The hallmark of sustainable finance is the integration of environmental, social and governance (ESG) factors in the DNA of a financial institution, from strategy to investment and credit decisions to risk management all the way to external reporting.
First, let’s define ESG risks:
1. Environmental Risks
The way a company impacts on and interacts with natural capital. Leaders agree that climate change poses one of the greatest threats to our planet, and that we should reshape our societies to be climate resilient. The ‘E’ includes physical risks such as biodiversity loss and the increased risk of flood and extreme weather events. Investors also face so-called transition risks, i.e. risks linked to the transition to a low-carbon economy. An example of transition risk is the shift to new technologies. Technological breakthroughs might decrease the price of renewable energy, leading in turn to a steep drop in the demand for fossil fuels and a radical change in the energy mix.
2. Social Risks
The way a company affects its various stakeholder groups (employees, suppliers, contractors, consumers and others). Negative social impacts can occur through direct operations and value chains. ‘S risks’ typically include the risk of infringing on the human rights of stakeholders. For investors, managing ‘S’ comes down to understanding which stakeholder groups are affected by the companies in their lending or investing portfolios, and assessing the extent to which these stakeholders are at risk of suffering any negative impacts as a result of corporate practices.
3. Governance Risks
Relates to two core components: corporate governance and business integrity. The first can really be seen as the way a company ‘governs’ itself through policies, processes and controls to achieve compliance and secure transparency in its dealings. Business integrity, on the other hand, is about the way a company steers clear of corruption and bribery and avoids openly engaging with politically exposed persons who may pose a reputational risk to the company’s brand.
ESG risks cover issues ranging from a company’s response to climate change, to the promotion of ethical labour practices, to the way a company grapples with questions around privacy and data management. A growing number of investors, both institutional and retail (non-institutional), and in developed and emerging markets alike, look at ESG risks as a testing ground for their portfolio companies.
The following 6 key challenges can – if properly tackled – move financial institutions towards not only compliance to ESG regulation, but also to long-term value creation:
Challenge 1 –Seeing past the ESG label and getting to the issues
The hard work of breaking down E, S and G for a specific company or investor is the starting point to any successful ESG approach. For example, when defining its material ESG risks a Dutch bank can break down each sub-category into a concrete area of focus. Instead of pushing to address human rights, it can decide to work on those human rights that present a concrete risk for the bank in its roles as employer, lender or investor. This analysis, and the effort to tie the risks to the core activities of the bank, can unearth the specific rights at risk of being negatively impacted.
Challenge 2 –Integrating ESG in the credit or investment cycle
Once an investor has understood which ESG issues to focus on, questions of ‘how’ and ‘where’ to address them remain. When investors – be it banks or asset managers or development finance institutions – plan on moving ESG from policy to practice, it is useful to embed ESG in existing processes rather than creating parallel checks. The credit or investment cycle is the formal flow of decisions playing a central role in how funds or assets are managed, and these processes are therefore the natural framework for ESG integration.
Challenge 3 – Adapting stakeholder management and spreading ESG knowledge in-house
Many investors have the chance to directly engage with the companies in their portfolio. The due diligence phase, the post-investment phase and the reporting check-ins all represent opportunities for the investor to collect and analyse ESG information about a company. Making sure that those chances are used in the best possible way to manage ESG risks is essential.
Challenge 4 – Using CDD / KYC practices for ESG data collection
Data collection is essential for investors to successfully identify and assess ESG risks and integrate ESG into risk modelling.Collecting this information is however resource-intensive and may require investors to contact individual clients. Resorting to third parties such as ESG data providers is helpful, although information obtained through these channels is not always comparable and is not equally mature for all asset classes. Where possible, investors can use their existing Client Due Diligence/Know Your Customer (KYC) to collect and process the data. Integration of ESG into KYC would also remove the need to design and implement new channels and systems for client outreach, thus avoiding generating so-called reporting fatigue on the clients’ side.
Challenge 5 –Delivering and communicating on ESG commitments
Every financial institution may at some point need to show why and how they have taken care of their ESG risks and if they managed to harness ESG opportunities. A clear baseline showing the ESG status of the company at the time of acquisition, accompanied by the roadmap of ESG actions undertaken during the holding period and the outcome of these actions would help buyers grasp the added value of ESG alongside the financial valuation information.
Challenge 6 –Integrating ESG in Risk Management Framework
Financial institutions can make themselves future-proof by integrating ESG risks in every stage of the risk management framework. This ensures that ESG risks are holistically integrated in existing risk practises. For instance, under risk monitoring, financial institutions should frequently engage with sustainability experts to stay informed on developments. For ESG risk identification, investors should consider whether their investments are concentrated in specific industries or regions. Climate stress testing can be used for ESG risk assessment. And finally, ESG risk can be mitigated by means of exclusion policies or adapted risk premiums.
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I'm a seasoned expert in the field of sustainable finance, with a comprehensive understanding of environmental, social, and governance (ESG) factors in the financial sector. My expertise extends from the strategic integration of ESG principles to investment and credit decisions, risk management, and external reporting. I've been actively involved in the practical implementation of ESG frameworks, making a tangible impact in promoting sustainable practices within financial institutions.
Now, let's delve into the concepts mentioned in the article about sustainable finance:
Environmental Risks (E Risks):
Environmental risks focus on a company's impact on natural capital. This includes biodiversity loss, increased risks of floods, and extreme weather events. Transition risks, such as shifts to new technologies affecting demand for fossil fuels, are also considered.
Social Risks (S Risks):
Social risks involve how a company affects various stakeholder groups, including employees, suppliers, contractors, and consumers. Negative social impacts can arise through direct operations and value chains. Managing social risks requires understanding and assessing the potential negative impacts on stakeholders.
Governance Risks (G Risks):
Governance risks encompass corporate governance and business integrity. Corporate governance involves how a company governs itself to achieve compliance and transparency. Business integrity is about avoiding corruption and bribery, steering clear of politically exposed persons that may pose reputational risks.
Key Challenges for Financial Institutions:
Challenge 1 – Seeing Past the ESG Label: Understanding and breaking down specific ESG issues for a company or investor is crucial. It involves identifying concrete areas of focus, such as human rights, and relating them to the core activities of the institution.
Challenge 2 – Integrating ESG in the Credit or Investment Cycle: Embedding ESG in existing processes, particularly the credit or investment cycle, is essential for effective integration into decision-making.
Challenge 3 – Adapting Stakeholder Management and Spreading ESG Knowledge In-House: Direct engagement with portfolio companies provides opportunities to collect and analyze ESG information. Ensuring effective stakeholder management and in-house knowledge dissemination is key.
Challenge 4 – Using CDD/KYC Practices for ESG Data Collection: Effective data collection for ESG risk identification requires integration with existing Client Due Diligence/Know Your Customer practices to streamline the process and avoid reporting fatigue.
Challenge 5 – Delivering and Communicating on ESG Commitments: Financial institutions need to showcase their ESG efforts and outcomes over time, demonstrating the added value of ESG alongside financial valuation information.
Challenge 6 – Integrating ESG in Risk Management Framework: Future-proofing financial institutions involves holistically integrating ESG risks into every stage of the risk management framework, including monitoring, identification, and mitigation.
This comprehensive approach is crucial for financial institutions not only to comply with ESG regulations but also to create long-term value through sustainable practices. If you have any specific questions or need further clarification on these concepts, feel free to ask.
