Agefi Luxembourg - mai 2024

AGEFI Luxembourg 30 Mai 2024 Fonds d’investissement ByHerwig TEMMERMAN ,PartneratBearingPoint Luxembourg andDimitri CORDENIER ,Manager at BearingPoint Switzerland* A t its core, environmental re- porting is about transparency and accountability in res- ponse to climate change and increasin- gly pressing environmental challenges. It serves a dual purpose: hel- ping banks assess their envi- ronmental impact and guiding their transition to- wardsmore sustainable prac- tices. In an erawhere climate change is a central concern, stakeholders are demanding transparency. This article aims to dissect the evolving landscape of cli- mate and environmental reporting, fo- cusing on the stringent regulatory environment in the EU, and Switzerland's own approach to reporting sustainability in the banking sector. Whatisthestateandevolutionofnon-financialand environmental reporting in the EU? The Corporate Sustainability Reporting Directive (CSRD) and the European Sustainability Reporting Standards (ESRS) are the twokey elements for banks operating in theEUwhen reportingonnon-financial matters. TheCSRDis thenext step in the evolutionof the Non-Financial Reporting Directive (NFRD), set- ting a newbenchmark for transparency in the finan- cial sector. It significantly expands the scope beyond the NFRD by including more companies, whereas previouslyonlybankswithover500employeeswere concerned. Thedirectivemandatesbankstoprovidedataonsus- tainability risks and impacts on the environment. Thesestandardsaredesignedtoensureuniformityin reporting and aim to sync with existing frameworks like the Global Reporting Initiative (GRI). For banks, this means navigating through more than 100 ESG KPIs, a significant increase in the volume and com- plexity of data required. The ESRS categorizes these KPIsacrossvariousnon-financialdomains,including climate change, pollution andbiodiversity. The concept of double materiality is central to CSRD. It asks banks to look in two directions: how their activities affect the environment (impact ma- teriality, for example, consideringhowa company's activitiesmight harmthe environment bypolluting and releasing greenhouse gases into the atmo- sphere), and how the applicable ESG issues influ- ence their financial performance and operations (financialmateriality, for example, consideringhow extreme events might impact a company's supply chain and subsequently its performance). This dual perspective is about acknowledgingandmeasuring the bank's contri- butions—positive or negative—to sustainability goals. To assess a firm’s CSRD com- pliance, conducting a gap analysis is an essential step. For many banks, this will highlight areas for improvement, be it data collection, operational pro- cesses or reporting processes. From 2024 onwards, the CSRD will progressively broaden sustainability reporting standards, and a roadmap has been defined until fiscal year 2028. Initially targeting large enti- ties with over 500 employees and those on EU stock exchanges, it will expand to cover more companies in subsequent years based on turnover and employee count. Small and medium-sized enterprises will also come under this mandate, with options for delayed compliance in certain cases. Eventually, the directive will en- compass EU branches and sub- sidiaries of non-EU parent companiesexceeding€150mil- lion in global revenue. How does Switzerland's ap- proach to environmental re- porting align with or differ from the EU's framework? In2021,Switzerlandupdatedthe Swiss Code des Obligations (CO) to introduce new transparencyrequirementsfornon-financialmatters through Art. 964 CO, inspired by the EU’s Non-Fi- nancial Reporting Directive (NFRD) and covering ESG-related issues. It requires subjected Swiss companies to report on their business model, policies, their effectiveness andmain risks, and key performance indicators re- lated to sustainability. Swiss companies classifiedas Public Interest Entities, having at least 500 full-time employees, andeither abalance sheet total of at least 20 million francs or a turnover of 40 million francs are subject to this regulation. Swiss regulation also adopts the double materiality principle within the CO, mirroring the EU’s CSRD. However, some un- certainty remains about its application, as double materiality is onlyaddressed through theOrdinance onClimateDisclosures, leavingquestions about po- tential impacts on biodiversity and other non-cli- mate matters. In addition, unlike its European counterparts, Swiss sustainability reportingdoesnot require third-party audits. In November 2022, the Federal Council enacted the Ordinance onClimateDisclosures,mandating com- panies to report additional climate-related informa- tion, including quantitative data and CO2 targets, within their environmental reports as outlined in the CO. Reportingwill bebasedon the four pillars of the recommendations of the TCFD (i.e., governance, strategy, riskmanagement, andmetrics and targets). Thisincludesadetaileddisclosureofgreenhousegas emissions, supported by clear methodologies to en- sure consistency and comparability. Finally, Swiss companies have the option to volun- tarilyadheretostricterEUorinternationalstandards, potentially eliminating the need for dual reporting (i.e.,thereisnoneedtoreportunderbothstandards). Companies are expected to publish their initial sus- tainabilityreportsinaccordancewiththeCOin2024, and their first reports adhering to both CO and the ClimateOrdinance in 2025. Howcanbanksmanage the transition effectively? Whether at the European or Swiss level, these regu- lationsfundamentallyrequirebankstocollectandre- port on a broad range of data that extends well beyond carbon emissions, encompassing key areas like biodiversity andpollution.As a result,many ex- istingsystemswithintheseinstitutionsmustundergo a comprehensive review, a task made even more challengingbythestringentdeadlinesimposed.This process can only be facilitated through comprehen- sive collaboration across various departments, from ESGteamsandcompliancetoportfoliomanagement andHR,ensuringthatdatacollectionandanalysisef- forts are cohesive and comprehensive. Furthermore,thisshifttowardsnon-financialregula- tion should be viewed as a strategic opportunity for financialinstitutions.Bymandatingtheevaluationof non-financial risks, these regulations, be they Swiss orEuropean,pushinstitutionstocriticallyassesstheir operations. They incentivize banks to consider not justthefinancialviabilityoftheirbusinessmodelsbut also their compatibility with global environmental and social thresholds. This perspective encourages banks to align their business strategies with broader sustainability goals. * Research performed by Henri Gogniat, Junior Consultant at BearingPoint. Navigating environmental reporting in the financial industry across the EU and Switzerland R ecent and current events clearly indi- cate that geopolitics and notably fi- nancial geopolitics play amajor role in shaping and understanding countries’ re- spective economic environments. Indeed, especially for smaller countries, macro-eco- nomic models are not very useful as a fore- casting tool as they aremainly dependent on external and strategic factors. Luxembourg being a case in point, as given its size, it is largelydependent onhowit is positioning itself in the international financial architecture,which im- plies the analysis of internal structural factors and the eventual strategic reactionof competitors. In that sense, Luxembourg would benefit from a strategic advisoryboardanalysing the global financial archi- tecture rather thandevelopingandfinancinguseless studies onmacro-economic indicators and produc- tivity. That said, the competitors being countries managedbydecisionmakers, this implies the study of decision making by governmental entities’ geopolitical interactions. Different definitions of geopolitics exist but the focus here is on geopolitics and finance (Caldara and Iacoviello (2022), Foreign Affairs (2018)) and geo-economic interactions (Blackwill andHarris (2016)). Caldara and Iacoviello (2022) define “geopolitical risk as the threat, realization, and escalation of ad- verseeventsassociatedwithwars,terrorism,andany tensions amongstates andpolitical actors, that affect thepeaceful courseof international relations”. Black- will andHarris (2016) definegeo-economics as “The useof economic instruments topromoteanddefend national interests, and to produce beneficial geopo- litical results; and the effects of other nations’ eco- nomic actions on a country’s geopolitical goal.” It is worthwhile highlighting that the role of geo- economics and the inherent risks that are implied, have seen an increase in importance in a more and more interconnectedworldand that those risks can- not be grasped throughananalysis of past statistics, the structure of the environment faced by decision makers changing constantly. The reactions of differ- ent countries, strategic “players” from a game-the- oretic viewpoint, can only be understood, by analysing the eventual degree of rationality of their decisions given the constraints they face.Which, in- cidentally also implies understanding their culture. Recently,Mearsheimer andRosato (2023) dealtwith the topic of rational decision-making in foreignpol- icy. As highlighted by the authors, the world in whichgovernments operate is characterizedby sub- stantial uncertaintyand international politics is thus, by essence, an information-deficient enterprise. The focus, here, is onbelief formationwhich implies understanding thedifferent contingencies or scenar- ios faced by decision makers and the evaluation of likelihoods of those scenarios. As already men- tioned, estimating likelihoods frompast statistics is only one possible approach, which is difficult and eventually senseless in non-stationary environ- ments.Often, uncertainty is so radical that probabil- ities are difficult to evaluate. Sometimes, even the potential contingencies (scenarios) are difficult to formulate. Concerning the rationalityof decisionmakers, there exist two fundamental schools of thought. Broadly speaking, for the first school, decisionmakers act as if they were rational even though the process is not analysed. The standardmodel is the expectedutility modelwheredecisionmakers evaluate thepossible scenarios and respectiveprobabilities and theneval- uate the expectationof theutility theydrawfroman action subject to uncertainty. For the second school of thought, decisionmakers aremostlynon-rational and exhibit biases in their decision-makingprocess. The most accepted theories being Prospect Theory popularized by Kahneman (2013) and Wakker (2010), even thoughdifferent biases canbe analysed independently of prospect theory. For many complex real-world environments, no past statistic canbe used to formulate likelihoods or probabilities of events. Interestingly, one of the pro- moters of the expectedutilityapproach touncertain environments, namely Savage (1972), also came up with the distinction between Small versus Large World problems in Statistical DecisionMaking. A SmallWorldproblem as a situationwhereoutcomes that canoccur are such that theyprovide “adescrip- tion of the world, leaving no relevant aspect unde- scribed”.Thisconceptappliestoproblemswherethe possible “states of uncertainty” are easy to describe andformalize.Thisisnotthecase,however,forcom- plex real world decisions where the possible out- comes of interest that can occur cannot be fully de- scribed. A decision problemwhich is known in the literatureinStatisticalDecisionTheoryas LargeWorld problems. Such LargeWorld problems have recently been addressed again by the economic literature. AsMarinacci (2015) pointedout, uncertaintyand in- formation are twinnotions. Uncertaintymeans that you have partial knowledge of the future possible contingencies and the realizations enable the deci- sion maker to learn through the process. Uncer- tainty is hence epistemic. The fundamental question is how to form the beliefs about future contingen- cies. Since Laplace (1812), this problemwas solved through the notion of probability, where the proba- bility of an event is measured through the number of favourable cases divided by the total number of cases. This notion of probability became viewed as aphysical andobjectiveway tomeasure likelihoods. Ramsey (1926) andde Finetti (1937) came upwith a different interpretation freed fromthe objective and physical notion of probability. They identify the probability of a decision-relevant event with the willingness tobet on the event,which ismeasurable. Those so-calledepistemic (also subjective) probabil- ities quantify decision-makers degrees of belief about possible events. Thedegreeof belief inanyeventwhether repeatable or not can be quantified. It means that, especially, the field of geopolitics where no past statistic is available, apart from analogies, is an area where such decision theoretic concepts might be of fore- most interest. In an earlier article (Agefi (2022) Oc- tober issue), I already alluded to the usefulness of elicitation techniques to evaluate cyber risks amajor geopolitical risk. Tomentionamore concretegeopo- litical example, Stephen Kotkin (2024) predicts five future scenarios for Russia but states that “readers seeking odds on Russia’s trajectory should consult betting markets”, which is line with the notion of epistemic probability. Apart from that, decision theory under uncertainty hasmade a lot of progress in providing rational ex- planations of so-called biases. Indeed, recent devel- opments in the academic literature indicate a convergence between the non-rational and rational schools of thought. Recent references such as Enke and Graeber (2023) analyse probability weighting as optimal and rational reactions when facing cog- nitive uncertainty in the information treatment. A recent literature neuro-economics suggests that probabilityweighting is efficiently irrational taking into account cognitive energy costs (Glimcher (2022)) and that probability weighting stems from informational frictions andefficient encodinggiven a constraint on limited resources. Many biases are thus efficient responses from an informationally constrained system. This short literature overviewclearly indicates that, given the stand of the literature on rationality in geopolitics (Mearsheimer andRosato (2023)), aswell as the type of decisionproblems faced, decision the- ory under uncertainty might be a useful guide to treat some topics in international geopolitics. Michel VERLAINE ICN Business School Michel.verlaine@icn-artem.com References Agefi(2022)OnelicitationtechniquesforCyberriskaudits, Octo- berIssue,p.48 . Blackwill,R.D.andHarris,J.M.(2016)“Warbyothermeans:Geo- economicsandStatecraft”, HarvardUniversityPress . Caldara,D.andIacoviello,M.(2022)MeasuringGeopoliticalRisk, AmericanEconomicReview ,112(4):1194–1225 De Finetti, B. (1937) La prévision; Ses lois logiques, ses sources subjectives. Annalesde l’InstitutHenryPoincaré ,7,1-68. Enke, Benjamin, and Thomas Graeber, (2023), Cognitive uncer- tainty, QuarterlyJournalofEconomics ,Vol.138,Issue4. ForeignAffairs(2018)ANewFinancialGeopolitics?TheU.S.Led MonetaryOrderinaTimeofTurbulence. ForeignAffairsAnthology. Glimcher,P.W.(2022)“Efficientlyirrational:decipheringtherid- dleofhumanchoice”, Trends inCognitiveSciences ,Vol.28,No.8. Kahneman, A. (2013) Thinking Fast and Slow, Farrar, Straus and Giroux Kotkin,S.(2024),TheFiveFuturesofRussia:AndHowAmerica CanPrepareforWhateverComesNext, ForeignAffairs, May/June issue Laplace , P.-S. (1812) Théorie analytique des probabilités, Courcier, Paris Marinacci, M. (2015) Model Uncertainty, Journal of the European EconomicAssociation ,Vol.13,Issue6. Mearsheimer, J. and Rosato, S. (2023) How states think: The ratio- nalityof foreignpolicy, YaleUniversityPress. Ramsay,F.(1926)TruthandProbability ,Chapter7inTheFounda- tionsofMathematicsandotherLogicalEssays ,(1931),p.156-198 Savage, L. (1972) The Foundations of Statistics. Dover Publications, NewYork.Originally1954 Wakker, P. (2010) Prospect Theory for Risk and Ambiguity, Cam- bridgeUniversityPress When geopolitics meets decision theory