Abstract
This chapter gives an overview of the main strategic and organisational implications for financial institutions when fully considering the actual and potential impacts of sustainability-related risks on their businesses. In this respect, the chapter first argues that, to ensure the effectiveness of the general risk management framework, developments are necessary at several levels of the organisation, in particular within the perimeter of competence of the management board, the risk management function and the operational business units. Then, the chapter discusses the issue of disclosing sustainability-related information by illustrating existing industry and policy standards. It concludes that more work is still needed in terms of quality and comparability of the information to foster market discipline via the disclosure of sustainability-related information.
The contents included in this chapter do not necessarily reflect the official opinion of the European Commission. Responsibility for the information and views expressed lies entirely with the authors.
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Notes
- 1.
Examples of sustainability-related risks linked to climate changes are: increase in the frequency and magnitude of floods, droughts and storms; permanent change in climate conditions; increase in the level of seas; distress and high volatility in commodity markets. Sustainability-related risks linked to environmental degradation include, but are not limited to: air or waters pollution; deforestation; loss of biodiversity. Types of sustainability-related risks linked to social inequality are: unfair treatment of workers; discriminatory treatment of women; discriminatory treatment of minorities; social dumping. From these risks direct and indirect financial risks can emerge for financial institutions. See Chapter 1 for a structured analysis.
- 2.
Under the point of view of the wider internal control system, risk management is one of the functions that form the “three lines of defence” model adopted in the financial sector and endorsed by relevant regulation. In this respect, the company’s first line of defence is typically formed by the business units responsible for identifying the risks associated with each transaction and ensuring compliance with the established procedures and limits when dealing with these risks. The second line of defence includes risk management, compliance and (for insurance companies) the actuarial function, which collectively have to guarantee that the risks are identified and treated in accordance with the established rules. Finally, the third line of defence is formed by the internal audit, which in turn assesses alignment with rules and procedures by all actors within the company and verify the effectiveness of the internal control system.
- 3.
- 4.
See Chapter 1 for a wider discussion on why sustainability-related risks should not be considered a new self-standing risk category.
- 5.
See Chapter 1 for a wider discussion and for a structured attempt to systematically link sustainability-related risks and financial risks.
- 6.
- 7.
Physical risk can be defined as the impacts today on insurance liabilities and the value of financial assets that arise from climate and weather-related events that may damage property or disrupt trade. Transition risk can be defined as the financial risk that could result from the process of adjustment towards a low-carbon economy, such as changes in policy, technology and physical risks that could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent (e.g. BoE 2015).
- 8.
For example, with the Paris Agreement the international community pledged for “holding the increase in the global average temperature to well below 2°C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5°C”. Under a risk management perspective, scenarios with 2 ℃ and 1.5 ℃ temperature increase can be built to assess the impact on the different economic sectors in terms of transition risk and physical risk. See, for some reference scenarios, EC (2018).
- 9.
For some additional reference on the parameters used to build climate change scenarios, see TCFD (2019, pp. 69–71).
- 10.
In this respect, it is important to underline that a number of national and international organisations, including the Network for Greening the Financial System (NGFS), the European Systemic Risk Board (ESRB) and the European Central Bank (ECB) are currently working on scenarios for climate-related stress tests.
- 11.
In April 2020, the Banque de France published a paper providing a tool to build climate change scenarios to forecast Gross Domestic Product (GDP), modelling both GDP damage due to climate change and the GDP impact of mitigating measures. It adopts a supply-side, long-term view, with 2060 and 2100 horizons. It is a global projection tool (30 countries/regions), with assumptions and results both at the world and the country/regional level. Five different types of energy inputs are taken into account according to their CO2 emission factors. Full calibration is possible at each stage, with estimated or literature-based default parameters. In particular, Total Factor Productivity (TFP), which is a major source of uncertainty on future growth and hence on CO2 emissions, is endogenously determined, with a model encompassing energy prices, investment prices, education, structural reforms and decreasing return to the employment rate. Four scenarios are also presented: Business As Usual (BAU), with stable energy prices relative to GDP price; Decrease of Renewable Energy relative Price (DREP), with the relative price of non-CO2 emitting electricity decreasing by 2% a year; Low-Carbon Tax (LCT) scenario with CO2 emitting energy relative prices increasing by 1% per year; High-Carbon Tax (HCT) scenario with CO2 emitting energy relative prices increasing by 3% per year. For full information, see Banque de France (2020).
- 12.
In a survey delivered by the Task Force on Climate-related Financial Disclosures (TCFD) to 198 financial institutions and other organisations, 43% of respondents confirmed the use of scenario for transition risk, 33% for physical risk, 15% for other risks, 19% were developing their first scenarios and 22% did not used any scenario (due to the lack of the availability of standard scenarios and assumptions, high complexity and costs, the consideration of climate-related risks as being non-material, the focus on other priorities, the use of other methods). The respondents also highlighted the main issues encountered in developing scenarios, namely: lack of appropriately granular, business-relevant data and tools supporting scenario analysis; difficulty in determining scenarios, particularly business-oriented scenarios, and connecting climate-related scenarios to business requirements; difficulties in quantifying climate-related risks and opportunities on business operations and finances; challenges around how to characterise resiliency. See TCFD (2019).
- 13.
Impact scenarios can also leverage existing catastrophe models. These models, developed in the last decades for insured losses, aim at identifying, assess and manage natural catastrophe risks linked in particular to seismic and climate hazards. Advanced models exist for tropical storms, floods, tornados or bushfires, mainly parametrised with historical data for specific countries or areas. These models can hence play a role in analysing physical risk for financial institutions, even though limitations remain. These latter are in particular due to the restrict number of countries and areas covered by existing models and the absence of structured relation between physical risk and financial risks.
- 14.
In many studies, this relationship has been proven even after taking into account the typical endogeneity problem (that is, the fact that the most financially successful companies may be the ones that decide to be involved in sustainable initiatives).
- 15.
In a survey deliverd by Task Force on Climate-related Financial Disclosures (TCFD) to 198 financial institutions and other organisations, 60% of respondents said that their organisations consider climate-related issues to be a material risk today or in the next one–two years, while 28% consider climate-related issues to be a material risk only in six years or more, or were not sure about it. See TCFD (2019).
- 16.
See here https://www.hsbc.com/our-approach/risk-and-responsibility/sustainability-risk the full set of sustainability risk policies adopted by HSBC, as a concrete example of exclusion criteria for non-sustainable projects or initiatives.
- 17.
At the same time, some credit rating agencies also include the regulatory environment, the legal and financial infrastructure, and the institutional environment in which governance takes decisions (ESMA 2019b).
- 18.
When considered, environmental risks are sometimes proxied by renewable resources’ usage and waste management, social risks are sometimes proxied by GDP per capita, income inequality, political risk, institutional strength and other indexes provided by accountable institutions such as the World Bank (ESMA 2019b).
- 19.
For an overview of the sustainability and environmental reporting evolution over time, see for example Weber and ElAlfy (2019).
- 20.
This can be a long-term result, for example linked to improved credit ratings for debt issuance and better credit worthiness assessments for bank loans, or to a better placement of company securities in the portfolios of actively managed investment funds. However, such a possible outcome can count thus far on little evidence in scientific literature.
- 21.
The large part of the considerations included in this book refers to this second category.
- 22.
If certain elements of the recommendations are incompatible with national disclosure requirements for financial filings, the TCFD encourages organisations to disclose those elements in other official company reports that are issued at least annually, widely distributed and available to investors and others, and subject to internal governance processes that are the same or substantially similar to those used for financial reporting (TCFD 2017).
- 23.
To this extent, the TCFD proposes that its recommended disclosures should be included in the company’s mainstream annual financial filings. If companies make cross-references to other reports or documents, this should be done in a simple and user-friendly way, for instance, by applying a practical rule of “maximum one click” out of the report.
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Migliorelli, M., Marini, V. (2020). Sustainability-Related Risks, Risk Management Frameworks and Non-financial Disclosure. In: Migliorelli, M., Dessertine, P. (eds) Sustainability and Financial Risks. Palgrave Studies in Impact Finance. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-54530-7_4
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