Response to discussion Paper on management and supervision of ESG risks for credit institutions and investment firms (EBA/DP/2020/03)
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MSCI Principles of Sustainable Investing set forth our views on the core principles and best practices for ESG integration by investors globally. This document can be viewed on our website at the following link: The MSCI Principles Of Sustainable Investing (https://www.msci.com/documents/10199/16912162/MSCI-ESG-House-View-FINAL.pdf/63bba1a1-aecf-ba80-aa49-7910748ed942).
One measure may be to have non-binding guidance to provide examples of factors to consider when setting objectives and/or limits. It should not be overly prescriptive to limit innovation of objectives but provide a base for institutions to consider when forming their objectives / limits. This may also be beneficial to assist smaller institutions in the process that may have resource constraints.
• On disclosing specific ESG risk-related strategic objectives and/or limits: We strongly believe that disclosure can enhance transparency and enable both institutional and individual investors to factor ESG consideration into their investment process. While being careful not to be overly prescriptive to influence type of objectives and/or limits, it may be useful to have non-binding guidance on what institutions should disclose as mentioned in response to question 16.
• On engagement: Best practices to date that we have come across in our analysis of global asset management firms are proxy voting policies addressing ESG issues and dedicated staff responsible for ESG engagement. For credit institutions, borrower engagement approach will depend on type of customer. Thought may need to be given on the practicality of how to implement engagement with SMEs versus say larger corporates. For example, this may take the form of educating SMEs so can reach a wider audience rather than direct one-to-one engagement.
• On incorporating ESG-risk related considerations in directives and regulations applicable to the banking sector: Enhanced transparency and comparability are fundamental to driving capital towards more sustainable investments, but inconsistent regional standards will confuse the market.
• In addition to recruiting and training staff within the business units and internal control functions to enhance expertise of ESG risks, it may be relevant for companies to also build up their ESG expertise at the board level.
• Institutions may also want to ensure they have clearly defined ESG due diligence triggers and risk escalation processes.
Institutions may also want to consider disclosing in their publicly available risk management framework how they are integrating ESG risks. This would allow institutional and individual investors to judge the risk management systems when comparing to peers.
Institutions may evaluate incorporating ESG risk in their framework that may reflect long-term perspective that characterizes this risk class. Long-term horizon limits and objectives may be reflected through metrics that can be monitored on an ongoing basis along with other existing monitoring frameworks.
Stress testing and scenario analysis represent useful and informative tools to assess sensitivities and vulnerabilities of financial institution’s portfolios. These analyses can provide insights on portfolio’s exposures and risk dynamics that may be considered while defining a more granular monitoring framework (i.e. counterparty level) on relevant prudential risks.
Our MSCI ESG Ratings model has two components for each key issue. Firstly, the risk exposure to the issue and second, management practices to mitigate risks. For the banks there are more key issues that we assess under the social pillar (e.g. consumer financial protection, privacy & data security, access to finance) compared to the environmental pillar. This means that we have a higher overall weight given to the social pillar in our banks model. MSCI ESG Ratings model calculates the weight of each of the key issues in the overall ESG assessment, based on the severity and the time horizon for associated risks. Some issues may therefore be equally relevant (equally weighted) based on the type and extent of potential impact, and the time horizon for the externality to become a potential cost to the firm.
We believe that business model decisions and strategies need to consider long-term objectives to ensure the achievement of environmental and sustainable goals. Financial Institutions may be required to monitor the evolution of the environment and adapt their business model on a timely basis to ensure that long-term objectives are achieved.
Financial institutions may be required to consider carefully the economic impact of ESG related objectives in light of the business environment in which they operate. This aspect is more relevant for mid and small size financial institutions that tend to be highly concentrated on specific sectors and toward counterparties that operates in a specific region or sub-region.
In relation to the risk management framework we would stress the importance of modelling assumptions and approaches for reflecting ESG factors on existing prudential risks. Along with stress testing and scenario analyses, financial institutions may evaluate reverse stress testing on ESG risks to ensure that adverse risk dynamics are properly captured by the existing risk management framework. In addition to recruiting and training staff within the business units and internal control functions to enhance expertise of ESG risks, it may be relevant for companies to also build up their ESG expertise at the board level as well.
Institutions may also need to ensure they have clearly defined ESG due diligence triggers and risk escalation processes.
In relation to capturing ESG risks in credit risk, concentration analysis over different dimensions i.e. sectors, geographical regions and counterparties, can be detrimental to mid and small size financial institutions that tend to present business models focused on certain sectors, regions and companies. Therefore, while assessing risk to capital for mid and small size financial institutions, supervisors may need to take cognizance of this inherent risk and consider the actual engagement with counterparties and stakeholders with regards to ESG risk mitigation strategies.
It is therefore our view that financial institutions should adopt a comprehensive approach in incorporating ESG risk across prudential risks, reflecting the impact of ESG factors on macroeconomic and market variables.
1. Ease of use and interpretation
Metrics without standardized thresholds or scoring to indicate what is good or bad on a relative basis are not intuitive and unlikely to be helpful for investors. Furthermore, metrics that are highly technical, may not be easily understood or interpreted unless read by a suitably qualified person.
In August 2020 MSCI recently undertook an independent survey of over 5,000 consumers/retail investors located in Germany, France, Italy, Sweden and Belgium, where 57% of respondents indicated that an overall sustainability score or rating was more useful in understanding the sustainability performance of a mutual fund than a set of metrics alone.
Our proposal/view:
- Widely used ESG scorings or ratings should be used as part of the disclosures.
- Requiring common, well-understood definitions/metrics that take into consideration local context outside of the EU will be important for consistent and comparable metrics. This should be subject to input/consultation with experts and the industry to provide comparability across companies.
2. Consistency of metrics and disclosure limitations
With an extensive number of disclosure frameworks, we would suggest that EBA rely on commonly accepted reporting metrics. Some indicators suggested in the Appendix are not consistently reported by companies which does not allow for comparability.
Below are examples of EBA suggested indicators that are not frequently or consistently reported by counterparties in our experience.
a. Metrics: Emissions of air pollutants and water pollutants
MSCI Comment: Without specifying type of pollutants for disclosure, institutions risk obtaining incomparable data. Emissions of ozone depleting substances is typically reported by a small subset of companies and industries. Many of these substances have been banned in the EU and other countries party to the Montreal Protocol.
b. Metric: Heatwaves per year with 5 or more days above given temperature (i.e. 35(°C))
MSCI Comment: Identifying a company’s operations impacted by heatwaves is dependent on company asset data which is inconsistent and not widely disclosed.
c. Metric: Number of internal or international displacements due to natural disasters
MSCI Comment: Without a more comprehensive definition of how this metric is applied, data is likely to be incomparable. It is unclear whether the number of displacements should be national figures, employees or based on whether the company operates within specific areas directly impacted by a natural disaster.
1. Please provide details of other relevant frameworks for ESG factors you use.
In addition to the regional and global frameworks referenced by EBA, we would mention other commonly adopted ESG disclosure frameworks: TCFD, SASB, SDG. Specific ESG indicators or factors covered by these frameworks for the most part overlap with the indicators and factors identified by EBA as common for disclosure. We would suggest expanding the list of the common factors to include indicators related to consumer protection (e.g., product recalls, use of regulated or restricted substances, nutrition profile of food, product labeling, false advertising, mispricing, predatory lending, etc). These indicators are relevant in the context of liability transmission channel discussed in the EBA proposal.2. Please provide your views on the proposed definition of ESG factors and ESG risks.
Proposed definitions are clear and relevant.3. Do you agree that, for the purpose of assessing their inclusion in institutions’ and supervisors’ practices from a prudential perspective, ESG risks should be approached primarily from the angle of the negative impacts of ESG factors on institutions’ counterparties? Please explain why.
We agree with the proposed approach to ESG risk assessment from a negative impact perspective. While specific indicators may include metrics that are indicative of improvements in ESG characteristics (e.g., emission reduction targets, investments in sustainable agriculture, gender balance commitments) they are intended to indicate measures to reduce embedded negative impact (climate change, land deterioration, inequality) and consequently minimize counterparty’s exposure to ESG risks. Negative impacts of ESG factors on counterparty, that can affect its business feasibility, need to be captured through transmission channels on prudential risk. Positive impacts of ESG factors on financial institution’s counterparties can be considered in business strategy definition but they are not relevant from a prudential perspective. While evaluating the extent of positive and negative impacts of ESG factors on counterparties, financial institution shall consider the effectiveness of counterparties’ initiatives and strategies for managing ESG risks with long-term horizon.4. Please provide your views on the proposed definitions of transition risks and physical risks included in section 4.3.
In general, the proposed definitions of transitional and physical risks are clear and relevant. It may be useful to specify how natural resource management or resource depletion (land, water, forest cover) fit within this framework.5. Please provide you views on the proposed definition of social risks and governance risks. As an institution, to which extent is the on-going COVID-19 crisis having an impact on your approach to ESG factors and ESG risks?
Proposed definitions of Social Risks and Governances Risks are clear and relevant. However, in the given context, since MSCI ESG Research LLC does not fall within the category of Credit Institutions or Investment Firms, we do not wish to comment on impact on ESG Factors and ESG Risks on account of COVID-19 crisis.6. Do you agree with the description of liability transmission channels/liability risks, including the consideration that liability risks may also arise from social and governance factors? If not, please explain why.
Proposed definitions of liability transmission channels and liability risks are clear and relevant. As noted in Question 1 of this questionnaire, it may be useful to expand the scope of ESG risk factors to include consumer protection and product integrity. These factors may be particularly relevant in the context of liability risks.7. Do the specificities of investment firms compared to credit institutions justify the elaboration of different definitions, or are the proposed definitions included in chapter 4 also applicable to them (in particular the perspective of counterparties)? Please elaborate on the potential specificities of investment firms in relation to ESG risks and on how these specificities, if any, could be reflected in this paper.
ESG risk factors specified in the consultation paper are relevant for both investment firms and credit institutions. In addition to ESG risk coming from counterparties’ exposures of their funds, Investment firms might need to consider ESG risk stemming from investors that can be negatively affected by ESG factors, increasing redemption risk for investment firms.8. Please provide your views on the relevance and use of qualitative and quantitative indicators related to the identification of ESG risks.
We believe that ESG factors specified in the Annex-1 are relevant for identification of ESG Risks to some extent and directionally correct. Given that for any ESG issue, different physical assets owned by a company could be exposed to different level of risks depending on the local regulations, standards and other factors, it is important to have disclosure at the individual physical asset level and should be interpreted in the context of geographic risk faced by the asset.9. As an institution, do you use or plan to use some of the ESG indicators (including taxonomies, standards, labels and benchmarks) described in section 5.1 or any other indicators, inter alia for the purpose of risks management? If yes, please explain which ones.
NA10. As an institution, do you use or plan to use a portfolio alignment method in your approach to measuring and managing ESG risks? Please explain why and provide details on the methodology used.
NA11. As an institution, do you use or plan to use a risk framework method (including climate stress testing and climate sensitivity analysis) in your approach to measuring and managing ESG risks? Please explain why and provide details on the methodology used.
NA12. .As an institution, do you use or plan to use an exposure method in your approach to measuring and managing ESG risks? Please explain why and provide details on the methodology used.
NA13. As an institution, do you use or plan to use any different approaches in relation to ESG risk management than the ones included in chapter 5? If yes, please provide details.
NA14. Specifically for investment firms, do you apply other methodological approaches, or are the approaches described in this chapter applicable also for investment firms?
NA15. Please provide your views on the extent to which smaller institutions can be vulnerable to ESG risks and on the criteria that should be used to design and implement a proportionate ESG risks management approach.
We think the risks apply to all institutions regardless of size. Smaller institutions are at least as vulnerable to ESG risks as larger institutions. Smaller institutions tend to be less diversified (e.g. high exposure to a region or sector) than larger institutions a trait that may increase vulnerability to ESG risks. More importantly, smaller institutions may have less budget to have dedicated ESG focused resources making it more difficult to implement ESG risks management. If they have not already, smaller institutions could be encouraged to perform ESG Risk Materiality assessments. This could assist in understanding potential ESG risks exposed to via counterparties to establish what is relevant and needs to be focused on. For smaller institutions, how they are developing their human capital may be important. They may need to introspect, whether the existing talent management systems have scope to integrate ESG training to build expertise internally. In the longer term, this may have a positive impact on smaller institution’s ability to implement ESG risks management.16. Through which measures could the adoption of strategic ESG risk-related objectives and/or limits be further supported?
We acknowledge that the examples given prior to this question are relevant for the discussion of approaches.MSCI Principles of Sustainable Investing set forth our views on the core principles and best practices for ESG integration by investors globally. This document can be viewed on our website at the following link: The MSCI Principles Of Sustainable Investing (https://www.msci.com/documents/10199/16912162/MSCI-ESG-House-View-FINAL.pdf/63bba1a1-aecf-ba80-aa49-7910748ed942).
One measure may be to have non-binding guidance to provide examples of factors to consider when setting objectives and/or limits. It should not be overly prescriptive to limit innovation of objectives but provide a base for institutions to consider when forming their objectives / limits. This may also be beneficial to assist smaller institutions in the process that may have resource constraints.
17. Please provide your views on the proposed ways how to integrate ESG risks into the business strategies and processes of institutions.
We agree on the need for enhancing the incorporation of ESG risks into institutions’ business strategies and processes. We agree with the proposals set out in the discussion paper but mention some specific thoughts below:• On disclosing specific ESG risk-related strategic objectives and/or limits: We strongly believe that disclosure can enhance transparency and enable both institutional and individual investors to factor ESG consideration into their investment process. While being careful not to be overly prescriptive to influence type of objectives and/or limits, it may be useful to have non-binding guidance on what institutions should disclose as mentioned in response to question 16.
• On engagement: Best practices to date that we have come across in our analysis of global asset management firms are proxy voting policies addressing ESG issues and dedicated staff responsible for ESG engagement. For credit institutions, borrower engagement approach will depend on type of customer. Thought may need to be given on the practicality of how to implement engagement with SMEs versus say larger corporates. For example, this may take the form of educating SMEs so can reach a wider audience rather than direct one-to-one engagement.
• On incorporating ESG-risk related considerations in directives and regulations applicable to the banking sector: Enhanced transparency and comparability are fundamental to driving capital towards more sustainable investments, but inconsistent regional standards will confuse the market.
18. Please provide your views on the proposed ways how to integrate ESG risks into the internal governance of institutions.
Proposed ways to integrate ESG risks into internal governance are clear and relevant. However, other considerations that may be relevant include the following:• In addition to recruiting and training staff within the business units and internal control functions to enhance expertise of ESG risks, it may be relevant for companies to also build up their ESG expertise at the board level.
• Institutions may also want to ensure they have clearly defined ESG due diligence triggers and risk escalation processes.
19. Please provide your views on the proposed ways how to integrate ESG risks into the risk management framework of institutions.
We would agree that it is important for institutions to incorporate ESG risks into existing risk management frameworks. This will allow ESG risks to be continually monitored as institutions do with other forms of risk they are exposed to. We agree with the proposals to achieve the EBA’s goals of institutions collecting at origination and monitoring ESG risks in their portfolios. It may be useful to have a recommendation over the minimum scope of assets that should be covered by the ESG risk management framework (e.g. all lending operations, corporate and project finance, etc) unless the intention is all assets already.Institutions may also want to consider disclosing in their publicly available risk management framework how they are integrating ESG risks. This would allow institutional and individual investors to judge the risk management systems when comparing to peers.
Institutions may evaluate incorporating ESG risk in their framework that may reflect long-term perspective that characterizes this risk class. Long-term horizon limits and objectives may be reflected through metrics that can be monitored on an ongoing basis along with other existing monitoring frameworks.
Stress testing and scenario analysis represent useful and informative tools to assess sensitivities and vulnerabilities of financial institution’s portfolios. These analyses can provide insights on portfolio’s exposures and risk dynamics that may be considered while defining a more granular monitoring framework (i.e. counterparty level) on relevant prudential risks.
20. The EBA acknowledges that institutions’ approaches to environmental, and particularly climate-related, risks might be more advanced compared to social and governance risks, and gives particular prominence in this report to the former type of risks. To what extent do you support this approach? Please also provide your views on any specificities associated with the management of social and governance risks.
We would agree that the methods for environmental risks (particularly climate) may be more advanced, as it is science based and there are international initiatives targeting this area (e.g. TCFD, etc). These give more prominence to the environmental pillar. The methods for banks to assess risks at counterparties may be less advanced in relation to the social pillar, however, they do remain important. For example, if an institution has robust consumer protection practices in place this may lower the risk of potential misselling of products to retail customers and should improve quality of portfolio.Our MSCI ESG Ratings model has two components for each key issue. Firstly, the risk exposure to the issue and second, management practices to mitigate risks. For the banks there are more key issues that we assess under the social pillar (e.g. consumer financial protection, privacy & data security, access to finance) compared to the environmental pillar. This means that we have a higher overall weight given to the social pillar in our banks model. MSCI ESG Ratings model calculates the weight of each of the key issues in the overall ESG assessment, based on the severity and the time horizon for associated risks. Some issues may therefore be equally relevant (equally weighted) based on the type and extent of potential impact, and the time horizon for the externality to become a potential cost to the firm.
21. Specifically for investment firms, what are the most relevant characteristics or particularities of business strategies, internal governance and risk management that should be taken into account for the management of the ESG risks? Please provide specific suggestions how could these be reflected.
NA22. Please provide your views on the incorporation of ESG factors and ESG risks considerations in the business model analysis of credit institutions.
We would agree that it is fundamental for EBA to proportionally incorporate ESG factors and ESG Risk into the business model analysis. With regards to the analysis of the business environment, the key aspects identified by the EBA are clear and relevant.We believe that business model decisions and strategies need to consider long-term objectives to ensure the achievement of environmental and sustainable goals. Financial Institutions may be required to monitor the evolution of the environment and adapt their business model on a timely basis to ensure that long-term objectives are achieved.
Financial institutions may be required to consider carefully the economic impact of ESG related objectives in light of the business environment in which they operate. This aspect is more relevant for mid and small size financial institutions that tend to be highly concentrated on specific sectors and toward counterparties that operates in a specific region or sub-region.
23. Do you agree with the need to extend the time horizon of the supervisory assessment of the business model and introduce as a new area of analysis the assessment of the long term resilience of credit institutions in accordance with relevant public policies? Please explain why.
We would agree that EBA needs to extend the time horizon of the supervisory assessment of the business model and therefore introduce a new area of analysis that concentrate on such aspect.24. Please provide your views on the incorporation of ESG risks considerations into the assessment of the credit institution’s internal governance and wide controls.
ESG risks are characterized by a peculiar nature that can require specific considerations for internal governance and controls. The financial institutions could define ESG dedicated center of responsibilities and committees that involve all the relevant departments involved for managing, measuring and monitoring ESG risks.In relation to the risk management framework we would stress the importance of modelling assumptions and approaches for reflecting ESG factors on existing prudential risks. Along with stress testing and scenario analyses, financial institutions may evaluate reverse stress testing on ESG risks to ensure that adverse risk dynamics are properly captured by the existing risk management framework. In addition to recruiting and training staff within the business units and internal control functions to enhance expertise of ESG risks, it may be relevant for companies to also build up their ESG expertise at the board level as well.
Institutions may also need to ensure they have clearly defined ESG due diligence triggers and risk escalation processes.
25. Please provide your views on the incorporation of ESG risks considerations in the assessment of risks to capital, liquidity and funding.
We agree on the importance of adopting long-term approaches in assessment of risk to capital in the context of ESG risks and we believe that capital adequacy should be evaluated over the long-term period. Due to the nature of ESG risks, scenario analysis and stress tests should be considered and built in its risk management framework.In relation to capturing ESG risks in credit risk, concentration analysis over different dimensions i.e. sectors, geographical regions and counterparties, can be detrimental to mid and small size financial institutions that tend to present business models focused on certain sectors, regions and companies. Therefore, while assessing risk to capital for mid and small size financial institutions, supervisors may need to take cognizance of this inherent risk and consider the actual engagement with counterparties and stakeholders with regards to ESG risk mitigation strategies.
It is therefore our view that financial institutions should adopt a comprehensive approach in incorporating ESG risk across prudential risks, reflecting the impact of ESG factors on macroeconomic and market variables.
26. If not covered in your previous answers, please provide your views on whether the principle of proportionality is appropriately reflected in the discussion paper, and your suggestions in this respect keeping in mind the need to ensure consistency with a risk-based approach.
NA27. Are there other important channels (i.e. other than the ones included in chapter 7) through which ESG risks should be incorporated in the supervisory review of credit institutions?
NA28. As an institution, do you use or plan to use some of the indicators and metrics included in Annex 1? If yes, please describe how they are used in relation to your ESG risk management approach.
NA29. If relevant, please elaborate on potential obstacles, including scope of applicability, granularity and data availability, associated with the indicators and metrics included in Annex 1.
The EBA has addressed the need for a uniform definition of ESG Risks, and assessment of relevancy and application of metrics as necessary means for identifying ESG risks. We understand that metrics presented in the Appendix represent an example of possible ESG metrics. However, the suggested metrics and indicators present potential obstacles to implementation in our view.1. Ease of use and interpretation
Metrics without standardized thresholds or scoring to indicate what is good or bad on a relative basis are not intuitive and unlikely to be helpful for investors. Furthermore, metrics that are highly technical, may not be easily understood or interpreted unless read by a suitably qualified person.
In August 2020 MSCI recently undertook an independent survey of over 5,000 consumers/retail investors located in Germany, France, Italy, Sweden and Belgium, where 57% of respondents indicated that an overall sustainability score or rating was more useful in understanding the sustainability performance of a mutual fund than a set of metrics alone.
Our proposal/view:
- Widely used ESG scorings or ratings should be used as part of the disclosures.
- Requiring common, well-understood definitions/metrics that take into consideration local context outside of the EU will be important for consistent and comparable metrics. This should be subject to input/consultation with experts and the industry to provide comparability across companies.
2. Consistency of metrics and disclosure limitations
With an extensive number of disclosure frameworks, we would suggest that EBA rely on commonly accepted reporting metrics. Some indicators suggested in the Appendix are not consistently reported by companies which does not allow for comparability.
Below are examples of EBA suggested indicators that are not frequently or consistently reported by counterparties in our experience.
a. Metrics: Emissions of air pollutants and water pollutants
MSCI Comment: Without specifying type of pollutants for disclosure, institutions risk obtaining incomparable data. Emissions of ozone depleting substances is typically reported by a small subset of companies and industries. Many of these substances have been banned in the EU and other countries party to the Montreal Protocol.
b. Metric: Heatwaves per year with 5 or more days above given temperature (i.e. 35(°C))
MSCI Comment: Identifying a company’s operations impacted by heatwaves is dependent on company asset data which is inconsistent and not widely disclosed.
c. Metric: Number of internal or international displacements due to natural disasters
MSCI Comment: Without a more comprehensive definition of how this metric is applied, data is likely to be incomparable. It is unclear whether the number of displacements should be national figures, employees or based on whether the company operates within specific areas directly impacted by a natural disaster.