Q&A: ESG risks in financial services

May 2024  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

May 2024 Issue

FW discusses environmental, social and governance (ESG) risks in financial services with Anthea Bowater at Freshfields Bruckhaus Deringer and Myron Mallia-Dare at Miller Thomson LLP.

FW: Based on your experience, what level of priority are financial services (FS) firms typically assigning to environmental, social and governance (ESG) issues?

Bowater: In my experience, financial services (FS) firms in the UK consider environmental, social and governance (ESG) matters to be high priority. This is partly because planning for the transition to net zero influences the strategic direction of firms and therefore impacts everything from the type of business that firms want to grow and the opportunities they want to take advantage of to the way that they engage with clients now. ESG matters are also given high priority because of the increasing expectations from the financial regulators in the UK, the expectations from investors and employees, the targeted campaigns from action groups, and the risk of high-profile litigation and potential for reputational damage if firms are perceived to have mishandled ESG-related matters. I also think that many firms genuinely want to do the right thing in this space.

Mallia-Dare: In my experience, the priority assigned to ESG issues by FS firms varies significantly. While some firms have elevated ESG considerations to the forefront of their business strategies, embedding sustainability principles into their core operations, others are still grappling with how to effectively integrate ESG factors into their decision-making processes. The level of priority often depends on factors such as organisational culture, regulatory environment, investor pressure and market dynamics. Firms that recognise the strategic importance of ESG tend to view it as essential for long-term value creation, risk management and stakeholder engagement. However, achieving widespread adoption of ESG practices remains a challenge, such as balancing short-term financial goals with long-term sustainability objectives and navigating the complexities of measuring and reporting ESG metrics accurately. As the business case for ESG continues to strengthen, driven by evolving stakeholder expectations and regulatory requirements, more FS firms are likely to prioritise ESG considerations as a core aspect of their business strategy.

FW: Could you outline some of the key ESG risks facing FS firms today? How have these risks shifted in recent years?

Mallia-Dare: The landscape of ESG risks facing FS firms is complex and continually evolving. Climate change-related risks, including physical risks from extreme weather events and transition risks associated with shifting regulations and consumer preferences, are top concerns for FS firms globally. These risks have intensified in recent years due to the increasing frequency and severity of climate-related events and the growing recognition of the financial implications of climate change. Social risks, such as labour practices, human rights violations, and diversity and inclusion challenges, have also gained prominence, driven by heightened public awareness and stakeholder scrutiny. Additionally, governance risks, including board effectiveness, executive compensation and regulatory compliance, remain critical considerations for FS firms, particularly in light of recent corporate scandals and regulatory reforms. Overall, the evolution of ESG risks reflects broader shifts in societal expectations, regulatory frameworks and market dynamics, underscoring the need for FS firms to adapt their risk management strategies accordingly. Engaging legal counsel with experience in ESG has become more critical.

Bowater: Around five years ago, the main risks faced by FS firms in the UK were the risks of being criticised – potentially via litigation – for failing to disclose or take account of climate-related financial risks. Now, the litigation risks are much more developed and complex. These risks have shifted from those associated with lack of disclosure and planning to the risks of having inaccurate or inadequate disclosures or ESG-related policies, which can be challenging due to the volume of ESG-related information which FS firms now need to disclose, how fast perspectives on what is acceptable are changing, and developments in how different risks, such as climate risks, should be measured. FS firms are now also expected to have more oversight over the operations of their clients and counterparties too, and litigants are trying to find ways to hold firms to account where they consider that they should be taking additional steps before supporting particular types of clients or projects. To make matters even more complex, firms operating in the US must balance these risks with the risks of anti-ESG litigation. Regulatory risks in the UK are focused on similar themes, with the added complexity of complying with the various prudential requirements on the management of climate risks and the Financial Conduct Authority’s sustainability-related labelling rules, many of which come into force this year.

“Establishing a comprehensive ESG strategy is essential for FS firms to effectively manage associated risks and seize opportunities for long-term value creation.”
— Myron Mallia-Dare

FW: How have evolving ESG regulations changed the way FS firms measure and monitor their ESG performance, and make related disclosures to the market?

Bowater: There has been an enormous amount of ESG-related regulation implemented over the last few years – and not all of it is consistent, which means that firms operating in multiple jurisdictions often need to consider competing requirements. In the UK, there are prudential requirements for FS firms, labelling requirements directed at certain types of investments and requirements that firms report in line with the Taskforce on Climate-Related Financial Disclosures (TCFD). The TCFD has probably had the broadest impact, requiring firms to plan and disclose their climate-related risks in a coherent way that is consistent with global practice. This standardisation is key for the market to be able to compare and assess firms’ relative positions, and it has also had the effect of pushing firms to develop their reporting capabilities faster.

Mallia-Dare: Establishing a comprehensive ESG strategy is essential for FS firms to effectively manage associated risks and seize opportunities for long-term value creation. A robust ESG strategy begins with a thorough assessment of ESG risks and opportunities, considering factors such as industry trends, stakeholder expectations and regulatory requirements. FS firms must then develop clear governance structures and accountability mechanisms to oversee the implementation of their ESG strategy, involving key stakeholders at all levels of the organisation. Additionally, integration of ESG considerations into decision-making processes and performance metrics is crucial for driving meaningful change and ensuring the long-term sustainability of the firm. Furthermore, FS firms should prioritise stakeholder engagement and transparency, fostering dialogue with investors, customers, regulators and communities to build trust and enhance their reputation as responsible corporate citizens.

FW: How should FS firms go about establishing an ESG strategy to manage associated risks?

Mallia-Dare: While regulatory compliance is a critical first step, FS firms can unlock the full benefits of embracing ESG by going beyond basic requirements. This entails adopting a proactive approach to ESG integration, embedding sustainability principles into the organisation’s culture, operations and strategic decision making. By viewing ESG as a strategic imperative rather than a compliance obligation, FS firms can enhance their reputation, attract top talent and gain a competitive edge in the market. Moreover, proactive engagement with stakeholders, including investors, customers, employees and communities, can create new opportunities for value creation and long-term growth, driving innovation and fostering resilience in the face of evolving ESG challenges. Ultimately, FS firms that prioritise ESG as a core aspect of their business strategy stand to benefit from enhanced brand loyalty, stakeholder trust and financial performance in the long run.

Bowater: Many firms in the UK already have good ESG strategies in place, particularly on climate risks, as this is something that financial regulators have been very focused on. However, for any firm looking to establish a good ESG strategy, I would recommend identifying the key ESG risks for the firm’s businesses and understanding how the different risks interact, such as the risks of climate and biodiversity loss, and then mapping out a strategy with clear objectives. Governance is key – so mechanisms for oversight and monitoring progress will be important. It is then crucial that the different business lines all understand how they are contributing to the firm’s strategy so that they can ensure their activities are consistent.

FW: Do you believe FS firms should go beyond basic regulatory compliance to unlock the full benefits of embracing ESG? What additional steps might they take?

Bowater: FS firms should be thinking beyond regulatory compliance and management of ESG-related risks. There is a lot of opportunity for firms to capitalise on the way that investors’ requirements are changing, for example, and to take advantage of the way that the economy will change during the transition to net zero. Obviously, the way firms embrace ESG is important though – the transition needs to be managed appropriately, which for FS firms may mean thinking about how to engage with clients in carbon-intensive industries and help them to transition, and thinking through the wider impacts of decisions made about particular clients. In terms of diversity and social objectives, there is research demonstrating that decisions made by diverse teams are better and more balanced in the long-run, which is certainly another reason to embrace this part of ESG.

Mallia-Dare: While regulatory compliance is essential, FS firms can unlock additional benefits by going beyond basic requirements and embracing ESG as a strategic opportunity. This may involve adopting best practices in ESG management, pursuing innovation in product and service offerings, engaging with stakeholders proactively and fostering a culture of sustainability throughout the organisation. By doing so, FS firms can enhance their competitive positioning, attract capital from responsible investors, and contribute positively to society and the environment.

“Financial regulators in the UK want to ensure that firms continue to invest in sustainable finance, but also want to build trust in those markets, so will be particularly on the lookout for any serious instances of greenwashing.”
— Anthea Bowater

FW: In your experience, are the boards of FS firms engaged enough in the ESG performance of their organisations to drive action? Do they need to take a more active role?

Mallia-Dare: Boards of FS firms play a pivotal role in driving ESG performance and ensuring accountability across the organisation. However, many boards have yet to fully engage with ESG issues, viewing them as peripheral to core business activities. To address this gap, boards must take a more active role in overseeing ESG strategy and implementation, integrating sustainability considerations into board-level discussions and decision-making processes. This requires board members to possess a deep understanding of ESG risks and opportunities, as well as the ability to effectively challenge management and drive meaningful change. By prioritising ESG at the board level, FS firms can demonstrate their commitment to sustainability and build trust with stakeholders, enhancing their reputation and long-term resilience in an increasingly complex and interconnected world.

Bowater: Boards in the UK are certainly often engaged, and are likely to be focused – rightly – on the significant ESG-related risks and opportunities rather than day to day regulatory compliance issues. In this context there is a lot to grapple with, such as how directors can feel confident they are meeting their duties when making decisions on ESG-related matters given the open texture of the law here, and when non-governmental organisations and other claimant groups would prefer there to be absolute requirements. Given the way that ESG-related risks are developing, and the way that many of them impact the strategic direction of the firm or touch on reputational matters, I would say that boards will need to continue increasing their oversight in this area.

FW: How do you expect ESG risks to develop, as far as FS firms are concerned? What trends might we expect to see?

Bowater: We will continue to see regulatory and litigation risks relating to ESG increasing over the next few years. Financial regulators in the UK want to ensure that firms continue to invest in sustainable finance, but also want to build trust in those markets, so will be particularly on the lookout for any serious instances of greenwashing. Litigation risks will begin to concentrate around firms’ transition plans, as those plans become more detailed and over time show how accurate firms’ planning has been – which might ultimately mean more litigation brought against firms for misrepresentation-based causes of action. I also believe that we will begin to see litigation in the UK focusing on the climate, human rights and biodiversity impacts of firms’ ESG policies.

Mallia-Dare: Looking ahead, the ESG risks facing FS firms are expected to continue evolving in response to shifting market dynamics, regulatory developments and societal trends. Climate change-related risks, including physical risks from extreme weather events and transition risks associated with shifting regulations and consumer preferences, are likely to intensify, driving demand for greater transparency and disclosure. Social issues, such as diversity, equity and inclusion, will also come under greater scrutiny, influencing consumer behaviour, regulatory requirements and investor expectations. Moreover, governance failures, including ethical lapses and regulatory breaches, will remain a persistent concern, highlighting the importance of strong corporate governance practices and effective risk management frameworks. Overall, FS firms must anticipate and adapt to these emerging trends to effectively manage ESG risks and capitalise on new opportunities for value creation and sustainable growth in an increasingly interconnected and uncertain world.

 

Anthea Bowater is a senior associate in Freshfields’ dispute resolution practice and a member of the financial institutions disputes group. She advises on a wide range of complex commercial and financial disputes, and on contentious regulatory matters. Her clients include leading financial institutions and multinationals. She regularly advises, speaks and publishes on sustainable finance matters, including in relation to ESG-related regulation and disputes. She can be contacted on +44 (0)20 7936 4000 or by email: anthea.bowater@freshfields.com.

Myron Mallia-Dare is a partner at Miller Thomson LLP in Toronto, Canada, and co-leader of Miller Thomson’s national high growth and emerging companies programme. He is also a key member of the firm’s private equity and ESG and carbon finance group. With a focus on domestic and cross-border mergers and acquisitions, private equity and venture financing, he brings extensive experience and insights to help clients navigate complex legal challenges. He can be contacted on +1 (416) 595 7948 or by email: mmalliadare@millerthomson.com.

© Financier Worldwide

THE PANELLISTS

 

Anthea Bowater

Freshfields Bruckhaus Deringer

 

Myron Mallia-Dare

Miller Thomson LLP

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