Environmental, Social and Governance risks
Environmental & Social (E&S) risk refers to risk posed by (potential) adverse impact of the FMO investments on the environment, their employees and workers, communities, and other stakeholders which may affect FMO's customers. Corporate Governance (CG) risks refer 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 the start 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 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 and categorizes all customers on ESG risk. FMO assesses customers with a high ESG risk in detail to identify ESG impact, risks and 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 impact 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. These assessments are undertaken by dedicated ESG teams specifically allocated to FMO's focus sectors. The ESG teams include more than 30 ESG experts that are often supported by specialized external ESG consultants.
In addition, for customers with a high ESG risk, 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 above 90 percent, meaning FMO’s ESG risk appetite translates to less than 10 percent of ESG risks in its high-ESG risk portfolio not yet being adequately managed by its customers/investees.
Similarly, to the 2021 ESG target, the 2022 ESG target group covers high risk customers in our portfolio contracted prior to 2022 (‘target list’) and those supported by a corporate governance specialist. We continue to register the ESG risk assessments of the customers with high risk and report against the ESG target.
We continue to learn from external evaluations and internal audits. In 2022, SIS was audited to assess the design and effectiveness of key controls ensuring completeness and accuracy of the data, as well as system governance. Findings included the need to further clarify roles and responsibilities, improve completeness and correctness of the supporting documentation and improve awareness of processes.
To further strengthen ESG risk management and oversight, an action plan is being developed to implement the findings. Actions include the design and delivery of enhanced training to ESG and investment staff, and steps to strengthen reporting items and links to supporting documentation and substantiation.
After a thorough development and stakeholder consultation process, FMO published the Position Statement on Impact and ESG for Financial Intermediaries which describes how FMO applies ESG risk management to financial Intermediary financing. The new approach makes it possible to more adequately customize ESG requirements to specific assets. The position statement describes FMO’s risk appetite to work with financial intermediaries towards compliance with ESG standards.
ESG regulatory requirements and voluntary standards have continued to proliferate across the globe, increasing the complexity of managing ESG risks and opportunities. We are appointing resources to follow-up on these EU-based regulatory requirements (including SFDR and EU Taxonomy) and translate these to emerging markets, for which FMO has joined the High-Level Expert Group on Sustainable Finance for low and middle-income countries established by the European Commission in the second half of 2022. FMO's internal project designed to embed climate risk in its investments and investee companies continued in 2022 with results from the first pilot determining direction for implementation in 2023 (see 'Climate related risk' section of this report).
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 Committee (RMC) and the Financial Regulation Committee to keep oversight of regulatory requirements and identify changes in regulations. The Financial Regulation Committee is a subcommittee. FMO is closely monitoring the process of translating Basel standards into European legislation as well as the development of the Sustainable Finance framework. We provide feedback to EC and EBA consultations and incorporate the latest available information in terms of capital planning and integration of ESG considerations in the investment process.
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 are expected to enter into force in January 2025 and 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), 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, credit valuation adjustment and market risk (incorporating the Fundamental Review of the Trading Book). An important element for FMO in the revised Basel III agreement (published in 2017) is a change in the treatment of private equity exposures under the standardized approach for credit risk. This no longer receives a 150 percent risk weight but instead falls under one of three categories: speculative equity (400 percent risk weight), equity holdings under national legislated programs (100 percent risk weight) and all other equity exposures (250 percent risk weight). Under the current draft CRR-3, however, the foreseen risk weight will be 250 percent rather than 400 percent if the intended holding period is greater than three 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 FX position in the banking book. In September 2021, FMO began reporting as per this standard purely for reporting purposes under the sensitivity-based approach, which on average has resulted in a 76 percent increase in market risk 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, 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 SREP, 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, which is not expected to be finalized until late 2023.
The Taxonomy Regulation (‘Taxonomy’) - a classification system for determining whether an economic activity is environmentally sustainable - applies partially since 2021. FMO is required to disclose how and to what extent our activities are associated with economic activities that qualify as environmentally sustainable and, by reference to associated KPIs for financial institutions. This obligation started in 2021 by reporting on Taxonomy eligibility, which is done by determining whether an investment falls within one of the sectors covered by the first two defined environmental objectives (climate change mitigation and adaptation). As FMO invests outside the EU, in emerging markets, none of our counterparties are in scope of the NFRD and, are not required to disclose their Taxonomy eligibility or alignment. As the regulation stipulates that the mandatory disclosure on eligibility must be based on actual information disclosed by financial or non-financial undertakings, FMO’s compliance with such reporting is challenging.
In 2021, the EC adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), which would amend the existing reporting requirements of the NFRD by introducing more detailed reporting requirements focused on ESG, and a requirement to report according to mandatory EU sustainability reporting standards. The final first set of European Sustainability Reporting Standards (ESRS) is expected to be adopted by the EC by mid-2023 and will apply to FMO in 2025. FMO will prepare once the standards are published.
In 2022, the EC adopted a proposal for a directive on corporate sustainability due diligence. This directive establishes a corporate due diligence duty for companies, including credit institutions, to identify, end, prevent, mitigate and account for negative human rights and environmental impact in the company’s own operations, their subsidiaries and their value chains. The directive also introduces duties for the directors of EU companies including setting up and overseeing the implementation of the due diligence processes and integrating due diligence into the corporate strategy. Most importantly, the new directive introduces civil liability as an enforcement measure; victims must get compensation for damages resulting from the failure to comply with the obligations of the new proposal. The EC’s proposal provides for some exceptions for banks, although discussions are ongoing between co-legislators to make the new rules stricter for the financial sector. FMO is in the scope of the proposal, meaning we would be required to undertake due diligence for our value chain and upstream and downstream subsidiaries, although the extent is not yet known. Also, the final decision on the concept of civil liability will be crucial for determining the risk of FMO being held liable for damages if it fails to comply with the new rules.
Business model and strategy execution risk
Business Model Risks
Business model risk is defined as the risk of a non-viable business model or strategy, in line with FMO’s 2022 Risk Appetite Framework. For banks in general, 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. For FMO, as impact investor, business model risk is also related to the (in)ability to reach our impact goals.
Risk appetite and governance
FMO’s appetite for business model risk is minimal: both the organization’s continuity and its ability to achieve its impact targets are highly dependent on its ability to generate investments and produce income from these investments. At the same time, exposure to this risk cannot be entirely avoided, given that FMO’s ability to invest is dependent on both demand-and supply-side factors, not all of which are within FMO’s direct control. This in turn affects FMO’s ability to generate operating income and impact.
FMO’s viability is dependent on its ability to maintain an investment portfolio of appropriate size and return to provide sufficient income to cover operational costs. Key drivers of business model risk are therefore related to the ability to maintain
A well-diversified, sufficiently large portfolio with a strong competitive position: this is driven by FMO’s production, but also by the competitive landscape and market liquidity, which influence prepayments; and
Sufficient income: operational income, and cost-to-income to denote longer-term trends in profitability; and
Impact: given that investing with positive impact is FMO’s raison d’être, measures of Green and Reducing Inequalities can be considered elements of business model risk.
The strategic focus in 2022, was to build back the portfolio and reverse the trend in portfolio decline witnessed as a result of the pandemic fallout. Throughout the first half of 2022, new investments for FMO-A were behind target. Business execution was hampered by market volatility, monetary policy tightening, and geopolitical uncertainty. In particular, the conflicts in Ukraine, Myanmar and Sri Lanka affected our portfolio negatively.
Production started to catch up in the second half of the year. At the same time, we noted a larger than expected level of prepayments. Prepayments largely depend on market developments and were offset by new investments and positive FX results. In 2022, FMO’s committed portfolio results were strongly impacted by the USD/EUR FX rate, as the majority of FMO’s portfolio is dominated in US dollar.
New Green and Reducing Inequality investments were lagging throughout the year as a result of limited pipeline build - up during the pandemic and due to the strategic focus on building up business in 2022. The priority for 2023 is to focus new production more on impact-labelled projects.
Strategy execution risk
Strategy execution risk is defined as the risk of failed execution of strategic initiatives and decisions, in line with FMO’s 2022 Risk Appetite Framework. 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, which contributes to our objectives. Example of risks related to projects are lack of experience, resources, project interdependencies and complexity, and dependency on external parties.
Risk appetite and governance
The Project Management Office (PMO) 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.
In 2022, the project selection process has been changed to better align with the annual planning process and strategic priority setting. It is expected that this will lead to closer alignment of projects with strategic ambitions and therefore enhance strategy execution.
Internal resource constraints particularly bottlenecks in the IT, Data and Operations teams, continued to limit project execution in 2022. Also, the investment teams’ contribution to project execution was limited, due to the strategic focus on building back business. Hiring additional people proved difficult due to a challenging labor market and limited internal hiring capacity. While FMO cannot influence the labor market, measures were taken to increase the internal hiring capacity at HR to remedy the staffing backlog.