Chapter 1
The increasingly complex ESG agenda
From climate change to diversity to inequality, social issues are affecting corporate strategy.
If 2020 started with a focus on climate change, 2021 presents a more complex web of issues. Summit participants discussed key items on their ESG agendas.
- Racial justice and equality: The deaths of Black men and women at the hands of police in the United States and the disproportionate impact of COVID-19 on communities of color across the Western world have heightened sensitivity around diversity, equity, and inclusion. Several organizations have taken a stance and announced public commitments to promote racial justice in their communities. Many stakeholders are now pushing firms to ensure management and boards are more reflective of their customer base and society. The Nasdaq recently called for the Securities and Exchange Commission to mandate new diversity requirements for boards of companies listed on its main exchange.2 Some firms have announced that it would require all companies it takes public to have at least one diverse board member.3
- Proper treatment of customers: Financial services firms have been pushed by regulators and other stakeholders to grant payment holidays, issue premium refunds, and extend government-guaranteed loans to customers to ease the economic pain associated with the pandemic. As the virus rages on and government support programs wind down, leaders of financial services firms foresee difficult decisions ahead, such as whether to lend money to unemployed individuals and support businesses that are not likely to survive.
- Climate change: While attention to climate change dipped at the onset of COVID-19, it quickly returned to the top of many agendas. Some participants saw climate change as the most significant systemic concern for organizations around the world.4 They recognize that it is both significant risk and a large opportunity. Pressure on financial institutions to reduce carbon outputs is increasingly hard to ignore. With regulators implementing climate stress tests in various markets in 2021, the pressure looks certain to intensify.
The combination of complex social issues, the profound challenges of climate change, and a deadly global pandemic have resulted in a situation fraught with risk for large banks and insurers. Clients and investors want their money in environmentally and socially equitable endeavors, and employees want to work for companies with values they support. Regulators are encouraging such corporate responsibility, too. Many stakeholders now expect ESG to move to the center of corporate purpose and strategy, without sacrificing or compromising returns.
Chapter 2
ESG opportunities
The biggest risks offer the most compelling opportunities for innovation and transformation.
The opportunities presented by ESG are well understood. One participant said, “The trillions needed to transition and preserve economies as we know them is a massive opportunity.”
The opportunities include:
- Asset and wealth management: Flows into ESG-linked financial products and services have increased significantly during the pandemic. According to Morningstar, ESG funds attracted US$71 billion in net inflows between April and June of 2020, pushing total assets above $1 trillion.5 Sustainable funds have outperformed other funds during the pandemic, in part due to their low exposure to oil and gas during the selloff earlier this year.6
- Sustainable finance: The ongoing growth of the sustainable finance market creates underwriting opportunities for banks. According to Refinitiv, US$275 billion was raised in the first half of 2020 in the form of sustainability bonds, syndicated loans, and equity capital linked to sustainability outcomes.7 Of that US$275 billion, sustainable bonds represented US$200 billion, an increase of almost half, year-on-year, and double the amount raised in H1 2018.8 As the world mobilizes to address climate change and poverty, trillions of dollars in capital will be needed. Just three of the UN’s sustainable development goals require US$10 trillion in investment. Emerging markets present both the greatest need for investment and perhaps the greatest opportunity for returns. For example, financing a solar power plant in India could reduce carbon emissions by seven times as much as financing a plant in France.
- Advisory services: Financial institutions can help clients integrate ESG into their strategies and business models. The need is particularly acute in industries heavily reliant on fossil fuels. Providing guidance on the transition to carbon neutrality can improve the relationship between firms and their clients.
Chapter 3
An investor’s perspective: BlackRock’s expectations and priorities
Oversight and accountability are driving the ESG agenda.
Sandra Boss, Global Head of Investment Stewardship at BlackRock, joined FSLS participants to discuss the firm’s ESG priorities and expectations:
- Climate risk and strategy: Ms. Boss emphasized that “for financial institutions, climate risk management issues are probably the most important.” She added, “We are looking for how a company will operate in a two-degrees global-warming scenario that is consistent with net-zero in 2050.” She acknowledged that financial institutions cannot simply discontinue financing or insuring carbon-intensive industries; the key question is, “What is the direction of travel for your portfolio?”
- Board accountability for sustainability oversight: Board oversight and sign-off on the sustainability strategy are increasingly important, as reflected in voting decisions. According to Ms. Boss, “It is clear in our guidelines that we expect the board to oversee sustainability risk, and that is translating into holding directors accountable.”
- Metrics, standards, and disclosures: Ms. Boss agreed on the need for convergence on common global standards for sustainability metrics. Until a common framework emerges, BlackRock favors metrics aligned with the frameworks from the Task Force on Climate-related Financial Disclosures and the Sustainability Accounting Standards Board.
- Social concerns beyond climate change: During the pandemic, BlackRock has seen the importance of purpose increasing, especially relative to “treating customers and employees fairly; providing meaningful work; promoting diversity, equity, and inclusion; respecting human rights throughout the supply chain; and contributing to local communities.”
Chapter 4
Key challenges to progress
Multi-dimensional challenges require nuanced strategies.
As financial institutions contemplate how to tackle the increasingly urgent ESG agenda, they are confronted by a series of challenges, starting with the complex interactions between different issues. One director summarized, “The world has changed, and the expectations of financial institutions have changed significantly. It all comes under the headline of doing the right thing. And the right thing to do is not totally clear.”
Limitations in measurement, metrics, and standards
Metrics and methodologies for assessing and measuring ESG impact remain imperfect, complicating both internal reporting and external disclosures. Firms need better tools to measure carbon footprints and model the impact of climate change across diverse client and investment portfolios.
Many participants are unsure of how to measure environmental risk. For example, human capital, a common social concern, is especially troublesome because, as participants observed, reskilling employees for future gains does not show up in the immediate financial numbers, making it difficult to rationalize with near-term targets.
In September, the International Business Council and the World Economic Forum, in collaboration with EY and other Big Four consultancies, produced a set of universal, material ESG metrics and recommended disclosures that could be reflected in the mainstream annual reports of companies on a consistent basis across industry sectors and countries.9 This set of metrics consists of 21 core and 34 expanded metrics, largely synthesized from existing standards and disclosures and aligned with the principles of the United Nations’ sustainable development goals.10
The five leading voluntary sustainability framework and standard-setting bodies are:
- CDP (formerly the Climate Disclosure Project)
- Climate Disclosure Standards Board
- Global Reporting Initiative
- International Integrated Reporting Council
- Sustainability Accounting Standards Board
They have announced their intention to work together toward a comprehensive corporate reporting system for sustainability.11 In addition, the International Organization of Securities Commissions and the International Financial Reporting Standards Foundation are also exploring the roles they can play.12
Gaining alignment on ESG considerations
Financial institutions are focusing on integrating ESG into strategic planning, business operations, and board oversight.
- Approaching ESG strategically: Gaining alignment starts with a clear view at the top about what ESG means to the firm’s business and strategy. For many senior leaders, it is a series of risks to be managed, and the diverse nature of the risks makes it difficult to view them holistically. Emphasis on ESG as a risk has been driven in part by the regulators, such as the UK Prudential Regulation Authority’s mandate that boards assess climate change-related financial risks.
- Clarifying board oversight: While investors increasingly are holding boards responsible for progress, there is little consistency in how boards are overseeing ESG issues. Some firms lack clear board ownership across the various pieces of ESG. To establish stronger oversight, some boards are setting up new, dedicated committees. Internally, participants have developed committees focused on issues such as ESG-focused lending, target setting, philanthropy, and employee culture and purpose. In some cases, clients are asking how to set up ESG or sustainability committees.
- Integrating ESG throughout the organization: Embedding ESG throughout the organization is easier when board committees can oversee such initiatives, while accountability is more important for executives. The need for centralized ownership, coordination, and accountability is elevating the role of the chief sustainability officer (CSO). Many firms are appointing senior people to these roles and giving them significant responsibility. In some cases, CSOs report directly to the chief executive officer (CEO), or top-level risk or finance leaders. At some firms, CEOs should own the ESG strategy, given its broad impact and growing importance.
- Managing exposure to fossil fuels: Financial services firms are feeling pressure to limit exposure to oil and gas, though few are prepared to fully exit. Insurers, for example, need to identify appropriate long-term alternatives for future cash flows to meet future claims. Participants noted that it is a balancing act, rather than all-or-nothing decisions. Financial firms also play a fundamental role in supporting the needs of their local economies. In many areas, the fossil fuel industry is a key employer and contributor to the tax base. Engagement, rather than exit, is the preferred approach in such cases.
- Navigating divergent policy responses around the world: Climate change and inequality requires a coherent response from policymakers and regulators. Europe has shown more focus on climate initiatives while, in the US, diversity, and inclusion requirements have received more attention than elsewhere.
The challenge in the United States is particularly acute, due to tensions between regulators and markets, such as proposed regulation that would impose penalties on United States banks that stop lending to oil and gas companies.13
For climate change, financial services leaders would like policy action to more clearly define the process for transitioning to carbon-neutral economies and create long-term plans focused on outcomes and risk-sharing between public and private sectors. Such an approach would also force industries to work toward common goals.
Despite the challenges, leaders of large banks and insurers are moving forward on their ESG agendas. A participant said, “We’re focused on sustainability and the entirety of the ESG agenda because we think it’s the right thing to do. Those factors are driving the future of the world and can’t be tackled by the public sector alone. Financially, it’s a good thing to do. And from a risk management perspective, it’s absolutely critical.”
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Summary
ESG concerns are top-of-mind for board leaders, as well as investors and regulators. These issues and opportunities will continue to shape the future of the industry. A long-term focus should guide near-term decision-making in facilitating shareholder returns and sustainable operations, even as regulatory standards emerge.
