Integration of ESG as a fundamental into decision making

Ekaterina Grigoryeva, Former Environment and Social Development Specialist (Global Lead, Financial Sector), The World Bank, was a speaker at our recent Risk Americas Convention 2023.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

Why should financial institutions include climate & ESG related risks in decision making?

A decade ago, the question of why was more relevant for the financial sector, as considering ESG may have been somewhat optional. One of the key tasks for ESG professionals, including myself, was to build a “business case” based on materiality of ESG risks to the financial bottom line. They needed to build a reputation of a good corporate citizen and capitalize on sustainable investing opportunities. While these basic arguments still hold true today, with regulation on the rise and stakeholder pressure mounting, the question of how is placed much more firmly on the strategic agenda. This is no longer optional. With greater availability of data and ability to quantify the role of ESG (including climate) risks in investment performance, we see more and more financial institutions ramping up their efforts in this area.

In what ways will climate risks impact financial organizations?

The impacts of climate change on the financial sector are now clearly defined and fall under two broad categories of physical and transition risk. The former has to do with eroding underlying investment values due to increasing damages to assets and infrastructure, disrupted supply chains, and climate-related social issues. The latter is being discussed though the lens of decarbonization and associated need to shift financial flows away from GHG-heavy business activities, especially but not limited to the global energy sector. Many lenders and investors today are well versed in this terminology and the underlying strategies to address each type of risk.

Climate risk is already affecting financial institutions. For example, some of the most impressive figures comes from the insurance industry where some reports show that insured losses from natural catastrophes have increased 250% in the last 30 years (Reuters). There are many other sources that try to quantify and project what investors, lenders, and other financial services providers stand to lose due to increasing climate impacts. Another report by WWF states that investors in 66% of listed companies are at risk of big losses and may face losses to assets and revenues as much as $8.4 trillion over the next 15 years as the climate crisis damages ocean health.

How can financial institutions look to balance conflicting objectives of decarbonization and profitability?

In the past few years, many financial institutions announced net-zero targets as part of their strategies to align with the Paris Agreement. Notable multi-stakeholder initiatives recently launched in this area include Glasgow Financial Alliance for Net Zero and the Net-Zero Banking Alliance. While backed by good intentions and healthy ambition, not making sufficient progress towards such targets in the eyes of the public and governments can expose banks and investors to substantial reputational risks. For example, an interesting report by a group of prominent NGOs – those who have been following the financial industry’s sustainability performance for decades, starting with international development banks and then turning their rigorous attention to the commercial sector – states that in 2022 major banks provided $673 billion to finance the fossil fuel industry. Most of these have net-zero or similar public commitments. The challenge for their sustainability teams thus remains to show how Paris alignment might be beneficial for the bottom line, help meet fiduciary responsibilities to shareholders, and not play a role in market shocks associated with potential divestment strategies – matters that have been subject to some political debate lately as part of the “ESG backlash”. Some of the ways forward, while preserving this delicate balance, might be to learn from and scale up collaborative efforts with development finance institutions whose approaches for engaging with their clients on climate-related risks and ESG in general has been historically more extensive. Without this engagement and extensive support for clients (or investees) to shift their business models and implement emission reduction steps and technologies, decarbonization targets might be out of reach. This, of course, needs to be coupled with expansion of financing to support the shift by enabling transition pathways. Here, again, DFIs’ experiences can help.  For now, commercial financial institutions regrettably seem to be more involved in “climate number crunching” and scope 3 debates with regard to their portfolios than actually changing their business models to meet climate commitments through action where it matters – on the ground with clients.

Where do you see the integration of ESG in risk over the next 5 years?

As things stand now, there may be a need to correct market distortion created by the flood of ESG data that suddenly appeared in the past few years. There seems to be a proliferation of data providers all trying to capitalize on growing demand from the financial service industry that is under increasing pressure to report on ESG, and climate in particular, whether due to their own commitments or new regulatory requirements. And they must do this while struggling with acute shortage of internal capacity. While there is some credible and robust data on the market that can support meaningful risk management, most of what we see today is very superficial and collected using questionable methods. Lack of asset-level information, actual technical verification capabilities on the ground, and for that matter, deep technical expertise, will continue to distort ESG strategies of financial institutions. We may be heading into an “ESG data bubble” that is rather disconnected from reality. This may be due to the fact that in the financial sector, ESG integration models are often conceptualized by people with purely financial markets background to whom this process may mean adding certain numbers to the spreadsheet that would correlate with ESG risks and possibly give out a risk score or a similar parameter. While such ways of integration are important in finance, my hope is that in the near future, the sector will realize the need for a greater injection of technical ESG expertise to balance these approaches with the need to ground truth the metrics, engage with clients where they do business, and move beyond the current data hype. I am not sure that the response to low quality data is collecting more data. Sometimes it adds a tremendous perspective to have seen the actual chimneys those GHG emission numbers are coming from.