Sustainable Finance

Connecting the dots: ESG risks and the financial sector

Racia Yoong | Aug 24, 2021

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Source: Nicholas Ahonen through Pixabay

“Impact investing”, “sustainable finance”, “green loans” and “sustainability-linked” portfolio. What do all these terms mean? From bioplastics to all organic, sustainability buzzwords have come a long way since the beginning. As sustainability starts to take center stage in the global economy, greenwashing or ‘cherry picking’ in the financial industry has morphed into a substantial concern for investors looking to approach an ESG investment.  

Today, social media brings attention to environmental causes and sustainability is rapidly gaining importance in society as the awareness of issues like climate change and corporate misconduct infiltrate the market space. With that also comes the evolution of sustainability reporting, which has become a key source of communication for companies to disclose information about the ESG (environmental, social and governance) dimensions of their sustainability performance.

The Implications of “ESG Risk” on the Financial Sector

Before we dive right into the topic of “ESG risk”, have you ever wondered what is the link between the role of the financial industry and ESG-related or environmental risks? 

Foremost, sustainability reporting helps to build a company’s reputation for transparency, often resulting in higher stakeholder returns. Do also bear in mind that “sustainability” reporting is interchangeably used with “ESG” reporting. Therefore, all dimensions considered, practicing sustainability goes beyond ‘saving the polar bears’ or ‘growing more trees in the Amazon’. In fact, financial regulators are starting to see ESG as having a material impact on the company’s performance – and compliance with international reporting guidelines and establishing a strong governance oversight on organisational policies is key to supporting the same. 

As such, financial executives need to be aware of ESG risks – physical, transitional and reputational – and their implications on the financial institutions. By integrating regulatory requirements regarding sustainability into frameworks, businesses are actively positioned to manage the potential challenges posed by unforeseeable regulatory and market changes. However, considering how risks associated with ESG are often a cause-effect relationship, developing a comprehensive risk strategy is likely a complex journey.

Accelerating Climate-Related Disclosures

The TCFD (Task Force on Climate-Related Financial Disclosures) is a market tool designed to guide the communication of corporate reporting on climate-related risks to financial stakeholders – investors, lenders and insurers.  The work of the Task Force has resulted in increasing investor scrutiny for disclosures of climate-related risk, coupled with growing momentum of corporate disclosures on the topic around the world. Scenario based testing of climate-related risks and capital planning are some effective ways to understand how ESG risks might impact the business and help companies shift through changing market dynamics by planning appropriate responses.

The key message here is for the financial sector to take on a forward-looking view on the organization’s vulnerability to ESG risks. However, the challenges that companies in the financial sector face in making such disclosures may discourage their efforts.

Some of the common challenges include:

  1. Lack of a standardized approach for integration of ESG factors

Due to the complex nature of the ESG landscape, determining which ESG factors to integrate into a financial institution can be highly discouraging. In fact, to effectively integrate ESG into a financial institution is dependent on the organization’s resource availability, company culture, target market and risk appetite. Systemic road mapping can be used to support a company’s approach in their own ESG development in a targeted and long term manner.

  1. Lack of consistent communication on ESG performance

Regulatory support has been a major push in the right direction for many businesses. Fortunately, with regulatory requirements, we are starting to see sustainability reporting and disclosures common practice among those in the financial sector. However, communication among the different stakeholders must be cognizant to ensure that vested interest is consistent.

  1. Lack in ESG data accuracy

While it is encouraging to see an increase in the number of companies practicing disclosures due to regulatory requirements, the quality and accuracy of data remains unvalidated and at times, uncorrelated. Due to the rise in the number of reporting frameworks and ESG metrics in the market, ESG scores have been found to provide contradicting information about a company’s ESG performance that are at times questionable. In fact, to supplement this data gap, proxy data is often used to address ESG factors – which is not entirely ideal as some proxies can modify the accuracy of data.

Nonetheless, despite these challenges, it is encouraging to see a rise in reporting from the financial sector.

Source: ESG 2020: the Transformation of Financial Services, Russell Reynolds Associates

Getting Started

As ESG-related issues and sustainability concerns evolve with climate-related financial reporting, the TCFD recommendations provide a strong foundation to improve investors’ and stakeholders’ oversight to accurately assess climate-related risks and opportunities; subsequently, setting the best “price” on investment activities and financial products. The way forward for corporates and financial institutions must involve active engagements with the board for continuous oversight, commitments from senior management to monitor the quality of financial disclosures on climate-related issues, and where resources apply, for companies to build up internal capacity and training to equip their staff with expertise and skills to support the same agenda.

Improving ESG practices begins with the willingness of market players to embark on this journey. Ultimately with time this will improve ESG-related data quality and quantification analytics to standardize the financial disclosures of climate-related risks in the global economy. The time to act for financial institutions is now.

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