Climate risk, resilience, and adaptation

Quality and scope of project-level climate risk management procedures

The Bank defines climate-related risk in their 2022 Annual Report as “the risks posed by direct exposure to climate change, or indirect exposure through counterparties that may potentially be affected by, or contribute to, climate change”. FMO currently assesses climate risk on an ad-hoc basis at the project level. However, FMO has been working to further embed climate risks through several mechanisms:

• Risk Management Framework: To incorporate climate risks into its overall Risk Management Framework, FMO performed a mapping exercise to identify how climate and environmental risk affect their other existing risk categories included in their Risk Appetite Framework (RAF). Additionally, FMO has started the process of embedding climate risks in its risk policies and processes, such as its investment process, liquidity risk policy, and market risk policy.
• Environmental and Climate Risk Workstream of the EU Sustainable Finance Package: In line with regulatory requirements, FMO has a project structure to embed climate risk within their operations and activities. This workstream further looks into developing and harmonising the “outside-in” perspective (the impact on FMO due to transition and physical risks) of double materiality. Currently, the Bank is piloting a new process and methodology to assess climate-related risks, and these two processes will be merged (see below).
• Climate Risk Analytical Methodology: Since 2021, FMO has been co-developing a methodology to perform climate risk assessments at the portfolio and investment level. In 2022, FMO began piloting the internal climate risk assessment methodology to perform initial physical and transition risk scans at the portfolio level. The methodology has been developed to comply with the ECB Guide on Climate Related and Environmental Risks. The assessment is used to identify potential risk areas and determine whether further due diligence is required. Risk areas identified are expected to be followed up by a more in-depth analysis of specific transactions, industries, or geographies.
• FMO Green Label: Climate adaptation and resilience is included as one of the sub-objectives for FMO’s Green Label. The ‘Green Label’ tags transactions that positively contribute to climate adaptation and increased resilience. This helps the Bank identify and track opportunities to finance activities that contribute to climate adaptation and resilience. The label’s methodology is currently undergoing an update process, expected to be finalised and implemented in 2024.[1]

FMO has previously been assessed (by the global development consultancy Itad) as having a greater capacity and appetite for environmental and social (E&S) risk than some other bilateral development finance institutions (DFIs), being “more likely to work with the client to develop and implement a feasible ESAP” (Environmental & Social Action Plan). In doing so, the Bank is notably supported by an explicit mandate to operate in high-risk countries. FMO appraises potential investments on their E&S performance, as well as their capacity to mitigate and manage associated risks, in line with the IFC Performance Standards. As per FMO’s Position Statement on Impact and ESG for Financial Intermediaries, their customers are also required to implement robust ESG and human rights practices. The Bank will focus on the quality, implementation and improvement of the policies, frameworks and systems developed by the client throughout the investment cycle, as agreed on in an Environmental and Social Action Plan. For every high-risk investment done through a financial intermediary, FMO assesses it “from a Human Rights and ESG risk perspective before and during the financing or investment, with the support of qualified ESG resources”. Clients are required to produce annual reports on ESG and FMO will conduct regular monitoring based on these.

In line with common practice among DFIs the Bank may accept ESG performance below its standards (which are typically higher than those of commercial banks) when it first starts working with a client. FMO then subsequently aims to mitigate the ESG risks through environmental and social action plans, monitoring, and technical assistance. For this purpose, the Bank has developed a series of ESG toolkits to support financial intermediaries (specifically private equity investment funds, microfinance institutions, and small and medium enterprise banks) in their ESG management. These toolkits support financial intermediaries with identifying initial risk factors which require further due diligence processes, and/or the involvement of a corporate governance officer from FMO. It is however unclear to what extent FMO requires clients to adhere to a timeline for improving their ESG performance, , in cases where this is initially below the necessary standard.

Adaptation finance and enhancing client climate resilience

FMO’s level of adaptation finance, as of 2023, stands at €183 million. Given the current state of adaptation finance in the private sector and associated barriers, FMO’s current level of adaptation finance is on-par with and in some cases higher than its peer DFIs.

As a private sector focused DFI, FMO focuses on supporting private sector investments in adaptation and resilience finance through a consortium with the Dutch Fund for Climate and Development (DCFD), a climate resilience fund that supports the private sector to invest in bankable climate adaptation and resilience projects in developing countries. Projects receive technical assistance and grant funding to become viable business projects. The consortium’s evaluation report also shares best practices for future funds to consider.

Recommendation:

• Noting that there are limitations in scaling up private sector adaptation finance, FMO should nonetheless establish a specific target for adaptation finance (as a % of total spending). This would reflect strong initiative by the Bank as a prospective leader in mobilizing private sector finance for adaptation and serve as a mechanism for monitoring progress in this regard.

[1] See “Promotion of green finance metric” for further detail.