How Financial Services can be successful when it comes to ESG risk

Santhosh Jayaram, Global Head of Sustainability, HCLTech

By Santhosh Jayaram, Global Head of Sustainability at HCLTech

Environmental, Societal and Corporate Governance (ESG) risk is rising to the top of the agenda for financial services worldwide. In the UK, it seems there’s pressure coming from all sides, from consumers worrying about how ‘green’ their investments are, to charities like WWF and Greenpeace reporting the UK finance sector is in the top ten for carbon emissions, to new UK legislation aiming to improve climate-related financial disclosure in the wake of the Paris Climate Accord.

All these pressures combined have made ESG a clear strategic priority – but how exactly can financial services set about understanding and minimising ESG risk?

How is ESG risk defined?

Traditionally, risk is assessed by examining what has gone wrong in the past and taking steps to ensure the same can’t happen in future. However, with climate change that doesn’t work. As Eric Usher, head of the United Nations Environment Programme Finance Initiative (UNEP FI) says, climate related Environmental, Societal and Corporate Governance (ESG) risk is now about forecasting the future.

That isn’t easy, particularly within finance, but it is an area that financial institutions are starting to take more seriously. The Bank of England’s first Biennial Exploratory Scenario, examining the climate risk progress being made by UK banks and insurers, found UK financial organisations are making good progress, but still need to better understand and manage their exposure to climate risks. It also revealed that the lack of available data on corporates’ current emissions and future transition plans is a common problem.

The industry is trying to solve this: in the last four years more than 170 ESG related regulatory measures have been proposed globally, and initiatives like the Taskforce on Climate-related Financial Disclosure (TFCD) aim to improve the disclosure of any climate-related risks within financial services.

This shows that ESG related climate risk is becoming more of a priority. It’s no longer seen as just an ethical issue, but one that has the potential to have an economic impact. For some financial institutions, however, the focus remains on the reputational and business opportunities driven by ESG. Instead, financial services should start to make ESG risk an integral part of their risk management portfolios.

Assessing the risk

That’s easier said than done, as the nature of ESG-related risk is fraught with complexity, making it difficult to assess. Financial institutions, much like trees in a storm, are vulnerable to environmental threats, social inequality and corporate misconduct issues. For instance, extreme weather conditions could expose them to mortgage defaults, property devaluation or reduced savings deposits – and environmental regulations, such as taxes on single use plastics, could also impact the bottom line.

Away from the financial risk, there are other elements to consider, such as reputational damage, operational disruption or strategic upheaval. An example to illustrate this is the conflict in Ukraine, which has affected thousands of organisations in a multitude of ways worldwide.

Given there are so many complexities, it’s no wonder organisations find it incredibly difficult to assess and evaluate ESG related risks. There’s a lack of understanding about the external factors at play, and a real struggle to determine what the non-financial impacts of a particular risk may be.

A framework for success

It’s critical financial services don’t leave ESG related risk to chance, and ensure they have a strong management system to ensure they grow in the right direction. But setting this up is no easy task: while progress is being made to improve regulation and make disclosure frameworks more streamlined, ESG data can still be hard to read and understand. This makes it difficult to assess the credibility and quality of existing ESG data, due to much of it remaining inaccessible and siloed away.

To get around this, there’s a real need for financial firms to move away from qualitative methods to a quantitative approach, harnessing the power of analytics tools and methodologies to accurately evaluate ESG risks.

Corporations must also be willing to harness and combine the skillsets of sector experts, data scientists, mathematicians, and economists. That’s because most ESG risks aren’t isolated but interconnected with a multitude of other risks, each with their own separate and significantly different outcomes and magnitudes. So, a range of individuals are needed to share their own expertise on the different risks present.

The answer to pulling all this together, while making data more accessible and having the expertise to assess all the risks at play, lies in technology. A combination of machine learning, AI, blockchain, and digital identity systems will make it possible for financial services to make the right move when it comes to ESG and climate related risk. It’s these innovations that will make it possible for financial organisations to run modelling exercises and assess risk.

The route to ESG risk success

As pressure heightens from all sides, from consumers insisting on greener investments and the development of new regulations, it’s imperative financial services take ESG related climate risk seriously. Failure to do this would leave them vulnerable from both a financial standpoint and a reputational one.

The first step is to work with the industry to improve disclosure, so in turn it becomes easier for them to assess their risks. Taking the lead and becoming more open will foster a better culture where climate and financial related data is easier to come by.

Secondly, institutions must put ESG related climate risk at the heart of their risk management strategies. They should move towards a quantitative assessment method, that embraces analytical capabilities delivered through new innovations such as machine learning and digital identity systems and the expertise of a wide skillset of people from sector experts to data scientists.

All of these actions will go a long way towards the development of an effective risk management system that can prepare financial institutions for charting their growth as the sector undergoes a sustainability transition.