Communications - Climate and Environmental Risks - Thematic Survey on a Sample of Non-Bank Intermediaries

Climate and Environmental Risks. Key Findings from a Thematic Survey Conducted by the Bank of Italy on a Sample of Non-Bank Financial Intermediaries.

1. Introduction Last April, the Bank of Italy issued an initial document on "Supervisory Expectations on Climate and Environmental Risks" ("the Expectations"), containing non-binding guidance for supervised banking and financial intermediaries regarding the integration of climate and environmental risks (physical and transition) into governance and control systems, business models and corporate strategy, organizational systems and operational processes, risk management systems, and market disclosure1. In this context, intermediaries were encouraged to conduct in-depth assessments of the relevance of climate and environmental issues for their operations2 and to define solutions consistent with their actual degree of risk exposure, based on the type, size, and complexity of their activities. In parallel with similar initiatives directed at less significant institutions (LSIs), the Bank of Italy subsequently distributed a self-assessment questionnaire to a sample of 86 non-bank intermediaries, aimed at assessing the level of integration of climate and environmental risks into management paradigms, with particular regard to the following areas: (i) governance and organization; (ii) business model and strategy; (iii) risk management system; (iv) market disclosure. The analysis of the responses reveals limited alignment with the expectations. Despite widespread attention to Environmental, Social and Governance (ESG) issues by senior management, in most cases widespread deficiencies were found, with delays in implementation and, often, even in the planning of structural interventions across the various corporate profiles involved. The objective of this communication is to report on the emerging critical issues and to urge the non-bank intermediary sector to continue efforts to thoroughly assess ESG risk exposure and adopt action plans capable of fostering, in the medium term, the progressive integration of climate and environmental risks into corporate strategies, governance and control systems, and risk management frameworks.

1 https://www.bancaditalia.it/media/notizia/aspettative-di-vigilanza-sui-rischi-climatici-e-ambientali/ 2 Although referring to environmental aspects, intermediaries may consider the expectations applicable also to the broader category of ESG risks, where relevant to their operations and taking into account sectoral regulatory requirements.

2. Key Emerging Critical Issues Below are the points of attention emerging from the examination of questionnaire responses, divided into three analytical profiles: "business model and strategy", "governance and organizational system", "risk management system and data bases". Regarding business model and strategy, areas of weakness emerged in assessing how environmental and climate risks might influence the competitive and regulatory context in which each company operates. The majority of intermediaries limited themselves to linking business model sustainability to the presence, in their commercial offering, of products marketed as "green" or "socially responsible". Attention to achieving measurable corporate strategy sustainability targets and monitoring specific performance indicators proved scarce, with the latter identified by only a small number of operators. In this regard, considering that market context analysis and its constituent variables are crucial for proper strategy definition, intermediaries are reminded of the need to conduct an in-depth and objective assessment of the materiality of their exposure to climate and environmental risks and to understand how this might affect their adopted business model. In the evaluation process, intermediaries should, as much as possible, complement qualitative assessments with quantitative metrics. The outcomes of such evaluations, properly formalized, serve to define comprehensive corporate strategies (or revise existing ones) that go beyond merely green-washing the commercial offering. It is appropriate that intermediaries intending to integrate climate/environmental mitigation objectives into their business model translate this commitment into measurable sustainability targets. Proper strategy definition is an essential condition to enable precise monitoring of the actual degree of target achievement, to be carried out through specific environmental and climate performance indicators defined according to the different business models adopted. Regarding governance and the organizational system, a differentiated degree of alignment with expectations emerged. While for a large portion of entities sustainability is on the radar of senior management, a non-negligible share of companies shows only partial or, in some cases, even zero involvement of governance bodies. In particular, areas of weakness emerged related to the lack of climate and environmental expertise in administrative bodies and an insufficient reporting system. Supervisory expectations require the board of directors to play an active and informed role regarding climate and environmental risks and generally presuppose enriching governing bodies with professionals possessing specific ESG expertise. In this light, greater commitment from intermediaries in leveraging training is also desirable: given the complexity of the subjects and their continuous evolution - in terms of both scientific knowledge and regulatory frameworks - training activities must be structured and recurring, not limited to sporadic initiatives. Proper oversight of ESG issues also requires that roles and responsibilities within the board of directors and/or board committees be defined and formalized, and that an effective reporting system with adequate periodicity be ensured. Finally, the capacity of remuneration policies to promote behaviors aimed at achieving ESG objectives must be strengthened - also through the identification of specific parameters. From an organizational standpoint - consistent and proportional to assessments made on the materiality of climate and environmental risks - there is a need to strengthen senior management's commitment to identifying modifications to organizational structures and operational processes. The following aspects should be evaluated in particular: i) the creation and/or adaptation of corporate structures dedicated to environmental sustainability; ii) strengthening the involvement of control functions in overseeing ESG risks; iii) integrating information systems and creating a database that provides the necessary elements to assess exposure to climate and environmental risks. Regarding the risk management system, the need for intermediaries to accelerate efforts to align with expectations by developing adequate control functions is highlighted. A very widespread problem stems from the difficulty in obtaining reliable data useful for risk measurement; the quality of information collected primarily from external providers is also not adequately assessed, given deficient data governance strategies and insufficient integration of such data into corporate information systems. Supervisory expectations require the systematic integration of sustainability risks into the corporate risk management system. To this end, intermediaries must complete the mapping of risk events that could materialize in relation to climate and environmental factors and assess their materiality and prudential implications. Once the complete map of such risks is identified, the acceptable exposure level must be determined by defining an adequate system of limits and risk indicators, integrating, where applicable, the Risk Appetite Framework. Intermediaries are urged to focus on developing coherent monitoring and reporting systems, with the latter also directed to senior management. To this end, efforts to source high-quality data and activate robust data governance systems must be intensified; it is emphasized, for example, that any reliance on external data providers and non-proprietary rating systems must be accompanied by appropriate safeguards - in terms of source transparency, data updates, robustness of estimation methods, and adequate validation by competent corporate functions - aimed at protecting the accuracy of the information used. Intermediaries are called to proceed with greater decisiveness in integrating the aforementioned risks into credit processes - to be made increasingly consistent with the principles set by the EBA (see EBA/GL/2020/06) - and in investment strategies. Companies managing securities portfolios (own or third-party) must strengthen their ability to measure not only the "sustainability" degree of investments, but also the potential impact on pricing of adverse events linked to the materialization of climate/environmental risks. In this context, greater attention must also be directed toward implementing measures that improve the oversight of liquidity and operational risks (legal, reputational, and those linked to the adequacy of information systems).

3. Action Plans Finally, the self-assessment questionnaires asked intermediaries to outline planned initiatives to achieve full alignment with Supervisory expectations. The analysis revealed that, in most cases, interventions to strengthen organizational safeguards were planned, mostly concentrated at the top levels of companies. However, these initiatives did not prove fully consistent with the self-assessment results; the general awareness of the need for adjustment measures has not yet translated into sufficiently defined and articulated programs. In light of this, all intermediaries are therefore requested to prepare an "Action Plan" that: (i) identifies the specific interventions intended to be implemented to address identified gaps; (ii) specifies the priorities and timelines necessary to complete the various initiatives, considering the intensity of risk exposure and the size and complexity of corporate operations; (iii) takes into account the weakness elements and improvement needs emerging from the aforementioned self-assessment questionnaires. The Plan, approved by the Board of Directors, must be submitted to this Institute, together with the statutory auditors' assessment, by 31.3.2023, and will be considered in the Supervisory Review and Evaluation Process (SREP) that the Bank of Italy conducts annually for all supervised intermediaries.