ESG checklist in the lending business:
Environmental – part 1
The topic of climate change is more present than ever. Numerous public debates, activists and even politicians are addressing the issue. Climate change and the environmental degradation that accompanies it also have an impact on the economy and thus on the financial system.
Accordingly, the EBA has already published regulatory requirements and guidelines on how financial institutions must take climate into account. In the credit business, this factor has an impact on existing risks, e.g. credit risk. There are two main drivers of risk here, physical risk and transition risk.
Anchel Kalra, Managing Consultant and Tim Kramer, Junior Consultant
in Risk Management
Definition of terms
a. Physical risk: Occurrence of extreme weather events and associated destruction and resulting financial impact. Example: A financial institution specializes in real estate loans and among the loan-financed real estate is a large portion of real estate that is vulnerable to physical risks. This in turn has an impact on the probability of default/credit risk of the bank and accordingly also on the capital to be deposited in accordance with CRR.
b. Transition risk: Losses resulting from the adaptation process towards a more environmentally sustainable economy, e.g. suddenly adopted policies on climate and environmental protection. Example: A financial institution is lending money to companies that have a significantly lower profitability due to the high adjustment costs, which results in a higher probability of default.
With the above drivers, it is advisable that lenders consider the factors associated with climate change when granting and monitoring loans. For this purpose, a checklist can be used both to facilitate the credit decision and to obtain the necessary information to fully incorporate the factors due to climate change into existing risks.
Information that should be obtained:
| Credit purpose | What is the environmental impact of the borrower’s operations? |
| Information about business goals | Obtain information on borrowers’ climate-related and environmentally or otherwise sustainable business objectives. |
| Assessment | Verify that projects to be financed by borrowers meet standards for environmentally sustainable projects or activities and related criteria. |
| Readiness and capacity | Ensure that borrowers are able and willing to make the adjustment process toward a more environmentally sustainable economy. |
| Monitoring | Ongoing monitoring of borrowers, for example by requiring borrowers to provide regular information on compliance with environmental standards until the relevant credit facility is repaid. |
Depending on the requirements and objectives of the financial institution, a checklist can be extended/adapted. The primary purpose of a checklist is to ensure that climate change is adequately considered and incorporated into credit decisions and monitoring. Thus, the financial institution can ensure that financial and non-financial risks are minimized.
Outlook
It is advisable that institutions establish a clear and detailed documented framework for credit decisions. This framework should provide a clear and stable structure for internal decision-making authority, including a clear hierarchy of credit decision makers. The position of these decision-makers in the organizational and operational structure of the Institute and their reporting obligations should be clearly defined.
Credit institutions should place their environmentally sustainable lending policies and practices in the context of their overarching sustainable finance goals, strategies, and principles. It is particularly important that financial institutions set clear qualitative and, if relevant, quantitative targets. These objectives serve to ensure the promotion and assessment of the development and integrity of environmentally sustainable lending and thus minimize the risks resulting from climate change. The extent to which this development meets or contributes to overarching climate and sustainability goals must be assessed.
Our recommendation
Address ESG-issues and internal implementation status as promptly as possible and review what actions need to be taken to fully integrate ESG into your credit process.
We at ADWEKO are happy to support you in ESG-preparation and implementation as well as in determining your implementation needs and efforts.
talk to
Anchel Kalra !
