Guidance on the Application of "ESG Risk Radar" and "ESG Questionnaire" Tools for Assessing Climate and Other ESG Risks

1. General Provisions

This Guidance defines the recommended procedure for applying the "ESG Risk Radar" and "ESG Questionnaire" tools to identify and assess climate and other ESG risks in credit activities.

ESG risks, including climate risks, can affect the financial condition of borrowers and the quality of the credit portfolio of financial and credit organizations (hereinafter referred to as FCOs); therefore, their consideration is an element of the risk management system and internal control.

The ESG Risk Radar tool, developed by Deutsche Sparkassenstiftung für internationale Kooperation (DSIK) jointly with the University of Applied Sciences Kempten, was proposed within the framework of the "Green Economy and Sustainable Development of the Private Sector in the Kyrgyz Republic" program, implemented by the German Society for International Cooperation (GIZ) and co-financed by the Federal Ministry for Economic Cooperation and Development of Germany (BMZ), the European Union, and the Government of Switzerland.

2. ESG Risk Radar. General Characteristics of the Tool

The "ESG Risk Radar" tool (hereinafter referred to as ESG Risk Radar) is designed to identify, initially assess, and compare climate and other ESG risks in the credit portfolio of an FCO, forming generalized results in the form of a heat map.

ESG Risk Radar is applied as a portfolio (top-down) assessment tool for ESG risks by economic sectors. The results of ESG Risk Radar can be used by FCOs to determine priority sectors and/or portfolio segments requiring in-depth analysis of ESG risks, to plan measures for managing ESG risks, and for subsequent monitoring as an informational basis for internal risk assessment procedures in lending (including pricing procedures, if corresponding internal methodologies exist).

Assessment of ESG risks in ESG Risk Radar is carried out based on systematized information and typically includes the following stages:

• desk research and formation of ESG risk assessments by economic sectors using open information sources, international reports, and analytical materials;
• involvement of local experts and/or scientific institutions to clarify and update results (if necessary);
• formation of an ESG risk database by economic sectors and industry profiles (if necessary – extended profiles for sectors with a higher level of ESG risk);
• formation of assessment results in the form of a heat map for a specific FCO, as well as (if corresponding data is available) in an aggregated form;
• documentation of the applied methodology and assessment results for the purpose of use and adaptation in accordance with the needs of the FCO.

3. Application of ESG Risk Concepts

The concepts of ESG factors and ESG risks for the purposes of this Guidance are applied in the meanings established by the Recommendations of the National Bank of the Kyrgyz Republic on the identification, monitoring, and disclosure of financial risks associated with sustainable finance factors (ESG risks) dated September 28, 2023, No. 37/1 (hereinafter – Recommendations on the Identification, Monitoring, and Disclosure of ESG Risks).

Within the framework of this Guidance, ESG risks are considered as factors influencing the level of traditional types of financial risks of FCOs, including credit, operational, market, liquidity, and funding risks.

The "ESG Risk Radar" and "ESG Questionnaire" tools are used to identify and initially assess ESG risks at the portfolio level and at the borrower (counterparty) level for the purpose of determining directions for in-depth analysis of ESG risks, planning risk management measures, and subsequent monitoring.

4. Methodological Foundations of ESG Risk Radar

ESG Risk Radar is applied for portfolio assessment of climate and other ESG risks and provides for the formation of industry (sectoral) assessments with subsequent visualization of results in the form of a heat map.

Assessment of ESG risks in ESG Risk Radar is based on a scoring approach and typically includes the following elements:

1. collection and systematization of information by economic sectors (including based on open sources, analytical materials, and reports);
2. calculation (assignment) of final industry ESG risk assessments in accordance with the ESG Risk Radar methodology;
3. formation of an ESG risk database by economic sectors and industry profiles;
4. aggregation of results by the structure of the FCO's credit portfolio and formation of a heat map.

The results of ESG Risk Radar are used by FCOs for:

1. identification of sectors (segments) of the credit portfolio characterized by an increased level of ESG risks;
2. determination of priorities for conducting in-depth assessment of ESG risks at the borrower (counterparty) level;
3. planning and monitoring of measures to manage ESG risks.

To transition from portfolio assessment of ESG risks to assessment at the borrower (counterparty) level, the FCO uses industry questions and indicators formed in the ESG Risk Radar, including through the application of the "ESG Questionnaire" tool (in the manner provided for by this Guidance).

4.1. Elimination of Data Deficit

When assessing ESG risks in credit activities, FCOs may face limited availability of comparable data on the ESG profile of borrowers (counterparties), including the absence of public ESG disclosures, ESG ratings, and other independent assessments, especially regarding small and medium-sized enterprises.

In conditions of data deficit, approaches oriented towards assessing the exposure of borrowers (counterparties) to the impact of ESG factors and potential financial consequences for the FCO are applied. The approaches outlined in this subsection take into account recommendations of international organizations and supervisory practice regarding the assessment of ESG risks.

The exposure-based approach is a scoring methodology aimed at determining the degree of a borrower's (counterparty's) exposure to ESG factors, taking into account the characteristics of its activities (including the economic sector, business model, and geographical location) and the possible impact of such factors on its solvency.

When using scoring methodologies, two methods of forming initial information are typically applied:

1. bottom-up approach – obtaining information directly from the borrower (counterparty) (survey, questionnaire, supporting documents) and using it when assessing ESG risks at the level of a specific credit transaction;
2. top-down approach – using available industry (sectoral) and other aggregated data for the initial assessment of ESG risks with subsequent clarification at the borrower (counterparty) level.

ESG Risk Radar uses the top-down approach and forms industry (sectoral) assessments of ESG risks, which allows for an initial portfolio assessment of ESG risks with limited data availability at the level of individual borrowers (counterparties).

Based on the results of the portfolio assessment of ESG risks, the FCO conducts a clarification of the assessment at the borrower (counterparty) level using the "ESG Questionnaire" (questionnaire) provided for by this Guidance.

Figure 1. Scope of Application of ESG Risk Radar within ESG Risk Management

4.2. Principles of ESG Risk Assessment

Principle of Systematicness and Structuredness: ESG risk assessment is carried out based on a structured qualitative approach using systematized information by economic sectors and a documented methodology for assigning scoring values.

Principle of Proportionality and Applicability: The choice of a qualitative approach to assessing ESG risks is due to the limited availability of historical and comparable data necessary for building complex quantitative models, including regarding forward-looking factors.

Principle of Transparency and Reproducibility: The ESG risk assessment methodology is transparent and provides that:

1. assessment criteria and the logic of assigning scoring values are subject to documentation;
2. assessment results can be reproduced and verified by users of the tool;
3. changes in assessment parameters are allowed provided they are documented.

Principle of Adaptability: The ESG risk assessment methodology can be adapted taking into account the national, industry, and portfolio characteristics of the FCO while maintaining the logic and comparability of results.

Principle of Using Results in Risk Management: ESG risk assessment results are used by FCOs as an informational basis for clarifying quantitative risk parameters and determining internal risk management measures, including establishing threshold values, additional collateral conditions, and/or considering ESG factors in pricing procedures, in accordance with the internal documents of the FCO.

Principle of Comprehensive Factor Consideration: When conducting ESG risk assessment, the FCO ensures the consideration of all significant factors provided for by the ESG Risk Radar methodology, including in accordance with the scheme (list of factors) provided in Figure 2.

Figure 2. Determination of ESG Risk Score at the Sector Level

Procedure for Industry Assessment of Climate Risks When conducting an industry assessment of climate risks within the framework of ESG Risk Radar, classifications and approaches to physical and transition climate risks are used.

Assessment of climate risks for each economic sector is carried out sequentially and includes:

1. assessment of physical climate risks (acute and chronic);
2. assessment of transition climate risks.

When assessing physical climate risks, the degree of exposure of the corresponding sector to climate impacts and potential channels of influence of such impacts on the economic activity of the sector are determined using available international and national information sources.

Assessment of transition climate risks is carried out taking into account the pace and intensity of the transformation of the economic sector and the probability of financial losses for organizations of the sector as a result of non-compliance with such changes.

When assessing transition climate risks, the following are taken into account, among others:

1. the sector's contribution to greenhouse gas emissions;
2. transition intensity, expressed in the level of regulatory, technological, market, and public pressure.

Transition intensity is assessed taking into account the combined influence of stakeholders within the following areas:

1. legal;
2. technological;
3. market;
4. socio-cultural.

Based on the aforementioned areas, transition indicators (TI) are formed, provided for by the ESG Risk Radar methodology (in accordance with Figure 3).

Figure 3. Modeling of Transition Period Intensity

Assessment Scale and Aggregation of ESG Risk Radar Results In addition to the assessment of physical climate risks and transition climate risks (in values established by the Recommendations on the Identification, Monitoring, and Disclosure of ESG Risks), ESG Risk Radar also takes into account other ESG risks, including risks associated with biodiversity loss, other environmental risks, human rights risks, and other social risks.

To assess the degree of prominence (significance) of risks in ESG Risk Radar, a five-level scale from 0 to 4 is applied (hereinafter – assessment scale):

• 0 – the risk is of a potential (theoretical) nature and may materialize in exceptional cases;
• 1 – the risk manifests itself and may lead to negative consequences in individual cases;
• 2 – the risk is pronounced and may have a significant impact on the activities of organizations in the sector;
• 3 – the risk is significant and may lead to substantial and large-scale negative consequences;
• 4 – the risk is critical and may lead to extremely significant negative consequences for a significant part of organizations in the sector.

This assessment scale is applied when assessing physical and transition climate risks and other ESG risks. The final assessment for climate risks is calculated as the average value of assessment components formed based on sub-scores.

For other ESG risks, an aggregated approach is applied without sub-scores: each risk category may be assigned an additional assessment (penalty score) in the range from 0 to 1 with a step of 0.25 (0; 0.25; 0.50; 0.75; 1.00).

The aggregate result of ESG Risk Radar is formed by summing three components:

1. the result of the assessment of physical climate risks;
2. the result of the assessment of transition climate risks;
3. the result of the assessment of other ESG risks.

Each of the components can form up to 4 points; the maximum value of the aggregate result is 12 points (in accordance with the calculation scheme provided in Figure 4).

Figure 4. ESG Risk Radar Scoring Table

Scope of Assessment, Sector Classification, and Profile Preparation Procedure Assessment of ESG risks in ESG Risk Radar is conducted by economic sectors of the Kyrgyz Republic and is applied to all sectors covered by the FCO's credit portfolio.

For the classification of economic sectors, the NACE classification (Nomenclature of Economic Activities in the European Union) and corresponding sector codes are used (if necessary – with comparison to national classifiers of economic activities).

Assessment is typically conducted at the main sector level. For sectors characterized by an increased level of ESG risks, assessment at the sub-sector (sub-industry) level is allowed for the purpose of clarifying results and increasing the detail of the assessment.

Assessment is carried out based on an expert (knowledge-based) methodology and includes:

1. desk research (analysis of available information sources);
2. expert verification and clarification of results with the involvement of local specialists (if available).

For sectors recognized as critical, extended industry profiles are prepared, containing justification for the assigned assessments and references to the information sources used. A sector is recognized as critical upon reaching a total aggregate ESG risk assessment of 6 points and above.

In the updated version of ESG Risk Radar, to increase the detail of the assessment and reduce the influence of subjective factors, sub-scores are applied, the procedure for forming which is described further in this Guidance.

4.3. Introduction of Sub-scores

To increase the comparability of results and reduce the influence of subjective factors, a system of sub-scores is applied for the main elements of the assessment table (Figure 4).

A sub-score is formed based on the sequential verification of a predetermined set of indicators and includes:

1. posing a key question regarding the corresponding assessment element;
2. determination of the preliminary value of the sub-score based on the answer to the key question;
3. clarification of the sub-score through verification of indicators (if the answer to the key question is positive) taking into account the quality of the information sources used.

The sub-score is determined according to the following scale:

• 0 – absence of relevance;
• 0.5 – presence of relevance;
• 1.0 – high probability (high degree of prominence) of relevance.

Examples of key questions and the procedure for their application are provided in the methodological materials of the tool (if necessary – in the Appendix to this Guidance).

If the answer to the key question is positive, the sub-score is clarified by checking the set of indicators provided for by the ESG Risk Radar methodology. The use of predetermined indicators ensures standardization of the assessment and uniformity of approaches when involving various specialists.

To increase the reliability of results when calculating sub-scores, the following are taken into account:

1. quality of the information source;
2. nature of the message (content) regarding the presence of the indicator (confirmation of the indicator's relevance or indication of its increased significance).

By quality, information sources are conditionally grouped into categories:

1. category 1 – open information sources that do not provide for formalized quality control procedures (including mass media materials and other general publications);
2. category 2 – sources with an increased level of trust and quality control (including official statements and scientific-analytical materials);
3. category 3 – sources with a high level of reliability (including legislative and regulatory acts, studies by government institutions, peer-reviewed scientific publications).

The combination of two parameters (source quality and message nature) is used to determine the clarified value of the sub-score within the range from 0.5 to 1.0, provided for by the ESG Risk Radar methodology (Figure 5).

Figure 5: Scoring Values for Indicators in Sub-scores

Weighting of Indicators and Expert Adjustment The value of the sub-score formed based on the verification of indicators may be adjusted taking into account the relative significance of the indicators for the analyzed sector and the conditions of the Kyrgyz Republic. In particular, priority may be given to information relating directly to the country and/or region of the sector's activity, compared to similar information relating to other countries (regions).

For weighting indicators, a total coefficient (total weight) equal to 6 is applied, distributed among six indicators. The values of weights for individual indicators are determined by the ESG Risk Radar methodology.

Changes in the distribution of weights are allowed in the presence of justified reasons (arguments) confirming the need to increase or decrease the significance of the corresponding indicator. In the absence of such reasons, a uniform distribution of weights is applied.

In addition to the results obtained based on indicators, the application of expert adjustment with the involvement of a local expert (expert assessment) is allowed, allowing for the consideration of sector and national context features insufficiently reflected in available information sources. The magnitude of the expert adjustment must not exceed ±0.5.

The final value of the sub-score (taking into account weighting and expert adjustment) cannot exceed the maximum value of the assessment scale. If the calculated value exceeds the maximum, the maximum value of the sub-score, equal to 4, is applied.

List of Sub-scores by Main Table Elements In accordance with the ESG Risk Radar methodology, sub-scores are formed for the following elements of the main assessment table (Figure 4):

1. physical climate risk (acute);
2. physical climate risk (chronic);
3. transition climate risk: contribution to greenhouse gas emissions;
4. transition climate risk: transition intensity – probability of regulatory changes;
5. transition climate risk: transition intensity – impact (effect) of regulatory changes;
6. transition climate risk: transition intensity – technological changes;
7. transition climate risk: transition intensity – behavior (change in preferences) of clients/consumers.

4.4. Sub-score for Physical Climate Risk: Acute Events

The sub-score for physical climate risk (acute events) is determined based on the key question: "Are acute climate events in the country/region significant for the sector under consideration?"

In the event of a negative answer to the key question, clarification is carried out using the question: "Is it likely that the significance of acute climate events for the sector under consideration will increase in the future?" Based on the answers, the base value of the sub-score is determined in the manner provided for by the ESG Risk Radar methodology.

In the event of a positive answer to the key question, the sub-score is clarified by assessing the following indicators:

1. observed loss of assets/property;
2. expected impact on income (revenue);
3. expected impact on costs (expenses);
4. expected growth in the indicators specified in points 1-3 in the future;
5. insufficient adaptability (resilience) of the sector's business model to acute climate events;
6. impact on supply chains: presence of closely linked sectors in the supply chain (upstream/downstream) having an increased level of acute physical climate risk.

The indicators specified in points 1-6 are applied with equal weight, unless otherwise provided for by the ESG Risk Radar methodology.

The indicator specified in point 6 is applied for the purpose of taking into account inter-sectoral risk transmission (supply chain effect). In the presence of closely linked sectors with an increased level of risk for the same type of risk (acute physical climate events), an adjustment (penalty score) may be applied to the assessment of the sector under consideration in the manner established by the ESG Risk Radar methodology.

Thus, the consideration of inter-sectoral links (including through supply chains) is provided for when assessing individual indicators in order to reflect the possible transmission of ESG risks between economic sectors.

Figure 6. Consideration of Sectors in Supply Chains

Clarification of Indicator Values and Documentation of Sources To ensure uniformity of assessment and subsequent verifiability of results, each indicator in the assessment table is assigned reference numbers used for:

1. detailing (specifying) the content of the indicator;
2. documenting the source...