Financial institutions around the world are increasingly facing risks due to regulatory and reporting requirements that focus on the environmental, social and governance (ESG) impacts of their operations.
ESG strategy is crucial
There has been new legislation on ESG matters for the financial sector in 2021, including the Sustainable Finance Disclosure Regulation in the European Union and the Executive Order on Climate-Related Financial Risk in the United States.
The ESG performance of companies and financial sector institutions gradually influences investment decision making, lending criteria and insurance considerations. Clearly, companies unable to demonstrate an ESG strategy will jeopardize the long-term viability and resilience of their business.
While there is no definitive list of ESG risks for financial institutions to consider, they typically include a mix of the following.
Criteria examining an organization’s impact on the planet include:
- Calculation of a company’s total emissions, as a measure of its commitment to fight climate change.
- An entity’s plans for the transition to low-carbon use to ensure energy security.
- Monitoring and reporting of greenhouse gas (GHG) emissions.
- Set targets for pollution and waste practices.
- The projects in which they invest or lend and the impact of these projects.
For financial institutions, the transition to green finance is not only key to an organization’s reputation, but is also emerging as a regulatory requirement globally.
Criteria examining how an organization treats and values its employees and surrounding communities include:
- Labor management policies.
- Health, safety and well-being commitments.
- Impacts that an organization has on the local community and whether these effects are beneficial or negative.
- Labor standards of a company’s suppliers.
These concerns are just a few of many for financial institutions, along with the need to incorporate policies for diversity and inclusion, social equality and customer privacy.
Governance criteria assess the corporate governance practices of a company. These focus on the structure of the board of directors, in particular the diversity of the board of directors, the quality and transparency of the audit, and compensation issues, such as executive compensation.
ESG risk preparedness varies
Financial institutions currently differ significantly in their preparation for the transition to sustainability, at which point organizational agility to meet new laws, requirements and customer expectations is going to be key.
In a recent Marsh poll, 80% of respondents in the financial services industry ranked climate change and ESG factors as an important or most important issue for their operations.
However, 42% of those surveyed said they have an ineffective process, if any, to identify, respond to and implement changes based on climate threats and ESG factors.
The survey also found that 80% of financial companies had yet to perform a full stress test on the financial impacts of climate threats on their current and future operations.
Organizations that take a more proactive and methodical approach to understanding the impact that ESG factors and climate change will have on their most valuable assets will undoubtedly be able to incorporate higher levels of resilience into their operations. As more attention is paid to ESG concerns globally, the need to act will continue to increase sharply.
Key actions to be taken include:
- Evaluate the implications of ESG for your organization using industry data, risk indices, physical climate models, and the perspectives of key stakeholders.
- Analyze and establish ways to control the physical, transition and reputational risks associated with ESG for your organization.
- Analyze external reporting requirements. Many financial institutions around the world are already aligning with reporting frameworks, such as the Climate-Related Financial Disclosures Working Group (TCFD) and the Global Reporting Initiative (GRI).
By acting on the above, support the execution of ESG objectives in line with an organization’s risk appetite and integrate the practices into established environmental resource management and resilience frameworks.