, which will define the content of the disclosures in detail and provide templates for sustainability information. These standards are anticipated to take effect at the beginning of 2023. This will make the disclosures more standardised and comparable, which is important both from the perspective of investors and supervision.
What is sustainable? Taxonomy provides the criteria
The Taxonomy Regulation lays down the criteria for defining environmental sustainability. It takes a stance on climate criteria but also covers other environmental criteria: biological diversity and preservation of the ecosystem, sustainability of water and marine resources, prevention of environmental pollution and the promotion of a circular economy. Disclosure obligations concerning the climate objectives entered into force at the beginning of 2022: for example, if a fund’s marketing states that it fosters the climate objectives under the Taxonomy, the prospectus must describe, among other things, how and to what extent the fund’s investments carry out this objective.
In accordance with the Taxonomy Regulation, large banks, insurance and listed companies that employ over 500 persons must also provide information concerning the sustainability factors in the report of the board of directors or as a separate report, for the first time in 2022.
Obligations concerning sustainability information also indirectly steer the sustainability of other activities. For example, as credit institutions must report on the greenness of their lending, this means in practice that sustainability factors will affect lending or its price. In Finland, an example of this was a revolving credit agreed by UPM, the price of which is contingent on UPM's performance in its biodiversity targets. The popularity of sustainable investments among investors also channels funding to sustainable assets and thereby also promotes the achievement of sustainability objectives in other sectors, too.
FIN-FSA becomes member of the NGFS
In June 2021, the FIN-FSA was accepted as a member in the Network for Greening the Financial System (NGFS), a global cooperation network of central banks and financial supervisors. The network develops procedures to improve the preconditions of sustainable finance and identify risks caused by climate change to the financial sector.