Many financial institutions around the globe have committed to fight climate change by setting ambitious goals in the near and long-term future and working to embed the management of ESG risks into their risk management organizations. For example, Bank of America has committed to net zero greenhouse gases through their financing operations before 2050 and disclosure of their financed emissions no later than 2023 1 . Other banks such as Morgan Stanley, Citi or UBS have made similar commitments through the UN-convened Net-Zero Banking Alliance 2 . Despite the public commitments of many financial institutions, the transition to a net zero portfolio and the management of climate-related risks is an enormous undertaking and the prioritization of initiatives has been challenging.  The focus of this blog is to suggest that firm’s prioritization the integration of ESG and Climate into existing processes for client lifecycle management of issuers, borrowers, and counterparties.

Focus Areas

The Integration of ESG into the client lifecycle process should be viewed as a starting point in the management of ESG risks and taking advantage of ESG opportunities.  However, there are specific focal points that we believe our clients should prioritize:

  • Emissions Footprint & Carbon Intensity. Driven by regulatory mandates in Europe and elsewhere on Financed Emissions, firms should initiate the process of integrating carbon metrics and exposures into the client lifecycle.
  • Energy Transition Strategy & Planning. Detailed evaluation of transition plans should be considered a pre-requisite in providing new credit, particularly for sectors that are carbon intense, but also for firms that are dependent on production inputs from high GHG emitters.  For example, a restaurant chain may not appear as carbon intense on its surface, however, many are dependent on GHG intense agricultural activities such as meat and livestock.
  • Enterprise and Supply Chain Physical Risk Exposure. As the frequency and intensity of climate-related events increases, financial institutions may need to evaluate the physical risk vulnerabilities of buyers and suppliers, as well as the strength of resiliency planning, to ensure production outages do not have material impacts on credit worthiness.
  • Diversity, Equity, and Inclusion. In addition to climate related risks and opportunities, Diversity, Equity, and Inclusion (DE&I) initiatives have become a very high priority for many financial institutions following the social justice movements of 2020.

Benefits

Even though there are many challenges in understanding the ESG risk embedded in the portfolio, ESG integration into client lifecycle management provides benefits that could support financial institutions on their sustainability journey.

  • Reputational Risk Management. An ESG assessment can decrease exposure to reputational risk through their customer association and can improve the reputation and brand value of financial firms. For example, firms can mitigate the risk of negative press related to indirectly financing environmentally unfriendly activities, while increasing the positive press from ensuring their financing activities are contribution to social justice through fair lending and supporting underserved communities.
  • Transition Risk Management. The transition to sustainable business models may become a burden for many corporate clients that can lead to liquidity and solvency issues. For example, a portfolio of issuers and borrowers that are dependent on fossil fuel credits, subsidies, or costly production processes in emission-intensive industries, could lead to write downs and defaults within the next 10 to 20 years. Rather than divestiture of carbon assets, early identification of “at-risk” clients may assist firms to proactively support their clients through the transition and support robust transition strategy planning.
  • Proactive Regulatory Change Management. Financial regulators have indicated an interest in emissions financed by banks, which may result in new regulations that requiring transparent, data heavy disclosures. By assessing the current portfolio and future credits/loans on their climate impact, capturing ESG data on clients, firms could be better positioned to implement the new disclosure requirements. There are different levers the regulator may use to include climate factors in regulations:
    • Direct requirements of financial institutions to report direct and indirect emissions through Greenhouse Gas accounting. The PCAF has created a standard to standardize GHG accounting in Banking. While this standard is still a recommendation in the US, other countries are already a step ahead and have either mandated the standard (New Zealand since September 2020) or are planning to mandate the standard (e.g. the UK in 2025) 3 . Additional information can be found in our blog entry on Mandatory ESG disclosures.
    • Mandate climate factors in calculating existing risk indicators. Adjustments to RWA calculations for assets issued by corporates or sovereigns with carbon exposure or modifying collateral requirements for securities issued by corporates in carbon intense sectors may be a lever used by regulators to reduce systemic risk
    • Inclusion of climate scenarios in existing stress testing frameworks such as CCAR is another lever that regulators may pursue
  • Green and Social Opportunities. ESG assessments are used as basis when creating green and social funds and bonds, which have drawn an increased interest from investors. ESG assessments guarantee that green funds are composed of environmentally friendly corporations. While most asset managers are using market data providers to avoid accusations of greenwashing, financial institutions that can provide green evidence for inclusion of securities from issuers may be at a competitive advantage by broadening the universe of securities available for selection.

Challenges

As ESG is still a comparably nascent topic, there are still several major challenges in integrating ESG into the organization’s strategy and risk management. As noted in a recent paper, “Bridging the Data Gaps 4 , The Network for Greening the Financial System (NGFS) has created an overview of the main challenges around data availability, transparency and consistency in ESG data and disclosure standards. ESG as part of the Credit process is especially affected by the first two challenges (data availability and ESG scores) while missing disclosure standards specifically impact regulatory reporting:

  • Data on emissions or other ESG-relevant criteria for corporations is not widely publicly available so financial institutions face difficulties creating their own scores based on public data. With increased reporting requirements and common disclosure standards, the data availability gap should decrease in the future.
  • Several large vendors have created their own scores based on proprietary information. These scores mostly cover the major global corporations but are still inconsistent when it comes to medium size to small corporations. Additionally, the underlying scoring methodology is not public, so the exact weighting of factors and the data quality is unknown to the customer. For financial institutions, the creation of differentiated ESG offerings could start with data collection.

Where do we get started?

Accenture suggests that financial institutions, particularly banks and insurers, start to evaluate how they can integrate the ESG assessment in their client lifecycle management processes. We recommend including an ESG assessment at two points in the credit lifecycle – new counterparty/borrowing onboarding and periodic Credit Portfolio review.

  • Materiality Assessment. Initiate a material assessment to identify the key ESG and climate-related risks in your portfolio. For example, the MSCI ESG framework enumerates 31 different ESG considerations. Relevant ESG criteria are different per each industry so financial institutions need to define the applicable criteria for each industry in their portfolio. SASB has created a matrix to help assess the relevant criteria by industry 5. For each criterion, financial institutions need to define thresholds that are required for a positive credit approval as well as how these criteria are weighted in an overall ESG score. These thresholds depend on the assessment solution the bank choses as there are no agreed industry-wide taxonomy yet. The institution’s defined risk appetite as well as public ESG targets (e.g., net-zero emissions, etc.) also impact the calculation of these thresholds.
  • Identify ESG and Climate Specific Gaps and Remediation Activities in the risk framework necessary. The measurement of credit risk owing to ESG & climate related events would require updates in several areas:
    • Enhance policies, processes, and procedures. ESG assessment should be integrated into the counterparty review process as part of Underwriting for new credits as well as Portfolio Management in the form of a one-time assessment of the existing portfolio and as a regular module for periodic reviews of credit line extensions
    • Adjust credit limits based on ESG assessment outputs e.g., allow for higher credit volumes for corporations with better ESG ratings.
    • Assess the current availability of ESG data in the credit approval process. For example, assessments on flooding are already a common part of the underwriting process for mortgages so existing processes or solutions can be leveraged for other areas within the ESG scope.
    • After assessing the availability of ESG data, financial institutions can then define how to include an ESG assessment in the overall Analytics architecture and integrate it with any necessary data sources.
  • Engage with clients and support them through the transition. Financial institutions have a unique role to play in helping their clients navigate the transition and prepare for physical risks. We have observed financial institutions proactively engage with clients on GHG emissions measurement and operational resilience.

Sustainability, ESG and climate regulation that affects clients and counterparties seems like an inevitability that will create new risks and new opportunities. Financial institutions can get ahead of the curve by starting to prepare now, and like most strategic risk initiatives, data is the starting point of the journey.

References:

  1. https://newsroom.bankofamerica.com/content/newsroom/press-releases/2021/02/bank-of-america-announces-actions-to-achieve-net-zero-greenhouse.html
  2. https://www.unepfi.org/net-zero-banking/ 
  3. https://carbonaccountingfinancials.com/standard
  4. Progress report on bridging data gaps; Network for Greening the Financial System (NGFS), May 2021. https://www.ngfs.net/sites/default/files/medias/documents/progress_report_on_bridging_data_gaps.pdf 
  5. SASB Materiality Map

 

George Dodd

George Dodd

Senior Principal - Risk and Compliance

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Michael Weiss

Michael Weiss

Management Consulting Manager - CFO&EV Risk & Compliance

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