Recommendations on the Identification, Monitoring and Disclosure of Financial Risks Related to Sustainable Financing Factors (ESG Risks)

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Created Date: 2023-10-05

Appendix to the Resolution of the Supervisory Committee of the National Bank of the Kyrgyz Republic dated September 28, 2023 No. 37/1

Recommendations on the Identification, Monitoring and Disclosure of Financial Risks Related to Sustainable Financing Factors (ESG Risks)

Chapter 1. General Provisions

1. These Recommendations on the identification, monitoring and disclosure of financial risks related to sustainable financing factors (ESG risks) (hereinafter – Recommendations) are developed with the aim of providing recommendatory guidance for the identification, measurement, management, control and disclosure of environmental, social and governance factors (hereinafter - ESG risks) in the activities of commercial banks, the State Development Bank of the Kyrgyz Republic, non-bank financial and credit organizations and other legal entities supervised by the National Bank, applying sustainable financing principles (hereinafter – bank).

2. The Recommendations define minimum norms regarding the safe and prudent management of ESG risks within the existing prudential framework. These recommendations may be used by banks in their activities when assessing ESG risks, formulating and implementing their business strategy, internal governance and risk management system, including ensuring transparency through the disclosure of information on ESG risks.

3. For the purposes of these Recommendations, the following terms are used:

Environmental, social and governance risks (ESG risks related to sustainable development) in the context of these Recommendations represent the probability of risk realization (as losses or additional costs, or loss of planned income, or loss of the bank's reputation, etc.) related to the impact/negative financial effect of current or future environmental, social or governance factors on the Bank's activities.

ESG element – a quantitative or qualitative variable, from the assessment of which the assessment of ESG risk management is composed.

Strategic goals and/or limits related to ESG risks represent definitions aimed at managing the bank's exposure to ESG risks in the short, medium and long term.

Physical risks – are risks for banks arising from the physical consequences of climate change:

• Acute physical risks — sudden short-term and long-term events that have a significant negative impact, arising from certain climate changes (for example, weather-related, such as floods, fires or abnormal heat, etc.), which may have a physical impact on the bank's activities (value chains).

• Chronic physical risks — are risks arising from long-term climate changes (for example, temperature changes, water resource depletion, loss of biodiversity and change in soil fertility, etc.).

• Transition risks – are risks for banks arising from the transition to a low-carbon and climate-resilient economy:

• Political-regulatory risks — risks related to energy efficiency requirements, carbon pricing mechanisms, increasing prices for fossil fuels, or policies promoting sustainable land use.

• Technological risks — risks related to the resulting consequences when replacing technologies with a less harmful climate impact, with technologies having a more harmful climate impact.

• Market risks — risks related to consumer demand for financial services towards services and/or products with a less harmful climate impact.

Green House Gases (GHG) - gaseous components of the atmosphere, both natural and anthropogenic (human-related), which absorb and emit corresponding radiation at certain wavelengths within the spectrum of thermal infrared radiation (greenhouse effect). The main greenhouse gases in the earth's atmosphere: water vapor (H2O), carbon dioxide (CO2), nitrous oxide (N2O), methane (CH4) and ozone (O3).

Green economy – is an economy that leads to increased human well-being and strengthened social equity while significantly reducing environmental risks, preserving and multiplying natural capital, efficiently using resources and stimulating the preservation of the country's natural ecosystems.

Sustainable development – is a process of economic and social changes, in which the exploitation of natural resources, direction of investments, orientation of scientific and technological development, personal development and institutional changes are coordinated with each other and strengthen the current and future potential to meet human needs and aspirations.

Sustainable financing — financing aimed at supporting economic growth, with reduced pressure on the environment, minimized waste and increased efficiency of natural resource use. Sustainable financing also covers an increased level of awareness and transparency of risks that can affect the state of the financial system, as well as the need to reduce the risks of financial and corporate entities through proper governance.

Green lending/investments ("green products") – the provision of lending/investment services that depend on environmental criteria for the target use of funds, aimed at reducing/preventing adverse effects on the environment or risks to the environment.

Environmental factors – are factors that determine the level of care for the environment, including reducing damage to ecology (low-carbon economy), which can have a positive or negative impact on the financial results or solvency of the bank, sovereign or physical person.

Governance factors – are factors related to management activities that can have a positive or negative impact on the financial results or solvency of the bank, sovereign or physical person.

Governance factors include such aspects as values and ethics (for example, conduct risk, fraud, etc.), bribery and corruption (for example, the presence or absence of anti-corruption policy; condemnation and violation of anti-corruption policy), compliance with tax legislation, various types of discrimination (for example, the absence of a diversity strategy or, for example, by age, gender, minority groups, etc.), as well as transparency (i.e., when preparing and publicly disclosing information).

Governance risks – are risks of any negative financial impact on the bank, arising from the current or expected impact of governance factors on its counterparties or invested assets.

Social factors — are factors related to social aspects that can have a positive or negative impact on the financial results or solvency of the bank, sovereign or physical person.

Social factors include such aspects as data security (i.e., protection of personal data), equality issues (for example, equal representation on the board of directors or in the total number of employees, equal remuneration, for example, the presence of a gender pay gap, etc.), social cohesion, labor relations, human rights, quality and innovation in customer service (for example, the number of customer complaint incidents), etc.

Social risks – are risks of any negative financial impact on the bank, arising from the current or expected impact of social factors on its counterparties or invested assets.

Greenwashing risks – are risks related to obtaining an unfair competitive advantage in the market by providing unreliable/incorrect information about offered products for sustainable financing purposes, or risks related to the provision of bank services to persons distorting information about their activities aimed at reducing/preventing adverse effects on the environment or risks to the environment.

Risk appetite – the aggregate level of risks that the bank is willing to take in accordance with the current business model to achieve corresponding strategic goals.

Taxonomy of economic activity means a classification system in which the list of environmentally sustainable economic activity and threshold values can be used to clearly define which economic activity corresponds to the goals of sustainable development, environmental goals and principles of sustainable economic activity.

Until the introduction of the national taxonomy of economic activity, within these Recommendations, banks are allowed to develop their own threshold values and system for classifying economic activity, and apply them to services/products that must correspond to the nature, scope, volume, size of the bank's business model, taking into account the mandatory economic ratios and requirements established for banks in accordance with the legislation of the Kyrgyz Republic.

Chapter 2. Recommendations on Bank Business Processes and Strategy

4. Business processes for identifying/analyzing/assessing ESG risks are developed by the Bank's Board of Directors in coordination with responsible structural units and approved by the authorized body of the bank (and in the case of non-bank specialized financial and credit organizations (hereinafter – NBSFCOs) – developed and approved by the board of directors, in the absence of a board of directors, approved by the company's head). The business process may be reviewed in accordance with the bank's internal regulatory documents.

The identification of ESG risks is recommended to be carried out at the level of key sectors, geographical directions, as well as with respect to products and services that the bank works or plans to work with, taking into account that some of these risks may materialize on a periodic basis.

Note: ESG-related risks, and more specifically climate and environmental-related risks, can affect, for example, economic growth, employment or real estate prices at the national, regional or local level. Weather phenomena can cause droughts or floods that affect agricultural production in the region, demand for housing or collateral costs at the national, regional or local level. At the same time, competition is influenced by the development of the "green" financing market and consumer preferences that shift from high-carbon or otherwise polluting goods and services to low-carbon or otherwise "green" goods and services. In the technology sector, banks serving clients in energy-intensive industries and power plants that largely depend on fossil fuels (thus, when determining risks, the bank may classify its clients or portfolios in accordance with exposure to climate risks. For example, grouping by geography can help identify exposures that are subject to high physical risks, such as a high risk of flooding or drought. Sectoral categorization can help identify transition risks, for example, by assessing the share of high greenhouse gas emission sectors in the loan portfolio, etc.).

5. Banks are recommended to identify and assess ESG risks that are material in the short, medium and long term, and are also recommended to assess the resilience of the bank's business strategy to these risks.

6. Banks must carry out proper documentation of the processes by which banks assess the materiality of ESG-related risks.

7. To account for material ESG risks, banks are recommended to define and control long-term key performance indicators (hereinafter - KPIs) in internal documents, where necessary in quantitative terms. Depending on the nature, complexity and scale of the bank's activities, these indicators may be distributed across business lines, clients and products where they are material and relevant.

Note: Indicators setting a specific target for "green" or social loans can, for example, be cascaded or broken down by corporate clients; individuals; business activity or economic sectors; types of loans (for example, consumer loans, mortgage loans, credit lines, etc.); geographical location; etc.

8. Banks are recommended to consider what impact the developed business processes and strategies will have on reducing ESG risks (for example, by measuring and limiting greenhouse gas emissions or resource efficiency of their main portfolios or resulting from their own activities, etc.).

Steps are recommended to be taken to reduce transition risks, for example, by gradually or even rapidly reducing and/or ceasing financing of environmentally unsustainable activities.

For these purposes, it is recommended to develop a bank's carbon neutrality plan in accordance with general climate and environmental sustainability goals (i.e., in accordance with maximum permissible values established at the national and international levels).

Note: Banks can evaluate the possibility of developing products more resilient to ESG risks (i.e., less exposed to ESG risks). For this, banks should develop credit policy consistent with the bank's general goals and/or limits regarding ESG risks. The following is an explanation of goals and/or limits related to ESG risks. It can be paraphrased as follows: "For the purposes of this guideline, strategic goals and/or limits related to ESG risks are understood as definitions aimed at managing the bank's exposure to ESG risks in the short, medium and long term. For example, banks may set strategic goals and/or limits regarding the share of exposure to certain types of economic activity or sectors that are expected to be more exposed to ESG risks (for example, limit the bank's exposure to mining sector companies; increase lending to companies ensuring equal representation of board members and/or total number of employees, etc.)."

9. Banks are recommended to conduct a strategic assessment of the need to develop sustainable products that are considered more resilient to ESG risks. Banks that create or plan to create environmentally sustainable credit products should regulate business processes for providing environmentally sustainable lending services in corresponding credit policies and procedures for managing credit risk, including assessment, analysis, monitoring and control of these risks.

Note: For the purposes of these Recommendations, strategic goals and/or limits related to ESG risks are understood as definitions aimed at managing the bank's exposure to ESG risks in the short, medium and long term. For example, banks may set strategic goals and/or limits regarding their share of exposure to certain types of economic activity or sectors. On the contrary, goals or limits that are not related to business model resilience and whose purpose is not to effectively improve the bank's management of ESG risks are not considered strategic goals and/or limits related to ESG risks. In addition, banks should keep in mind that establishing strategic goals will likely change their overall risk profile, leading to the need to review their risk appetite.

Chapter 3. Recommendations on Internal Governance

10. The Board of Directors (in the case of NBSFCOs – company head in the absence of a board of directors) must exercise effective oversight over the bank's exposure to ESG risks and regarding the impact of business strategy on ESG objectives.

11. The Board of Directors, Management Board (in the case of NBSFCOs in the absence of a board of directors – company head), key structural units involved in business processes must possess sufficient knowledge and understanding of ESG-related risks to exercise effective control over the bank's activities and financial condition, including by ensuring the appropriate level of risk taken by the bank.

12. Banks must ensure the provision of appropriate ESG risk reports or inform the Board of Directors (in the case of NBSFCOs – board of directors, in the absence of a board of directors – company head) of the bank on a periodic basis, but not less than once a year.

13. Banks must clearly delineate the responsibilities of each function and individual performing control functions regarding ESG risks, with a detailed description of powers, workflows and objectives of these functions, taking into account the established requirements of the Rules for forming a system of internal control and internal audit in banks and non-bank financial and credit organizations licensed and regulated by the National Bank of the Kyrgyz Republic, approved by the Resolution of the Management Board of the National Bank dated June 15, 2017 No. 2017-P-12/25-3-(NPA) (hereinafter – Rules).

14. When establishing internal duties and responsibilities for ESG risk management and control, banks are recommended to choose one of the following options: A separate organizational unit is created in the bank or a responsible person is designated who is responsible for ESG risk management and control. In case of creating a separate department or designating an ESG risk responsible person, banks are recommended to ensure the integration of the separate department or function of the responsible person into existing processes and its interaction with other functions is clearly defined (separation of responsibilities and duties, interaction and reporting obligations, etc.). Designate/establish internal duties and responsibilities for ESG risk management and control over existing services/departments responsible for bank risks. Otherwise, responsibility for ESG risk management and control, subject to appropriate separation of duties and responsibilities, must be assigned to the supervising Member of the Management Board (in the case of NBSFCOs – to the company head).

15. The Board of Directors and Management Board (in the case of NBSFCOs – board of directors, in the absence of a board of directors – company head) are responsible for compliance with the regulation of business processes in accordance with paragraph 13, which must be consistent, feasible and properly documented.

16. For the purposes of carrying out functions related to ESG risk management, the bank must be provided with sufficient resources, both human and financial.

17. Banks are recommended to provide appropriate opportunities for training bank staff involved in ESG risks, and ensure the possibility of conducting training on general ESG factors, especially for individuals performing control functions, in accordance with the Rules.

18. To take a comprehensive approach to risks considering the bank's long-term financial interests, the Board of Directors (in the case of NBSFCOs – board of directors, in the absence of a board of directors – company head) is recommended to develop a bank action plan for assessing ESG risks and sustainable development objectives in the form of an ESG risk management strategy by integrating ESG risks into the risk management system, including the bank's remuneration policy.

19. Banks are recommended to integrate ESG risk exposure assessment into internal reporting systems for the Board of Directors and Management Board (in the case of NBSFCOs – board of directors, in the absence of a board of directors – company head) regarding risk assessment to ensure reliable, complete, objective and timely information necessary for making appropriate decisions.

20. For proper internal control, the bank is recommended to ensure the presence of effective and reliable internal and external reporting, disclosure and data transfer systems capable of aggregating ESG risk data. Banks are recommended to assess the need to adapt their information systems for collecting and aggregating necessary data to assess the bank's exposure to ESG risks.

Chapter 4. Minimum Risk Management Requirements §1. Risk Management System

21. Banks must ensure a comprehensive and detailed documented approach to assessing the impact of ESG risks on existing risk categories, while banks may consider these risks as a separate category for organizational or analytical purposes.

Note: For example, extreme weather phenomena (for example, drought) can be considered as a factor affecting credit risk (as an existing category) in agricultural lending, while other physical risks (for example, floods) can affect multiple risk categories simultaneously (for example, credit risk), operational risk, liquidity risk, etc.). Nevertheless, banks may consider them as part of a separate risk category called "ESG", "climate" or other.

22. Banks are recommended to take measures to quantify ESG risks. Banks must make proportional efforts to use quantitative indicators in the quantification, striving to take any corrective actions for data deficiencies they may encounter. At the same time, a broader understanding of indicators and/or metrics is allowed for climate and environmental risks compared to social and governance risks.

23. Banks may review risk management policies and other internal regulatory documents of the bank, which clearly define functions, systems, processes, procedures, activities and methodologies, as well as competencies, duties (collective and individual) and reporting at all levels of the bank's organizational structure taking into account ESG risks.

24. Banks are recommended to develop appropriate risk indicators and establish corresponding limits for ESG risks.

25. Banks are recommended to monitor and disclose (independently, at their discretion) the bank's policy regarding economic sectors, geographical risks, current data on ESG risk exposure, preferably in the form of quantitative indicators based on a combination of historical data and forecast estimates, in accordance with the requirements of Chapter 5 of these Recommendations.

§2. Credit Risk Management

26. Banks are recommended to develop internal documents related to ESG risks taking into account the bank's general objectives, strategy and sustainable financing policy. The definition of sustainable lending requires the development of a new internal set of criteria or the inclusion of existing or future standards in credit risk policy and lending strategy taking into account compliance with minimum requirements of regulatory legal acts of the National Bank regarding credit risk management and regulatory legal acts of the National Bank governing the activities of guarantee funds.

27. Banks are recommended to take into account ESG-related risks at all relevant stages of credit risk/ exposure approval and credit risk management.

28. When determining sustainable financing policy, banks are recommended to have up-to-date information for large corporate clients (as defined by the bank) regarding:

• client's resilience,
• client's exposure to physical and transition risks;
• client's plans for climate change mitigation;
• social