„Traditional risk (in the financial sector) is about what has failed in the past. Unfortunately, in the case of climate change, this does not work. Now we need to predict the future, which is not easy, and that's where we are working with our members to develop the norms and standards needed to respond,“ said Erik Usher, head of the United Nations Environment Programme Finance Initiative (UNEP FI).
As of 2018, more than 170 ESG-related regulatory measures have been proposed worldwide. As a result, financial institutions are increasingly looking at ESG risks from an ethical perspective and through the prism of the economics that affects their business more broadly.
The impact of the financial services sector on climate change outcomes cannot be underestimated. Annual investment in clean energy is set to more than triple to around USD 4 trillion per year by 2030, and financial firms have a crucial role to play in the transition towards a green economy.
The coronavirus pandemic has further highlighted the interdependence between financial institutions and climate change. Regulators are tightening disclosure requirements for financial services firms and investors are increasingly looking for sustainable products. Central banks, financial institutions, and corporations have taken note of initiatives such as the Taskforce on Climate-related Financial Disclosure (TFCD).
However, some institutions continue to focus on the reputational and business opportunities arising from ESG. Therefore, it is now time for the financial sector to consider ESG risks as an integral part of its risk management package.
ESG risk realities
Environmental threats, social inequalities, and corporate misconduct make financial institutions vulnerable if a strong ESG risk management framework does not accompany them.
Extreme weather events, such as floods, can expose financial institutions to the risk of loan defaults, real estate depreciation, or a reduction in savings deposits. Meanwhile, environmental regulations, such as taxes on single-use plastics or non-renewable energy, affect financial performance.
Climate risk can also affect the assets in which a financial institution invests. For example, the shift towards electrification in the automotive sector will lead to surplus assets in internal combustion engine production lines.
Institutions need to look at examples of external and financial impacts when assessing ESG risks. Still, the consequences can also affect other business areas, such as operational disruption, reputational damage, and strategic changes.
For example, the war in Ukraine has suddenly changed Europe's energy security scenario, which may have implications for implementing the EU's sustainable financing taxonomy as new investments will be needed in the short term to develop energy contingencies.
Not surprisingly, ESG risk assessment is a challenge for many organisations. The lack of understanding of the external factors influencing risk and the growing importance of non-financial impacts for financial institutions may not be immediately apparent due to the traditional way companies operate.
This is compounded by the constant change in definitions of sustainability. Global events and geopolitical shocks can affect the pace and nature of ESG risks. For example, oil and gas consumption declined before the war in Ukraine, but now EU governments have to accelerate this reduction for geopolitical reasons.
Once you see it, you can manage it
The nature, quality, and reliability of ESG data are improving as regulation tightens and disclosure systems are streamlined. This is driving the need for increasingly sophisticated analytical tools and methodologies for assessing risk and stress testing, moving from qualitative to quantitative approaches.
In addition, ESG risk assessment will combine the skills of industry experts, data scientists, mathematicians, and economists. Most ESG risks are not isolated but interlinked with other risks, resulting in separate risk clusters with very different consequences and magnitudes.
Therefore, the tools that organisations develop need to use sophisticated algorithms that can perform multiple regression modelling steps simultaneously. Furthermore, climate change should not be treated as an isolated risk but should be considered in combination with, for example, water scarcity and poor agricultural production. The resulting interrelationship between these variables will result in a cluster of risks that is much larger than the risks associated with each variable individually.
As climate change is changing the nature of coffee production, water scarcity is increasing, and poor technology is prevalent, the cumulative effect of the variables exacerbates the negative impact on the income of coffee pickers. This, in turn, has a negative impact on the local economy and businesses. Accurately assessing the extent of such risks requires data collection, analysis, and a deep understanding of the socio-economic situation.
ESG risks remain complex and difficult to predict, but future risk assessment tools and strategies will be developed based on a variety of data sources. They will include external and non-financial factors that are not the usual financial variables analysed for investment purposes, but which will need to be considered as they will help to provide a generalised picture of the interconnectedness of risk clusters.
Many of the necessary digital solutions are still under development. New digital technologies will help financial institutions to process vast amounts of data and information using algorithm-based models. In the future, risk managers in financial institutions will rely on machine learning and artificial intelligence with digital identity systems and probabilistic blockchain to make timely risk management decisions.
These solutions will help managers manage risk and run their businesses responsibly.
