There is a growing appetite for more sustainable business practice. According to Bloomberg Intelligence, ESG investing was estimated to be worth $35tn in 2021 and expected to reach $50tn in 2025. Meanwhile financial firms are making their commitment towards net zero through initiatives such as Glasgow financial alliance for net zero (GFANZ) and Net-zero banking alliance and according to the latest report from the European Central Bank (ECB), most banks have started to adapt their practices to incorporate climate and environmental (C&E) risks into their daily business.
Fidelma Clark:e: "SEAR will require companies to articulate the inherent and prescribed responsibilities of each senior executive in their Statement of Responsibilities with ESG to be included as one of the prescribed responsibilities."
Increasing regulatory and supervisory focus on ESG
However, the lack of transparency and inconsistency in how each company is operating has led to increased regulatory actions. In the EU, during 2021, there was a flurry of disclosure regulations targeting the financial sector for example the recent raids by the Securities Exchange Committee and BaFin on certain financial firms over their ESG claims.
With growing concern on how climate and environmental (C&E) risks impact financial stability, Central Banks are increasing their level of supervision on ESG integration by institutions.
Since the introduction of the C&E risk management guidance in 2020, the ECB has carried out two annual assessments on the implementation of the guidance by systemically significant banks.
In Ireland, the Central Bank of Ireland (CBI) issued guidance in 2021 and will conduct its first assessments throughout 2022.
Up until now, the EU were dominant in terms of enforcing the ESG Agenda, however with the introduction of the Principles for Effective Management and Supervision of Climate-related Financial Risks from the Basel Committee, the regulatory lens on this area is now very much a global one.
What does this mean for Boards and C-Suites?
Our recent CEO Outlook Survey found that many companies consider climate change a major risk to their company’s future growth with 74% of respondents viewing ESG as a significant value driver and 33% have put sustainability key performance indicators into operation.
With increasing materiality of impacts of C&E and ESG factors to the business combined with heightened demand from regulators and supervisors, the onus now is on Boards and senior management to address, prepare and plan for this increased regulation. It will require significant strategic planning across the business.
CBI’s guidance issued in 2021 sets out an expectation on Board and Senior management to demonstrate clear ownership over ESG risks and ensure they have access to sufficient information and expertise to enable clear, transparent decision-making in this area.
With regards to the EU significant banks, there’s still much to do to meet the supervisor expectation. The ECB’s 2022 assessment into ESG implementation cited a lack of detail with respect to Board Oversight structure, capacity to oversee climate and environmental-related risks and plans to address those risks.
In Ireland, the demand for Board and Senior Management’s accountability on ESG will also be brought into sharper focus at an individual level. SEAR (Senior Executive Accountability Regime) will require companies to articulate the inherent and prescribed responsibilities of each senior executive in their Statement of Responsibilities with ESG to be included as one of the prescribed responsibilities.
What does an effective ESG management framework look like?
The Basel Committee’s chief aim is to implement common standards across jurisdictions for internationally active banks, as well as for their supervisors. There is specific guidance on what Board and Senior Management should do, namely:
• Impact and materiality assessment: In developing the banks’ understanding and assessing the impact and materiality of climate-related risks, the board and senior management should be involved in relevant stages of the process, and the approach established by the board should be clearly communicated to the bank’s managers and employees.
• Strategy development: Take material physical and transition risk drivers into consideration when developing and implementing their business strategies and should ensure that their internal strategies and risk appetite statements are consistent with any publicly communicated climate-related strategies and commitments.
• Incentive alignment: Consider whether the incorporation of material climate-related financial risks into the bank’s overall business strategy and risk management frameworks may warrant changes to its compensation policies.
• Assignment of responsibilities: Clearly assign climate-related responsibilities to members and/or committees to ensure material risks are appropriately considered as part of the bank’s business strategy and risk management framework.
• Sufficient capacity: The board and senior management should have an adequate understanding of climate-related financial risks and are equipped with the appropriate skills and experience to manage these risks.
• Access to data: Climate-related financial risks should be accounted for in the risk data aggregation capabilities and internal risk reporting practices and timely information should be provided to the board and senior management to allow for effective decision-making.
Through working with clients on the implementation of the EU ESG-related regulations, EY found that in addition to absence of data, data considered, and risk calculations are unfamiliar to a financial services organization. In many instances firms responded reactively and there was a lack of both capacity and capability to fully integrate ESG factors into operating model.
How should companies prepare?
There are several steps financial services’ companies can take to prepare and structure the business.
1. Oversight Structure and Individual Accountability
Our 2021 Centre for Board matters survey found that C&E risks and opportunities and diversity, equity and inclusion initiatives are predominantly overseen by the entire Board within an institution. In 2020 only 15% of Boards discussed ESG agenda and reporting at every meeting but this has risen to 49% in 2022. This is a positive change, and one that needs to be built upon to ensure strategic review, at a Board level, continues in this area.
Given the rate at which the ESG environment is developing, the oversight structure should be agile and adaptable, with access to credible, forward-looking data and the appropriate tools to interpret it.
2. Building ESG Expertise
A key aspect of the Board’s role is to review, challenge and ask the appropriate questions of management in both the short and long term. Not only does this mean building their own knowledge and awareness of the key criteria within ESG regulation but also hiring candidates who will strengthen the teams’ skillsets in this area.
Whilst climate is at the top of the agenda to date, ESG consideration goes beyond this and takes in other environmental and social aspects as well. The ECB 2022 assessment found only 25% of the banks in the sample referenced other environmental risk, such as pollution, water usage, biodiversity, contravening the ECB guide’s expectations.
Boards should consider creating and leveraging ESG advisory groups that include academics or scientists that have a particular understanding of environmental or social issues.
3. Leveraging Reward Programs
In our survey, 75% of companies said there is more focus today on the personal responsibility and accountability of board directors and management teams in terms of making progress against ESG goals. It’s worth considering the approach to executive remuneration and incentive plans to further enhance leadership accountability on sustainability.
4. Trust and Transparency: Effective Reporting
Corporate reporting is expected to include enhanced and material ESG disclosures alongside other information to show how a company is driving value for all stakeholders. CEOs and boards need to move quickly to meet stakeholders’ expectations and articulate a unique narrative on how they create long-term value.