Q&A: Tackling ESG and climate risk: advice for financial services
May 2023 | SPECIAL REPORT: FINANCIAL SERVICES
Financier Worldwide Magazine
May 2023 Issue
FW discusses ESG and climate risk advice for financial services with Michelle Kirschner at Gibson, Dunn & Crutcher UK LLP, Bryony Widdup at Hogan Lovells, Haney Saadah at Norton Rose Fulbright LLP and Peter Plochan at SAS.
FW: Could you provide an insight into where environmental, social and governance (ESG)-related issues, such as climate change, generally rank on the agenda of financial services (FS) firms?
Kirschner: Undoubtedly, in recent years, environmental, social and governance (ESG) has become a key area of focus of firms within the financial services (FS) industry. Firms are in a position where ‘ESG’ cannot simply be a buzzword in their marketing literature anymore. Pressure from stakeholders, including both regulators and investors, means that firms are having to take action, or face being left behind. While the degree of action taken by firms in the FS industry certainly varies, there is no doubt that the emphasis on ESG is here to stay.
Saadah: We are seeing a greater number of FS firms across all key sectors start to significantly incorporate ESG into their governance frameworks. From product and board governance through to various communications where climate ‘E’ was steadfastly the priority, including board reporting to regulators and clients, we are now seeing both ‘S’ and the ‘G’ gather pace. In particular, firms are looking more holistically at how to incorporate a diverse range of ESG topics into their strategic priorities and then disseminate, and incorporate, more into the day-to-day management of their products and services. Where regulator sentiment is pivotal, so too is the customers’ – who are increasingly showing more interest in ESG. Firms will therefore need to respond with a greater array of ESG-orientated offerings and more recognition of topics such as sustainability, across the board.
Plochan: ESG issues are front and centre and have attention at board level at every bank. Most of the large international FS firms have allocated significant budgets and resources to deal with ESG and climate risk. Depending on the region and applicable regulations, regional and smaller banks have already engaged with sustainability and climate-related initiatives. Some banks are already experiencing first losses due to climate change. At the same time, banks are increasingly required to measure their direct and indirect emissions, with leading banks using the information to adjust their lending and investment strategies. They are involved in financing the transition to a more sustainable future, while looking to reduce their financed emissions through sector-specific lending policies and targets. Significant exercises are ongoing at major lenders to acquire and integrate ESG data, create and implement frameworks to calculate exposures, and to deploy the results into lending and other decisions.
Widdup: These issues are high on the agenda, but they sit alongside a number of other competing priorities, and it is always important to remember that they do not stand alone. ESG needs to be integrated with firms’ urgent short-term priorities and their long-term sustainability. We advise firms to take a ‘G’ approach first, which means prioritising governance without which considerations around long-term sustainability cannot be integrated into organisational direction.
“Most of the large international FS firms have allocated significant budgets and resources to deal with ESG and climate risk.”
FW: How would you characterise the awareness and effectiveness of managing ESG issues across the FS sector to date? In your opinion, does more need to be done?
Saadah: While the momentum is picking up, we are still at the foundations of this journey. The FS market is highly regulated, and participants are accustomed to acting on regulatory guidance. ESG implementation, when effective, should be absorbed by the organisation top-down. The extent of this is entirely subjective and some firms may choose to identify as strongly sustainable and climate conscious – from the services they offer, to the buildings they occupy, to the sourcing of materials and the causes they identify with. However, in reality most FS firms will start by incorporating specific regulatory requirements, wherever required, while keeping a check on the tone and sentiment of their customer and investor base. Most firms are also starting to adopt a more conscious strategy toward incorporating global ESG principles into their core strategy. Navigating the ESG agenda is challenging, but we also know it is the future. When key market players start to make significant headwinds in delivering a strong ‘green’ agenda, then that is likely to influence peers and prompt greater momentum.
Plochan: The effectiveness of banks’ sustainability and climate efforts is where results are somewhat mixed. This is also very region-specific due to different levels of regulatory scrutiny. Banks also have different ambitions and approaches to dealing with the issue. Each requires a different level of effort and sophistication embedded into the organisation. Some banks focus only on compliance with regulatory or disclosure requirements in mind, while other more mature banks are aware of the associated risks and take steps to actively manage them. But leading banks go beyond and focus on the opportunities presented by ESG and climate risk. Financing the transition will require massive investment, and consumers have shown an appetite for investment funds that consider ESG and sustainability in addition to financial returns. According to the chief executive of BlackRock, decarbonisation is the greatest investment opportunity in our lifetime. To tap into this new market, more and more leading financial institutions (FIs) are starting to plan and execute decarbonisation strategies for their portfolios. The 550-plus global FIs joining the Glasgow Financial Alliance for Net Zero (GFANZ) and committing to fully decarbonise their portfolios by 2050 are great examples of this.
Widdup: More does need to be done around managing ESG issues and the sector absolutely recognises that. It is also true that much has already been done and firms are learning by doing when it comes to integrating the bigger climate picture and other purpose considerations into a necessarily profit-orientated sector. No-one can wait to build the ‘perfect’ solution before starting, however more progress needs to be made by creating the right incentives. Strong, clear stakeholder motivation, including through initiatives like the Principles for Responsible Investment (PRI), enhanced transparency through mandatory reporting under initiatives like the Task Force on Climate-related Financial Disclosures (TCFD) and regulatory action against greenwashing are all helping with this. Strong governance is absolutely key. Unsubstantiated sustainability claims and evidently manipulated data are direct governance failures and many of the other controversies in this area also come down to age-old governance challenges, for example integrating short- and long-term priorities, dealing with powerful, entrenched interests in a changing world, and establishing interoperable calculation and reporting systems so that real world, global impacts can be genuinely measured.
Kirschner: The growth in awareness of, and the importance placed by stakeholders on, ESG issues has been rapid over the last few years. This has meant that many firms in the FS industry have had to ‘feel their way’ in a new world of regulatory and investor expectations. This is not always easy. From a UK regulatory perspective, the UK government and the Financial Conduct Authority (FCA) have moved quickly to be, alongside our European Union (EU) neighbour, at the forefront of ESG regulation globally in the FS industry. The initial reaction to, for instance, the FCA’s Sustainable Disclosure Requirements regime has been, generally speaking, fairly positive. This forms an important part of the government’s ‘Roadmap to Sustainable Investing’. It builds further upon the FCA rules relating to TCFD-aligned disclosures required by, among others, UK asset managers, which were aimed at the ‘E’ of ESG – more particularly, climate change – to also cover the ‘S’ and the ‘G’.
“As always with ESG, firms need to be clear as to the commitments and messages they wish to impart, as confusion or misinterpretation can risk denting or harming the goodwill they are trying to create.”
FW: To what extent has a surge in ESG and climate risk regulations led to more challenging disclosure and reporting requirements for FS firms?
Plochan: ESG and climate risk regulations requirements have certainly identified some key gaps on the banking side. For example, the availability of ESG data is one of the key challenges. Many bank customers do not collect, calculate or disclose the key factors used in the ESG assessments performed by banks. There is no standardised way of measuring scope 3 emissions for example, although there are efforts to get there. In the ‘ECB 2022 Climate Risk Stress Test’, participating banks acknowledged that 60 to 70 percent of the corporate carbon footprint data that they reported to the European Central Bank (ECB) was based only on their own internal approximation as the real data from customers was not available. There are questions about the consistency and robustness of reported data, as well as time lags for reporting such data. However, the benefit of going through these disclosure exercises is that they reveal the challenges, which can then be addressed. Once firms start reporting according to the new mandatory sustainability disclosure regimes, such as International Financial Reporting Standards (IFRS) Sustainability, Corporate Sustainability Reporting Directive or the Securities and Exchange Commission (SEC) climate-related disclosures, this will significantly help banks to close the current data gaps.
Kirschner: FS firms, particularly those with a strong international presence, can certainly face difficulties in complying with the regulatory disclosure and reporting regimes to which they are subject. Such challenges stem primarily from the infancy of such regimes, where the industry is not always clear on exactly what is expected of them, together with, in some instances, the lack of availability of data, or at least good quality data. Where there are multiple regulatory regimes that apply to a firm, the requirements under such regimes are not always aligned, further adding to the complexity. Of some comfort is the fact that some legislators and regulators are, to a degree, seeking some level of consistency in the requirements imposed on firms. For example, the FCA has sought, as far as possible, in creating the Sustainable Disclosure Requirements regime, to achieve international coherence with other regimes, such as the EU Sustainable Finance Disclosure Regulation. However, it should be noted that, despite some similarities, they are still very much two different regimes.
Widdup: We have noticed that spend on human, technology and structural resources to support ESG and climate risk functions has increased dramatically in the last few years. Uncertainty at so many levels can create real institutional challenges. Climate risk has to be tracked across multiple potential scenarios. Past-looking statements remain uncertain because of the ongoing need to build in significant estimations due to lack of ‘real economy’ data inputs, and pathways to achieve future targets are inherently dynamic, with all of the usual uncertainty associated with future-looking statements. As a result, climate-related reporting contains significant potential liability for institutions. Mitigating the risks of misrepresentation and similar bases for claims is a major challenge and creates competing interests: best estimate open transparency is likely to serve long term climate outcomes, but regulatory and litigious risk mitigation may mean institutions lean toward narrowing disclosures as much as possible. We see regulatory authorities beginning to take action over disclosure quality, for example with due diligence and disclosure guidance concerning ESG-labelled capital markets products issued recently in the Netherlands requiring stronger substantiation of ESG claims and a trend toward increasing obligation to include more detail in public offering documents, thereby elevating the potential risk associated with misstatement and other associated liabilities.
Saadah: While there has been a distinct increase in certain disclosure requirements, many firms have already become accustomed to increased disclosures and reporting to regulators, markets and clients. Requirements born out of recent significant regulatory change, such as the Markets in Financial Instruments Directive 2014 (MIFID II), provided FS organisations the opportunity to make longer-term strategic calibrations to their propositions, systems and infrastructure in anticipation of ever-increasing demands of regulation, disclosure and reporting. However, the reality for many firms is that all but the most determined executive teams have been able to take full advantage and implement strategic change. Additionally, for international firms, they have the added complexity of needing to converge multiple regulators’ demands into a cohesive framework. The reality remains that some organisations are better equipped than others to take on increased reporting and governance demands, and so will feel the challenges more acutely. Successful firms will invest in effective in-house or third-party solutions along with effective use of data to support the demands placed on them by ESG disclosures, as they increase.
FW: What steps should firms take to implement an effective ESG and climate risk framework that covers all their activities, operations and places of business? What are the potential consequences for firms that fail to properly manage these issues?
Widdup: We recognise the need for firms to concentrate sustainability-related expertise in specialist teams and departments but anticipate better risk management when institutions are able to effectively make sustainability everyone’s business. Some initiatives include balance sheet approaches which seek to allocate risk weightings across the board, and it is always encouraging where there is a strong commitment to internal education and training. The right governance model from the top down is essential for holistic reach and to ensure continuous reassessment. Incomplete assessments risk internal contradiction, meaning overall progress cannot be made toward targets, green and broader sustainability-washing claims, loss of marketability and market reputation, regulatory and legal risks including enforcement by standards bodies resulting in fines, claims for misstatement induced losses, as well as the broader public reputation negative consequences.
Saadah: ESG, in some respects, has a more contained set of regulatory reporting requirements compared to other regulations, so this kind of framework might be manageable with the right focus provided. However, outside of any mandatory reporting, organisations must decide for themselves what commitments they make. They must be prepared to pledge adequate resourcing and budgets to determining, through rigorous analysis and assessment, the right infrastructure for managing risk. Extending the focus of the firm’s governance to manage ESG risk will be key and the tone from the top must align to this, so that staff are aware of the priorities. It is vital that any commitments or promoted ‘green’ credentials are properly resourced from the outset.
Kirschner: As a starting point, it can be useful to stop and think about what the firm already does – it will likely be the case that the firm takes into account ESG in some areas in an informal, undocumented way. The firm should then take a holistic approach and look at both what the firm can do itself, for example what it can do to make the functioning of its offices more environmentally efficient, and how ESG is integrated into its products and services. Consideration should, of course, be given to what the firm has to do under law or regulation. The firm should also consider what it has volunteered to do, pursuant to one of the many voluntary ESG reporting frameworks in existence. It is important that there is engagement and support at board level – it is also often helpful to appoint one individual, whether on the board or otherwise, to take responsibility for driving the creation of the ESG framework.
Plochan: As David Carlin, head of climate risk and the TCFD for the UN Environment Programme’s Finance Initiative (UNEP FI), has stated, banks should stop thinking of a climate-specific strategy and rather focus on integrating climate into their business as usual strategy. Sustainability and climate and decarbonisation-related activities should be embedded into day-to-day banking operations, such as loan underwriting and investment decisions. Many global banks have performed analytics to relate ESG ratings to estimate future credit risk performance, for example as a way to integrate ESG factors into lending decisions using analytics in addition to current subjective assessments. Banks around the globe are concerned with underwriting green loans in order to access the sustainable finance markets. ESG assessments are now integrated in loan onboarding processes, either in the form of heatmaps, quantitative ESG ratings or qualitative assessments. To assess the impacts of climate change on the next frontier of financial services, many banks are extending their scenario analysis and stress-testing frameworks to climate risk scenarios. This is a helpful tool, firstly, to comply with climate-related regulatory stress testing and, secondly, to allow various stakeholders to better understand the short- and longer-term implications of climate risk on financial portfolios. Failure to manage these issues will result in lost opportunities, increased losses and likely higher capital charges for lenders.
“The right governance model from the top down is essential for holistic reach and to ensure continuous reassessment.”
FW: What benefits and advantages can FS firms gain by embracing ESG risk management as an opportunity, rather than simply a matter of minimum regulatory compliance?
Saadah: For many clients and customers, ESG is an important issue. Embracing the topic can provide significant kudos to an FS firm’s brand with its captive market. However, as always with ESG, firms need to be clear as to the commitments and messages they wish to impart, as confusion or misinterpretation can risk denting or harming the goodwill they are trying to create. The ‘G’ is also an opportunity for firms to evaluate long-term efficiencies in core areas of governance that, when implemented correctly, will have positive knock-on effects for the rest of the business in areas as diverse as communications, reporting, optimal use of data and record keeping.
Plochan: There are both financial and reputational rewards for embracing ESG. Many firms have already announced policies to stop financing the mining of coal, and its use in energy generation and new fossil fuel-related projects. This is in response to public sentiment, for reputational risk reasons. Financially, it is likely that high greenhouse gas (GHG) emission projects will represent higher risks and cost more money in terms of capital. This will mean banks have less money to lend, therefore missed opportunities. There is also expected investment in the trillions of dollars needed to finance the transition to a greener economy. Investment in public infrastructure, retrofitting factories, buildings and private homes, electrification, renewable energy, GreenTech and others will be on the table for firms with the know-how and credibility.
Kirschner: There are numerous incentives for FS firms to embrace ESG risk management and proactively adopt broader ESG strategies. For instance, a more comprehensive analysis of ESG factors may help firms identify new opportunities for growth and innovation, and develop new product ranges in response to changing consumer preferences on ESG. Additionally, firms that emphasise ESG factors in their investment approach may be rewarded with improved investment returns – according to Bloomberg, ESG-aligned investments outperformed the overall market in the wake of the 2020 coronavirus (COVID-19) sell-off. As investors become increasingly mindful of the environmental impact and ethical standards of their investments, firms with strong ESG credentials will also be better able to attract and retain investment. Finally, firms with good ESG reputations may find it easier to recruit and retain talent – particularly among the younger generations who value purpose in their work – and to build trust with regulators, allowing them to expand into new markets.
FW: What essential advice would you offer to FS firms on integrating ESG and climate change risk management processes into business-as-usual operations?
Plochan: Running climate-related stress tests may be sufficient for now, but not in the long run. In general, the narratives of regulatory stress testing rely on only a handful of scenarios and broad-brush model assumptions that are not necessarily specific to a bank’s balance sheet or its risk profile. Rather than focusing on regulatory climate stress testing, leading banks are using stress testing to help them make better strategic portfolio decarbonisation decisions. Leveraging advanced analytics, leading scenario analysis and simulation capabilities, these banks can more quickly and easily assess the impact of the alternative decarbonisation and net zero portfolio strategies on their key performance indicators (KPIs) and key risk indicators (KRIs) at the institution, portfolio, sector and even individual customer level. Understanding quantitatively the potential future impact of alternatives, such as net zero portfolio decarbonisation mixes, is an important input for making optimal portfolio and customer-level decisions. Lenders should relate ESG and climate factors to individual counterparty level to make day-to-day lending decisions. Firms have used approaches such as ESG and risk rating matrices, overlay models and judgmental ratings for this. We also suggest treating climate risk-based decisions similarly to how we used Basel II – there must be a governed, explainable, repeatable and integrated process encompassing data, modelling, calculations and inputs into decisions.
Kirschner: Risk management processes should be clear and demonstrable. For instance, if a due diligence questionnaire for a real estate investment identifies an environmental issue, what is going to be done as a result? There should be some way to measure what the firm aims to achieve against what is actually achieved in practice. In addition, buy-in is required at all levels, from the top down. This may also necessitate training on ESG matters.
Saadah: Effective risk management culture is a good place to start. Organisations that are agile and adept at embedding new risk controls in response to any given requirement should find that ESG and climate change become manageable. The difference with ESG is that it is arguably less binary than more defined regulatory change – therefore, organisations are often tasked with more self-reflection as to what they must do. FS firms should take the right advice on that journey and always consider, first, what the market should understand about the firm’s ESG strategy and commitment. It is imperative that voluntary commitments are risk-managed with the same focus as mandatory regulatory requirements. Once again, investing in the right resources and expertise will be key – this can be more intricate with ESG, as it is a fledgling topic, so effective training will help.
“Firms are in a position where ‘ESG’ cannot simply be a buzzword in their marketing literature anymore.”
FW: Looking ahead, how do you expect ESG and climate risk issues to evolve? What medium- and long-term impact is this likely to have on FS firms, and their regulatory obligations?
Saadah: Successful firms must navigate a range of differing stakeholder demands – from regulators through to activists, investors and customers. Firms will utilise modern tools and techniques to engage with their customers and feel the pulse of the market, whether this is social media or more targeted communications. ESG, in many ways, is an all-encompassing directive and in the future, many firms might look – and feel – significantly different from what they are today. This applies to their corporate identity through to the products and services they offer, as well as how they procure and manage supply chains. We expect regulators will continue to ramp-up their focus on ESG. Greenwashing, in particular, remains a risk and a likely focus for authorities and activists keen to ensure transparency. We will start to see more alignment of global standards, affecting reporting and disclosures. Investors and customers will be presented with an ever-growing array of ‘green’ products, transforming traditional services such as lending and investing.
Kirschner: In the coming year, we expect greenwashing to take centre stage, with increased regulatory scrutiny to address concerns that FS firms may be making exaggerated, misleading or unsubstantiated claims about the ESG credentials of their financial products. The UK FCA and the SEC have both proposed measures to regulate the sustainability labelling of investment products, and European supervisory authorities have also recently published a call for evidence regarding greenwashing practices in the EU’s financial sector. Sustainability-related governance is also likely to be a hot topic for regulators. For instance, the FCA has recently published a new discussion paper inviting all regulated firms across the UK financial sector to give their views on sustainability-related governance, incentives and competence, to determine if increased regulation is needed in this area. Across the pond, the SEC’s new proposed rules would require firms to, among other things, disclose information about their governance of climate-related risks and relevant risk management processes. With increased regulatory scrutiny and the coming into force of new regulations, FS firms are likely to face additional compliance costs and challenges in implementing the appropriate systems and processes to collect, analyse and report relevant ESG and climate risk data. In addition, some firms may need to adjust their marketing strategies to ensure that their sustainability claims are accurate, transparent and supported by verifiable evidence.
Widdup: This area is constantly evolving but we anticipate increased understanding that ESG issues are not separate among themselves and do not stand alone in a separate category to other market priorities either. To succeed, firms increasingly need to understand that integrated approaches are paramount. In the short term, focus on biodiversity and its climate-related impact is rising up the agenda. Insufficient data is available in this area, and there is a lack of agreement on measurement, on what constitutes appropriate integrity in projects, and on how to tackle the issues. The progress of the Task Force on Nature-Related Financial Disclosures (TNFD) means these challenges need to be resolved in the short term. Prudential regulatory focus is also requiring more action by institutions on modelling of climate-related risks and improved scenario analysis, including better understanding of the physical risks of climate change on higher temperature trajectories. Finally, social pressures are increasing through issues like the cost of living crisis and lack of action to date on just transition. More focus on the ‘S’ in ESG demonstrates that approaches that focus too narrowly on particular issues and not on others leave institutions open to the types of sustainability washing claims which are increasingly attracting attention from the regulatory and disputes perspective. To help tackle these challenges, moving reporting from a voluntary to mandatory basis, alongside global initiatives like the International Sustainability Standards Board (ISSB), means that better quality comparable data should soon be available to help financial institutions aggregate, report and act more effectively themselves. At the same time, as pressures to disclose more and better information intensify, enforcement actions, fines and claims in this area are becoming more prevalent, leaving firms in a high risk environment needing top quality governance arrangements and advisory support to navigate the challenges.
Plochan: 2023 is going to be, for many jurisdictions, a year of implementation when discussions turn into concrete and often measurable actions. The decarbonisation commitments made by, for example, the 550-plus GFANZ members, are now becoming operationalised, measured and monitored. A number of regulatory and reporting requirements are going live in 2024, such as Pillar 3 reporting for EU banks on their transition decarbonisation pathways toward achieving Paris Agreement goals by 2050. In other less climate-mature regions of the world, we will see the intensification of regulatory requirements with, for example, climate stress testing activities going live in the US. We may also see more prescriptive regulations coming out of these tests. To date, they have been mostly discovery exercises with very little in the way of evidence to justify calculated capital charges. Over the longer term, we will see more climate risk-related losses experienced in banking portfolios, and thus also the discipline of climate risk modelling becoming more crystalised and backed by real climate loss data.
Michelle Kirschner is an English law partner in the London office of Gibson, Dunn & Crutcher, and co-chair of the firm’s global financial regulatory group. She advises a broad range of financial institutions, including investment managers, integrated investment banks, corporate finance boutiques, private fund managers and private wealth managers at the most senior level. Ms Kirschner has a particular expertise in FinTech businesses, having advised a number of FinTech firms on regulatory perimeter issues. She can be contacted on +44 (0)20 7071 4212 or by email: mkirschner@gibsondunn.com.
Bryony Widdup is a finance and FinTech lawyer, with over 15 years’ experience advising on fundraising solutions in the financial services sector. Known for her dedication to clients, she is skilled in transaction structuring, in finance for funds, broader lending platforms (including blockchain-based offerings) and digital assets including token structuring and issuance. She is passionate about sustainable finance and investment solutions, including green, social and sustainability-linked instruments, transition finance and impact investing. She can be contacted on +44 (0)20 7296 2000 or by email: bryony.widdup@hoganlovells.com.
Haney Saadah is the head of risk consulting for Europe, Middle East and Asia based in London. He has extensive experience in the delivery of highly technical programmes of work in broad areas of risk, including regulatory, governance and operational, conduct and reputational risk, along with specific advice on more general regulatory advisory topics and interventions. He has worked in and across all the key global financial hubs with a variety of financial services providers. He can be contacted on +44 (0)20 7444 2519 or by email: haney.saadah@nortonrosefulbright.com.
Peter Plochan is the EMEA principal risk management adviser at SAS who helps financial institutions deal with their challenges around finance and risk regulations, enterprise risk management, risk governance, forward looking risk analysis, stress testing, model risk management, risk modelling and climate change risk management. He has a finance background and is a certified financial risk manager with 14 years of experience in risk management in the financial sector. He can be contacted on +43 (1) 2524 2516 or by email: peter.plochan@sas.com.
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Hogan Lovells
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