Dutch Central Bank publishes final guidance on financial institutions’ management of climate and environmental risks

The Dutch Central Bank (De Nederlandsche Bank, “DNB”) expects Dutch financial institutions to have an understanding of the material risks associated with climate change and environmental degradation, and to manage such risks. DNB research (in Dutch only) shows that financial institutions are aware of these risks, but that they have not yet fully integrated these into their core processes. DNB therefore published guidance to further clarify its expectations of financial institutions’ management of sustainability risks.

After having consulted the financial sector in Q1 of last year, DNB now published its final Guide to managing climate and environmental risks for certain Dutch financial institutions (the “Guide”). The Guide provides guidance (including good practices) for the management of climate and environmental risks and should be viewed in conjunction with applicable legislation. The Guide is primarily intended for the following financial institutions:

• investment firms and investment funds (together “IFs”);
• insurance companies;
• pension funds; and
• electronic money and payment institutions.

Although the Guide thus also applies to IFs, the content that is relevant for these institutions has directly been integrated from the Good Practice Guide for IFs that DNB already published in 2021.

The European Central Bank (“ECB”) and DNB published similar guidance for credit institutions:

• DNB’s Good Practice Integration of climate-related risk considerations into banks’ risk management, April 2020;
• ECB’s Guide on climate-related and environmental risks, November 2020.

What is the (legal) context of this Guide?

Dutch financial institutions are required to have controlled and sound business operations and manage prudential risks. This also means that financial institutions are required to manage material climate and environmental risks, as such risks can be a source of financial and non-financial risk.

Financial institutions may be vulnerable to the financial risks related to physical and transition risks:

• Physical risk refers to the physical consequences of climate change, including more frequent extreme weather events such as droughts, floods and storms, sea-level rises, and environmental degradation, including air, water and land pollution, water stress, biodiversity loss and deforestation. Physical risks can result in damage to property (including office buildings and data centres) or reduced productivity or lead to a disruption of supply chains and jeopardise business continuity. For example, extreme weather events can cause capital destruction and increase unforeseen claims for non-life insurers.
• Transition risk is related to the transition to a lower carbon and more environmentally sustainable economy (such as changes in environmental policies, technological progress or market sentiment). Compliance with changing legislation or policies or meeting changed market sentiment or consumer preferences may require significant financial investments.

Physical and transition risk factors may not only lead to financial and non-financial risks for financial institutions, including market and reputation risk, but also to systemic risks (e.g., if the financial problems of one or more financial institutions spill over to the entire system). These factors can cause changes in the economy, which in turn affect the financial system.

Financial institutions themselves also have an impact on the climate and the environment through their activities. This also comes with risks. DNB uses the example that financial institutions investing in companies with a major negative environmental impact may run increased reputational and legal risks.

DNB stipulates that the extent to which climate and environmental risk factors affect a financial institution differ per sector and also depend on the institution’s business model. The Guide therefore differentiates between the various financial institutions and contains examples of how risk factors affect different (non-)financial risks.

Suggested focus areas and good practices

DNB points out four (4) focus areas that may be relevant for financial institutions to achieve integrated management of climate and environmental risks.

• Business model and strategy: Institutions should consider all material risks to which the business model may be exposed. DNB therefore suggests to involve climate and environmental risks in the formulation and implementation of the strategy.
• Governance: DNB considers it important that policymakers embed climate and environmental risks in the governance, strategy, risk appetite and risk management framework. By allocating responsibilities and resources for climate and environmental risk management within its organizational structure, the institution can make well-informed decisions such risks.
• Risk management: DNB suggests, among others, to include all (material) risks to which the institution is exposed in its risk appetite framework, to integrate such risks in its current risk management cycle and to use scenario analyses and stress tests to estimate its exposure to climate and environmental risks.
• Information provision: DNB suggests to set up an adequate data infrastructure for climate and environmental risks, pay attention to new reporting standards when determining data needs, and provide meaningful information about material climate and environmental risks.

For purposes of providing examples of a good application of these focus areas, the Guide also includes good practices per category of financial institution for each of the focus areas. DNB stresses that, when applying the good practices, it is important to keep an eye on the proportionality and materiality of the risks for a specific institution.

One example of a good practice that DNB points out in the area of governance, is a management board of a pension fund that established minimum requirements for its management and supervisory board members on their knowledge of climate and environmental risks and opportunities. In this case, the minimum requirements were also incorporated into the board members’ job profiles. In doing so, the board took as its starting point that the management and supervisory board should have insight into and understanding of the most important developments in the area of climate and the environment, the legislation and regulations in this area, what society and stakeholders expect of the institution and what this means for its business operations.

Another example of a good practice that DNB refers to in the area of governance, is that the remuneration policy of an insurer's board is based on both financial and non-financial KPIs, whereby the non-financial KPIs are aligned with the strategic sustainability objectives set by the insurer. These targets are then concretized and have deadlines attached to them (such as, a certain CO2-reduction percentage to be achieved by a certain year or long term strategic goals for a CO2-reduction of the investment portfolio).

Final remarks and next steps

As climate change and environmental degradation can lead to risks for Dutch financial institutions, DNB expects financial institutions to have insight into all associated material risks and to manage them adequately. In the Guide, DNB sets out its expectations and provides guidance for managing these risks. Although the Guide is not binding and financial institutions could consider a different approach, it should be kept in mind that adequate management of risks (including climate-related and environmental risks) is a regulatory requirement. DNB made clear that the good practices will be referred to in its supervisory dialogue with financial institutions about the management of climate and environmental risks.

DNB indicated that it will start a survey in April 2023 on the management of ESG risks among pension funds and insurers, whereby the focus areas in the Guide will form the basis for its survey. DNB aims to update the Guide in about a year, whereby the Guide will be supplemented with additional good practices and amended in accordance with legislative developments.

Finally, DNB indicates that is working towards the further embedding of ESG factors in the risk assessments that it carries out at financial institutions. For example, in 2024 DNB expects to include ESG risks in the annual surveys that DNB carries out for sector-wide supervisory risk analyses. DNB also develops ESG dashboards to gain insight into institutions' exposure to various ESG aspects. The information from these dashboards will be used, among other things, as a basis for supervisory interviews and as input for risk assessments.