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.”