Supervisory News: Nature Risk Assessment

Supervisory News

Latvian Bank has been working long-term and purposefully in collaboration with stakeholders to achieve a breakthrough in lending. This has resulted in positive trends in recent years. For example, since the beginning of 2023, the outstanding balance of bank loans to the agriculture, forestry, and fisheries sectors in Latvia has grown by 35.5%, with the agriculture sub-sector growing by 30%, while overall business lending has grown by 29%. Lending in these sectors has grown faster than overall business lending and GDP growth (nominal GDP grew by 21%), providing sectors with the opportunity to invest and become more competitive outside Latvia's borders.

It is often observed that banks, not understanding or being unable to assess a certain risk, decline to manage it. In practice, this means a negative impact on companies' cooperation with banks and lending. Latvian Bank's guidelines for identifying nature-positive and nature-negative economic activities are a voluntary practical instrument – a methodology – for banks to assess one of the components of nature risks in their operations; they are not lending guidelines for banks, nor are they indications for sectors or companies.

Nature risks consist of physical risks (excessive drought, deterioration of soil quality, floods) that arise from the decreasing availability and quality of natural resources and directly affect a company's operations, as well as transition risks associated with legal, technological, or market changes on the path to halting biodiversity loss. These risks also include the company's own impact on biodiversity, as it can contribute to the occurrence of these risks. Both types of nature risks can create significant financial impact on a company's operations, which is why the financial sector is paying attention to them.

Until now, there has been no methodology suitable for Latvian conditions developed for assessing the impact on biodiversity. If such a risk is assessed, other international methodologies are usually applied, for example, ENCORE. It is universal, but not always appropriate for each country's situation, and in Latvian conditions, it is considerably more restrictive.

Latvian Bank's guidelines reduce the identified impact on biodiversity for a significant part of credit institutions' credit portfolios, especially in the real estate sector, which means they are less restrictive and more favorable to the economy. Compared to the ENCORE methodology, the definition of impact on biodiversity has been narrowed down from entire sectors to specific activities of individual sectors that create a negative impact on biodiversity.

The guidelines are a methodology developed by Latvian scientists that is more suitable for the Latvian situation and is a voluntarily used instrument for banks that, in accordance with their operational strategy and shareholders' risk appetite, pay increased attention to environmental and impact on biodiversity risk assessments.

It is important to remember that banks' credit policies are not formed solely by environmental considerations. Credit decisions are made by evaluating other factors and risks as well. The guidelines do not set requirements for farmers or foresters. In them, economic activity is assessed only from the perspective of the company's impact on biodiversity, and such an assessment is not intended and is not considered a general assessment of operations or a mandatory requirement.

Environmental risk management in the financial sector is still in a development stage, so there is no basis for concern about excessive requirements. Although EU regulations and supervisory requirements stipulate that banks must identify, assess, manage, and monitor climate and environmental risks, the improvement of methodologies, data, and practical implementation is happening gradually. This means that the supervisory goal is to ensure the gradual improvement of banks' climate and environmental risk management, taking into account the development of methodologies and data availability.

Banks already have the obligation to assess environmental, social, and governance (ESG) risks. This is provided for by EU regulations, in particular the Capital Requirements Regulation (CRR), the Capital Requirements Directive (CRD), as well as the European Banking Authority guidelines. Meanwhile, the European Central Bank has outlined supervisory expectations for climate and environmental risk management in its climate and environmental risk roadmap.

Banks must assess the extent to which ESG risks can affect their operations, taking into account the bank's business model, strategy, credit portfolio, and other significant factors. At the same time, the principle of proportionality is applied in this area, taking into account the bank's size, business model, and the significance of identified risks. Therefore, if a specific ESG risk is identified as significant, banks conduct in-depth management and integration of this risk into risk management processes.

Latvian Bank is open to dialogue with various sectors. So far, the development process, content, and significance of the guidelines in banks' operations and risk management supervision have been discussed with banks, the Agricultural Organizations Cooperation Council, representatives of various ministries, and the dialogue continues. The guidelines will be improved by evaluating received proposals.