From the European Commission’s perspective, the financial sector has an important role to play when it comes to increasing the economy’s resilience and resource efficiency and reducing CO2 emissions. The EU’s goal is to make Europe the first climate-neutral continent by 2050. The European Commission has launched a far-reaching package of legislation to implement this “Green Deal”. Many of the measures contained in this package relate to the financial sector, and additional rules for the financial markets and other areas of the economy are under development.

As the infographic shows, sustainability is not a new issue for BaFin: the supervisor published a Guidance Notice on dealing with sustainability risks back in 2019 to provide non-binding guidance to the companies under its supervision. In this document, BaFin set out the ways in which supervised companies should accommodate sustainability risks in their strategies, corporate management and risk management activities. The Guidance Notice contains a series of questions and examples that provide guidance on binding rules such as the MaRisk – the Minimum Requirements for Risk Management for Banks.

In November 2021, BaFin made sustainability one of its ten medium-term objectives. In line with this, it intends to analyse and where necessary mitigate the financial risks arising in relation to this topic for the companies it supervises, and to combat misleading marketing practices.
And since sustainability risks develop over a relatively long time frame, BaFin is also paying particular attention to them in its 2023 “Risks in BaFin's Focus“.

Sustainability milestones at BaFin

*The SFDR was published on 9 December 2019. Certain provision have applied since 29 December 2019 and were amended by the Taxonomy Regulation. Most of the disclosure requirements have applied since 10 March 2021. The Taxonomy Regulation entered into force in July 2020 and will apply from 1 January 2022/1 January 2023. © BaFin

The Taxonomy Regulation: defining environmental sustainability

Following the Paris Agreement on climate change, the EU introduced an extensive package of climate-related regulatory requirements for the financial market. Take the EU Taxonomy Regulation, for example (see the infobox).

This means that supervised companies now have to collect data that were, in part, irrelevant in the past, such as borrowers’ carbon footprints and buildings’ energy labels. BaFin also needs to know about any transition and physical risks that are reflected in the balance sheets of the companies it supervises. The markets naturally also expect such disclosures.

What makes the topic of sustainability even more complex is the fact that it comprises not just environmental, but also social and governance dimensions. This is the background to why the term “ESG criteria” is always used. However, social and governance aspects have not yet been codified to the same extent as environmental aspects. Nevertheless, minimum labour and human rights standards must already be observed if investments are to be classified as environmentally sustainable under the Taxonomy Regulation. The Platform on Sustainable Finance published recommendations on implementing social criteria in February 2022. No decision has been taken so far on how governance will be embedded in the regulatory framework.

The Sustainable Financial Disclosure Regulation: transparency as the basis for decisions

Another example of increasing regulatory requirements is the EU Sustainable Finance Disclosure Regulation (SFDR). In contrast to the Taxonomy Regulation, which defines environmentally sustainable economic activities, the SFDR requires transparency with regard to adverse sustainability impacts and defines sustainable investments. The Regulation is designed to create transparency for retail and institutional investors, allowing them to understand in future how sustainable the investments underlying individual financial products actually are. The SFDR has, in large part, applied since 10 March 2021. Not until over a year later – in August 2022 – were greater details on its requirements set out in Regulatory Technical Standards (RTS). These apply with effect from 1 January 2023. In addition, the European Commission has published Q&As on the SFDR for companies and supervisory authorities.

In practice, the SFDR requires financial market participants and financial advisers to make comprehensive disclosures of information on sustainability that investors should use in their investment decisions. At the same time, since 2 August 2022 the Insurance Distribution Directive (IDD) and the Second Markets in Financial Instruments Directive (MiFID II) have obliged providers of investment products to ascertain their clients’ sustainability preferences. The idea behind this is to enhance investor awareness of sustainable financial products even further.

The SFDR’s transparency requirements, supplemented by the RTS, are extremely detailed. There is a good reason for this: excessively general and unspecific statements on financial products’ potential relevance to sustainability run the risk of greenwashing, and hence also of investors making their investment decisions on the basis of misconceptions. In particular, the detailed transparency requirements set out in the RTS are designed to combat this.

Curbing greenwashing

BaFin believes that transparency is critical to such a complex and in some areas highly politicised topic as sustainability. Only if retail and institutional investors alike are provided with comprehensive information on financial products can they decide for themselves whether investments that have been labelled as “sustainable” actually meet their own, individual definition of sustainability.

The term “greenwashing” is frequently heard in this context (see infobox). BaFin takes greenwashing extremely seriously in its supervisory practice, from correct and complete disclosure down to the adequate implementation of ESG risks in risk management. Another focus of its activity is on ensuring appropriate governance structures. In addition, BaFin’s administrative practice for sustainable retail investment funds ensures that sustainable fund products aimed at retail investors are labelled consistently.

Greenwashing is also an issue at European level. Among other things, the European Commission issued a call for input in May 2022 in which it asked the ESAs (European Supervisory Authorities) to consider the problem of greenwashing. This resulted in the creation of working groups – of which BaFin is also a member – which are providing important information to guide supervisory practice.

BaFin checks compliance with the SFDR

Since 2021, BaFin has monitored whether the financial market participants and financial advisers that it supervises comply with the SFDR. By law, BaFin’s monitoring builds on the audits of companies’ financial statements or on audits under the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG), which are performed by external auditors.

BaFin expects that those disclosure obligations entailing a greater potential risk of greenwashing will be audited more intensively. Auditors must state their findings clearly and transparently for BaFin in their audit reports. Should they uncover any violations of the requirements, BaFin will respond to these, assess their plausibility and then pursue them using the means at its disposal as the competent supervisor. In addition, BaFin can impose fines in response to violations.

However, audit reports are not BaFin’s only source of information. Indications of violations of the SFDR leading to further investigation may result, for example, from consumer complaints, tip-offs from insiders, or from media reports. In addition, BaFin performs its own random checks: for example, it uses “surf days” to look for irregularities on the websites of financial market participants and financial advisers under its supervision, questions the companies concerned and examines the required product information.

Taking ESG into account in risk management

How can ESG risks be integrated into risk management at supervised companies? BaFin is currently focussing on this question. All companies must ensure efficient and proper risk management at all times. This includes addressing and assessing all risks, monitoring and managing them in an appropriate manner, and ultimately reporting on them. Sustainability risks are also part of this.

As in all areas of its supervisory activity, BaFin applies the principle of proportionality with respect to sustainability factors. This means that the more important sustainability risks are for a supervised company – in other words, the greater the danger is that they might materialise – the more intensively the company has to address these risks.

Insurers’ duties

For supervised insurance companies, for example, this means that – thanks to the amendment to Solvency II – sustainability risks have been a mandatory element of the prudent person principle since 2 August 2022. In addition, insurers and pension funds have been required since 2022 to take long-term climate change scenarios into account when assessing their risk and solvency positions.

For insurance supervisors, and especially in the case of property and casualty insurers, natural catastrophe risks (nat cat risks) are playing an increasingly large role. For example, one of BaFin’s main focuses in 2022 and 2023 is on the impact of catastrophic flooding on risk management, building on the evaluations and analyses of the torrential rainfall event around the rivers Ahr and Erft in 2021. At the heart of the matter is the need to ensure that the Solvency Capital Requirement for nat cat risks is calculated appropriately. BaFin’s aim is to ensure that both climate change and the risks resulting from it are adequately included in risk modelling.

Banks’ duties

For banks, on the other hand, the risk management requirements will be set out in greater detail in the seventh amendement to the MaRisk. The MaRisk will address core expectations on how to deal with sustainability risks that are already set out in BaFin’s Guidance Notice, giving them binding force and making them audit-relevant. The amendment will also incorporate European Banking Authority (EBA) guidelines on handling ESG risks.

BaFin’s banking supervisors also contributed to a thematic review by the ECB. This aimed, among other things, to establish whether banks can quantify climate and environmental risks and how they incorporate them into their lending process, when valuing collateral and when setting their terms and conditions. The results showed that, while small and medium-sized German banks have made progress in dealing with climate and environmental risks, there is still room for improvement. In contrast to the situation in property insurance, nat cat risks generally do not lead directly to cost increases at banks. However, they can result in higher risk provisioning or, in the worst case, to borrower defaults.

BaFin is contributing to future developments

BaFin is involved in ongoing developments in sustainable finance at EU level via the three European supervisory authorities. In addition, it acts as a permanent observer on the Federal Government’s Sustainable Finance advisory Committee and is a member of the Network for Greening the Financial System (NGFS).

For BaFin, sustainable finance cuts across organisational boundaries within the authority. This is why it has established the Centre for Sustainable Finance, which is responsible for strategic questions and is working together with the individual sectors to develop positions on sustainability in the financial sector. In September 2022, the Centre also hosted the Sustainable Finance Conference in Berlin, at which experts discussed the regulatory environment and practical questions relating to ESG.

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