Risk management

Organization of risk management

The risk management framework of the Dutch Fund for Climate and Development (“DFCD”, or “the Fund”) is based on two pillars: (i) prudent financial risk management, and (ii) preventing non-financial risks such as reputational risk, environmental, social and governance risk, compliance risk, operational risk and legal risk. For FMO, acting in its role as Lead Partner, to be able to carry out the Fund’s strategy, it is essential to have an adequate risk management system in place to address both pillars of risks across all three Fund facilities.

With respect to financial risk management, the DFCD has a pre-defined risk appetite translated into limits for country, region and maximum exposures per client/ project. Limit usages are monitored on a monthly basis and for each proposed transaction. The assessment of the financial risk of each proposed financing is further defined for each of the three Finance Facilities and delegated to their respective managers. As there is a range of financial products provided across the three facilities, from grant finance in the Origination Facility to equity finance in the CFM Facility, the specialized and delegated financial risk assessment approach of the DFCD provides for an appropriate, project-specific assessment of financial risk.

The approach for compliance (including business integrity) and reputational risks is set out in the policies that each of FMO, CFM, WWF-NL and SNV have implemented in their respective organizations. FMO, as the Fund Manager, receives reporting on the specific risks and mitigations assessed for each project financed by each of the Finance Facilities.

Financial risk

Financial risk management for the Fund is delegated to each of the facility managers.

Credit risk

As the Origination Facility provides grant finance, rather than loans or investments, the core focus of the financial risk approach is ensuring financial alignment with counterparts. Financial risk is minimized by assessing the financial figures of an organization or project entering the Origination Facility, ruling out unviable businesses. The Origination Facility provides financing in the form of grants, for which the recipient of the grants is required to co-fund, typically for 50%. WWF-NL and SNV apply their internal financial monitoring and risk management systems and procedures.

For FMO and CFM’s role of providing loans and equity finance, the assessment of financial risk is embedded in the project assessment and approval process. FMO reviews each transaction and provides consent to eligible proposals. Departmental Investment Committees, comprising of senior representatives of several departments, review financing proposals for new transactions. Each financing proposal is assessed in terms of specific counterparty, product risk as well as country risk. All financing proposals are accompanied by the advice of the credit department before approval. This department is responsible for credit risk assessment of both new transactions and the existing portfolio.

In addition, the loans and equity investments of FMO are subject to periodic reviews, which are in general executed annually. Fair values of equity investment are reviewed periodically. Exposures that require specific attention are reviewed by the Investment Review Committee. The larger and higher risk exposures are accompanied by the advice of the Credit department. If the Investment Review Committee concludes that a client has difficulty in meeting its payment obligations, the client is transferred to the Special Operations department – responsible for the management of distressed assets – where it is intensely monitored.

CFM manages financial risk of its equity investments both at fund level and at individual investment level. At fund level CFM minimizes portfolio risk through diversification requirements, including limiting investments to a maximum of 25% of its capital into one single country and investing no more than fifteen percent of the total commitments into one project. Further financial risks at fund level are managed within the CFM’s Risk Appetite Framework. The fair value of each equity investment is reviewed periodically.

The amount of contingent liabilities include €453k for potential reputation risk expenses of the consortium.

Credit quality analysis

In addition to on balance loans, irrevocable facilities (off-balance) represent commitments to extend finance to clients and consist of contracts signed but not disbursed yet which are usually not immediately and fully drawn.

In measuring the credit risk of the emerging market portfolio at counterparty level, the main parameters are the credit quality of counterparties and the expected recovery ratio in case of defaults. Counterparty credit quality is measured by scoring counterparties on various dimensions of financial strength. Based on these scores, FMO assigns ratings to each counterparty on an internal scale from F1 (lowest risk) to F20 (default), equivalent to a scale from AAA to C ratings.

Non-Performing Loans

Non-Performing Loans (NPL) are defined when any of the following occur:

• • When FMO judges that the customer is "unlikely to pay" its credit obligation to FMO and IRC decides on a specific impairment on a loan (Stage 3);

  • Loans with interest, principal or fee payments that are past due for more than 90 days (Stage 3);

  • One of the loans is classified as non-performing due to criteria mentioned above, all loans of the customer will be identified as non-performing (Stage 3);

  • Forborne exposures which are economically performing but are still in probation (curing) period due to Regulatory Standards (Stage 2). Probation period before returning to performing status is one year;

  • Additional forbearance measures are applied for forborne performing loans which have exited the NPL probation (Stage 2);

  • Performing forborne loans which have exited the NPL probation period have past due amounts for more than 30 days (Stage 2).

The NPL percentage for the loan portfolio is nil as all loans are performing.

Modified financial assets

Changes in terms and conditions usually include extending the maturity, changing the interest margin and changing the timing of interest payments. When the terms and conditions are modified due to financial difficulties, these loans are qualified as forborne. Refer to paragraph related to 'Modification of financial assets' in the Accounting Policies chapter. At this point the loan is performing there are no forborne assets

Equity risk

Equity risk is the risk that the fair value of an equity investment decreases. It also includes exit risk, which is the risk that the Fund’s stake cannot be sold for a reasonable price and in a sufficiently liquid market.

The Fund has a long-term view on equity investments. The Fund can accommodate an increase in the average holding period of its equity investments and so wait for markets to improve again to realize exits. There are no deadlines regarding the exit date of equity investments. Equity investments will be assessed in terms of specific obligor as well as country risk. The performance of the equity investments in the portfolio will be periodically analyzed during the fair value process. Based on this performance and the market circumstances, exits will be pursued in close cooperation with our co-investing partners.

Counterparty credit risk

Counterparty credit risk in the treasury portfolio stems from bank account holdings and placements in money market funds to manage the liquidity in the Fund. The risk department approves each obligor to which the Fund is exposed through its treasury activities and sets a maximum limit to the credit exposure of that obligor.

Liquidity risk

Liquidity risk is the risk that insufficient funds are available to meet financial commitments. The Fund has a conservative liquidity management to ensure sufficient liquidity is available. In case of a liquidity shortfall, the Fund can make a funding request to FMO for up to a maximum of 10% of the Fund’s net portfolio.

Market risk

Market risk can be divided into interest rate risk and currency risk.

The interest rate risk is the risk of potential loss due to adverse movements in interest rates. Changing interest rates mainly have an effect on the value of fixed interest balance sheet items.

Currency risk is defined as the risk that changes in foreign currency exchange rates have an adverse effect on the value of the Fund’s financial position and future cash flows. The Fund offers financing in both hard and local currencies. Aim is to match currency needs of the clients, thereby reducing their currency risk. All equity deals are considered local currency given the local exposure.

Non-financial risk

Reputation risk

Reputation risk is inevitable given the nature of the Fund's operations in developing countries, focusing on water and land-use specific interventions. FMO has a moderate appetite for reputation risk, accepting that reputational impact of activities may incidentally lead to negative press coverage, NGO attention or undesirable client feedback, as long as these activities clearly contribute to FMO’s mission.

These risks cannot be completely avoided, but they are mitigated as much as possible through strict policies, upfront assessment and, when necessary, through agreements with the Fund’s clients. Potential impact is conducted by feasibility studies and impact assessments, evaluated either by professionals of FMO, CFM, WWF-NL or SNV, or as needed, by specialist third party consultants.

FMO has in place a Sustainability Policy, as well as statements on human rights, land rights, and gender positions. FMO and CFM have established an Independent Complaints Mechanism consisting of an Independent Expert Panel for assessing issues and breaches of their respective policies.

Environmental, social and governance (”ESG”) risk

Environmental & Social (E&S) risk refers to potential adverse impacts of the Fund’s investments on the environment, employees, communities, or other stakeholders. Corporate Governance (G) risks refer primarily to the governance of the client’s business activities. ESG risks can lead to non-compliance with applicable regulation, NGO and press attention or reputation damage. These risks stem from the nature of the Fund’s projects in difficult markets, where regulations on ESG are less institutionalized.

The DFCD actively manages ESG risks in its projects, which becomes in particular relevant for the investment facilities of CFM and FMO. The risk appetite for deviations from the exclusion list and human rights violations is zero. The Fund expects the highest standards in professional conduct. Each of the Fund’s investments complies with international standards for managing environmental and social impacts and risks, such as IFC Performance Standards, ILO Core Conventions, or the UN Guiding Principles on Human Rights. By taking an active role in the project development, CFM supervises, monitors and reviews project companies on an ongoing basis. In an event of an incident occurring, CFM will conduct a full investigation and a corrective action plan will be prepared.

Compliance risk

Compliance Risk is the risk of failure to comply with laws, regulations, rules, related self-regulatory organization, standards and codes of conduct applicable to FMO’s services and activities.

Definition

Fund’s customers follow FMO’s procedures to mitigate compliance risk. FMO’s standards and policies and good business practices foster acting with integrity. FMO is committed to its employees, customers, and counterparties, adhering to high ethical standards. FMO has a compliance framework that entails identifying risks, designing policies, monitoring, training, and providing advice. FMO has policies on topics such as financial economic crime (including KYC, sanctions, anti-bribery, and corruption and transaction monitoring and unusual transaction reporting), conflicts of interest, anti-fraud, private investments, protection of personal data and speak-up.
FMO also regularly trains its employees to raise awareness through virtual classroom trainings and mandatory compliance related e-learnings. Employees are also encouraged to speak up in case of suspected integrity violations conducted by an FMO employee. Management is periodically informed via the Compliance Committee or when required on an ad-hoc basis, on integrity related matters at customer or employee level. In case of signals of violations, e.g., money laundering, fraud or corruption, Management will take appropriate actions.

The governance of compliance also entails the following key risks:

Financial Economic Crime, incl. sanctions

FMO’s financial economic crime procedures include, amongst others, screening of customers on compliance with applicable anti-money laundering, counter financing of terrorism and international sanctions laws and regulations. Due diligence is performed on customers, which includes checks such as identifying and verifying the ultimate beneficial owners of the customer we finance, identifying politically exposed persons, and screening against relevant international sanctions lists. These checks are also performed regularly during the relationship with existing customers.  

There is always a risk that a customer is involved or alleged to be involved in illicit acts (e.g. money laundering, fraud or corruption). If such an event occurs, FMO will initiate a dialogue with the customer, if possible and appropriate given the circumstances, to understand the background in order to be able to assess and investigate the severity. When FMO is of the opinion that there is a breach of law that cannot be remedied or that no improvement by the customer will be achieved (e.g. awareness, implementing controls) or that the risk to FMO’s reputation is unacceptably high, FMO may be able to exercise certain remedies under the contract such as the right to cancel a loan or suspend upcoming disbursements and will report to regulatory authorities if deemed necessary.

In 2021, FMO completed its financial economic crime (FEC) enhancement project. This included an extensive Know Your Customer (KYC) file remediation, tailored to the specific requirements of developing and emerging economies. The external validation, which was overall positive, identified several recommendations that FMO has followed up in 2022. For certain compliance themes, such as anti-bribery and corruption, as well as sanctions and unusual transactions, awareness sessions (refreshers) were organized with targeted front-office departments. We are determined to continue to improve in the regulatory domain and to ensure that the changes we implement are tailored to the day-to-day realities and complexities of the markets we are active in.

General Data Protection Act (GDPR)

In 2021, FMO started a project to further develop a data privacy framework and raise privacy awareness within the organization. The project is almost completed and has delivered several essential privacy improvements. A GDPR eLearning for all employees was rolled out to ensure the necessary knowledge within the organization. Next to that the privacy governance is strengthened in the organization by appointing a Data Protection Officer (DPO). The DPO conducts privacy assessments in new projects and initiatives, gives advice on reducing privacy risks and monitors FMO's privacy compliance.

Sanctions

Several additional measures have been taken since the start of 2022 in relation to sanctions involving Russia, Belarus and Myanmar to ensure FMO’s funds are not directly or indirectly provided to sanctioned parties. These measures include, setting up of a Sanctions Working Group, increased frequency of adverse news screenings and communication with customers in the affected regions and industries. In August 2022, FMO received a request from DNB to participate in an industry-wide investigation on the effectiveness of its sanctions screening system (transaction screening and customer screening).

Operational risk

Operational risk is the risk of loss resulting from inadequate or failed processes, people and systems or loss caused by external events. Operational risks are not actively sought and have no direct material upside in terms of return/income generation, yet operational risk events are inherent in operating a business. Operational risk events can result in non- compliance with applicable (internal and external) standards, financial losses or misstatements in the financial reports, and reputational damage.

Overall, FMO is cautious with operational risks. Safe options, with low inherent risk are preferred, despite consequence of limited rewards (or higher costs). There is no appetite for high residual risk. Risk metrics are reported on a quarterly basis. These metrics cover operational risks in general, such as the amount of loss per quarter and timely follow-up of management actions, and specific metrics for risk-(sub)types.

Management of the first line of defense is primarily responsible for managing (embedded) risks in the day-to-day business processes. The first line acts within the risk management framework and supporting guidelines defined by specialized risk functions that make up the second line of defense. Internal Audit in its role of the third line of defense provides independent assurance on the effectiveness of the first and second lines.

Departmental risk control self-assessments are conducted annually in order to identify and assess risks and corresponding controls. The strategy and business objectives are also reviewed annually by the Directors in a risk perspective. Based on among others these Risk and Control Self Assessments, the Directors sign a departmental In Control Statement at the year-end, which provides the underpinning for the management declaration in the Annual Report. Despite all preventive measures, operational risk events will occur. FMO systematically collects risk event information and analyses such events to take appropriate actions.