Uncovering Climate Transition Risk in EU Sustainable Finance Regulation

By Dr. Pooja Khosla, Chief Innovation Officer at Entelligent, and Nels Ylitalo, Vice President, Director of Product Strategy for Regulatory Solutions at FactSet

Sustainability (ESG) risk is a broad new regulatory concept prevalent in EU financial services regulation. Specifically, climate risk has emerged as one of the biggest macroeconomic forces that impact economic and business sustainability. As a result, investment firms face key decision-making challenges for sustainability risk measurement, reporting, and portfolio assets.

Over the past several years, legislators have written principles-based sustainability risk requirements into pan-European legislation—for investment firms, mutual fund and exchange-trade fund managers, UCITS (undertakings for collective investment in transferable securities), alternative investment fund managers, banks, insurers, pensions and financial advisers. Virtually all EU financial services firms are under an existing or imminent regulatory obligation to assess, measure, manage, and disclose sustainability or ESG risk.

Investors need deep understanding of companies’ resilience and exposure across climate and energy price scenarios. Investment firms should have a valuable dataset to assess sustainability risk exposures in their portfolios and to incorporate forward-looking sustainability risk metrics in both their investment decisions and financial products. Doing so can help reduce the carbon footprint of portfolios and could boost financial performance.

Following the 2008 financial crisis, regulators implemented new risk management and reporting requirements for financial firms and banks. This was intended to enhance oversight of market risk management practices and bolstered requirements across other risk domains, including leverage, liquidity, counterparty, and credit. But the post-financial crisis risk landscape is not fixed.

Globally, the climate crisis is emerging as a new risk driver in the financial system, spurring the development of risk management concepts, tools, data, and disciplines such as climate risk measurement, stress testing, and reporting. In the EU, financial system risk from climate change is included under broader umbrella terms: sustainability risk or ESG risk.

In the EU, there are new sustainable finance regulations. For example, the Sustainable Finance Disclosure Regulation (SFDR) adds sustainability risk requirements for in-scope firms. In parallel, EU legislators and regulators are updating existing financial sector framework laws and technical standards such as:

• AIFMD, the Alternative Investment Fund Managers Directive

• IFD/IFR, the EU's Investment Firms Directive and Investment Firms Regulation

• UCITS Directive

• PRIIPs, packaged retail and insurance-based investment products

• EU regulatory authorities ESMA, the European Securities and Markets Authority

• EBA, the European Banking Authority

• EIOPA, the European Insurance and Occupational Pensions Authority

These entities are filling in the details via regulatory technical standards, guidelines, reports, and opinions. This multilevel, multi-industry process is ongoing and at varying stages across financial industries. EU regulators have published thousands of pages on these topics and will publish thousands more in the coming years.

Task Force on Climate-Related Financial Disclosures

In addition to SFDR, another key international entity is the Task Force on Climate-Related Financial Disclosures. TCFD was established in 2015 by the Financial Stability Board to improve reporting of climate-related financial information across companies and financial institutions.

TCFD’s framework enables companies to identify and disclose climate-related risks and opportunities, and in turn enable investors, lenders, and other stakeholders to make more informed decisions. The TCFD disclosure framework has gained significant support from businesses, investors, and governments worldwide—more than 2,300 organizations have publicly expressed their support, according to the most recent published data.

TCFD’s recommendations are structured around four key areas:

• Governance

• Strategy

• Risk management

• Metrics and targets

Its framework has increasingly gained the force of law, notably within EU jurisdictions. TCFD recommends that companies determine the potential financial impact on operations resulting from different climate scenarios, including those consistent with limiting global warming to well below 2 degrees Celsius, as outlined in the Paris Agreement.

Chart: When Entelligent’s T-Risk, a factor identifying sustainability risk, is added to investment portfolios such as MSCI World Climate Change Risk Index, it further reduces the portfolio’s carbon exposures and footprint. The blue bars (showing a T-Risk screened portfolio) have a lower carbon footprint relative to the benchmark index. Adding climate transition risk as a factor to the MSCI World Climate Transition Risk Index authenticates that addressing sustainability risk is financially material.

Source: FactSet PA and Entelligent

New Risk Management Focus

The broad concept of sustainability risk (or ESG risk) is relatively new and amorphous in financial regulation. For example, SFDR, in force since March 2021, defines sustainability risk as “an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.”

While regulators and the industry have been iteratively developing highly specified climate stress tests for banks and insurers through annual exercises, sustainability risk assessment for asset managers remains in flux. It is dependent on emerging data, tools, and methodologies, according to a European Banking Authority report on incorporating ESG risks in the supervision of investment firms:

“The EBA acknowledges the challenges presented by the assessment of ESG risks in light of current data and methodological constraints. It is recommended that the supervisory processes follow a gradual approach, prioritising the recognition of ESG risks in investment firms’ strategies and governance arrangements, and later incorporating ESG risks in the assessments of risks to capital and liquidity. Supervisory assessment practices are expected to develop over time, alongside the expected improvements in the availability of ESG data as well as the development of methodologies to assess the impact of ESG factors on financial risks.”

The SFDR definition of sustainability risk is used in other sectoral legislation, such as the UCITS Directive, where it’s incorporated by reference. The overarching risk management provisions of the UCITS delegated regulation have been updated to include sustainability risk:

“The risk management policy shall comprise such procedures as are necessary to enable the management company to assess for each UCITS it manages the exposure of that UCITS to market, liquidity, sustainability and counterparty risks, and the exposure of the UCITS to all other risks, including operational risks, which may be material for each UCITS it manages.”

Similar high-level requirements are now in sectoral legislation for alternative investment fund managers.

The imperative now facing the EU financial industry is to augment existing risk management governance structures, policies, and procedures with a sustainability risk component. It would enable compliance with principles-based regulatory requirements in the face of a vaguely defined risk that is difficult to measure.

The target state for financial firm sustainability risk management is that it will be as quotidian, measurable, and manageable as market, leverage, liquidity, counterparty, and credit risk are today. Eventually, it might become as commonplace to incorporate climate risk exposures into investment decision-making as it is to consider volatility, sector, region, asset class, or single issuer exposures.

EU financial services regulation is pushing firms in that direction. The pathway to that target state is in development; empirical, innovative, science-based, quantitative solutions will play a key role as financial firms’ approaches mature.

Impact of SFDR on Sustainability Risk in EU Investment Decisions and Financial Products

While existing sectoral legislation, such as the UCITS Directive and AIFMD, now include high-level sustainability risk management requirements for managers of in-scope funds, the SFDR has the broadest sustainability risk disclosure mandates—both at entity and product levels.

Entity-Level Disclosures: SFDR Article 3 is an entity-level mandate to disclose how in-scope firms integrate sustainability risk in their investment processes. It applies irrespective of firms’ ESG aspirations—it’s a broad disclosure mandate. It does not impose any particular methodologies or approaches, enabling firms to select innovative solutions that reasonably address the mandate.

Product-Level Disclosures: SFDR Article 6, is a product-level disclosure requirement for firms to disclose in precontractual documents (such as a fund prospectus):

(a) the manner in which sustainability risks are integrated into their investment decisions; and

(b) the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available.

As with the entity-level disclosures, the SFDR does not dictate a particular approach to integrate sustainability risk into investment decisions or assess the impacts of sustainability risks.

Sustainable Financial Products: SFDR creates two categories of sustainable financial product: Article 8 and Article 9. Article 8 financial products “promote” one or more environmental or social characteristics, while Article 9 products have sustainable investment as an objective.

SFDR in-scope financial products include:

(a) managed portfolios

(b) alternative investment funds

(c) IBIPs (insurance-based investment products that feature both an insurance and investment component)

(d) pension products

(e) pension schemes

(f) UCITS (undertakings for collective investment in transferable securities)

(g) PEPPs (the pan-European Personal Pension product, a voluntary personal pension scheme that offers EU citizens a new option to save for retirement)

In the context of Articles 8 and 9 for sustainable financial products, the relevant definitions and standards are amorphous and principle-based. Financial product manufacturers can adopt any number of approaches to construct and manage a qualifying financial product, with certain exceptions for taxonomy-related objectives.

Investment Firms Regulation / Investment Firms Directive

IFR/IFD is a comprehensive package of financial regulations the EU introduced in 2019 to overhaul the prudential framework for investment firms operating in the region. It comprises two sets of rules—highlighted by revised capital requirements, liquidity, and concentration risk rules—and reporting and disclosure requirements for investment firms, including climate and ESG requirements.

Under IFD/IFR regulations, investment firms that exceed certain size thresholds must report on a range of ESG factors, including their approach to manage climate-related risks and opportunities. Investment firms must take into account the potential impact of their activities on the environment and climate as well as the potential risks and opportunities associated with climate change. They are required to integrate the regulations into their risk management processes and ensure they have appropriate governance arrangements in place to address these.

Firms must also disclose how they account for ESG factors in their investment and risk management processes. In addition, investment firms that engage in certain activities deemed to have higher ESG risks must meet specific capital requirements. For example, firms that invest in assets with a high-carbon footprint may be subject to additional capital charges.

Pension Fund/Insurer and Reinsurer Compliance

EU regulations for nonfinancial and climate disclosures for pension funds are covered under SFDR and the EU Taxonomy. The aim is to provide greater transparency and information to investors regarding the sustainability and climate risks of their investments.

As described above, pension funds are required to disclose information about their policies on sustainability risk, their approach to consideration of adverse sustainability impacts, and the extent to which sustainability risks are factored into their investment decision-making processes.

The EU introduced Solvency II to establish a more comprehensive and risk-sensitive regulatory framework for insurance companies. In force since 2016, Solvency II sets requirements for insurers and reinsurers to ensure adequate protection of policyholders and beneficiaries. Its risk-based approach enables assessment of the overall solvency of their undertakings through quantitative and qualitative measures.

In recent years, Solvency II has focused on assessment and management of climate-related risks. Under the rules, insurers must conduct scenario analyses to determine the impact of climate-related risks on their businesses, including both:

• Physical risks such as extreme weather events

• Transition risks such as changes in government policy or market conditions related to the transition to a low-carbon economy.

Conclusion

The European Union has approved new law and regulations to address climate change, promote sustainability, and reduce greenhouse gas emissions. It conducts regular climate scenario analysis and climate transition risk analysis. These analyses help the EU prepare for different climate futures and ensure that policies and measures are in place to mitigate impacts.

This blog post has been written by a third-party contributor and does not necessarily reflect the opinion of FactSet. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.