Business risk
Environmental, social and governance risks
Definition
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 for investments to be 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. For a detailed description of our ESG risk management process, refer to the chapter 'Our investment process'.
Our ESG assessment of high-risk customers is integrated in the investment process. FMO monitors and rates gross risk exposure and customer performance on key ESG risks 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.
FMO’s ESG target indicates portfolio alignment with our ESG risk appetite. Our ESG target of 90% refers to 90% of the ESG risks of our high ESG risk portfolio managed adequately by our customers/investees. Our methodology is further elaborated in the 'ESG target' section.
Developments
Similarly, to the 2022 ESG target, the 2023 ESG target group covers high risk customers in our portfolio contracted prior to 2023 (‘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 and implement improvements. 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. An action plan was designed in response to the audit findings and was implemented in 2023. Actions included the design and delivery of enhanced training to all FMO investment and ESG staff to increase awareness of processes and improve completeness and correctness of information. In addition, steps were taken to strengthen reporting items and links to supporting documentation and substantiation.
ESG regulatory requirements and voluntary standards have continued to proliferate across the globe, increasing the complexity of managing ESG risks and opportunities. In 2023, FMO implemented organizational changes to adapt to sustainable finance developments.
Business model and strategy execution risk
Business model risk
Definition
Business model risk is defined as the risk of a non-viable business model or strategy, in line with FMO’s 2023 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 impactful investments in often higher-risk environments and produce sufficient returns from these investments. At the same time, exposure to this risk cannot be entirely avoided, given the nature of FMO’s business model. FMO’s ability to invest is dependent on both demand-and supply-side factors (such as respectively demand for funding, and market liquidity and peers’ activities), not all of which are within FMO’s direct control. On the demand side, this is most notably the demand for funding provided by FMO, which is itself dependent on activity of other DFIs and impact investors as well as commercial market risk appetite. On the supply side, in addition to market liquidity FMO needs to attract public funding and funding from private investors willing to take higher risks. Additionally, the nature of FMO’s investments leads to investment risks. This in turn affects FMO’s ability to generate operating income and impact.
Developments
The year 2023 commenced with considerable business model risks for our public funds and Reducing Inequalities-labelled portfolio, due to limited production in these two areas in 2022. This continued to affect the performance of our portfolio in 2023. Quarter on quarter, we noted an improvement in pipeline build-up and deal conversion. This resulted in a cautious risk reduction for these two metrics over the year. Still, FMO continued to see risks of falling behind target for our impact-labelled, public funds and mobilized portfolios. This is due to increasing geopolitical tensions (e.g., continuing war in Ukraine, conflict in Sudan, war between Israel and Hamas), inflationary pressure, high debt burden in several LDCs, and an unfavorable global growth outlook (IMF, July 2023). By contrast, FMO-A and Total Committed Portfolio developments were in line with our ambitions. New production for the on-balance sheet portfolio remained above the previous three-year averages quarter on quarter. Yet, 2023 target was not met. On the financial side, FMO started the year slightly behind target on regular income, mainly due to lower-than-expected dividends. As of Q2, both regular income and cost-to-regular income ratio were as budgeted.
Strategy execution risk
Definition
Strategy execution risk is defined as the risk of failed execution of strategic projects, initiatives and decisions. FMO is willing to take only strongly justified project 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 risk-reward trade-offs, where the potential rewards will clearly contribute to our strategic ambitions and objectives. Example of risks related to projects are lack of experience, resource constraints, project interdependencies and complexity and dependency on external parties.
Risk appetite and governance
FMO’s performance is measured against the YTD realization of agreed deliverables (total overall FMO project portfolio level). Baseline and performance are measured in the PMO model, based on quantified data from project templates/reports. Please note that no weighting is applied for different types of deliverables.
Developments
In 2023, project selections were strongly aligned with FMO’s priorities set out in the annual business plan, as well as driven by regulatory requirements. Due to the high complexity of many projects in the project portfolio and human resource constraints, particularly in the data, ICT and operational team, strategy execution carried considerable risks. Mandatory deadlines of regulatory projects required some prioritization during the year. External staff was recruited to support project delivery.