“Sustainability is obviously no longer as important to people in Germany as it was a few years ago”, a major business newspaper reported recently. In view of the war going on in our region, sluggish economic growth and the tensions surrounding global trade, other topics have gained more attention. However, less attention does not at all mean less relevance.

Sustainability remains essential for the financial sector – for two reasons. First, the European Union aims to become climate-neutral by 2050. This will require mobilising private investments on a large scale. Second, the European financial system needs to build its resilience to the risks posed by advancing climate change.

In order to achieve these objectives, the EU has adopted numerous sustainable finance regulations in recent years, many of which also relate to BaFin’s mandate. As financial supervisors, we monitor how companies in the financial sector implement the requirements of these regulations in practice. Overall, the financial sector has made significant progress in the last few years, but there is clearly still room for improvement: particularly with regard to the integration of the physical risks of climate change into companies’ risk management and in terms of disclosure and proportionality.

Physical risks of climate change on the rise

Advancing climate change and long-term damage to important ecosystems entail considerable physical risks for companies in the financial sector. There are many indications that we will feel the changes in nature and the climate much more strongly in the coming years. In concrete terms, this will mean for example more flash floods, high water levels and droughts. This is the forecast provided in the latest climate status report from the German Weather Service. According to the World Meteorological Organisation and the EU’s Copernicus Earth Observation Programme, Europe is the continent that is warming the fastest.

Once the physical risks of climate change materialise, they could have a direct impact on the financial sector, for example in banks‘ loan portfolios or insurers’ loss amounts. Many companies in the financial sector are already taking physical risks into account – but at different levels of intensity.

Measuring physical risks quantitatively

What measures need to be taken? Companies must be able to assess the economic damage that could be caused to their business, for example by extreme weather events. A purely qualitative description of environmental, social and governance (ESG) risk drivers is no longer sufficient. We expect the companies we supervise to measure physical risks quantitatively and to integrate these risks into all aspects of the risk management process. This is essential if they are to be in a position to adequately plan for and price in potential consequences – such as credit defaults – of extreme weather events.

Insurers are already successfully reflecting natural catastrophe risks in their risk management. However, they should consider whether their risk management is keeping pace with the current speed of climate change and the decline in biodiversity. The good thing is that companies are able to access more and more data for their analyses, including from publicly accessible sources. And just to be very clear: relying on state aid in the aftermath of a natural disaster is not an acceptable approach.

Making disclosure easier to understand

There is also a need for action in terms of disclosure. The key set of rules here is the European Disclosure Regulation. The basic idea is that investors should be able to use the disclosed data to make an informed decision about whether a particular product meets their expectations in terms of sustainability. So much for the theory. In practice, we see that many disclosures are very comprehensive, yet say very little. This is also partly due to current regulation.

It would make more sense for the Disclosure Regulation to set out clear and easily understandable product categories based on mandatory minimum standards. For example, a category for sustainable products that only invest in economic activities that pursue an environmental objective, a social objective or both. Or a category for transition products that invest in activities that support the transformation of the economy towards greater sustainability. Furthermore, it would certainly be good if the Disclosure Regulation could provide us with a clearer definition of what a sustainable investment is – a definition that is based on other regulations such as the Taxonomy Regulation. This would also help the supervisory efforts to identify and monitor greenwashing.

There is room for improvement in the rules and regulations, no doubt about it. One thing companies in the financial sector can already do today, however, is to implement the requirements of the Disclosure Regulation in such a way that their information is as easy to understand as possible.

Allowing for more proportionality

When it comes to the management of climate-related financial risks, we must take care not to jeopardise the achievement of important objectives with overly bureaucratic methods and make sure to apply as proportionate an approach as possible. If we burden SMEs with more and more reporting obligations, we will not be saving the planet – we will even risk making the necessary reforms more unpopular. The EU Commission’s omnibus package recognises that small enterprises should not be treated like large corporations. We must now be careful to ensure that companies in the financial sector do not demand extensive data from their small and medium-sized corporate customers under the guise of supervisory requirements. When it comes to sustainability, banks must be prepared to work with publicly available information and with estimates, for example based on data from comparable customers. Needless to say, there should not be any blanket restriction keeping supervised companies from obtaining necessary data from their contractual partners for the purposes of risk management. However, an exaggerated level of precision in this area – one that is based on many assumptions – is inappropriate.

At the same time, the regulation of small companies in the financial sector must remain appropriate. The new guidelines issued by the European Banking Authority (EBA) on ESG risk management for banks, for example, are appropriate for large institutions with complex loan books or many international activities – but not for small credit institutions. For this reason, we have decided not to apply these European guidelines to less significant institutions. We already anticipated the EBA’s general requirements to a large extent in our principles-based Minimum Requirements for Risk Management (MaRisk). We will not win the battle against climate change with reports from small banks.

Today, one thing is clear: sustainability will remain high on the financial sector agenda in the coming years. It is important that companies effectively manage the physical risks of climate change and ensure clear and understandable disclosure. Likewise, it is important that we take as proportionate an approach as possible when it comes to the management of climate-related financial risks. Our guiding principle should be “the higher the risk, the greater the supervisory attention”.