ESG: Preparation supervision meeting – part 2

Sustainability continues to gain in importance and the implementation status of the individual institutions is surveyed in the annual meeting with the banking supervisory authorities. The following article covers the second part of the preparation for the supervisory interview and deals with the main terms of sustainability risks as defined by supervisory law.

In the supervisory discussion, it is important to clarify the basics of the banking supervisory definition of sustainability risks (source: BaFin bulletin on dealing with sustainability risks as of 13.01.2020):

  • Definition of sustainability risks: environmental, social or corporate governance events or conditions (see 2.3 Sustainability risks are ESG risks), the occurrence of which may have an actual or potential negative impact on the net assets, financial position and results of operations, as well as on the reputation of a supervised entity (see 2.4)
  • Sustainability risks in the areas of climate and environment are divided into physical risks and transition risks
Axel Becker and Johannes Hugo

Axel Becker & Johannes Hugo
Regulartech-IT-Audit-Consult & ADWEKO

Scope of regulation

A comprehensive ESG implementation is expected by means of the 7th MaRisk amendment. The draft has been available for consultation since September 2022. Institutions can already prepare for compliance with the new requirements as part of their MaRisk/ ESG implementation projects.

Physical risks

The consequences of individual extreme weather events as well as long-term changes in climatic and ecological conditions. Physical risks can also have indirect consequences (breakdown of supply chains; abandonment of water-intensive business activities to climate-induced migration and armed conflict).

Similarly, companies that have promoted climate change could be responsible for governmentally (e.g., Ontario Bill 21, Liability for Climate-Related Harms Act, 2018) or judicially consequences.

Transition risks

Existing in connection with the transition to a low-carbon economy: Political measures can lead to an increase in the price / shortage of fossil fuels or emission certificates (examples: coal phase-out, CO2 tax) or to high investment costs (refurbishment of buildings / plants).

New technologies can displace familiar ones (example: electromobility), changing preferences of contractual partners and societal expectations can endanger companies that have not adapted.

Interdependence between physical risks and transition risks

A sharp increase in physical risks would require a more abrupt transition in the economy, which in turn would lead to higher transition risks. If the necessary reduction in greenhouse gas emissions is not made in time, the physical risks and pressure to act will increase. In the worst-case scenario, extreme climate-related damage resulting from a long-delayed energy transition eventually forces a sudden and radical shift in the economy.
Sustainability risks in the areas of social affairs and corporate governance

Events, developments or behavior that are attributable to the areas of social affairs and corporate governance may have a negative impact on the net assets, financial position and results of operations of a company if the probability of their occurrence is not sufficiently factored into the measurement of the assets or liabilities affected.

Reputational impacts are possible in the process.

Social risks are also characterized by negative effects on stakeholders of the company.

Examples: Successful claims for billions of dollars in damages against manufacturers of cigarettes; building permit for a large-scale project fails because the land rights of indigenous inhabitants were not taken into account; fines paid for evaded taxes or wrongfully received refunds

Effects on the reputation of regulated entities

Reputational risks are a key aspect of sustainability risks. On the one hand, there is a financial loss potential in the above context as an additional consequence of events, developments or behavior that occur.

On the other hand, supervised entities are also exposed to a potential loss of the occurrence of specific events, merely by virtue of maintaining a business relationship with an entity that may be exposed to a sustainability risk.

Failure to carry out sufficient sustainable external and internal activities, which can result in a loss of trust among contractual partners and employees, potentially poses a significant reputational risk.

Our recommendation

Address ESG issues and internal implementation status as promptly as possible and review what preparations are needed for the supervision meeting. ADWEKO and Regulartech-IT-Audit-Consult are happy to support you in ESG preparation and implementation as well as in determining your implementation needs and efforts.

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Johannes Hugo