Integrating ESG into the organisation’s risk management system

Proper definition of the risks associated with climate change is necessary to take action to increase resilience to these risks. It also provides a way to better exploit the opportunities associated with the challenges posed by climate change in order to improve the growth dynamics, financial performance and image of the Group. In line with TCFD recommendations, climate change risks are identified and analysed under two categories: physical and transition risks.

Physical risks arise from the increasing severity and frequency of extreme weather events, such as violent storms or floods (acute physical risks). In many sectors, these can cause direct damage to assets and disruption to infrastructure. Such risks can also affect companies indirectly, by necessitating a change in their business profile, increasing costs (e.g. insurance) or even preventing them from operating.

The second group of physical risks are those associated with gradual and prolonged changes in climate patterns over the medium to long term, particularly as a result of increases in average temperatures (chronic physical risks). In this category, the agricultural sector has an inherent exposure, due to an increase in the risk of land erosion, which has an impact on the quality and quantity of the yields achieved. In the medium to long term, the deteriorating hydrological situation of Poland and the threat of drought is also a risk factor. Lack of adequate water retention systems and water shortages can have a number of negative effects. They may affect various sectors of the economy, including, inter alia, the energy sector (e.g. thermal power plants using river water in cooling systems may have to reduce energy production during periods of drought). Deterioration of hydrological conditions may also mean an increase in fire risk and potential losses in timber production, among other negative impacts.

Transition risks relate to the transition towards a low-carbon economy, in line with the goals of the Paris Agreement and the strategic direction set by the European Green Deal. Such a transition implies major structural changes in the global economy, entailing many risks, including rapidly emerging losses from so-called stranded assets. The consequences of these processes are complex and multidimensional, making the assessment of transition risks difficult but extremely important. From the Group’s perspective, these risks can affect the Group both directly and indirectly through their impact on the Group’s customers.

Regulatory risks are one category of transition risks. They relate to the revision of regulations aimed at preventing climate change and promoting adaptation to climate change. New, stricter regulations that will force climate-friendly solutions may lead to higher operating costs for some companies. Sectors dependent on coal and other fossil fuels, on which the Polish energy mix is predominantly based, are particularly vulnerable to these risks. Regulatory risks arise from the rising cost of CO₂ emissions, stricter reporting and data collection requirements and even regulatory changes imposing restrictions on the operation of some particularly carbon-intensive businesses. A risk not yet so widespread in Poland, but already noticeable in Western European countries, are lawsuits brought, for example, by NGOs. These are aimed at holding companies legally responsible for contributing to climate change or combating so-called greenwashing. The risk of litigation applies largely to companies operating in the most harmful and carbon-intensive sectors.

Technological risks are another group, as decarbonisation and the transformation of the economy will require support in the form of technological innovation. For many companies and industries, profound technological change may mean the loss of asset and infrastructure value and the need to invest in R&D and the implementation of new technologies.

The economic transformation and structural changes also involve market risks. Changes in the demand and supply of raw materials and commodities will affect their prices and, as a result, the production costs of companies. Consumer choices and the wider macroeconomic environment, including the competitiveness of the economy or the level of interest rates, will also be subject to change.

The final group of transition risks are reputational risks. These relate to increased consumer awareness and unethical or unconscious greenwashing actions on the part of businesses.

The opportunities ahead of the Group are particularly related to the development of the RES market and the possibility to invest in projects and businesses in this sector, as well as the possibility to be involved in the financing of transport electrification projects, including the uptake of electric and low-emission cars and low-emission public transport. The opportunity to engage in financing decarbonisation projects for the bank’s clients is also an important prospect. New business opportunities identified in the longer term will be related to cooperation with companies taking part in the transformation of the Polish energy sector and the development of advisory services for the selection of low-carbon solutions for the agribusiness sector and the development of financial services in this area.

Climate risk management is part of a wider, comprehensive risk management process at Santander Bank Polska Group. In line with the results of the material risks identification and update process completed in the first quarter of 2023, climate risks have not been set aside as a separate category of these risks. Channels of transmission of climate risks to banking risks were identified, including credit, compliance, reputational, business and operational risks. The analysis of risk transmission channels is being enhanced all the time and the perspective of the impact analysed is now being extended to include market risk for the trading book and liquidity risk. The application of this approach has an impact on the process of estimating and quantifying material risks.

ESG risks are also taken into account in the bank’s annual Risk Profile Assessment process.

The process of reporting the materiality of climate risks for the portfolio, based on the materiality matrix described above, will continue to be refined and deepened. The first quantitative report on the materiality of climate risks based on the new methodology was presented to the Credit Risk Committee in the fourth quarter of 2023. Following modifications planned for the first half of 2024, a summary of materiality assessment results by physical and transformational risks will also be included in the main risk report, which currently contains qualitative information on climate risks and ESG risks in general.

Preparations are also underway for a climate stress test in 2024, which will take into account both the transition risks materialisation scenario and additional factors associated with the materialisation of physical risks.

Santander Bank Polska is implementing a project for the systemic collection of data on climate risks and ESG data in a wider sense, in support of its risk management processes. We use external databases for this purpose, including the Central Register of Energy Performance of Buildings and databases maintained by the Credit Information Bureau. We also work with external data providers. The process of acquiring the first iteration of the data should be completed in the first half of 2024. Information on the quantitative assessment of climate risks (and ESG risks more broadly) is gradually being integrated into the processes of identification, valuation and monitoring of banking risks. ESG risk indicators are already included in analyses of operational, market and liquidity risks.

Climate risk issues are increasingly being integrated into risk assessment at the stage of credit processes.

As part of the Policy for the management of social, environmental and climate change risks, the following procedures have been defined for the analysis of ESG risks:

• the Environmental, Social and Climate Change Risk Analysis applicable to customers of the Corporate and Investment Banking (CIB) segment,
• the Environmental and Social Risk Analysis procedure for BCB Customers, applicable to customers of the Business and Corporate Banking segment.

The ESG risk assessment aims to assess the customer’s ability to manage all ESG risks allowing for an analysis of the impact of the customer’s actions on their mitigation.

The risk analysis for the global client segment is carried out locally, in line with the solutions used in the Banco Santander Group. An individual ESCC (Environmental Social & Climate Change) risk analysis is performed. It applies to transactions or clients operating in the sectors defined in the Social, Environmental and Climate Change Risk Management Policy, in particular including the oil and gas, energy, mining and metals and soft commodities sectors. The ESCC risk analysis and the resulting recommendation is taken into account in the client’s credit application and is a component of periodic reviews. New sensitive sub-sectors are integrated into this process, such as automotive and food and chemical sectors (in particular plastic production and agrochemicals).

In addition, for customers from sectors with high CO2 emissions, a structured analysis of plans to transform operations towards lower carbon emissions is carried out. The analysis includes customers from such industries as energy, coal mining, airlines and steel production. Moreover, for international corporate clients, the analysis of physical and transition risks is taken into account in a qualitative part of the client rating process. If these factors have a significant impact on the credit risk assessment, an appropriate description is added to the rating.

For project finance, an analysis in line with the Equator Principles, a market standard and common language for assessing environmental and social risks in projects among large financial institutions worldwide, is applied. This assessment is carried out as part of the ESCC Risk Analysis for Financed Projects, a procedure implemented in 2023, in cooperation with the business line and ESCC analysts. As a first step, it identifies a project category, which depends on the potential impact on environmental and social issues. This is followed by an environmental and social impact analysis, the granularity of which depends on the category assigned. The recommendation resulting from the analysis becomes part of the credit application.

For other corporate customers, a largely automated algorithm is now used. It enables the preselection of climate risks, based on which customers receive statuses within specific areas, so-called environmental flags. These are assigned to all customers as part of a portfolio analysis conducted on the basis of the characteristics of individual companies (including the section of the Polish Classification of Activities in which they operate). In addition, if a potentially elevated ESG risk is identified by any participant in the credit process (banker, credit analyst or Credit Committee), a request for additional individual analysis is made to the ESG Risk Management Office (this process has not yet been formalised).

Further work is planned for 2024 to comprehensively integrate ESG factors into the structured risk assessment process for Business and Corporate Banking customers. The implementation of the relevant solutions should take place in the third and fourth quarters of 2024. As a next step, an appropriate translation of this process to the SME segment will be developed in line with the principle of proportionality.

With regard to retail customers, the bank is primarily working on expanding the data held and analysed on transition risk and the risk of changing consumer preferences with regard to the mortgage portfolio. This data will also be key to developing the assessment of ESG risks (including climate risks) in the business property segment.

Work is also currently underway to collect data to properly reflect climate risks in collateral valuation, in line with the letter received from the PFSA in March 2023 communicating supervisory expectations in the ESG area. Market solutions and guidelines for property valuations are monitored on an ongoing basis, but at the moment there are no uniform standards. Work on defining an internal methodology for the impact of climate risks on collateral valuation is scheduled for the second half of 2024. This will ultimately allow the definition of procedures resulting in a requirement for external appraisers to provide certain data and reflect the  identified risks in property valuations.

As of January 2024, the bank has a standardised and streamlined process for obtaining building energy performance certificates for properties securing the repayment of a loan, if the purpose of the loan is the same as the collateral property. This process will allow for the massive acquisition of energy efficiency and CO2 emissions data at property level.

Projects are also underway to obtain data from external sources,  regarding, for instance, physical risks at the municipality level, including chronic and acute risks, relevant climate scenarios and time horizons, and data from a central register of building energy performance.