ESG risks in EU prudential regulation for Investment Firms

During the last years the notion of Environmental-Social-Governance (thereafter “ESG”) risks has been attracting ever more attention with the climate crisis, COVID-19 pandemic, and surging inflation, sowing the seeds of the introduction to ESG regulation. One of the various industries affected from this thematic area is the dynamic financial services industry, comprised of entities regulated and authorised to offer investment services. Specifically, following the introduction of the Investment Firms Regulation (thereafter “IFR”), investment firms shall be required to comply with additional requirements and adopt practices against risks related to ESG.

ESG risks are separated within three distinctive but interrelated categories of risks. As per the European Banking Authority’s (thereafter “EBA”) report on management and supervision of ESG risks for credit institutions and investment firms, environmental risks are defined as financial risks arising from an institution’s exposures to counterparties or invested assets which may be affected or contribute to negative impacts of environmental factors. On the other hand, social risks are defined as any social factors which may have a positive or negative impact on the financial performance of a firm or individual. The last component of ESG, namely Governance Risks, involve the processes and internal controls established within a financial institution with regards to corporate behaviour, ethics, management, and internal governance as well as any practices used to manage the environmental and social risks to which the firm is or may be exposed to.

As regards the IFR requirements on ESG matters, investment firms should assess the average value of their on and off balance sheet items for a consecutive 4-year period to examine whether they exceed the 100 million euro threshold, and determine whether they fall under the definition of significant investment firm. Moreover, firms should review the EBA’s guidelines, reports, technical standards and discussion papers issued on the matter, in order to begin understanding the definitions, current or potential exposures to ESG risks, and be able to proceed with applying mitigating actions, controls and relevant disclosures to the national competent authority and market participants as applicable.

As regards disclosures to the competent authority, significant investment firms are required to publicly disclose information on ESG risks as part of their Pillar III Disclosure reporting requirement, including physical and transition risks. This requirement has been applicable since 26 December 2022 and onwards.

What is interesting with ESG risks, is the challenge posed to identifying, quantifying, and assessing their impact both for the institution itself and the regulatory authority. Whilst a technical approach has been developed by the EBA, further guidelines are expected on monitoring and managing these risks on a firm-specific level. Thus, a dual challenge is expected to arise; investment firms are expected to face difficulties in compliance with the respective requirements, whilst on the other hand, the review and evaluation of the Report by the competent authority, which shall also need further guidance on responding to the application of ESG risks within the prudential regulatory framework for investment firms.

Notwithstanding the newly introduced market disclosure requirement in the context of ESG, there are also other prudential regulatory aspects expected to be affected, depending on the stringency and focus devoted to eradicating ESG risks by the relevant European Union (EU) institutions. Keeping in mind that public disclosures on ESG for significant investment firms have become a requirement, it would not come as a surprise to develop additional requirements whereby these investment firms are required to embed ESG risk detection and mitigation within their daily operations and activities. Moreover, a requirement for implementation of ESG risk management techniques or developing risk management tools dedicated to the said risks, as well as providing the competent authority with a list of actions and a set of quantitative and qualitative indicators used to assess and control ESG risks, could be introduced.

Furthermore, the EBA intends for EU investment firms to assess the relevance and exposure to ESG, based on the firms’ business model as well as operations and activities. Therefore, disclosing information to the national competent authority regarding ESG may not be deemed enough as per the European Banking Federation’s response, following the issuance of the EBA’s discussion paper on the role of environmental risks in the prudential framework. On the contrary, investment firms should draw the relevant connections and incorporate exposures to ESG risks within their existing risk management framework and assessments, by embedding ESG requirements within their basic and additional regulatory requirement calculations i.e. as part of the Internal Capital Adequacy and Risk Assessment Process (thereafter “ICARA”). The ICARA process is a continuing risk management process within the firm which is documented in a report and is aimed at ensuring investment firms have adequate capital and liquid resources to cover the risks they are exposed to in an integrated and forward-looking manner. Therefore, additional reviews and checks must be conducted whereby the firm assesses the need for additional capital and/or liquid resources to be held against ESG risks and across all its regulatory obligations (i.e. additional K-factors requirement arising from ESG risk exposures, increased capital/liquidity threshold requirements arising from ESG risk exposures as part of the ICARA).

As previously mentioned, the EBA has already shifted its attention on the topic of ESG risks by issuing several reports, technical standards and providing further guidance for EU investment firms. Moving forward, the EBA has announced that its next steps shall involve:

1. incorporation of the Social and Governance aspects of ESG within the EBA’s mandate at a later stage,

2. developing further guidelines on identification, measurement, management, and monitoring of the said risks,

3. the effective integration of environmental risks into Pillar II, Supervisory Review and Evaluation Process and stress testing, and

4. a holistic approach to be provided across all Pillars of the Basel framework.

Furthermore, the EBA plans to deliver a report assessing the need for introduction of a dedicated prudential treatment for exposures associated to environmental objectives during the first half of 2023, whereby it remains to be seen how and whether this report will translate into further legislative changes for EU investment firms.

What becomes evident is that the need to incorporate ESG risks within EU investment firms’ business models has become more pressing than ever. ESG factors will have to be incorporated into the firms' decision-making procedures, policies, risk mitigation techniques, investor protection rules and finally, relevant disclosures to demonstrate to the regulator and other stakeholder’s compliance with the new requirements.

EU and national competent authorities seem determined to reduce socioenvironmental impacts; thus, investment firms must follow a prudent approach by acting proactively to incorporate and account for ESG risks within their models. This way, as the prudential and regulatory framework concerning ESG risks evolves, investment firms will not bear the immediate consequences of increased regulation and heightened costs.

MAP Risk Management Services Ltd

Panayiotis Antoniou, CEO

Katerina Kyriakou, Consultant