In the wake of high profile incidents of executive mismanagement and unethical behavior, banks and financial organizations around the world are turning their attention to environmental, social, and governance (ESG) factors as an important component of risk management.
The negative effects of ESG-related incidents can be significant and may include environmental damage, injury to wildlife, the destruction of natural habitats, or the exploitation of vulnerable communities and workers. Given the urgent global need to take action on issues like climate change, social inequality, and human rights abuses, ESG considerations should be a priority for all banks, corporate entities, and large enterprise organizations.
ESG failures can be extremely damaging to an organization’s reputation, resulting in regulatory fines and even exposure to criminal liability. With those risks and consequences in mind, and in order to promote corporate responsibility, banks and large corporations in jurisdictions around the world are implementing ESG screening solutions, while regulators are developing and introducing ESG compliance regulations.
In 2021, the EU conducted a study into the integration of ESG risk factors with business strategies and investment policies, looking specifically into EU banks and the EU Banking Prudential Framework. Given the increased regulator focus across the global corporate landscape, every organization should ensure that they understand the ESG risks they face, ESG risk transmission channels, and the relevant ESG compliance obligations within their jurisdiction.
What is ESG risk?
Environmental, Social, and Governance (ESG) describe a range of ethical and sustainability concerns relating to banking and business practices. While ethical financial practices were a social and governmental concern throughout the 20th century, ESG emerged as a significant priority in the wake of the 2008 financial crisis, which exposed industry-wide failures in governance, and reckless corporate behavior, that caused unprecedented damage to markets all over the world.
Beyond unethical financial behavior, ESG considerations extend to observance of environmental sustainability practices such as the need to reduce carbon emissions and preserve natural habitats, and to social practices such as the use of ethical labor, involvement in communities, and sponsorships of local initiatives. Governance concerns may relate to the way an organization makes decisions or responds to both the detail and spirit of laws within its operating jurisdiction.
Adverse media and ESG screening
In order to manage ESG risk factors and comply with relevant ESG regulations, organizations must understand what kind of risks they face, and when those risks emerge.
This means that banks and corporate entities should monitor their customers, clients, and third-party relationships on an ongoing basis, with a particular focus on adverse media stories that concern ESG risks. Breaking news stories often indicate that ESG risk profiles have changed before that change is confirmed by official outlets: a client’s involvement in an ecological disaster, for example, such as a forest fire or oil spill, may be reported on activist websites or local news before government authorities confirm the news.
However, given the significant data requirements of adverse media screening, banks should develop and implement an automated software solution to meet their adverse monitoring needs efficiently. The monitoring solution should capture and organize data from all related news articles and media, including traditional screen and print sources, and online sources. The diversity of the modern media landscape and the ubiquity of online news sources means that adverse media screening should take in as broad a range of news as possible, and include more obscure sources such as social media feeds and activist websites.
ESG Screening Considerations
The EU’s 2021 study into the integration of ESG factors into bank’s strategies and investment policies, identified the following key ESG risk management elements:
Risk definition and identification: Banks should define and identify their ESG liabilities based on the relevance of ESG factors to their approach to risk management.
Risk governance and strategy: Banks should ensure that ESG risks are understood at an executive level so that ESG risk processes can be organized around strategic objectives.
Risk management processes and tools: Banks must put measures in place to assess the ESG risk that they face. ESG data may be gathered directly from customers and clients or sourced externally. Once those risks are understood, banks can measure their exposure quantitatively against their risk appetite.
Risk reporting and disclosure: The ways in which banks report and disclose their ESG risk should vary based on their audiences. Banks should decide on the level of transparency and granularity with which they should disclose their ESG risk level in order to remain compliant with local regulations.
Integrating ESG Risk Processes
While banks may be able to closely control their ESG compliance responsibilities at a day-to-day operational level, managing ESG risk transmission channels such as investments and financing activities or third party relationships may be more challenging. Accordingly, banks should work to understand the relevance of ESG risk transmission channels to their risk assessment framework and how those risks may damage their operations.
|Examples of significant ESG risk transmission channels include:|
|Credit risk||ESG factors may affect credit risk exposure for corporate entities of every size. When borrowers’ assets lose value due to climate change issues, for example, their ability to pay back loans may be negatively affected.|
|Reputational risk||ESG factors, such as financial or environmental scandals, may affect an organization’s reputation negatively, discouraging investors and stakeholders and decreasing corporate valuation.|
|Cybersecurity risk||Inadequate cyber-security measures, loss of customer data, privacy breaches, or cyber-crimes can result in direct financial loss and legal penalties.|
|Market risks||Markets may be negatively affected by a range of ESG risks, including environmental damage or climate legislation. Those factors may result in losses of earnings and value.|
|Legal risks||Breaches of law or codes of conduct may result in legal and civil penalties, which may, in turn, result in significant fines or even prison sentences for culpable individuals.|
|Climate risks||Many institutions frame climate and sustainability factors as risks that cut across different transmission channels. Banks that are exposed to climate change risks, for example, may also be exposed to legal, market, and reputational risk.|
Regulator Guidance on ESG Screening
Many global financial regulators have responded to the rise of ESG risk factors by implementing new legislation and publishing jurisdictional guidance. Notable examples of authorities and entities that have published ESG guidance include:
|Austrian Financial Markets Authority (FMA)||In 2020, the FMA published its Guide for Handling Sustainability Risks which sets out definitions of ESG risk factors, along with risk management best practices.|
|The Prudential Control and Resolution Authority (ACPR)||The French banking supervisory authority published a good practices guide to governance and climate risk management in May 2020. The guide focused on climate-related risks and set out recommendations for risk management tools, disclosures, and strategies.|
|China Banking Regulatory Commission (CBRC)||In January 2020, the CBRC published its ‘Guiding Opinions’ on the development of its banking and insurance industry. Although not specific to ESG, the guidance encouraged banks to incorporate or improve their ESG risk management, information disclosure, and reporting systems.|
|De Nederlandsche Bank (DNB)||The central bank of the Netherlands published a good practice guide to ’climate-related risk considerations’ in April 2020. The document emphasized the importance of banks developing risk identification in climate scenarios and of disclosing their carbon footprints.|
|European Banking Authority (EBA)||In December 2019, the EBA released its Action plan on sustainable finance. The plan encourages banks to incorporate ESG factors into their business strategy and to integrate climate change scenarios within their risk assessment processes. |
In May 2020, the EBA published its Guidelines on loan origination and monitoring. The guidelines recommend that banks incorporate ESG risks into their internal risk policies and perform assessments of borrowers’ exposure to ESG risks.
|European Central Bank (ECB)||The ECB published its guide on climate-related and environmental risks in November 2020, setting out definitions of risk characteristics and its supervisory expectations regarding banks’ ESG risk management practices.|
|Financial Supervisory Authority (BaFin)||Germany’s financial regulator released its Guidance Notice on Dealing with Sustainability risks in December 2019. The guidance included BaFin’s requirements for banks to integrate sustainability risks into their risk management frameworks.|
|Monetary Authority of Singapore (MAS)||Singapore’s financial regulator released Guidelines on Environmental Risk Management for Banks in December 2020. The guidelines set out MAS’ ‘expectations on environmental risk management for all banks, merchant banks, and finance companies in the city-state, including their ESG risk disclosure policies.|
|Prudential Regulation Authority (PRA)||The UK’s PRA released a supervisory statement, Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change, in April 2019. The statement focused on the financial risks of climate change issues and set out its expectations for banks’ integration of ESG risks into their existing risk management infrastructure.|
|Securities and Exchange Commission (SEC)||In March 2021, the US’ SEC released a statement emphasizing the need for an ’adaptive and innovative approach to ESG risk screening and invited public input on proposed new ESG disclosure rules. |
In April 2021, the SEC’s Division of Examinations issued a Review of ESG Investing in which it encouraged banks to ensure that ESG disclosures were accurate and consistent with internal practices and that ESG investment policies were subject to appropriate oversight and compliance.
Tailoring ESG Compliance Solutions
Definitions of ESG risks vary significantly by a range of factors, including business sector and jurisdiction, while many ESG factors overlap. Environmental concerns, for example, including damage to local wildlife or plant species, may, over the short and long-term, impact local populations, negatively affecting farming and fishing practices and causing unforeseen financial damage.
To account for the diversity of ESG factors, banks, and other corporate entities should consider how their approach to ESG risk can be tailored to the specific challenges of their operating environment, and make their own call on the best way to integrate ESG into their existing risk-management frameworks.