5.5.3 Climate-related risks as part of fit and proper testing

Let us now move to the question of how, exactly, climate-related risks could actually be integrated into fit and proper testing.

Existing fit and proper-regulation nor the relevant ESA Guidelines mentioned in paragraph 5.5.2 contain specific provisions regarding climate-related risks or ESG-matters. In the future, this may change as the Action Plan also calls for the ESAs to provide direct support to its implementation, and promote convergence on the implementation of sustainability considerations in EU law. As part of this process the ESAs will consider if sustainability considerations could, and should, have a more prominent place in their Guidelines. So, future changes to the aforementioned EBA/ESMA Guidelines on suitability and the EIOPA Guidelines on internal governance, specifying how sustainability considerations can be taken into account in fit and proper assessments, cannot be ruled out. For now, however, the integration of climate-related risks in fit and proper-assessments can only be based on the existing and more generically formulated fit and proper-requirements. As we will see, mostly thanks to the comprehensive Dutch Policy Rule on Fitness, these requirements may in the Netherlands prove more than adequate.

The Dutch Policy Rule on Fitness demands that all members of the management body possess sufficient relevant knowledge and skills and display the required professional behaviour to perform their duties. When assessing fitness, relevant education, work experience and competencies are taken into account.

Fitness is assessed on four, partly overlapping areas: A) management, organisation and communication, including providing direction and guidance to employees, ensuring compliance and enforcement of generally accepted social, ethical and professional standards and being transparent towards clients and regulators, B) the institution’s products, services and markets, including financial aspects and ensuring compliance and enforcement of relevant laws and regulations, C) sound and ethical business operations, including controlled business processes, duty of care, risk management and compliance, and D) balanced and consistent decision making, in which the interests of clients and other stakeholders take a central position.1

Climate-related risks, as discussed in this chapter, make for a rapidly changing business environment which may affect every one of these four areas. When assessing fitness, climate-related aspects and considerations could therefore be integrated into the assessment. For example, supervisors could assess whether members of the management body are sufficiently aware of the developments regarding climate change and the transition towards sustainability, including the changing (European) legal and regulatory environment. Board members should possess adequate knowledge and expertise to monitor and assess relevant climate-related risks, to consider the impact of these risks on their company’s strategy, business model, risk profile and viability, and to make changes where necessary.

Specific questions may relate to whether the board members are aware of potential climate risks to the company’s assets and loan collateral, like exposures on high emitting sectors or commercial real estate, and the creditworthiness of counterparties that face new, stricter sustainability regulation. Knowledge and expertise relating to the company’s valuation of climate-related assets and liabilities may be assessed. Also, questions may see on the internal risk and integrity policies, the need to adapt these policies to actual climate-change developments and the way these policies, including commitment to sustainability Codes and Guidelines, are actually integrated in daily business operations.

Naturally, the impact of climate-related risks can differ substantially between different financial institutions.2 However, in those cases that the assessment of climate-related risks does lead to the conclusion that major changes to the business model and strategy are needed, board members should possess the necessary knowledge, skills and professional conduct to implement these changes.

This might, in practice, prove quite a difficult process. It is noted that most financial institutions in the Netherlands support the principle of sustainable finance, but many fail to really put this principle into practice (see also paragraphs 5.4.1 and 5.4.2). Little awareness in the organization of climate-related risks and underestimation of these risks can lead to resistance against the making and following of new rules and policies. So, for a successful implementation of new policies that do incorporate sustainability considerations and climate-related risks, a change in corporate culture, values and behaviour within the management body and the institution may well be necessary. Such a change in culture will, however, require time and continued attention. Also, the tone from the top and top executives giving the right example (leading by example) are deemed essential for the success of such (profound) shifts in culture and focus.3 The members of the management body should reflect the values being espoused and be consistent in their behaviour and communication (“walk the talk”).4

Board members should not only possess the necessary knowledge and experience, but they also need to possess the appropriate skills and competencies to fulfil the above mentioned tasks. The Annex to the Policy Rule on Fitness, as well as the almost identical list of competencies summed up in the Annex to the EBA/ESMA Guidelines on suitability, contain several skills that may be relevant in this respect.

Relevant skills may be:

Not every member of the management board needs to possess all the competencies listed above, and perhaps other competencies may be assessed. Different competencies apply for each position (proportionality principle, see also hereafter). However, independence of mind is deemed necessary for all members of the management body, executive members and non-executive members alike. Independence of mind means the capacity to make one’s own sound, objective and independent judgement and to act objectively, critically and independently.5 This quality may be of specific importance in financial institutions where awareness of climate-related risks may still be low. It may take courage and the ability to resist group pressure to keep the climate-issue on the table and make sure that relevant risks are, indeed, adequately assessed and mitigated.

Fitness assessments are specific to the position (proportionality principle). This means that the assessment considers the specific position of the candidate, the nature, size, complexity and risk profile of the institution and also the composition and functioning of the board as a whole.

The impact of climate-related risks may differ between financial institutions, depending on the specific activities and businesses that are undertaken. When assessing fitness, supervisors will take this into account and the required level of knowledge, skills and expertise will be assessed accordingly. Also, each member of the management body will be assessed at a level commensurate with their relevant positions and responsibilities. For example, the members of the board of directors should be able to adequately manage and mitigate material climate-related risks, including the implementation, review and –if necessary- adjustment of the institution’s strategic objectives, risk strategy and business policies, whereas the members of the supervisory board should be able to effectively oversee and challenge the decision-making of the board. Also, different knowledge, skills and expertise may be required for the CFO, CEO, Chair or members of the Risk Management Committee.

When assessing fitness, the composition and functioning of the board as a whole is considered. This means that all areas of knowledge and expertise required for the institution’s business activities should be covered by the management body collectively, with sufficient expertise among members of the management body.6

This may lead to the conclusion that not each and every member of the management body is required to possess, for example, in depth knowledge of climate-related risks, relevant technological developments and climate-related regulations. However, all members of the management body should have an up-to-date understanding of the business of the institution and its main risks. This includes an appropriate understanding of those areas for which an individual member is not directly responsible but is collectively accountable, together with the other members of the management body. So, should climate-related developments pose major risks to the financial stability of the company or affect its future profitability and stability, every member of the management body is expected to possess adequate knowledge of the issues at hand. If needed, this specific knowledge and expertise can be gained by additional education and training.

Supervisors also assess whether or not a member of the management body has conflicts of interest to an extent that would impede his or her ability to perform his or her duties independently and objectively. Many different situations can lead to actual or potential conflicts of interests. For example, the acceptance of another job or position at heavily polluting companies may damage the credibility of the financial institution that wishes to steer into a more sustainable direction. The same holds true for members of the management body with considerable economic interests in such industries.

Having a conflict of interest does not necessarily mean that the board member concerned is not suitable to fulfill his or her function. Mitigating measures, like not participating in deliberations and voting, should be considered.

According to Dutch law, the propriety (integrity) of the members of the management body must be beyond doubt. The proportionality principle does not apply when assessing propriety. All members of the management body should uphold high levels of integrity and honesty and should act in line with high standards of conduct, regardless of the nature, scale and complexity of the institution or their specific position.7

To establish propriety, supervisors examine criminal, financial, supervisory, tax and administrative law antecedents, as well as past personal and business conduct and the relationship of the board member, if any, with the supervisory or regulatory authorities. Also, non-compliance, dishonest behaviour, untruthfulness and not meeting commitments are relevant circumstances that should be considered.8

So, when assessing the propriety of board members, breaches of financial regulation will be taken into account even when those breaches are committed by the financial institution and not by the board members in person. Obviously, the involvement and responsibilities of the specific board members regarding these breaches will be taken into careful consideration. However, as climate-related regulations increase, the risk of non-compliance also increases. Should this lead to actual breaches of climate-related regulation, and should it be concluded that these breaches were intentional or the result of deliberate recklessness of individual board members, supervisors may conclude to impropriety.

In the same way, the adherence to sustainability Codes and Guidelines without the intention to actually live up to the responsibilities and commitments that come with it, may not only affect the financial institution itself (see paragraphs 5.2.3 and 5.2.4) but also the individual board members who are responsible and accountable for these malpractices. An appearance of impropriety may, at the least, be created.

Importantly, in the Netherlands, the conclusion of impropriety will in practice result in a removal from all relevant positions in the Dutch financial sector.