EU investors

EU institutional investors are subject to multiple regulations which encompass ESG matters and deal with how investors should consider and report on sustainability topics. The main pieces of EU legislation for investors to abide by are Solvency II (for insurance companies), IORP (for pension funds), and CRR (for credit institutions – banks). Revisions to these frameworks suggest that ESG is becoming an increasingly important aspect for investors.

Solvency II framework

For the purposes of this chapter, the Solvency II framework encompasses the Solvency II Directive, Delegated Regulation, and EIOPA guidelines.

What is Solvency II?

The Solvency II Directive (Directive 2009/138/EC) introduces enhanced solvency requirements for insurers based on a holistic view of risk and establishes new valuation rules for assets and liabilities, which are to be recognised at market value in the future. In this way, the risk of insurer insolvency is aimed to be reduced. At the same time, the Directive serves to harmonise supervisory law in the European internal market. The Directive is further specified in the Solvency II Delegated Regulation (Regulation (EU) 2015/35), various implementing technical standards and guidelines issued by EIOPA as European insurance regulator, all of which together form the Solvency II framework. The Solvency II framework is divided into three main pillars:

The first pillar deals with the own funds requirements, the provisions for the calculation of technical provisions and the review of the calculation approaches.
The second pillar establishes the principles and methods of supervision and the qualitative requirements for the conduct of insurers’ business.
The third pillar deals with market discipline, transparency and publication obligations, and reporting to the supervisory authorities.

Who is in scope of Solvency II?

The Solvency II framework applies to reinsurers and life and non-life insurers (including certain pension funds) which operate in the European Economic Area (EEA), including insurers that have subsidiaries in the EEA or which deal with EEA counterparties. It excludes small insurers (which are still subject to local regulation), occupational pension funds covered by the IORP Directive, credit institutions and financial conglomerates.

How do Solvency II investors have to consider sustainability in general?

The prudent person principle laid down in Article 132 of the Solvency II Directive requires that insurers and reinsurers only invest in assets the risks of which they can identify, measure, monitor, manage, control and report properly. This includes all risks that may potentially impair the value of investments, including risks resulting from environmental or societal events such as climate change or political upheaval. However, sustainability risks did not per se feature as a separate risk category and insurers and reinsurers had no general obligation to take account of such risks if they did not consider them to be relevant for the value of their investments.

Effective from 2 August 2022, the Solvency II Delegated Regulation has been amended by the Commission Delegated Regulation (EU 2021/1256) to provide for a stronger anchoring of sustainability risks both for investments and for insurance underwriting. For investments, the Commission Delegated Regulation sets out three main drivers for the consideration of sustainability:

Sustainability risks now have to be integrated into reinsurers’ and insurers’ risk management, governance and remuneration policy as own risk category, no longer leaving a choice to reinsurers or insurers on whether to consider them.
Moreover, as part of the prudent person principle, insurers and reinsurers will also need to take into account the potential long-term impact of their investment strategy and decisions on sustainability factors. This relates to the ‘double materiality’ concept the European Commission favours and for the first time requires insurers and reinsurers to extend their perspective from own financial risks resulting from sustainability matters to the impact their investments create on ‘sustainability factors’. These are defined by reference to Article 2(24) SFDR and include environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.
Finally, to the extent insurers need to take account of their customers’ sustainability preferences when designing their insurance products, their investment strategy and decisions should be aligned with such sustainability preferences. This applies to life insurers offering insurance-based investment products (IBIPs) which are subject to the new rules on sustainability preferences introduced by Commission Delegated Regulation (EU) 2021/1257.

Meanwhile, EIOPA considers it essential to foster a forward-looking management of sustainability risks to ensure the long-term solvency and viability of the (re)insurance industry, with a special focus on climate risks. This affects both insurers’ and reinsurers’ regular reporting in the context of the Own Risk and Solvency Assessment (ORSA) as well as the regular stress testing exercise for the European insurance industry carried out by national regulators following the principles set out by EIOPA. For the ORSA and the resulting reporting to the national regulators, see below.

While the previous insurance industry stress tests (the latest was carried out in 2021) did not yet take into account climate risks, this will certainly follow in the next stress testing exercise, as demonstrated by EIOPA’s Methodological Paper on principles for climate change stress testing published in January 2022. With regard to investments, the Methodological Paper covers transition and physical risks which may have an impact on the value of insurers’ and reinsurers’ investment portfolios.

Transition risks include events that lead to the impairment of equity, real estate or infrastructure assets (e.g., as ‘stranded assets’, ‘brown real estate’ or investments in carbon intensive industry sectors) or the deterioration of the creditworthiness of borrowers, issuers or counterparties that fail to properly address their own transition risks. Physical risks for investments for example include events such as windstorms, floods, heatwaves, wildfires and droughts impairing value of investments (because they affect the profitability of companies or create damage to real estate) or deteriorating the creditworthiness of borrowers, issuers, counterparties or reinsurers (due to financial losses resulting from climate change).

There is currently no guidance on other sustainability risks which are not related to climate change.

On which sustainability topics do Solvency II investors have to report?

Solvency II introduced harmonised reporting requirements which complement and, in part, replace national rules. EU Member States are permitted to maintain additional reporting requirements that are tailored to national specificities or are based on information required under commercial/accounting law.

The regular reports submitted by insurers and reinsurers to their national regulator must include the following documents:

the Solvency and Financial Condition Report (SFCR);
the Regular Supervisory Report (RSR), which predominantly contains explanatory information particularly in relation to the business and its results, business organisation, risk profile as well as capital management and the valuation of assets and liabilities for solvency purposes;
the Own Risk and Solvency Assessment (ORSA) Supervisory Report on the outcome of own risk and solvency assessments, which undertakings must submit after each routine assessment (to be performed at least annually); and
annual and quarterly quantitative reporting templates (including reporting on investments).

Of these reports, the ORSA report is the most important one for reporting on sustainability risks and the impact on sustainability factors. In April 2021, EIOPA issued an Opinion on the supervision of the use of climate change scenarios in the Own Risk and Solvency Assessment (ORSA) addressed to national regulators. According to the Opinion, national regulators should expect insurers to integrate climate change risks in their system of governance, risk management system and ORSA. In the ORSA, insurers should perform an assessment to identify material climate change risk exposures and subject the material exposures to a risk assessment (both in the short and the long term). For the purposes of ORSA both climate transition risks (such as policy change, litigation, technological change, market sentiment shifts and reputational issues) and physical climate risks (acute risks from particular events such as storms, floods, fires or heatwaves and chronic risks from temperature changes, rising sea levels, lack of water, biodiversity loss and land degradation) shall be taken into account. There is currently no specific guidance in relation to other sustainability risks which are not related to climate change.

Does Solvency II define specific sustainability indicators?

Different from the SFDR framework, the sustainability risks and sustainability factors concept under the Solvency II framework does not define specific indicators which insurers and reinsurers have to use when measuring these risks and factors. Since the sustainability factors are defined by reference to SFDR, this may be an argument to use some of the principal adverse impact (PAI) indicators under SFDR to measure impact on sustainability factors. However, there is no legal or factual connection between ‘sustainability factors’ under the Solvency II framework and the SFDR PAI and due to the lack of market practice it is not yet visible in which direction this will evolve.

Further harmonisation of indicators may be driven by the insurance industry’s obligations relating to non-financial reporting, currently under the EU Non-Financial Reporting Directive 2014/95/EU (NFRD) and in the future under the Corporate Sustainability Reporting Directive (CSRD) being negotiated between the European Commission, Parliament and Council. Insurers and reinsurers subject to NFRD also have to report on the Taxonomy-alignment of their investment and underwriting activities pursuant to Article 8 Taxonomy Regulation (EU) 2020/852 and the Article 8 Taxonomy Delegated Act (EU) 2021/2178, drawing either on the official Taxonomy reporting of their investee companies or, in relation to real assets such as real estate, on data received directly from the asset, leading to further harmonisation of required sustainability data.

Finally, as mentioned above, both ORSA and regulatory stress testing draw on sustainability data relating to physical risk exposure and transition risks of assets which leads to requests from insurers and reinsurers to provide the underlying data (e.g., greenhouse gas emissions, flood risk) on their investments. It can therefore be expected that over the next years common reporting standards for data underlying climate risks and potentially also broader sustainability risks and impacts on sustainability indicators aligned with SFDR will emerge.

IORP framework

For the purposes of this chapter, the IORP framework encompasses the IORP II Directive, national implementing provisions, and EIOPA guidance.

What is IORP?

The Directive on the Activities and Supervision of Institutions for Occupational Retirement Provision (EU) 2016/2341 (IORP II Directive) entered into force on 13 January 2017 and replaces the previous IORP Directive.

The IORP II Directive sets common standards by ensuring the soundness of occupational pensions and better protecting pension scheme members and their beneficiaries, by setting out requirements relating to:

technical provisions and own funds;
governance and key functions (including risk management);
own risk assessment;
outsourcing, investment and use of depositaries;
information to beneficiaries; and,
effective supervision by national regulators.

The IORP II Directive seeks to improve the way occupational pension funds are governed, to enhance information transparency to beneficiaries and to clarify the procedures for carrying out cross-border transfers and activities.

It does not apply directly to IORPs but only via the respective national implementing provisions. EIOPA as EU regulatory body for insurers and pension funds has issued guidance on various topics of the IORP II Directive. All of this together forms the IORP framework.

Who is in scope of IORP?

IORPs are financial institutions that manage collective retirement schemes for employers to provide retirement benefits to their employees (i.e., pension scheme members and beneficiaries). They are long-term investors that aim to deliver the best returns to their members and beneficiaries at the same time as keeping their investments safe.

Pension provisions and support relief funds are not covered by the IORP II Directive.

How do IORP investors have to consider sustainability in general?

Having been enacted prior to SFDR, the Taxonomy Regulation and other elements of the EU Sustainable Finance Action Plan, the IORP II Directive does not use the term ‘sustainability risks’ or ‘sustainability factors’ but refers to ‘environmental, social and governance factors’ (ESG factors) which are important for the investment policy and risk management systems of IORPs. The IORP II Directive makes reference to the UN PRI and requires that national implementing provisions permit IORPs to take into account ESG factors in their investment decisions. Contrary to the Solvency II framework, IORPs may however choose not to consider ESG factors, inter alia based on disproportionate efforts required or the lack of materiality of ESG factors.

Within the context of the IORP II Directive, IORPs can address ESG factors in the areas of:

investment decisions (i.e., taking into account the potential long-term impact of investment decisions on ESG factors)
general governance requirements (i.e., considering ESG factors related to investment assets in investment decisions)
risk management (i.e., environmental, social and governance risks relating to the investment portfolio)
own-risk assessment in relation to investments (i.e., an assessment of new or emerging risks, including risks related to climate change, use of resources and the environment, social risks and risks related to the depreciation of assets due to regulatory change), and
the statement of investment policy principles (which needs to explain if and how the investment policy takes ESG factors into account).

Although the IORP II Directive leaves it to the IORPs to decide whether they want to consider ESG factors in their investment decisions, EIOPA nevertheless sees the increasing risks to all IORPs' investment portfolios caused by climate change. Accordingly, in 2022 EIOPA has carried out its first IORP climate stress test with the support of the national regulators reflecting a sudden, disorderly transition to climate neutrality due to delayed policy action resulting in a sharp increase of carbon prices triggering transition risk effects to the entire economy. Participating IORPs had to submit their data in June 2022 and the results of the stress test are expected to be published by end of 2022.

On which sustainability topics do IORP investors have to report?

If they have chosen to consider ESG factors in their investment decisions, IORPs will need to report on new or emerging risks (including risks relating to climate change, use of resources and the environment, social risks and risks related to the depreciation of assets due to regulatory change) to their national regulators as part of the own-risk assessment to be carried out at least every three years. IORPs not considering ESG factors will not need to report on ESG factors in their own-risk assessment.

Moreover, IORPs must disclose to prospective members whether and how ESG factors are considered in the investment approach/decisions, and how they form part of their risk management system. The relevance and materiality of ESG factors to a scheme’s investments and how such factors are taken into account should be part of the information provided by an IORP.

As explicitly stated in the IORP II Directive, this does not preclude an IORP from satisfying the requirement by stating in such information that ESG factors are not considered in its investment policy or that the costs of a system to monitor the relevance and materiality of such factors and how they are taken into account are disproportionate to the size, nature, scale and complexity of its activities. However, if the EIOPA 2022 climate stress test leads to the conclusion that IORPs’ investment portfolios are materially affected by climate risks, it may become difficult to argue for IORPs that ESG factors are not material or that they are still acting prudently if they do not consider ESG factors that may significantly impair the value of their investment portfolios.

Does IORP define specific sustainability indicators?

The IORP framework does not define specific indicators which IORPs have to use when considering ESG factors or risks. Different from the Solvency II framework, there is no link to SFDR having been enacted several years after the IORP II Directive. Moreover, different from insurers and reinsurers, IORPs are not subject to non-financial reporting obligations under the EU Non-Financial Reporting Directive 2014/95/EU (NFRD) and the respective Taxonomy reporting under Taxonomy Regulation (EU) 2020/852. Pension schemes offered by IORPs are subject to SFDR which may cause the respective IORPs to align the concept of ‘ESG factors’ and ‘ESG risks’ with the SFDR ‘sustainability risks’ and ‘principal adverse impact (PAI) on sustainability factors’ (including the respective indicator framework). It remains to be seen which market practice will evolve, also following EIOPA’s 2022 climate stress test.

CRR framework

For the purposes of this chapter, the framework for banks/credit institutions includes the Capital Requirements Regulation (CRR), further relevant acts and guidance by the European Banking Authority (EBA).

What is CRR?

The Capital Requirements Regulation (CRR), which is directly applicable in all EU Member States, lays down prudential requirements for capital, liquidity and credit risk for investment firms and credit institutions (‘banks’) in order to ensure their resilience, particularly during times of market stress.

The Regulation requires banks to have set aside enough capital to cover unexpected losses and keep themselves solvent in a crisis. As a main principle, the amount of capital required depends on the risk attached to the assets of a particular bank. In the Regulation, this is referred to as the ‘own funds requirement’ and is expressed as a percentage of risk-weighted assets. The risk-weighted assets concept in essence means that safer assets are attributed a lower allocation of capital, while riskier assets are given a higher risk-weight. In other words, the riskier the assets, the more capital the bank has to set aside.

Who is in scope?

The CRR applies to credit institutions and contains provisions relating to, among other things, own funds and capital requirements, large exposures, liquidity, leverage, supervisory reporting and disclosure.

How do investors have to consider sustainability in general?

On 27 October 2021, the European Commission adopted a review of the EU banking rules (the Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD IV)).

One of the elements included in the package relates to “Sustainability - contributing to the green transition”. More specifically, the new rules require banks to systematically identify, disclose and manage sustainability risks (environmental, social and governance or ESG risks) as part of their risk management.

In 2022, the European Central Bank (ECB) has carried out a stress test dedicated to climate risks for supervised credit institutions as part of its annual regulatory stress testing. It focused on transition risks (short-term stress and long-term transition paths) and physical risks (drought and heat, flood) with different climate transition and climate change scenarios. The ECB found that climate risks are relevant for the large majority of credit institutions directly supervised by the ECB since they generate non-negligible income from greenhouse gas emitting industries and are exposed to the materialisation of acute physical risks linked to their lending activities. The ECB noted that many credit institutions lacked clearly defined long-term strategies for credit allocation reflecting transition paths and did not have sufficient real data underlying their climate risk assessments.

On which sustainability topics do investors have to report?

Since 1 January 2014, the disclosure requirements have been anchored at European level in Part 8 of the CRR and are thus directly applicable EU law. In terms of content, the Pillar 3 transparency requirements relate to the following areas:

Scope of application of the capital adequacy regulations
Risk management objectives and policy
Own funds and capital requirements
Individual disclosures on the risks assumed
Remuneration
Indicators of global systemic importance
Unencumbered assets
Leverage ratio
Liquidity requirements
Environmental, social and governance risks

In January 2022, the EBA published binding standards on Pillar 3 disclosures of ESG risks. More information is set out below.

Does the CRR framework define specific sustainability indicators?

Article 434 of the CRR required the EBA to develop implementing technical standards specifying uniform disclosure formats, and associated instructions in accordance with the disclosures required in Part 8 of the CRR.

The technical standards aim to ensure that stakeholders are well-informed about institutions’ ESG exposures, risks, and strategies and can make informed decisions and exercise market discipline.
The standards put forward comparable disclosures and KPIs, including a green asset ratio (GAR) and a banking book taxonomy alignment ratio (BTAR), as a tool to show how institutions are embedding sustainability considerations in their risk management, business models and strategy and their pathway towards the Paris Agreement goals.
In developing this framework, the EBA has built on the recommendations of existing initiatives, like those of the Task Force on Climate-related Financial Disclosures (TCFD) of the Financial Stability Board (FSB), but has gone further by defining binding granular templates, tables, and instructions, to ensure enhanced consistency, comparability, and meaningfulness of institutions’ disclosures.

More specifically, in line with the requirements laid down in the CRR, the final draft implementing technical standards (ITS):

set out comparable quantitative disclosures on climate-change related transition and physical risks, including information on exposures towards carbon-related assets and assets subject to chronic and acute climate change events
include quantitative disclosures on institutions’ mitigating actions supporting their counterparties in the transition to a carbon-neutral economy and in the adaptation to climate change
include KPIs on institutions’ assets financing activities that are environmentally sustainable according to the EU Taxonomy (GAR and BTAR), such as those consistent with the European Green Deal and the Paris Agreement goals
provide qualitative information on how institutions are embedding ESG considerations in their governance, business model, strategy, and risk management framework.

The EBA has integrated proportionality measures that should facilitate institutions’ disclosures, including transitional periods and the use of estimates.

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