For over a decade, several Costa Rican financial institutions, both public and private, have incorporated processes to manage the environmental and social risk of their loan portfolios. The vast majority of these institutions have acted upon the request of multilateral development agencies, which seek to reduce their reputational risk. The rest have done so on their own initiative, aware that the need to incorporate this analysis will come sooner or later.
This requirement is standing just around the corner. By December 2026, at the latest, financial institutions must have an environmental and social risk management framework for their lending and investment activities. This was proposed last July by the National Council for the Supervision of the Financial System (CONASSIF) through a proposal to amend the June 2010 regulation on integrated risk management.
Challenging our sustainable imaginary
In the last twenty years, there have been frequent reports in the press questioning the idea of a sustainable Costa Rica. There have been problems of contamination of aquifers or water sources by agrochemicals due to excessive use of these substances or the destruction of the protection areas of these aquifers. This has occurred in both the Central Valley and the Caribbean area.
In the north, third-party workers have been reported, who are not insured and do not receive overtime pay. The International Labor Organization ranks Costa Rica as the most dangerous country to work and reports around five fatal work accidents per month, mostly associated with construction activities. On the other hand, in the South Pacific, there have been murders due to land disputes in indigenous territories.
Despite all this, the most frequent question when financial institutions in the country address environmental and social risk management is, why do we have to worry about these risks if in Costa Rica we are very green, we have robust legislation on environmental and social issues and, in addition, there are institutions in charge of overseeing these processes?
The oversight capacity of state institutions is limited. This generates a false sense of good performance of the companies, until the bad news happen: deaths, water source closures and labor accidents. On the other hand, it is key to address the problem of climate change, as requested by the amendment to the Regulation on Integrated Risk Management. We are located in an area highly vulnerable to climate change, which will directly or indirectly affect all economic activities.
Leadership, tools and competencies
The environmental and social risk of the loan portfolio is managed through an Environmental and Social and Management System (ESMS). Simply put, an ESMS is everything a financial institution does to identify, mitigate and monitor portfolio risk. An ESMS is successful when clients perceive that the financial institution wants to help them improve their performance. Sometimes this means that the institution must finance some of these improvements.
An ESMS should not mean more bureaucracy. On the contrary, it should be incorporated into the institution’s day-to-day operations. This is achieved through a working group that validates processes and tools and involves personnel from the credit, legal, commercial, institutional risk and sustainability areas. In addition, the appointment of an ESMS manager to lead, validate and assist with the definition of the risk appetite is key.
On the other hand, the tools are designed for the reality of the country in which they are applied and not for generic situations. In other words, the evaluation of a farm in Costa Rica should focus on the respect of protection areas, the correct application of pesticides and the fair payment of overtime. In addition, those who are going to use these tools must develop the skills to identify risks and relate to clients and their collaborators in a constructive way.
Climate risk management
Climate risk can be managed within an ESMS. It is just another environmental risk. The activity or project to be financed will have a physical risk associated with its location, for example, suffering from potential flooding due to sea level rise, and a transition risk, which is associated with changes in policy, regulation, technology or market behavior.
Geographic Information Systems (GIS) are often used to assess physical risk. Transition risk is assessed, at least in its initial stages, by associating the activity with existing taxonomies or by checking its compatibility with Nationally Determined Contributions (NDCs).
Environmental and social risk management of the loan portfolio is one of the aspects requested by the proposed amendment to the Integrated Risk Management Regulation. The proposal also includes the need to address these risks in investment portfolios. In those cases, the analysis is based on the availability of environmental, social and governance ratings or indices. This could be addressed in a future article.