Key Challenges for the Financial Industry in dealing with ESG risks

2021 is the year of the ESG business change. Another month reaches its end and we would like to draw your attention to the key challenges for the financial industry in dealing with ESG risks. Our experts summarise the basics of this long lasting initiative, which is now set in motion, and outline the consequences for bankers, asset managers and insurers in particular. Sustainability risks need to be implemented in the day-to-day operations. But what should you consider doing next? Our team shares a few key aspects.

A long-lasting initiative now set in motion

In order to achieve the goals of the Paris Agreement on Climate Change, in March 2018 the European Commission adopted the EU Action Plan on Financing Sustainable Growth. The European Union sees the financial services sector as the catalyst to supporting the real economy in meeting the EU’s goals of a climate neutral economy and during the transition phase towards these objectives. The Plan includes ten actions, aiming at addressing three critical objectives. One of these objectives is to ensure that sustainability risks are better monitored and disclosed by the financial sector, recognising the link between sustainability risks and financial stability risks. This article further develops the implication of these new sustainability risks consideration requirements on banks, asset managers and insurance companies. The Action Plan has since been further detailed and has resulted in several new regulations or amendments of existing regulations and directives – such as a uniform taxonomy for (environmentally) sustainable economic activities, an extensive new *Disclosure Regulation (SFDR, EBA CP on Pillar 3 and NFRD), new CO2-Benchmarks, as well as amendments to MiFID II, IDD, UCITS Directive, AIFMD, CRR II, or CRD V, Solvency 2 and several ESA initiatives such as EBA on managing ESG risk,the ECB guide on climate-related and environmental risk and EIOPA’s opinion supervision of the use of climate change risk scenarios in the Own Risk and Solvency Assessment (ORSA) for insurers.

The impact is therefore particularly broad for the financial industry, which is not only imposing new requirements in terms of compliance, but also a range of analyses and disclosures that were not systematic until now.

As part of this, risk analyses become increasingly a challenge that is not to be underestimated.

Sustainability risk, another button to press?

Based on the first feedback from the industry, along with work by experts and solutions proposed by the main vendors, it is obvious that the assessment and monitoring of the sustainability risks will not be simple to address.

The definitions provided by the different regulations are particularly wide and the scarcity and reliability of data is a recognised and widespread issue. However, the need to satisfy the related requirements is not an option.

What does it mean for bankers, asset managers and insurers?

Banking:

While some banks started to develop temperature-based scenarios to assess the impact of climate change and in particular transition risk on their portfolios as early as 2017 following the Paris Agreement, and asset and wealth managers updated their prospectus following SFDR requirements, 2021 has marked an acceleration for banks and asset and wealth managers to integrate ESG factors into their risk management and measurement frameworks.

Following the dedicated guidelines provided by the ECB (for “directly-supervised banks”) on the one hand, and by the EBA on the other hand, banks will not only have to assess the climate risk and the related physical and transitional risks on their activities, but also the environmental, social and governance risks more broadly speaking. Such ESG risks are to be assessed by counterparty and will entail the duties to assess and to measure the risks, with clear implications on capital requirements and business acceptance procedures.

Asset management:

SFDR has clarified that consideration of material sustainability risks is part of the asset manager fiduciary duties and disclosure as to how they are integrated into investment decisions shall be included in the funds’ prospectuses. Similar requirements apply to investment mandates and any portfolio managed on a discretionary basis. This requirement has also been reconfirmed in the recently introduced changes to UCITS, MiFID and AIFMD delegated acts.

In general, risk analysis within the asset and wealth management industry is based on a set of factors, guidelines and standards that are considered as best market practice (e.g. Value-at-risk, Liquidity-risk assessment etc.). 

So far, when it comes to sustainable risk assessment, there is no consensus per se yet to follow a specific standard or guidelines. However, with the provision of the Taxonomy, Principal Adverse Impact etc, a range of metrics start to be identified as references. Also, some materiality maps, such as those agreed on in the Sustainability Reporting Ecosystem of the Sustainability Accounting Standards Board (SASB) are recognised by a wide range of constituencies. They can also be used to support the risk manager in linking sectors to sustainability factors to assess.

It is important to note that a complete set of new standards are emerging with all stakeholders trying to reach a reliable sustainable risk assessment.

Insurance:

Similarly, as with banks, the insurance industry is directly affected by the impact of climate change — through increased climate-related risks to insured property, and indirectly affected through changes to its claims and reserving management practices. Known as physical climate risk (as opposed to transition risks), it is already becoming a major driver of underwriting risk for insurers. On the left side of the balance sheet, insurers are also significant financial investors and, in the case of life and pensions, these investments are in long-term assets with a  maturity profile that matches their long-term liabilities. The value of these investments is being affected not just by some of the same physical climate risks affecting liabilities, but also by so-called transition risk (new regulations, technologies, shifts in consumer preferences) leading potentially to partial to full losses in asset values (and in the extreme to so-called “stranded assets”). 

Compared with asset managers and banks, what is uniquely challenging for the insurance sector is the need to assess climate risks in a highly integrated manner that will expressly link underwriting and capital management with investment portfolios. Getting insurance actuaries to work with scientists to build new forward-looking models that explore how climate change may alter the current spatial and peril dependencies and correlations will be a daunting, yet fascinating task for the years to come.

Is it only about risk assessment?

This raises the challenge of data gathering and management as well as the types of metrics to be collected to perform a risk assessment, taking into consideration that ESG data is relatively new. However, there is no standardised set of data elements that has yet been defined, to be used by asset managers. 

Being able to assess sustainability risk and its impact on the business model leads to the next logical step: embedding sustainability risk in the portfolio managers’ business and investment strategy and in the banks’ and insurers’ business and risk strategy, respectively their internal governance, and risk management. 

This does not include solely defining the investment targets/risk appetite or enhancing existing risk management policies, procedures and processes but also the upskilling of employees to bring life to the ESG mindset and risk culture. This ensures that sustainability risk becomes an integral part of the asset and wealth manager’s, bank’s or insurer’s operations and not simply a tick-box exercise.

Overall impact of sustainability risk for the market

Although the financial sector is differently affected by the EU Action Plan and its resulting regulation due to differences in business model and business strategy, it is crucial to keep, or even accelerate, the pace at which sustainability risk is implemented in the day-to-day operations, and related strategic ambitions. 

The challenges of data availability, risk assessment and of establishing an appropriate strategy are not new and specific to sustainability: they are similar at the introduction of any risk a financial player should manage starting with credit risk. 

What is new compared to other risk types is the expectations of various stakeholders for more transparency on how the individual player in the financial sector is responding to this new risk and is setting its goals to make the EU Action Plan a real deal. Recent years showed that stakeholders are asking for more actions rather than words when it comes to environmental, social and governance changes in society. Their feedback to the industry will continue to shape how sustainability risk will be managed and assessed.

What should the next steps be for you?

• Define your engagement and ESG strategy and convictions;

• Ensure that what sustainability risk means for your organisation is clearly defined;

• Define sustainability indicators and risk limits;

• Define and agree on the methodologies / tools / solution to implement;

• Agree and recognise that unfortunately a single source of information / score will not cover all your needs;

• Identify the impact of ESG risk factors on your business model and on your counterparties;

• Set a road map to meet regulatory requirements and business impact management;

• Define your data needs by considering your measurement approach (EBA and EIOPA discussion papers on managing ESG risks), internal and external reporting (SFDR, EBA on Pillar 3 disclosure of ESG risks, NFRD).

_*Acronyms

_{AIFMD = Alternative Investment Fund Managers Directive}

_{CP = Consultation Paper} 

_{CRR = Capital Requirements Regulation} 

_{EBA = European Banking Authority} 

_{ECB = European Central Bank}

_{EIOPA = European Insurance and Occupational Pensions Authority}

_{ESA = European Supervisory Authorities (EBA, ESMA, EIOPA)}

_{ESMA = European Securities and M}

_{MiFID II = Markets in Financial Instruments Directive} 

_{NFRD = EU Non-Financial Reporting Directive}

_{SFDR = EU Sustainability Finance Disclosure Regulation}