Time to rethink risk

31/03/2020 Why integrating ESG should be a strategic priority in financial services.

In February, Mazars and OMFIF released the findings of an international survey of 33 central banks. The research found that 70% of respondents saw climate change as a major threat to financial stability. However, this has not yet fully translated into radical action taken by central banks to overhaul their supervisory approaches, despite the fact that the integration of climate change and environmental, social and governance considerations is gaining traction.

For instance, only 15% of respondents declared that they included climate related considerations in their routine stress tests of financial institutions. And only 13% supported the call for ‘green-supporting’ or ‘brown-penalising’ factors to incentivise banks to increase credit for green investments or reduce lending to unsustainable ones.

These results may appear disconcerting in the wake of increasingly vehement global calls from society for greener business practices, as well as a growing concern around the resilience of banks’ business models in the face of climate change.

However, the survey results also show that the direction of travel is clear. Financial institutions and investors should expect, and prepare for, ever-tougher regulatory action on climate change and ESG criteria. In the UK, the Prudential Regulation Authority published its expectations for climate risk management in April 2019. The Bank of England plans to launch climate stress tests in the UK in the second half of 2020 and publish the results in 2021. The European Commission, European Banking Authority and other national regulators are also active in promoting better understanding and management of these risks.

Voluntary sustainability frameworks are emerging. For instance, only a few months ago the United Nations Environment Programme Finance Initiative Principles for Responsible Banking were launched by 130 banks from 49 countries during the annual United Nations general assembly. Although a wave of change is definitely underway, more needs to be done to reshape business practices and ensure that ‘every financial decision takes climate change into account’, as called for in the ‘COP26 Private Finance Agenda’.

Future-proof strategies

To understand why businesses, and in particular financial institutions, are not embracing ESG with more enthusiasm, we need to look more closely at the concept of risk. First, climate and other sustainability-related risks have long been considered as potential issues caused by companies to the environment and the people with whom their products or services interact. The financial threat caused by climate change to financial institutions has only gained recognition in recent years, most notably with BoE Governor Mark Carney’s famous 2015 speech, ‘Breaking the tragedy of the horizon – climate change and financial stability’. Since then, climate risk has increasingly been discussed as a strategic, financial risk in its own right, as opposed to a reputational or corporate social responsibility matter.

The notion of timeframes is important. Businesses have tended to plan with short to medium-term horizons. In contrast, climate-related and sustainability risks are perceived as longer-term threats that do not necessarily have an immediate financial impact. The challenge is to bridge the gap between the perceived long-term risk with the necessary investments which must be made today in order to ward off the threat tomorrow. Businesses with longer strategic horizons will be the ones that have a better chance of achieving sustainable growth on the long run.

In response to the climate emergency, the imperative of low-carbon transition across all sectors and industries generates significant financing opportunities. An array of new revenue streams lie ahead for those who will be smart and forward-looking enough to adapt their business models first. Missing out on transition financing opportunities could be as damaging as failing to identify and mitigate climate risks in existing bank portfolios.

Ultimately, beyond the need to comply with current and upcoming regulatory expectations, the integration of climate change and ESG into governance, risk management and disclosure arrangements has become a strategic priority for any financial institution looking to future-proof its business model.

To download the report, ‘Tackling climate change: the role of banking regulation and supervision report’, visit omfif.org