How ESG is reshaping global financial Services

While many have suggested that we cannot afford to be ‘green’ in the current environment, we would suggest that the current Covid-19 crisis brings into sharp relief the need for better integration of environmental, social and governance (ESG) considerations into business and government decision-making.

And we see a gathering swell of opinion in this regard.  Prominent institutions such as the International Monetary Fund are calling to seize the opportunity to build a stronger, more resilient and inclusive society.  The recently appointed European Commission has built its strategy on the platform of a new Green Deal, which is designed to propel Europe into the leadership position on environmental issues.  Similarly, a coalition of over 150 global corporations — with a combined market capitalisation of over US$2.4 trillion and representing over 5 million employees — is urging governments around the world to align their Covid-19 economic aid and recovery efforts with the latest climate science.

The world of finance has an enormous role to play in managing the process of transformation of our economy.  Financial institutions are, as a system, designed to assess and mitigate risk, capitalise investment and structure reward.  In the context of societal change, ESG is the modern-day equivalent of the industrial revolution and carries with it enormous potential benefits, as well as challenges.

Regulators are already beginning to focus on this as a key issue to be addressed in their work.  This was very evident in our report in conjunction with OMFIF ‘Tackling Climate Change: The Role of Regulation and Supervision’ published earlier this year which surveyed 33 Central Banks and Regulators on their supervisory and regulatory approach to the impact of Climate Change.  While not yet prescriptive, regulators will look at the resilience of firms in the face of shock scenarios, including those arriving from environmental and social issues.  Our study shows that internationally, regulators are already constructing models and parameters to support this work.  Similarly, they will seek to understand and stress-test risk posed by holdings of more investments in both industries exposed both directly and indirectly to ESG risks.

So, what do firms need to action as they face a growing sustainability agenda? Essentially companies need to treat ESG issues as a core part of their business strategy.  This means working to:

• Identify and manage not only their impact on the environment and society around them (Corporate and Social Responsibility), but perhaps more crucially, the risks they face from climate change and other sustainability issues — including the risk of so-called ‘stranded assets’. According to Lex estimates, around $900bn (or one-third of the current value of big oil and gas companies) would evaporate if governments more aggressively attempted to restrict the rise in temperatures. This is a significant risk consideration for financial services institutions.
• Seize the significant opportunities brought by the transition to a more sustainable economy. As an example, the EU’s ambition to achieve a green recovery post-Covid could lead to c. EUR 260 bn additional investments in Europe alone every year.
• Lastly, companies must increase transparency and disclose meaningful information about their sustainability performance. To date, most ESG disclosures have been voluntary, but the direction of travel is clear — regulation is on the way with mandatory disclosures to be integrated into mainstream annual reports.  The UK and the EU are leading the way with a number of measures including the EU taxonomy disclosures which will enter into force from 2022 for financial market participants and large companies and the UK’s proposal to introduce climate-related financial disclosures (TCFD) from 2022 for all listed companies on a ‘comply or explain’ basis.

Along with the increasing pressure for transparency comes the demand for more consistency.  ESG standards have been proliferating in recent years.  We see initiatives in Europe, UK, China and the US as well as significant input from Non-Governmental and Corporate bodies who are seeking to steer the development of reporting and measurement approaches.  This poses a challenge if considered from the overall goal of ‘moving the dial’ on ESG issues.  On one the hand, large corporates are spending significant resources implementing and following the various standards.  On the other hand, investors need to go through cumbersome processes to compare the various ESG performance reports in order to take informed investment decisions.

To tackle challenges faced around ESG reporting, finance and accounting functions are being brought to the fore.  What is measured is managed.  CFOs have a crucial role to play by finding efficient ways of implementing and complying with the various disclosure standards, defining relevant and meaningful ESG metrics for Board and investor decision-making, preparing ESG performance reports, and ensuring that these reports meet quality expectations and are consistent across standards.  In addition, external auditors have a responsibility to challenge management to assess and report the impact of climate change on their business.  In the UK, the Financial Reporting Council has announced a major review of company and auditor responses to climate change.  Others will, no doubt, follow.

We can see that the ESG agenda is not going to go away.  The global news stories of today – environmental destruction, Black Lives Matter, Covid-19, – neatly circumscribe the different sets of challenges facing society – environmental, social, and governance.  All businesses will have to engage with these issues in some regard, and if we have learned anything in the past six months, it is that events and their impacts can be faster and more profound than we imagine.  Financial Services firms are, in a way, the life-support system of an economy and society – and we can see now that the future of Financial Services firms will be profoundly shaped by their reaction to the ESG challenge.

This article first appeared in the Finance Dublin Yearbook 2020 in August 2020.