Banks have not been slow to adopt policies regarding ESG – environment, social and governance factors. It is an acronym whose relevance is hard to deny in the context of climate change and the global struggle for human rights. However, making ESG considerations part of a banks deliberations means more complexity for managers as they look to factor in ESG risks in a way compatible with financial risk management. The challenge is to embed ESG risk into a wider risk framework.
The Paris Climate Protection Agreement (2015) has committed 195 countries to limit global warming to 1.5 degrees Celsius above pre-industrial levels. The United Nations, with this goal in mind, launched their Agenda for Sustainable Development that sets out 17 Sustainable Development Goals (SDGs). 2030 is the year earmarked for implementing these goals. It is also the year climate scientists indicate as the point of no return: if we don’t get to the 1.5 degrees Celsius target by then, irreversible damage will be done to the planet and its inhabitants.
The challenge for banks is to balance the needs of both sustainability and economic growth. People need both a sustainable and healthy environment as well jobs, infrastructure, public services and a flourishing economy.
In the light of this challenge the UN in its Agenda for Sustainable Development has set out a Sustainable Finance Action Plan. The plan seeks to channel capital flows towards sustainable development.
In response several banks and related authorities including the European Central Bank (ECB), the Bank for International Settlements (BIS) and the European Banking Authority (EBA) have begun to set out frameworks to fulfil the brief set for them by the UN’s Sustainable Action Plan.
One of the main problems for banks in Europe and around the world is how to deal with large corporates heavily invested in fossil fuel technology. Banks want to finance the automotive industry; they can’t force them to electrify vehicles but at the same time allowing them to continue on as before is not an option for future sustainability.
While social and governance risks are palpable and can damage society, it is environmental risks that rise to the top of the sustainability agenda due to existential risk. Key to these risks is global warming and climate change.
Extreme weather can damage property, public services and infrastructure. It can diminish or even destroy asset value as, for example, ‘paradise locations’ such as the Maldives disappear under water. Food production is also greatly at risk from extreme weather. Moreover, food production that focuses on factory meat, genetically modified inputs and polluting pesticides face financial nudging to go green. Their traditional business model of making food as cheap as possible has ESG risks – banks will become more and more reluctant to offer financing.
To take stock, banks face regulatory and political pressure to use their unique position to promote sustainability in the markets. Like all of us, they face the disastrous impacts caused by climate change. Banks sitting on their hands face reputational damage. The devastation caused by rising CO2 levels in the atmosphere will lead to asset value loss and economic instability. At the same time, banks offering incentivised financing solutions to meet sustainability targets will cause a backlash from carbon intensive sectors who will see themselves as being unfairly punished considering they are big drivers of economic growth and job creation.
Banks don’t act on noble principles: they act on the basis of profit for their shareholders. Banking systems have been developed over centuries. They don’t rip up rule books out of principle, rather they set up quantifiable metrics, analyse data and alter procedures accordingly. The challenge for banks and ESG rating agencies is to be at the vanguard of qualitative change by using tried and tested quantitative methods.
