Introduction

According to the German Council for Sustainable Development (Rat für Nachhaltige Entwicklung), sustainable business encompasses business activities that preserve ecological resources while achieving welfare and social justice. According to the Council, it is based on a culture of sustainability characterised by a respect for nature, social knowledge and creativity, and reduces the use of natural resources to a level that is consistent with sustainable development.⁵

Until the late 20th century, little attention was paid to the environment in business endeavours, and this did not really seem to be necessary for a long time either. But now, the environment is starting to cost money. A wide range of scenarios illustrate the cost of environmental damage: the degradation of up to 60% of global cropland⁶; an increase in strong tropical cyclones of up to 55%⁷; dying boreal and tropical forests that clean the air⁸; a rise in ocean acidification of up to 150%⁹; water shortages, heat stress, the spread of diseases and the climate-induced migration of several hundred million people.¹⁰ The risks that we are facing are more far-reaching, more diverse and more significant than can be described in this article.

As it is unlikely that we will succeed in keeping global warming within the target range of 1.5°C to 2°C,¹¹ the consequences in many cases will be worse than feared, which will result in substantial private losses and significant social costs¹² and require major efforts from both the public and the private sector¹³ These costs could be effectively reduced by making sustainable investments, cutting emissions and changing the way we lead our business and private lives.

Sooner or later, there will need to be a social, political, economic, sociological and cultural debate on whether and how we want to give value to what we can do to preserve natural resources. If added value is the driving force of the global economy, how can we ensure that the fight to stop exploiting and wasting resources, for instance, is given due recognition? As long as we continue to think in monetary terms, a price tag will have to be put on saving the planet – through the entire real economy value chain. This is precisely why the financial industry in particular can make a significant contribution to ensure that money is used sustainably and serves to preserve natural resources.

Transfer of risk into the financial market

It is certainly less the risk of a storm blowing off a roof or a flood hitting the data centre of a credit institution that is attracting the attention of regulators, supervisors and central banks. Rather, their attention has been drawn to the indirect risks involved – i.e. the risks resulting from the customer structure of financial institutions – or the indirect physical and transition risks of insurers and banks.¹⁴ This is because, when combined, these risks can certainly pose a threat to financial stability.¹⁵

Sustainability risks are increasingly becoming a macroeconomic threat and a challenge with a financial stability dimension. Financial institutions, regulators and supervisors must take on this challenge. In BaFin’s case, for instance, insurers, and reinsurers in particular, have been expected to address physical risks for a long time already. Insurance undertakings must at all times be able to settle claims for insured losses.¹⁶

Another aspect is the long-term investment of policyholders’ money, an area where insurance undertakings are increasingly focusing on sustainability.¹⁷ Of course, the main focus for credit institutions and investment firms is the return on investments. But they are also increasingly taking into account the indirect physical and transition risks described above, such as the impact of sustainability risks on borrowers, in the decision-making process.

However, it should be noted that this is not only about the risks that we need to keep an eye on in terms of sustainability. There are also significant opportunities that the financial sector can take advantage of when generating and redirecting funds to meet sustainability goals.¹⁸ If a societal challenge is to be shifted to the balance sheets of financial institutions, we also need to talk about the incentives and hedging systems that would be needed for this purpose, of course.

But how should financial supervisors position themselves with regard to this challenge for society as a whole? Various global regulatory initiatives are closely examining this question.¹⁹ These initiatives are described below.

Global regulatory initiatives

Recommendations for action of the Central Banks and Supervisors Network for Greening the Financial System

The Central Banks and Supervisors Network for Greening the Financial System (NGFS), which both BaFin and the Deutsche Bundesbank are part of, has drawn up a list of recommendations for action aimed at supervisory authorities and central banks.²⁰
Expectations placed on central banks and supervisory authorities

Firstly, central banks and supervisory authorities are advised to include climate-related risks within their mandates. They are invited to address these issues urgently and incorporate sustainability risks into their analyses, be it at the level of the financial institution or at macroprudential level. For this purpose, physical and transition risk transmission channels need to be mapped and key risk indicators need to be adopted in order to monitor these risks. A unified taxonomy of sustainable and less sustainable exposures would come in handy – but if we were to wait for a taxonomy that would be applicable worldwide, we would be ignoring the urgency of this issue.

Central banks and supervisory authorities are also urged to build capacity and develop analytical tools and methods for assessing sustainability risks. There is a need for a more data-driven approach on the one hand and more forward-looking observations and forecasts on the other. Even if they leave room for interpretation, sustainability scenarios will play a significant role for predicting potential developments not only on financial markets worldwide but also within individual business segments and institutions in the financial sector.

According to the report, supervisory authorities should expect supervised institutions to develop strategies to achieve sustainability. Sustainability risks need to be understood, especially at management level, to ensure good corporate governance and appropriate risk management. This has a clear role to play in the internal and external communications of institutions, too. Of course, this also covers disclosure and reporting requirements and how they help promote market discipline in terms of sustainability.

Risk management

As far as the direct supervision of financial institutions is concerned, supervisors have adopted a number of approaches that have proved successful. If a risk has been identified – which can be assumed in the case of sustainability risks – awareness of this risk needs to be raised. Banks, savings banks, insurance undertakings and asset managers alike all need to analyse their business activities, portfolios and processes to determine whether they are exposed to sustainability risk. The consequences of these analyses will be as extensive as sustainability risks themselves. There is a new dimension to this, too: collateral used in the past to cover risks may now be subject to the same or even greater physical and transition risk – resulting in an additional burden.²¹

Finally, regulators and supervisors should examine which Pillar 1²² and Pillar 2²³ requirements could be laid down or reformulated in order to address sustainability risks. Regulators and supervisors must ultimately ensure that the risks resulting from a changing environment are covered. But of course, they should also lead by example themselves: central banks should integrate sustainability factors into their portfolio management just as much as they expect institutions to do the same. It is also worth mentioning the State Secretaries' Committee for Sustainable Development’s (Staatssekretärsausschuss für Nachhaltige Entwicklung) call to examine whether sustainability should be a key decision-making factor for the Federal Government’s investments and the emission of green and sustainable German Federal Bonds (Bunds).²⁴

Data, data, data

“Bridging the data gaps” is one of the key recommendations made by the NGFS. Physical, transition and financial stability risk can only be assessed reliably on the basis of sound data and forecasts. For instance, those seeking a Pillar 1 risk premium must be able to convincingly demonstrate that investments in sustainable buildings, companies and funds etc. entail less risk than what would be allowed under current regulatory minimum capital requirements. Sustainability risks are still relatively new in data history. And it is also problematic that historical data does not reliably reflect future risks, especially in relation to climate change. This is particularly true if there is no linear function between a climate event and the probability of default, for instance. We do not know whether the increase in risks will still be linear when a certain rise in temperature is reached or if risks will increase progressively or even exponentially in this case. It is also difficult to predict where and how often climate events will occur or how extreme they will be. For investors, it can make a significant financial difference whether a tornado will strike a particular area or not. Expressing what is to be expected in the form of data is virtually a mission impossible. But in spite of that, data histories and portfolio structures can at least help us to derive the potential effects of various scenarios; plausible conclusions and forecasts can be made, too. The main challenge is to lay down the requirements for data and scenarios.

At present, it is virtually impossible to provide the evidence required above, such as proof that sustainable assets entail less risk than those that are not sustainable. We suspect that there is a correlation between sustainability and the probability of default. But how reliable is this assumption? What is the basis for this? In the case of residential property, it is realistic to assume that a certain group of clients will opt for sustainability standards that exceed statutory requirements. Such clients are interested in sustainability within the meaning of sustaining value – and generally have good qualifications and a high income. Financing arrangements in such cases are likely to reflect that: they will be calculated prudently, have sufficient capital backing and will be less likely to default compared to others. But we do not have any experience when it comes to what will happen if the average customer also takes out a sustainable loan to finance real estate.

Another data gap can be found in the area of long-term investments. We do not know how investments in sustainable assets develop over the whole of an economic cycle – let alone the whole of a credit cycle. Long-term financing is not uncommon. Infrastructure projects, industrial facilities and real estate tend to be financed over the long term. In this context, it is essential to take into account the fact that price developments may worsen and that supply or sales conditions may change. Future CO2 emissions must be taken into account as well. However, forecasting the probability of default and loss given default will be a more difficult task due to new physical and transition risks. In any case, before new data requirements are introduced, there should be evidence that such requirements fulfil the desired objective of making forecasts more precise.

Transparency

Another NGFS recommendation that is closely linked to the issues surrounding data is the development of an internationally consistent climate and environmental disclosure and reporting framework. To ensure a well-functioning capital market, there needs to be transparent pricing mechanisms, based on information on risk management within the individual financial institutions and an idea of what climatic changes are to be expected in the regions where investments are made. Discussions are still underway regarding the extent to which requirements for the disclosure and reporting of sustainability-related information should be binding. However, the central banks and supervisory authorities that are part of the NGFS agree that minimum requirements should be laid down for sustainability-related corporate strategies, climate goals, measurable risk factors and key figures. If no internationally harmonised solution is found, there is a risk that the requirements set will diverge, rendering a comparison impossible.

Recommendations in the context of securities supervision

Although the NGFS mainly consists of central banks and banking supervisors, insurance and securities supervisors are represented here as well. This is because the NGFS also includes integrated supervisory authorities, such as BaFin, and “twin peaks” supervisory authorities, such as De Nederlandsche Bank, the Dutch central bank. However, it should be noted that there are sustainability initiatives taking place in the area of securities and insurance regulation as well.

For example, the International Organisation of Securities Commissions (IOSCO) or, to be more precise, IOSCO’s Growth and Emerging Markets Committee (GEMC), held a consultation until 1 April 2019 on its paper “Sustainable finance in emerging markets and the role of securities regulators”.²⁵ This paper is aimed at helping securities regulators and supervisors in developing and emerging countries in particular, as well as investors and asset management companies, to better understand sustainability-related risks. It sheds light on sustainability-themed capital market products, such as green and sustainable funds, social-impact funds and renewable energy investments. And of course, the report also focuses on the disclosure of information. In a list of 11 recommendations, IOSCO has set out what it expects supervisory authorities, firms and products to consider in relation to sustainability:

• Integration by issuers and regulated entities of ESG-specific issues²⁶ in their overall risk appetite and governance (Recommendation 1);
• ESG-specific disclosures and reporting (Recommendation 2);
• Data quality (Recommendation 3);
• Definition and taxonomy of sustainable instruments (Recommendation 4);
• Specific requirements regarding sustainable instruments (Recommendations 5 to 9);
• Integration of ESG-specific issues into the investment analysis, strategies and overall governance of institutional investors (Recommendation 10); and
• Building capacity and expertise for ESG issues (Recommendation 11).

Cooperation between the UN and insurance supervisors

Global efforts for more sustainability are being made in the area of international insurance regulation, too. To give an example, the United Nations (UN) founded the UN Sustainable Insurance Forum (SIF) together with a group of insurance supervisory authorities. The SIF was launched in 2016.²⁷ It works in cooperation with the International Association of Insurance Supervisors. In 2018, they jointly released a paper on climate change risks to the insurance sector.²⁸ And in early 2019, the SIF and the IAIS started a new project: analysing the implementation of the Recommendations²⁹ of the Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosures (TCFD). The survey is aimed at obtaining a representative overview of the level of awareness and understanding of sustainability risks and the degree of implementation of the TCFD recommendations across different jurisdictions. This will result in a report assessing the information provided by insurers and highlighting any implementation shortcomings. The report is to be released in 2019.

Sustainability within and beyond the financial industry

Globally, there is one key demand that is reflected across regulatory analyses and recommendations: investors and consumers need to be aware of sustainability issues and understand the risks that they entail. All stakeholders must be able to identify and manage sustainability risks, regardless of whether they are managing a credit institution or an insurance undertaking, or working as asset managers with their clients’ money or creating their own portfolio. The knowledge, the experience gathered and the prediction of potential developments make it possible to identify opportunities that are associated with the transformation of business activities towards more sustainability. And although the prospects of achieving climate goals are currently bleak, it is clear that humans will continue to try to control their own destiny until we reach – or even go beyond – a point of no return. Communication, education, fair reporting and information improve our prospects for the future. This is because this is the only way to avoid a “Minsky moment”, meaning that even though the causes are identified in the aftermath of a financial crisis, financial systems still automatically fall back into crisis time and again.³⁰

This brings us to the responsibility of the financial industry, which sometimes feels that it is unfairly held hostage as far as sustainability is concerned. Politicians and society are right to expect that financial institutions contribute towards sustainability.³¹ Besides the government, they are the most important players steering investment flows. But they are by no means the only ones that are required to take action and adjust to stricter requirements. The number of emission allowances under the Emissions Trading Scheme (ETS) is set to decline at an annual rate of 2.2% from 2021 onwards.³² And the free allocation of manufacturing industry allowances is set to decrease from 80% of its allowances in 2013 to 30% in 2020.³³ This will put those producing emissions under growing price pressure.³⁴ The CO₂ emissions of new vehicles are expected to fall by 37.5% by 2030 as against 2021. This automatically means that more electric vehicles need to be manufactured – otherwise it will be impossible to meet fleet targets.³⁵ The European Union (EU) is even seeking to reduce emissions to zero by 2050.³⁶ It is therefore untrue that only the financial industry must achieve political climate goals.

Of course, sharing the burden on a “polluter pays” basis would be the best possible solution. Strong public finances to save the planet and make it a world worth living in without having to use private funds would be desirable, too. But in the end, what will also matter is whether people have fulfilled their responsibilities through their actions or not. In the area of financial supervision, we call this reputational risk. As supervisors, our sphere of responsibility – which includes ensuring the stability and proper functioning of the financial market – is clearly growing as new financial risks emerge. As a result of this, we are also delving deep into the sustainability debate.

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