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 a cautious appetite for ESG risk in investments. FMO strives to ensure that investments are brought in line with our ESG risk mitigation requirements in a credible and reasonable time frame. It is understood and accepted that customers/investees need knowledge and resources to implement ESG improvements, so full adherence cannot generally be expected at inception of the relationship. Consequently, the appetite for ESG risk is open during the initial phases of an investment and reduces over time. The appetite for unmitigated ESG risk is minimal for repeat investments. At the portfolio level, FMO also has a cautious appetite for ESG risk. In view of FMO’s own available capacity to support and monitor customers/investees in improving their ESG risk mitigation, FMO seeks a manageable mix of customers/investees with (partially) unmitigated ESG risk and customers/investees with adequate risk mitigation in place. FMO accepts a limited gap in successful ESG risk management to our standards. This gap acknowledges residual risk posed by contextual and implementation challenges in our markets.
As part of its investment process, FMO screens all customers 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 customers 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 customers is an important part of its development impact ambitions.
In addition, for customers with a high ESG risk category, FMO monitors and rates gross risk and customer performance on key ESG risk themes using FMO’s proprietary Sustainability Information System (SIS). SIS ratings are revised throughout the lifetime of the investment as part of the annual review cycle of each customer, enabling FMO to have an up-to-date portfolio-wide view of the ESG risks in its portfolio.
At portfolio level, FMO measures its alignment with its own ESG risk appetite through its ESG steering metric, an indicator of to what extent FMO is delivering on its ESG commitments and operations. The ESG steering metric is targeted at >90% - in other words, FMO’s ESG risk appetite translates to less than 10% of ESG risks in its high-ESG risk portfolio not yet being adequately managed by its customers/investees.
Similarly, to the 2020 ESG target, the 2021 ESG target group covers 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 whether FMO is leading or not (n=268). We continue measuring the ESG risk and performance of the entire FMO’s high ESG risk portfolio in FMO’s proprietary Sustainability Information System (SIS) and reporting against the ESG target.
FMO has initiated an internal project to embed climate risk in its investments and investee companies. As an Equator Principles Finance Institution, climate risk assessments are already being undertaken for EP-triggered transactions.
ESG regulatory requirements and voluntary standards have continued to proliferate across the globe, increasing the complexity in managing ESG risks and opportunities. These include, as an example, the introduction of EU-wide regulatory requirements on mandatory human rights due diligence and human rights reporting. The allegations of forced labour and other human right abuses in the global solar module supply chain linked to Xinjiang have triggered an international response including US sanctions or an announcement that the European Commission would propose a ban on products in the EU market that had been made by forced labour. FMO has endeavored to align its response to such allegations with other DFIs and seeks to continue strengthening its approach towards the mitigation of ESG risks in the supply chains of its customers/investees.
On COP26, FMO committed to the Statement on International Public Support for the Clean Energy Transition, initiated by the UK government. The Statement is in line with FMO’s Position Statement on Fossil Fuels in Direct Investments, which was published and effective in June 2021. This Position Statement sets out FMO’s firm commitment to end the financing of fossil fuels in direct investments except in exceptional circumstances with clear criteria consistent with the goals of the Paris Agreement.
Also, at COP26, the newest version of the Joint Impact Model (JIM), which is based on the standard of the Partnership for Carbon Accounting Financials (PCAF), was presented by FMO to the Dutch Climate Envoy Jaime de Bourbon de Parme.
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 or working groups 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.
On 27 October 2021, The European Commission published proposals for reforms to the Capital Requirements Regulations (CRR-3) and Capital Requirements Directive (CRD6). These draft regulations focus on three main parts: 1) the implementation of the finalized Basel III reforms into European legislation, 2) new rules requiring banks to systematically identify, disclose and manage sustainability risks (ESG risks) as part of their risk management, and 3) stronger enforcement tools for supervisors overseeing EU banks. The first two parts are of relevance to FMO and are discussed in more detail below.
With regards to the European translation of the Basel III standard, updates were included on the use of internal models, recalibrations to the standardized approach for credit risk, operational risk, CVA and market risk (incorporating the Fundamental Review of the Trading Book). When comparing the draft CRR-3 with the Basel standard, the implementation date was postponed from 1 January 2023 to 1 January 2025. An important element for FMO in the revised Basel III agreement (published in 2017) included a change in the treatment of private equity exposures under the standardized approach for credit risk, no longer receiving a 150% risk weight but instead falling under one of the three categories: speculative equity (400% risk weight), equity holdings under national legislated programs (100% risk weight) and all other equity exposures (250% risk weight). Under the current draft CRR-3 however, the foreseen risk weight will be 250% rather than 400% if the intended holding period is greater than 3 years. Another important element is that FMO shall apply the alternative standardized approach for market risk capital requirements as of 2025, due to FMO’s open foreign exchange position in the banking book. As of September 2021, FMO has already started reporting on this standard purely for reporting purposes under the sensitivity-based approach, which has resulted in an 68% increase in capital requirements due to the change in methodology.
The CRR-3 and CRD-6 proposals included several amendments in relation to ESG risk. Most notably, according to the draft FMO is required to start disclosing ESG risks as part of its Pillar 3 disclosures on a semi-annual basis starting in 2025. The proposal also adds ESG risks into the scope of the Supervisory Review and Evaluation Process, which is the annual assessment of banks conducted by banking supervisors. Furthermore, the proposals introduce amendments regarding the possible capitalization for ESG risks, and adjusted risk weights for assets with high levels of climate risk. FMO will continue to closely monitor the regulatory developments while these new regulations are being drafted and discussed at a European level.
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 can cover all its costs and provide an appropriate return on equity, considering 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 if and how several key performance indicators deviate from targets or initial projections (total investment volumes of FMO and the State Funds, FMO portfolio growth, 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 reflects 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 organization's representative. 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 growth, FMO’s investment portfolio has declined from a peak of US$ 15.1bn in December 2019 to US$ 14.1bn in November 2021. This decline started in 2020, when customers demand for financing dwindled on the back of Covid-19 lockdowns and supply chain disruptions, and as deleveraging by customers led to increasing prepayments.
In 2021, FMO had to divert significant resources for KYC remediation, hampering our ability to source new customers and transactions. Ongoing travel restrictions further complicated business development. As a result, FMO was unable to significantly recover its portfolio over 2021.
FMO is now focusing efforts in 2022 and 2021Q4 on building back business. Limited travel is also again taking place. Still, the ongoing pandemic is expected to continue to have some impact on our production. Travel restrictions to some markets may keep on challenging business development, while excess liquidity from government and central bank intervention in some markets may dampen demand for FMO funding.
Strategy execution risk
Enabled by the change in 2019 in project (portfolio) governance and in 2021 in initiative (portfolio) governance, increasing MB’s involvement and Directors’ accountability for project and initiative 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.