Stockholm (NordSIP) – Understanding the nature of the ESG risks, how it affects the real economy, the role of the banking sector and how it integrates ESG considerations in its investment decisions and how regulators can guide these processes is crucial to the sustainability agenda.
To shed some light on this topic the European Commission published a report it commissioned from BlackRock about the development of tools and mechanisms for the Integration of ESG Factors into the EU Banking Prudential Framework and into Banks’ Business Strategies and Investment Policies.
The study, completed in May 2021, but only published at the end of August, explores the integration of ESG factors into banks’ risk management processes, business strategies and investment policies, as well as into prudential supervision.
The report collected and aggregated information from a wide range of representative stakeholders. It provides an overview of current practices and identifies a range of best practices for the integration of ESG risks within banks’ risk management processes and prudential supervision. Of the many insights and challenges that the reports highlights, two interesting facts stood out to us on first reading: the different focus that each ESG factor received and the discussion of ESG risk transmission channels.
Not all Factors are Born Equal
Findings show that ESG integration is at an early stage. The report argues that the pace of implementation needs to accelerate if banks are to effectively integrate ESG into their risk management and business strategies, as well as prudential supervision.
More specifically, the report notes that not all factors are equal. “Most banks have not integrated ESG risks within their internal risk reporting frameworks. The highest degree of integration is observed for the E pillar, specifically on climate-related risks. ESG risk-related information is usually included in banks’ public ESG disclosures, influenced primarily by national and EU-wide legislative and regulatory reporting requirements,” the report explains.
“ESG themes falling under the S pillar – external and internal stakeholder management – received the lowest scores from supervisors in terms of relative ranking. External stakeholder management was ranked lowest, in contrast to the perception from banks, where it was ranked as third most relevant,” the report adds.
Another aspect that the report highlights is the distinctive treatments given to ESG factors within the financial industry. “Whilst many respondents acknowledged the importance of developing a holistic ESG risk strategy, few banks have an explicit and comprehensive strategy in place that ensures coordination between the ESG pillars and visibility on potential trade-offs. Environmental and social risks are often grouped as part of sustainability risks, whereas the governance aspect is more often viewed as a compliance topic and therefore tends to be structurally and conceptually separated,” the report continues.
Transmission Channels of ESG Risks
Another interesting topic covered by the report is its inclusion of a detailed discussion of the transmission channels of ESG Risks. BlackRock identified 8 channels through which ESG risks can affect banks:
Lower household wealth is considered the least important transmission channel. Next comes economic deterioration and lower productivity and output it implies, followed by financial contagion via credit tightening and market losses, and the economic deterioration created by lower demand. Lower residential and commercial property values as well as lower corporate profitability are perceived to be the main transmission channels.
However, the study reports that although interview respondents generally agreed that an improved understanding of the various ESG risk transmission channels is seen as an important step in developing a clear map of ESG factors to risk types, such a common understanding does not yet exist.
“Despite efforts to advance work on this topic, many respondents stated that there is still no common understanding of the importance and relative relevance of these transmission channels, for instance, due to the different time horizons associated with ESG risks,” the report warns.
To support the pace of ESG integration, the report recommends priority be given to improving ESG definitions, measurement methodologies, and associated quantitative indicators and deal with the challenges posed by inadequate data and variable standards. “Cross-stakeholder collaboration, as well as supervisory initiatives and guidance, will be critical in tackling this global and pervasive topic,” the report argues.