Financial Services risk:
Environmental, Social and Governance (ESG) factors take center stage

“ESG regulations and guidance will be a driver of risk going forwards. With new rules on disclosure and taxonomy, and around green investments, the compliance risk for financial institutions is growing,” says Tindal. Outside of Europe, the new Democrat administration of President Joe Biden is expected to signal a shift in ESG policy in the US, with more ‘rules-based’ disclosure now on the cards. The Federal Reserve recently joined the global central banks’ Network for Greening the Financial System while the Securities Exchange Commission (SEC) has launched a review of climate-related disclosure for public companies.

“The new Biden administration is likely to result in a period of regulatory change, including the potential for an ESG framework for financial institutions in the US. Financial institutions should anticipate swift and sudden changes in US regulation around ESG, although these changes may not follow the same approach taken in other markets like Europe,” says Anton Lavrenko, Regional Head of Financial Institutions, North America, at AGCS.

At an international level, global accounting standards setter the International Financial Reporting Standards (IFRS) is consulting on whether to create sustainability reporting standards, while the G20’s Financial Stability Board is due to set out plans to build on its Task Force for Climate-related Financial Disclosures (TCFD). The  UK government said  in March 2021 that it intends to make TCFD mandatory for public companies by 2022.

The past decade has seen marked progress on international co-operation and commitments to address climate change and greenhouse gas emissions. Practically every country has signed the Paris Agreement, which calls for keeping the global temperature to 1.5°C above pre-industrial era levels in order to avoid the worst of warming, and a growing number of countries are striving to achieve carbon neutrality within the next two decades.

These commitments are now materializing as government policy and regulation, in a wide range of areas, including climate change reporting and disclosure and greenhouse gas emissions controls. By mid-2019, more than 1,600 laws and policies relating to climate change had been created across 164 jurisdictions, according to law firm Herbert Smith Freehills [2]. This surge of climate and sustainability-related regulation, in combination with inconsistent approaches across jurisdictions and a lack of data availability, represents significant operational and compliance challenges for companies.

Climate change is also giving rise to litigation, which is beginning to include financial institutions. These cases have tended to focus on the nature of investments, although more recently there has been an escalation in the use of litigation by activists and advocacy groups seeking to advance climate policies, drive behavioral shifts and force disclosure debate. For example, investors sued Commonwealth Bank of Australia (CBA) in 2017 over a proposed investment in a controversial coal mine. The claim was eventually withdrawn when CBA increased its disclosure. Outside of financial services, more recently, non-profit law firm, ClientEarth, forced the closure of a giant coal plant in central Poland.

Banks and insurers are already under increasing pressure from environmental groups to withdraw their support of industries involved with carbon intensive activities, such as new oil, gas and coal projects. More recently, firms are being challenged over their financing for a wider range of environmentally damaging industries, such as beef or soya farming in the Amazon, palm oil in Malaysia and oil exploration in Africa. A number of institutional investors decided not to invest in food delivery service Deliveroo’s 2021 IPO in London due to concerns over pay and conditions.

Regulators and pressure groups are increasingly likely to turn the spotlight on greenwashing, in which companies provide misleading information in order to present a more environmentally-friendly and responsible public image. Companies have already been the subject of litigation in the US. In the UK, the FCA has developed a set of principles to tackle concerns over false claims. The Task Force on Climate-Related Financial Disclosures, the SEC in the US and European supervisors are also looking at this issue more closely.

With more compliance, it will be easier for regulators, investors and other stakeholders to hold companies to account on social and environmental issues, says Lavrenko. Pressure groups, for example, often use institutions’ own ESG reports to do so when it comes to assessing carbon-neutral targets. “Companies that commit to addressing climate change, diversity and inclusion will need to follow through,” says Lavrenko. "For those companies that do not, it will come back to haunt them.”

As investment decisions are increasingly influenced by this new environment, so too will be the role of risk management and in particular that of the board of directors. Questions and clarity about who is responsible for ESG topics, such as climate change, on the company board will not just be a matter of “nice to have” but essential if the duties of directors are considered to be adequately fulfilled in future.

ESG was named by 38% of financial institutions as being one of the three risk types that will increase the most in importance over the next two years, more than for any other, according to a recent Deloitte global risk management survey [3]. However, only a third of respondents considered their institutions to be extremely or very effective at managing ESG risk.

It is important that ESG is not only on the board agenda a few times per year but that a company embeds sustainability topics and thinking into the whole organization. Beyond internal steering, it is also crucial for the board to acquire appropriate skills and understand the external requirements in order to be successful in the long-term. Financial institutions will also need to monitor carefully how expectations regarding ESG evolve among regulators, investors, and customers. 

“Elevating and identifying ESG risks through a business’ risk registers and committees and making sure it is understood how they will perform in and out of the boardroom, is crucial,” says Shanil Williams, Global Head of Financial Lines at AGCS.

“Disclosure is not just about the various regimes coming in around the world but also about how you disclose to the wider community – employees, stakeholders and the media – the latter, in particular, can have a devastating impact on reputation. We are already utilizing ESG data in our D&O insurance underwriting,” adds Williams (as part of a partnership with investment and risk consultant, the 

Value Group). “We have statistically modeled ESG data points against claims and public litigation and we do see some predictive power there. From an insurer’s point of view, conversations around ESG-related topics, in addition to financial topics, are becoming much more important.”