Over the two days we heard a number of different speakers discussing the challenges posed by greater interest and awareness of ESG issues, particularly in respect of climate change. The discussions across the two days could be bundled into the following:
Integrating ESG information into more informed risk decisions
How financial services should address the risks posed by climate change
How regulators are holding financial institutions accountable for ESG
We have tried to capture the essence of these discussions below.
Integrating ESG information into more informed risk decisions
Sustainability, ESG and CSR are used interchangeably in business to refer to the integration of social and environmental considerations such as climate change and income inequality into business strategy and capital allocation process.
Prior to the Covid driven health crisis, much of the focus on ESG was on the climate change agenda. However, over the last 6 months, social aspects have risen up the priority list and acted as a catalyst to improve:
Restructuring/crisis management
Social responsibility
Stakeholder capitalism – moving from a focus on investors and shareholder value with its shorter-term incentives to include customers, suppliers, employees, and communities and a longer-term stakeholder value
With this widened focus, there is then the challenge of knowing what is relevant. A wealth of information is available but the sheer volume of sustainability issues that attract investment (see below) raises the question of materiality.
Source: MSCI ESG Research
A Harvard study* provides the first empirical evidence that good performance on material issues contributes to higher financial returns and out performance of firms that either do well on immaterial issues or perform poorly overall. So, if there is a positive relationship between ESG and financial performance (and investment returns), then screening for competence in ESG makes sound economic sense.
However, it is not as simple as it sounds. The materiality of different sustainability issues varies systematically across firms and industries. It also varies depending on who is measuring the issues and their materiality – there is a lack of correlation between ESG ratings providers, especially around governance, despite being based on the same available data.
Additionally, even if these all did align, it is not a panacea. Boohoo rated highly before allegations of poor working practices came to light. This just goes to emphasise that firms still need to do the due diligence on the firms they are engaging with.
There is still a long way to go. Much of the coming months and years effort will be focused on improving these indicators within risk teams, integrating this information into their risk appetite, governance, models and reporting with those who are most successful reaping the financial benefit.
How financial services should address the risks posed by climate change
The risks posed by climate change are now beginning to be considered a mainstream financial risk. The risks posed can be subdivided into transition risk (the financial risks which could result from the process of adjustment towards a lower-carbon economy) and physical risk (event driven or longer term shifts in climate patterns creating financial implications such as direct damage to assets and indirect impacts on, e.g., supply chain disruption). It is incumbent on firms identify and monitor these risks to ensure financial resilience.
The challenge presented by climate change is driven by many factors, not least:
The time horizons are longer than we are accustomed to thinking about – especially banks.
There are huge uncertainties on the risks we are facing – the climate and the range of political and economic responses to it are so complex, even the most sophisticated models cannot predict the multitude of possible outcomes
The impacts are non-linear on socio-economic outcomes, with huge cliff edge effects e.g. a small increase in the level of flood water can change a small loss into a huge one.
The transition to a low carbon economy is going to be hard to manage. Financial institutions will need to balance supporting and nurturing green clients with a strong financial future whilst not abandoning existing clients who may be swept away by transition or not just on the path as yet. This will require balancing the risks and opportunities presented by both types of client.
Many feel that the financial services industry must take a leadership role, that it has a responsibility to society, even more so since the financial crash. Banks, insurers and asset managers can offer more green products and promote green culture. How they behave and products they roll out can influence and change society in a significant way. However, firms must not fall into the cynical trap of “green-washing”. Firms need to take people with them but to do this successfully there must be authenticity behind their decision making and the governance and frameworks that support it.
Some insurers are well placed to provide this leadership role. The industry has a long history of weather-related risk management and have more sophisticated tools to do so than their banking counterparts. They also, particularly in their life businesses, have longer duration credit portfolios that are increasing in size due to the Solvency 2 benefit these accrue.
To get themselves ready to lead the way in climate risk management, firms will need to embed climate considerations into their strategic thinking and by using levers such as pricing and risk appetite to ensure incentives and actions provide the right outcomes. It requires a lot of effort in particular with regard to governance:
Who will be responsible for assessing the climate change risk?
How is climate change risk measured and converted into risk appetite?
How do we monitor against risk appetite?
How do we reflect these in our disclosures through financial reporting?
Climate risk will also have to be incorporated into the already complex macroeconomic stress testing. This is hard enough and imprecise as it is, and climate change modelling will be even more so but this doesn’t mean it should be ducked. In fact, stress testing needs to be more dynamic in order to manage the increasingly likely cliff effect – e.g. sudden changes in government policy.
Looking ahead to 2021 there is a huge amount of work to do for those tasked with delivering on the above agenda, not least the PRA stress testing, analytical development, enhancing governance and increasing disclosure to meet investor demands.
However, at the end of the conference, one of the panel speakers made the very salient point: it is not just incumbent on firms to mitigate and manage climate risk and impacts but on all of us at personal level - we each need to do our bit no matter how small.
How regulators are holding financial institutions accountable for climate change
This topic has been on the agenda for firms for several years. The primary reason is that it is something regulators focused on – the PRA in particular – and so the industry followed. For now, the regulators are focussing on financial stability and management of risk but once that is mastered, expectations are that they will use their influence to facilitate and incentivise a transition to a more sustainable economy.
The regulators are continuing to churn out new regulation, all looking to see improvements in firms’ governance, risk monitoring and disclosure. However, the regulators are moving at a different pace to each other and there is a need for firms to manage the differing expectations:
The PRA are seeking to lead the agenda, requiring firms to assess themselves against supervisory statements and providing feedback on where the firms need to do more work. They are expecting embedding of plans into day to day governance by the end of 2021
The ECB (and the US regulators) are more focussed on managing and monitoring the climate change risk but still aligned with PRA guidance, for now.
Current expectations are that the board to has an informed business strategy, linked to the firm’s strategic objectives and dedicated senior manager responsibility. The business plans that are developed from this must be global in nature (for multinational firms) and not just for the location of the parent company. After all, this is a global issue.
To achieve this, firms must be developing tools to identify, measure and monitor the risks and their links to business strategy. As discussed above, stress testing, already a difficult and complex process, will need to include scenarios related to climate change for both physical and transitional risks in the short term (3-5 years) and long term (decades).
All this activity will mean that dialogue with the regulators is imperative. Only by working closely with them, will the challenges be met in a sustainable, constructive fashion.
* “Corporate sustiainability”: First Evidence on Materiality. Khan, Serafeim, Yoon, Accounting Review Vol 91 (Nov 2016)