By Richard Moss, Global Head of Risk Strategy, Adenza

As the world transitions to increasingly green priorities, everyone acknowledges that no organisation will be insulated from having to confront Environmental, Social, Governance (ESG) issues that are shaping the present and whose consequences will affect future generations. Regulations including Sustainable Finance Disclosure Regulation (SFDR) and Non-Financial Reporting Directive (NFRD) and initiatives including the Taskforce on Climate Related Financial Disclosures (TCFD) framework and the European Union taxonomy promise to address climate change as a core priority are shaping the world of finance and investment. Furthermore, stakeholders from all sides – financial institutions, regulators, governments, the United Nations, non-governmental organisations, and investors – agree that actions that will yield a greener investment landscape are a win for everyone. Care must be taken to unify requirements and best practices for ESG risk assessment. There cannot be “gaps” across jurisdictions. But asking how to get there doesn’t seem to yield a simple answer.

In addition, other questions emerge:

• Have we been doing ESG risk assessment the right way?
• Has tunnel vision led us to draw the wrong conclusions about how to create effective risk frameworks for accommodating ESG disclosures?

Don’t Get Left On The Platform: ESG Risk Assessment and Deriving Insights

As stakeholders assess their credit, market, operational, and ESG risks and how best to address them holistically, there seems to be even less consensus on a unified way to assess risk than there is on sustainability and global guidelines for ESG. There has not been a meeting of the minds by global regulators to create a harmonised set of standards to guide unified requirements for disclosures.

One could speculate that a mishandling of risks is what has caused delays in adoption and implementation of green policies and a unified approach to regulation. After all, discussion of how to create sustainability among corporations as well as with investing has been going on for over 20 years. But governments have made the decision to delegate the burden – and thus the risk – to institutions. In turn, those institutions have put the onus on capital markets. However, a market-driven view of risk is not the same as an ESG-driven view of risk and thus we are left with the result: uncertainty regarding how to define ESG disclosures and disparate approaches across the globe. Organisations must solve the problem of collecting data to build ESG risk assessment frameworks and meet disclosure requirements. They are therefore wondering how best to derive insights and responsibly grow their businesses in line with green principles.  The bottom line is that the world is changing and so is the risk landscape; no one wants to be left standing on the platform as the last train leaves the station.

Where Is This Train Going? Critical Questions On The ESG Journey

Action must be taken to standardise ESG disclosures and the data that financial institutions are required to provide given the fact that risks including natural disasters, population demographic pressures, and environmental weaknesses are significantly impacting the world around us. It is not only the organisations themselves that need clarity, but investors are also on this journey. Accusations of green washing will continue unless the “shades of green” associated with various types of investment can be standardised, and very importantly, supported by transparency. As they choose what to invest in and who to invest with, investors are in the midst of educating themselves. They want to know what they are looking for in a disclosure and how to interpret this data across global markets.

Both financial firms and investors may be asking themselves the same questions as they analyse ESG disclosures and the accompanying regulations that are becoming part of every investment conversation including:

1. Are the expectations of the financial sector and society at large reconcilable?
2. In terms of meeting goals per the 2030 Agenda for Sustainable Development, adopted by all United Nations Member States in 2015, we are still “transitioning” in the financial industry – are we running out of time?
3. Is it possible to meet the requirements of SFDR, NFRD, ECB, and other frameworks simultaneously and with aligned data?
4. What risks do institutions face and perhaps even more importantly, what risks do they pose?
5. How can the “global gap” be closed so that regulation requirements are unified across jurisdictions and investors can make decisions about investing worldwide?

Answering these questions effectively will require active engagement by all market participants. And to move forward on the journey of sustainability, a unified taxonomy for what ESG disclosures should include is required.

A Precise Train Timetable: Regulators Can Influence Actions

Creating a unified set of requirements is one step closer to creating comparability across jurisdictions and a “sustainable morality” within the industry. Once there are defined rules the question becomes how to enforce the terms and act against transgressors.  Regulatory policy has the power to change the behavior of actors and it should be used as such.  The TCFD as well as a framework outlined by International Financial Reporting Standards Foundation (IFRS) are good starting points for examples of what disclosure requirements could look like. In addition, with definitions and deadlines for requirements already laid out by the ECB, Europe is leading by example. 

All Aboard! Participation Of All Market Players In Sustainability Disclosures Is Essential

The notion of one jurisdiction leading the way is not a bad one, but the key will be getting an “all aboard” from other regions and their respective regulators. The key may be to make it simple and seamless for organisations to supply the relevant data – thus ensuring a high level of participation. High participation levels will enable the industry to meet the targets of the United Nations 2030 Agenda for Sustainable Development, and without further delays. The global nature of organisations in the year 2021 will hopefully create a momentum towards building a centralised database with “green info” that is transparent and accessible to everyone in the industry. This will mitigate confusion and subjectivity about what disclosures should include and will serve the responsible investor as he seeks to educate himself.

Next Stop Approaching …. Clear Data Requirements And Critical Calculations

To adequately confront the challenges of incorporating diverse data sets and disclosure requirements into new or already existing ESG systems, accurate, transparent, and consistent data is essential. Institutions need to perform more calculations, scrutinise more analytics, and generate new disclosures – generally at their own discretion given the lack of standardisation of ESG requirements. The right data must facilitate clarity and standardisation and must enable organisations to perform the necessary calculations so that they are prepared with adequate strategies for ESG risk assessment as well as for understanding their credit, market, operational, and liquidity risks. Critical calculations include probability of default (PD), loss given default (LGD), exposure at default (EAD), and their impact on risk weighted assets (RWA)). Organisations may benefit from assessing their preparedness with the following questions:

1. Are we prepared to process large volumes of granular data to facilitate ESG risk assessment?
2. Do we have adequate models and sufficient data to calculate PD, LGD, and capital adequacy?
3. Is there a consistent way to measure credit risk across sectors given an ESG risk perspective?
4. Is the right approach to incorporate ESG-related risks into the traditional risk framework (credit/market/operational) or is the right approach to assess ESG risks completely separately?

Organisations must be able to respond to the demands of a changing investment landscape by leveraging systems that are flexible and able to pivot to accommodate new data points when required. A system that can aggregate ESG, credit, market, and operational risk data becomes critical, as does having a central data repository. Whether or not an institution is able to access this flexibility may determine their fate since they are faced with the challenge of what to do and what not to do based on their own expert judgement.

Trains Don’t Use Keys, But Data Is Key

Easily accessible and transparent data, and futureproofed technology delivers functionality while decreasing the resources required to effectively manage diverse risks and grow businesses that will have positive global impacts, including promoting sustainability and driving economic and social progress. Once they have transparent and efficient processes place, firms are empowered to create organiaation-wide clarity on how to aggregate their data and create frameworks so they can deliver uniform and transparent ESG disclosures. This “key” will enable organisations to build impeccable ESG credentials so investors can make informed decisions.