Compliance and long-term value creation
Six key challenges can – if properly tackled – move financial institutions towards not only compliance to ESG regulation, but also to long-term value creation. In this blog we will link good practices to these challenges. But first, we will define ESG risks and what ESG risks should be addressed first. The hallmark of sustainable finance is the integration of environmental, social and governance (ESG) factors in the DNA of a financial institution, from strategy to investment and credit decisions to risk management all the way to external reporting.
ESG risks cover issues ranging from a company’s response to climate change, to the promotion of ethical labour practices, to the way a company grapples with questions around privacy and data management. A growing number of investors, both institutional and retail (non-institutional), and in developed and emerging markets alike, look at ESG risks as a testing ground for their portfolio companies. The ones that perform well on ESG are well-positioned for the future and have better chances of adapting their products and services to a global consumer base that is increasingly pushing for environmental protection, respect for human rights and corporate transparency. The number of financial institutions that integrate ESG in their decision-making processes is on the rise globally, and it is expected to increase in a post-Covid economy as studies have shown that companies with high ESG ratings held up better than their competitors during the crisis.
Environmental risks
The ‘E’ is about the way a company impacts on and interacts with natural capital. Leaders agree that climate change poses one of the greatest threats to our planet, and that we should reshape our societies to be climate resilient. The ‘E’ includes physical risks such as biodiversity loss and the increased risk of flood and extreme weather events. When looking at ‘E’, investors also face so-called transition risks, i.e. risks linked to the transition to a low-carbon economy. An example of transition risk is the shift to new technologies. Technological breakthroughs might decrease the price of renewable energy, leading in turn to a steep drop in the demand for fossil fuels and a radical change in the energy mix. Businesses or countries that mine, process, or sell fossil fuels may need to write down assets or ultimately default. Banks, insurers and pension funds that have outstanding loans or corporate stocks in the fossil fuel industries will see the value of their investments decrease in the long term. The speed, scale and success rate of adopting climate-resilient solutions, as well as investor preparedness, will determine the actual impacts on the financial services industry.
But the business case for embracing integration of ‘E factors’ in investment decisions is not only about risk management. The move towards more sustainable business models translates to concrete opportunities for companies to become more innovative and reduce the now high costs of production and waste management. A clear example is set by the shift from linear to circular models in the way companies make use of plastics. Only nine per cent of total plastic used for packaging is actually recycled – while a third is left in fragile ecosystems, and forty per cent ends up in landfills. Discarded plastic is obviously harmful for the environment, but it also harms the balance sheets of companies. According to the World Economic Forum, plastic packaging waste represents an 80–120 billion US dollar loss to the global economy every year. This is what encouraged Unilever and others to embark on a journey from linear to circular, where plastic packaging can be reused, recycled or composted.
Social risks
The ‘S’ is about the way a company affects its various stakeholder groups (employees, suppliers, contractors, consumers and others). Negative social impacts can occur through direct operations and value chains. ‘S risks’ typically include the risk of infringing on the human rights of stakeholders: for example, limiting workers’ freedom of association would result in a direct negative impact on workers’ rights. Other examples include: discriminating based on gender or ethnicity when hiring or promoting employees; failing to monitor whether suppliers or contractors pay a living wage to their workers; handling customer data in a non-transparent and non-secure way; investing in projects or sectors with severe health implications such as the tobacco industry. For investors, managing ‘S’ comes down to understanding which stakeholder groups are affected by the companies in their lending or investing portfolios, and assessing the extent to which these stakeholders are at risk of suffering any negative impacts as a result of corporate practices.
Again, just as for environmental issues, social issues present opportunities for investors and companies alike. According to the UNPRI, one of the sectors that will be pivotal for achieving the SDGs while driving business savings and revenues is health and well-being. Once a niche for impact investors, health investments are rapidly becoming appealing to mainstream investors as well. The health sector is large and diverse, but its various sub-sectors have one thing in common: the potential to generate positive social impact alongside robust investment returns. This can be observed in traditional healthcare investments such as those in physical infrastructure of hospitals and clinics catering to the emerging middle-class in high-growth markets, but also in more innovative products such as financial solutions to enable poorer communities access health services. Another sub-sector worth watching is the field of diagnostic developments, where innovative companies are piloting digital diagnostic tools including blockchain technology to engage patients and improve outcomes in developed and developing markets alike. The variety of sub-sectors and options in the fast-growing health sector allows investors to bring a high degree of diversification to their portfolios and better balance risks and returns.
Governance risks
The ‘G’ relates to two core components: corporate governance and business integrity. The first can really be seen as the way a company ‘governs’ itself through policies, processes and controls to achieve compliance and secure transparency in its dealings. Business integrity, on the other hand, is about the way a company steers clear of corruption and bribery and avoids openly engaging with politically exposed persons who may pose a reputational risk to the company’s brand. The ‘G’ has been on the radar of the financial services industry for over twenty-five years, and market trends continue to indicate that good governance is one of the levers needed to accomplish higher returns.
Understanding materiality
Addressing all ESG concerns at once is impossible even for the most forward-looking and well-intentioned companies. The key to success is materiality. That is, the understanding of which ESG risks are relevant to a company’s sector and overall operating context. A company’s or an investor’s materiality assessment will show which issues are most important to its business and to stakeholders. Industry and geography are two leading criteria for identifying a long list of potentially material issues. The list then needs to be refined and narrowed down to a short list of ‘most material’ issues. How a company or an investor decides to act on their most material issues will be determined by a range of factors, including their risk appetite, but the advice is to be proactive. Material ESG issues may vary, but their influence on the bottom lines of companies and investors is increasingly visible. Doing too little or waiting too long to address the most material ESG issues will result in companies having to play catch-up to their peers and investors potentially seeing the value of their assets being challenged over time.
Extreme weather events: a highly material E risk for insurers
Extreme weather events such as heavy rainfall, hail, storms and droughts have a high impact on our daily lives and economies. They damage production facilities, disrupt business processes and decrease residential and commercial property values, as well as commodity prices. Climate change is expected to worsen the magnitude and frequency of extreme weather events in the coming decades, also in the Netherlands. Of the extreme weather events since 2012, around seventy per cent can be attributed to climate change. Extreme weather events have a large impact on insurers. When rain, storms or floods become heavier and more frequent, damages will increase and insurance companies will need to pay out larger sums to their clients. According to AON’s 2020 Weather, Climate & Catastrophe Insight report, last decade was the costliest in terms of natural disasters, with the total economic damage and losses amounting to 2.98 trillion US dollars. For Europe in 2019, the costliest disasters were the November flooding in Italy (3.5 billion US dollars), the September flooding in Spain (2.5 billion US dollars) and the spring droughts in Spain (1.7 billion US dollars). Insurance pay-outs peaked, as 845 billion US dollar was paid out by private and public insurers. It is therefore of fundamental importance for insurers to monitor global warming and to anticipate its effects on homeowner insurance products. Navigating this landscape is complex, and data gathered across areas heavily hit by extreme weather events (such as Australia’s ABC Climate Risk Hotspots) shows that many homes will see their insurance premiums double or even triple within decades- and entire geographical areas will become uninsurable.
Global warming also has devastating effects on agriculture, threatening farmers and food production and supply. Higher temperatures increasingly harm agricultural production through extreme droughts, cropland decline and facilitating the spread of agricultural diseases. Moreover, the agricultural sector is also strongly exposed to transition risks, as governments adopt ambitious emission reduction policies targeting agriculture. Insurers must anticipate the effects of reduced crop yields in the future. They may adapt their premiums, insurance policies and require additional certifications from their clients.
Social disruption following Robotics and AI: an underestimated ‘S risk’ for financial institutions
Artificial intelligence (AI) will be increasingly important in enhancing productivity and profitability. AI breakthroughs constantly attract public attention – e.g. robotics development and self-driving cars – and the concern that AI might eventually take over many jobs is becoming an urgent one. In 2018, the OECD estimated that fourteen per cent of jobs in OECD economies are under high risk of replacement by automation, while another thirty-two per cent is at high risk of being replaced partially. The jobs that risk being ‘lost’ are the ones with predictable, routine tasks (e.g. assembly line workers, record clerks etc), and those with a low level of customer interaction (e.g. food service workers, travel booking). In fact, robots performing tasks outside of manufacturing (for example making phone appointments) are already old news. What is worthwhile exploring, from an investor perspective, are the social consequences of these fast-paced developments. Depending on how governments will act on the matter, large-scale job losses could result in structural unemployment and increased inequality. The technology transition has the potential to fuel populist and anti-globalization movements – especially as most of the to-be-displaced workers are already at risk of slipping below middle-class wages. Against this background, shifting investment from human capital to robotics and AI has the potential to fundamentally change societies. Another interesting investment segment is represented by platform technologies that have brought about the so-called ‘gig economy’. The business model underpinning these companies is even riskier from a social disruption perspective, because it causes concentrated job loss and effectively shifts profits from final service providers to platform owners.
In conclusion, the social implications of the technology transition remain a blind spot, and investors need to further explore them. Companies and investors must consider their role in the technology transition and decide how to anticipate or cushion the effects on their employees, sales and markets. Specifically, investors must integrate the effects of technology shifts in their risk management through putting the social implications on their radar for risk identification.
Key challenges and good practices
Six key challenges can – if properly tackled - move financial institutions towards not only compliance to ESG regulation, but also to long-term value creation:
- Striking the right balance: anticipating adequately to relevant risks
- Translating the ESG strategy into the organization’s ecosystem
- Adapting stakeholder management and spreading ESG knowledge in-house
- Collecting, managing and using ESG data for risk modelling
- Delivering and communicating on ESG commitments
- Embedding ESG in existing risk practises
Good practice to key challenge 1:
Seeing past the ESG label and getting to the issues
The hard work of breaking down E, S and G for a specific company or investor is the starting point to any successful ESG approach. For example, when defining its material ESG risks a Dutch bank can break down each sub-category into a concrete area of focus. Instead of pushing to address human rights, it can decide to work on those human rights that present a concrete risk for the bank in its roles as employer, lender or investor. This analysis, and the effort to tie the risks to the core activities of the bank, can unearth the specific rights at risk of being negatively impacted. For example, in the case of the bank as an employer, non-discrimination and privacy can play a large role. When looking at the bank as an investor, it is important to assess the sector and geographic exposure of the bank’s portfolio – issues such as land rights, impacts on indigenous people or human rights defenders in a specific market might be more prominent than standard labour issues. Having a clear understanding of the specific issues that are material will help financial institutions focus their time, energy and resources on fewer, yet more impactful, issues.
Good practice to key challenge 2:
Integrating ESG in the credit or investment cycle
Once an investor has understood which ESG issues to focus on, questions of ‘how’ and ‘where’ to address them remain. When investors – be it banks or asset managers or development finance institutions – plan on moving ESG from policy to practice, it is useful to embed ESG in existing processes rather than creating parallel checks. The credit or investment cycle is the formal flow of decisions playing a central role in how funds or assets are managed, and these processes are therefore the natural framework for ESG integration. Investors should incorporate ESG factors throughout their credit or investment cycle: from loan origination to completion or renewal. By incorporating ESG factors in credit worthiness assessments, for instance, investors can anticipate ESG risks well before investing.
Good practice to key challenge 3:
Training investment teams on effective ESG engagement with a diversity of companies
Many investors have the chance to directly engage with the companies in their portfolio. The due diligence phase, the post-investment phase and the reporting check-ins all represent opportunities for the investor to collect and analyse ESG information about a company. Making sure that those chances are used in the best possible way to manage ESG risks is essential. The skills of the people in this process are the real key to success, therefore investors should ensure that investment managers and teams can access training on how to effectively engage corporates on ESG.
Good practice to key challenge 4:
Using CDD/KYC practices for ESG data collection
Data collection is essential for investors to successfully identify and assess ESG risks and integrate ESG into risk modelling. For instance, information on clients’ greenhouse gas emissions or the locations of their production facilities allows investors to assess the exposure to physical and transition risks. Information on clients’ supply chain structure, including exposure to geographies with higher human rights risks or poor governance can give investors a picture of their exposure to social and governance risks. Collecting this information is however resource-intensive and may require investors to contact individual clients. Investment portfolios may be sizeable, information can be difficult to obtain or there is a need for data interpretation. Resorting to third parties such as ESG data providers is helpful, although information obtained through these channels is not always comparable and is not equally mature for all asset classes. Where possible, investors can use their existing Client Due Diligence/Know Your Customer (KYC) to collect and process the data. Integration of ESG into KYC would also remove the need to design and implement new channels and systems for client outreach, thus avoiding generating so-called reporting fatigue on the clients’ side.
Good practice to key challenge 5:
Delivering and communicating on ESG commitments
Every financial institution may at some point need to show why and how they have taken care of their ESG risks and if they managed to harness ESG opportunities. For example, a private equity fund may seek to successfully exit a company with strong ESG credentials. These credentials (and all the fund’s efforts behind them) need to be clearly visible, quantifiable and shareable with broader audiences. A clear baseline showing the ESG status of the company at the time of acquisition, accompanied by the roadmap of ESG actions undertaken during the holding period and the outcome of these actions would help buyers grasp the added value of ESG alongside the financial valuation information.
Good practice to key challenge 6:
Integrating ESG in Risk Management Framework
Financial institutions can make themselves future-proof by integrating ESG risks in every stage of the risk management framework. This ensures that ESG risks are holistically integrated in existing risk practises. For instance, under risk monitoring, financial institutions should frequently engage with sustainability experts to stay informed on (policy) developments. For ESG risk identification, investors should consider whether their investments are concentrated in specific industries or regions. Climate stress testing can be used for ESG risk assessment. And finally, ESG risk can be mitigated by means of exclusion policies or adapted risk premiums.
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