Transformation financing is also a major topic for the financial supervisory authorities. The financial supervisory authorities are not pushing the topic of sustainability independently. However, they must increasingly integrate it into their supervisory work. This is because there is a need for transparency about the risks arising from climate change and the resulting transformation and suitable instruments to address them.
In recent years, politicians have drawn up various strategies to tackle climate change. The European Green Deal and the EU Taxonomy at European level and the Climate Protection Act, the System Development Strategy and the Climate Action Plan at federal level. These strategies also affect the financial sector, for example through sustainable finance strategies. The financial supervisory authorities are also increasingly developing sustainable finance strategies as they analyze and assess the risks of climate change and the resulting necessary transformation of the financial sector. As part of the 7th MaRisk amendment, the German Federal Financial Supervisory Authority (BaFin) has referred to requirements for the consideration of sustainability risks that must be audited. The amendment came into force on June 29, 2023. These risks include environmental aspects as well as social and governance aspects. ESG risks fall into the following three classes:
- Physical risks due to climate change: One example of this is the number of days on which rivers are not navigable or only navigable to a limited extent. This can be the case during both high and low water. This results in interruptions to supply chains, which lead to liquidity problems for companies and therefore also affect their financing banks. Similar risks result from drought and forest fires. The flood disaster in the Ahr valley is another example of a physical risk, as not only the real assets of companies were destroyed by the flood, but also the ground on which the production facilities stood, which can lead to a total loss for the companies and thus represent a credit default risk for the financing banks.
- Transformation risks due to the transition to a low-carbon economy: Companies that want to become climate-neutral must invest in new production facilities that meet new climate standards. As with any investment, there may be failures over which companies have no control. Companies may succeed in making their production climate-neutral, but this will increase production costs, for which potential customers are not prepared to pay higher prices for the end product. A lower turnover for the companies would then limit their ability to repay loans and thus represent a risk for the financing banks.
- Operational and reputational risks: These risks arise when a company sources and processes seemingly sustainable primary products that subsequently turn out to be unsustainable. This risk exists not only for companies, but also for financial institutions if they offer green financial products that subsequently turn out to be greenwashing.
As part of banking supervision, these transformation risks must be monitored, assessed and addressed by supervisory authorities. BaFin treats them as part of its supervision and does not transfer them to a new risk category. Climate risks are therefore reflected in the usual risk categories of credit risks, market risks, operational risks, liability and reputational risks, underwriting risks and strategic risks. With regard to these risks, banks must hold sufficient equity to cover unexpected losses. From BaFin's perspective, however, the challenge for banks' risk management is to translate climate transformation risks into the established risk classes.
BaFin points to the consideration of sustainability aspects in supervisory practice. To this end, it has developed the following understanding of roles:
- BaFin views sustainability fundamentally in terms of ESG aspects and places a focus on decarbonization.
- BaFin sees ESG risks as part of its regular supervision, whereby it does not pursue its own environmental, social or economic policy objectives or direct financial flows. This means that the focus of its work on sustainability is to review how banks translate the consideration of sustainability into their risk management.
- BaFin is not tasked with promoting a sustainable financial system, it merely ensures the integrity and stability of the financial system. It therefore treats the trend towards a sustainable financial system like all market trends from the perspective of financial market integrity and financial market stability.
- BaFin does not set any assessment criteria for the ESG effectiveness of investment strategies or financial products, but supervises the implementation of ESG transparency obligations by companies and for financial products. This includes, for example, protecting investors from being misled. Preventing and combating greenwashing is crucial here.
Relevance of sustainability
The topic of sustainability is not only relevant for financial supervision from a risk perspective. The supervisory authorities must also check that there is consistency between the various financial market sectors and that there is proportionality and practicability. There is also a need for legal certainty in the interpretation of the new rules.
Reliable data on financial climate risks is of crucial importance as it forms the basis for financial decisions (e.g. lending), particularly in the banking sector. From the perspective of financial supervision, it is therefore also relevant how the supervised institutions disclose their sustainability risks and provide information on environmental risks.
The European Central Bank (ECB) is also pursuing a sustainable finance strategy, which it justifies by recognizing that climate change poses risks for the economy and the financial sector. It is therefore essential to consider the impact of climate change and decarbonization on the economy in order to ensure both monetary stability and the stability of the financial markets. However, its strategy goes beyond monitoring risks. Rather, it also recognizes its own role in promoting decarbonization as part of its mandate. Specifically, it defines its task as promoting sustainable finance and creating incentives to decarbonize the financial system.
The European Banking Authority (EBA) has developed a roadmap to supplement its Sustainable Finance Action Plan. This includes measures for the disclosure of ESG risks, the inclusion of ESG factors in the risk management of financial institutions and in their supervisory approach, for example as part of climate stress tests. It also wants to contribute to the development of green standards and labels to counteract greenwashing.
Transformation financing can be addressed by the financial supervisory authority from both a microprudential and a macroprudential perspective:
- The microprudential view deals with risks from the perspective of an individual bank. The focus here is on the stability of individual institutions against the risks arising from climate change and transformation.
- The macroprudential perspective deals with risks from the perspective of the financial system. The focus here is on the stability of the financial system as a whole in relation to risks resulting from climate change and transformation.
From a macroprudential perspective, the risks from climate change and transformation can arise along two dimensions:
- In the cross-cutting dimension, risks to the financial system can arise if a major institution has taken on a particularly high exposure (i.e. risk exposure) to sectors affected by climate change or transformation risks. This can also be the case if assets become stranded assets (i.e. assets that lose value in the course of the transformation), e.g. in the transition from combustion engines to electric motors. From a macroprudential perspective, however, this does not create a new risk category, but rather the familiar too-big-to-fail problem if a large bank has particularly high exposures to CO2-intensive sectors.
- In the temporal dimension, macroprudential risks arise when financial institutions build up common risk factors. In the period before the global financial crisis, these were risk positions related to the US real estate market. In the context of climate change and transformation, common risk positions could also build up that are still unknown or inconspicuous at the present time.
Overall, it is clear that climate change and transformation are also relevant topics and sources of risk for financial supervision. These can be integrated into the established risk categories and addressed within the framework of the established supervisory instruments. However, the scope and complexity of regulation have increased significantly, which will also be reflected in supervisory practice.
