Environmental, Social and Governance risks
Environmental & Social (E&S) risk refers to risk posed by (potential) adverse impacts of the FMO investments on the environment, their employees and workers, communities, and other stakeholders. In turn such risk may pose business risk to our customers and/or to FMO. Corporate Governance (G) risks refers primarily to risk to customers’ business and - as a result - to FMO.
Risk Appetite and Governance
FMO has an appetite for managed risk in our portfolio. Our clients operate in countries where ESG regulations are less institutionalized. Initially, when conducting a transaction with a customer, we accept the risk that the ESG performance may be below our standards. In addition, impact on the environment, employees and workers, communities and other stakeholders, ESG risks can result in non-compliance with applicable regulation, NGO and press attention, reputation damage and financial loss where such risk adversely affects operational and financial performance.
As part of the investment process, FMO screens all clients on ESG risk and categorizes them according to the ESG risk that their activities represent. FMO assesses in detail customers with a high ESG risk category to identify ESG impact and risks and to assess the quality of existing risk management and mitigation measures. Due diligence also includes an analysis of contextual and human rights risk. In case of gaps in ESG risk management, FMO works with clients to develop and implement an Action Plan to avoid adverse ESG impacts and/or to improve ESG risk management over time. Key ESG risk items are tracked during the tenor of the engagement. FMO’s ESG risk management support to clients is an important part of development impact ambitions.
In addition, for customers with a high ESG category, FMO monitors customer performance on key ESG risk themes (against the IFC Performance Standards) using the ESG Performance Tracker (ESG-PT). The ESG-PT keeps track of key ESG risks and client performance level, enabling FMO to have a portfolio-wide view of its ESG risks.
The 2020 ESG target expanded in scope compared to the 2019 ESG target. While the 2019 ESG target included all E&S Category high risk rated (A and B+) customers and customers that have a CG Officer in the deal contracted in 2017 and 2018 and where FMO leads the transaction (n=40), the 2020 target group increased to all E&S Category A and B+ customers and customers that have a CG Officer in the deal, irrespective of the year of contracting and FO leading yes/no (n=308). We will continue reporting ESG performance using the ESG target.
The Sustainability Information System (SIS) was launched in September 2020 to replace FMO’s previous ESG Performance Tracker. The SIS is a robust and audit-proof solution to monitor, report and follow-up on Impact and ESG risk exposure, performance and progress made. The Performance Tracker data have undergone a thorough remediation exercise prior to migration into SIS ESG. This means that all E&S category A and B+ customers have now gone through the process of drafting, archiving, and approving, as per the requirements in the PT manual. Performance Tracker data have been migrated to the new SIS. We will use the subsequent review cycle to optimize data quality and fully achieve SIS requirements.
As a response to COVID-19, we have included a feature in the incident register to track COVID-19 related ESG events and implemented a COVID-19 response package including customer support in managing risks which would affect workers and communities. Furthermore, FMO launched a best practice guide (co-branded with Proparco) for COVID-19 related ESG risk management for customers. We have implemented operational guidance for digital ESG due diligence and operationalizing – together with EDFI partners – retrenchment requirements as part of waivers, moratoria and emergency liquidity requests by customers and investees.
With a focus on the ECB Guide on climate-related and environmental risks, various departments within FMO have come together to discuss and develop further steps in the area of Climate Risk Management. A climate risk project for implementation in 2021 was approved by the Management Board.
The COVID-19 pandemic has increased risk to people related to the projects that FMO invests in. The most salient impacts are related to worker health and (possible) temporary or permanent job loss as well as community health and threats to community livelihoods due to restricted movement.
- 1 As defined in FMO's Sustainability Policy, and described further under ESG definitions in the 'How we report' section of this annual report.
FMO has been participating in an EDFI initiative to review the EDFI Exclusion List, which is expected to result in further harmonized fossil fuel related exclusions as well as a more general update. We also participated in initiatives towards the further EDFI alignment in our ESG risk management approach with respect to direct investments, including a particular workstream on human rights. COVID-19 and the business challenge it poses has emphasized the importance of harmonized practices across (E)DFIs and our ability to leverage ESG resources.
The EU Taxonomy, which entered into force on July 12, 2020, is at the heart of the EU sustainable finance package, aiming to create a uniform and harmonized classification system in order to protect against greenwashing, avoid market fragmentation and provide a basis for future regulation and standards. It is a tool to help plan, report and achieve the transition to a sustainable economy and EU’s ambition to be climate-neutral by 2050.
To inform its work on the action plan to implement the Taxonomy, the European Commission established a Technical Expert Group on Sustainable Finance (TEG). The TEG published its final recommendations in March 2020, including a technical annex with recommended screening criteria. In late 2020 and beginning 2021 European Commission published a consultation on the Delegated Acts for climate mitigation and climate adaptation criteria. FMO is following the developments of the Taxonomy and cooperates with other development finance institutions.
FMO defines two types of regulatory risks. Regulatory compliance risk is defined as the risk that FMO does not operate in accordance with applicable regulations, and regulatory risk is the risk that a future change in regulations will impact the viability of the business strategy of FMO.
Risk Appetite and Governance
FMO is subject to banking laws and government regulation in the Netherlands. DNB has broad administrative power over many aspects of the banking business including liquidity, capital adequacy, permitted investments, ethical issues and anti- money laundering. Changes in banking regulation may adversely affect FMO's operations or profitability. To ensure that FMO adheres to existing financial and prudential regulation and to assess the impact on the business strategy, FMO has in place a regulatory risk policy and committees such as the Regulatory Monitoring Group (RMG) and the Financial Regulation Committee (FRC) to keep oversight of regulatory requirements and identify changes in regulations. FMO is closely monitoring the process of translating Basel standards into European legislation, providing feedbacks to EC and EBA consultations and incorporates the latest available information in terms of capital planning.
In December 2017, the Basel Committee on Banking Supervision (BCBS) published the finalization of the Basel III reforms (BCBS 424). An important element for FMO is a change in the treatment of private equity exposures under the new standardized approach for credit risk. FMO’s private equity exposures would no longer receive a 150% risk weight but they would fall under one of three categories: speculative equity (400% risk weight), equity holdings under national legislated programs (100% risk weight), and all other equity exposures (250% risk weight). The exact impact of the new standard will depend on the translation into European legislation. The Basel standard is expected to become mandatory per January 2023 with a five-year phase-in period.
In May 2019, the European Council adopted a comprehensive legislative package of reforms to CRR, CRD IV, the BRRD and the SRMR (the "EU Banking Package"). Most of the rules will start applying in mid-2021. The most relevant reform for FMO is the requirement to apply a look through for investments in equity and some debt funds. In short, investments in Collective Investment Undertakings (CIUs, or Funds) will no longer automatically labelled as ‘high risk’ with a 150% risk weight. Instead, risk weights will be determined using the look-through approach (LTA) or mandate-based approach (MBA) which requires an institution to look at the funds underlying investments and calculate the risk weights based on funds actual investments and leverage. FMO is finalizing a project that will facilitate the application of this requirement. Other changes in the EU Banking Reforms will only have minor impacts to FMO, primarily due to adjusted reporting requirements.
In January 2019, the BCBS published the final standard on the capital requirements for market risk (BCBS 457). Although FMO does not have a trading book portfolio, the revised standards affect the capital requirements for FMO’s foreign exchange position in the banking book. The capital requirements for foreign exchange positions will increase with a multiplication factor of 1.2 under the simplified alternative approach. In case a sensitivity-based approach needs to be implemented, the capital requirements will depend on the type of currency and the correlation between the currencies. Based on the threshold proposed by EBA, it is deemed likely that FMO will apply the sensitivity-based approach both for reporting and capital requirements. The final CRR-2 provided only a reporting requirement for market risk and the final standard is expected to come into effect in January 2023 or later.
Business model and strategy execution risk
Business model risk
Business model risk is defined as the risk of a non-viable business model or strategy. Long-term viability is achieved when a bank is able to cover all its costs and provide an appropriate return on equity, taking into account its risk profile.
Strategy execution risk
Strategy Execution risk is defined as the risk of failed execution of strategic initiatives and decisions. FMO is open to project risk and will take strongly justified risks. Some uncertainty and variation are expected. We prefer options that are most likely to result in successful delivery while also providing an acceptable level of reward. These potential rewards contribute to our objectives.
Risk Appetite and Governance
Business model risk
Business model risk is monitored by comparing the deviation of actual volumes from targets or initial projections (total investment volumes of FMO and the State Funds, proportions of Green and Reducing Inequalities as part of total production; and operating income). The results of this monitoring exercise are evaluated yearly in the rolling four-year strategic cycle and in sector evaluations. The strategic process is used to adjust the current strategy with the goal of optimizing our business model.
Strategy execution risk
The Project & Process Management (PPM) team monitors the project portfolio using several metrics such as external budget utilized, internal budget utilized, realization of deliverables, open risk status. Potential identified risks related to projects are amongst others: lack of experience within FMO, unavailability of (internal) resources, interdependencies between projects (mainly resources and systems), complexity of project execution and/or implementation, time sensitivity of deliverables, dependency on and/ or by external parties.
FMO’s project performance is measured against the YTD realization of the deliverables of the total project portfolio. Currently, the target is set at >85%, which reflect FMO’s risk appetite in strategy execution risk. In 2019, FMO changed its project (portfolio) governance by increasing the Management Board’s (MB) involvement and Directors’ accountability for project delivery. The MB is accountable for managing FMO’s project portfolio in alignment with FMO’s strategic objectives, sector business plans and ICT strategy. The MB selects projects (ICT and non-ICT related) and manages the integral project portfolio (start project, postpone, put on hold, budget release, closure). The PPM team supports the MB in its role of managing FMO’s project portfolio. The PPM team is responsible for the monitoring and reporting on the projects and the project portfolio. The PPM team acts as knowledge center for projects, project owners and project managers. The project owner is a Director who is the single person overall accountable for the project. The Director is primarily concerned with ensuring that the project delivers the agreed business benefits and acts as the representative of the organization. The project owner maintains oversight of the project and decides - within boundaries set by the MB - on scope, deliverables, planning, budget, resources, and progress of the project. The Architecture Board is responsible for ensuring that changes in respect to product, process, data architecture, systems and technology adhere to the guidelines and principles agreed upon.
Business model risk
After years of strong portfolio growth, COVID-19 has significantly affected FMO’s business performance in 2020 and will remain of sizeable influence on our performance and operations at least until mid-2021. However, this impact is expected to be of a temporary nature: as the pandemic may ease in the coming period, it is expected that pressures on our business model will also wane, although some could have sizeable lagging effects after the crisis has passed.
Since the onset of the COVID-19 pandemic, many clients have faced dwindling demand and an inability to produce due to lockdowns and supply chain disruptions, which weakened firms’ financial positions. FMO also saw increasing prepayments, as some clients deleveraged their balance sheets. The pandemic has also affected FMO’s business performance. Travel bans hampered our ability to source new clients and transactions, and the cost of risk (impairments, fair value adjustments) has increased due to financial difficulties at clients.
The implementation of know-your-customer policies will possibly put pressure on FMO's ability to engage in new transactions on the short term. As a result, it will not affect the long-term viability of the business model.
Strategy execution risk
Enabled by the change in 2019 in project (portfolio) governance, increasing MB’s involvement and Directors’ accountability for project delivery, we have seen a strengthening of our portfolio monitoring and control. For 2021 we will further invest in our ability in managing interdependencies, internal resources as well as benefits.