KPMG Lower Gulf: Banking on ESG Risks in Future

Author: Abbas Basrai

ESG risks have the potential of negatively impacting banks’ assets, earning capacity, and sometimes their reputation, argues Abbas Basrai.

Environmental, social and governance (ESG) factors and the emerging risks associated with them are becoming increasingly relevant to organizations, especially banks. Issues regarding environmental change, race and gender equality are shaping our society, with increasing levels of awareness and participation from stakeholders.

In an era of fast-moving data and ease of information availability, corporate reputations rise and fall not only due to their financial earnings but also based on their position on social and environmental issues. For modern-day organizations, fulfilling the needs of employees, customers, and the communities they operate in is critical.

Experts estimate that millennials alone could place close to USD 20 trillion in ESG-related investments over the next 30 years in the US, providing a significant platform of opportunity for businesses looking to capture long-term growth. As of mid-2019, assets under management for ESG-related funds stood at approximately USD 800 billion, representing a three-fold increase in the past ten years. All these factors point to businesses no longer being able to afford avoiding ESG matrices if they are to survive.

“While the risk itself is not stand-alone, it does provide a degree of influence on banks’ existing risks, be it financial or non-financial in nature.”

The levels of corporate social responsibility (CSR) reports and adoption of various global standards on sustainability such as the GRI (Global Reporting Initiative) and the UN’s Sustainable Development Goals (SDGs) by organizations globally have increased multifold in the last 20 years. But there have also been increasing carbon-emission levels and damage done to the environment during the same period. Additionally, while corporations have made significant progress in enhancing sustainability in their business models, there is still a long way to go.

Risky Business?

ESG is poised to stir up questions of ethics within the banking industry and raise economic and existential queries, activating a new category of risk: ESG risk. While the risk itself is not stand-alone, it does provide a degree of influence on banks’ existing risks, be it financial or non-financial in nature. ESG risks increase the chances of negatively impacting banks’ assets, earning capacity – and sometimes their reputation.

We can draw similarities from the current Covid-19 crisis and its impact on banks with ESG risks. The pandemic raised various issues for banks, such as travel restrictions that forced employees to work from home for an extended period. There were also issues with IT infrastructure, including cyber risks and network capacity constraints. These risks were unforeseen and not expected to happen at an organization-wide level in such a short span of time. In addition, banks also encountered problems around decreased demand for products and services from customers and disruptions to the supply chain. These risks warranted a quick and efficient response from these organizations, and mostly in an ad-hoc manner.

How successful banks are in coping with Covid-19-associated risks can mainly be attributed to the maturity of their operational resilience, and the same can be expected when dealing with ESG-associated risks. While banks can undoubtedly leverage their experience from the pandemic to prepare for upcoming sustainability risks, they will also have to develop new and innovative ways to confront these risks.

Planning and Testing for Risk

Existing risks identified by banks, such as credit and counterparty risks, market risks, liquidity risks and operational risks, are generally recognized to have potential impact on the institution. With ESG risks, the impact is limited to the bank itself, and all its stakeholders, and the risks to which the bank is exposing its stakeholders and the environment, due to its business activities. Dealing with such risks requires an approach of embedding them into the risk-management framework, with comprehensive risk governance and practical risk strategy, before implementation into the risk management cycle.

ESG risks can affect all divisions of a bank, including profit and cost centers and various parts of the three-lines-of-defense model. Enhancing the roles and responsibilities of existing units in the organization can be key to a successful governance model for banks. For instance, clear decision criteria and control mechanisms must be embedded into lending decisions for banks. ESG factors should also be assessed, similar to examining reputational risks in the know-your-customer (KYC) process.

Banks must also be cognisant of the fact that ESG risks’ planning horizons are usually much longer than the three to five years traditionally considered in business and risk strategy design. This especially applies to the climate-change-related components of ESG risks. The strategy on ESG needs to be aligned closely with overall business strategy, requiring regular reviews and updates when necessary.

So far, major International banks have begun their journey of overhauling their governance structures and risk frameworks to counter climate-related risks – especially around oversight of climate strategy and management of climate-related risks. While most banks have set net-zero targets by 2050, the process of quantifying their financed emissions is still underway. As the next course of action, banks need to include quick and early assessment of climate stress tests using available data sources. This is especially important as supervisory bodies in countries like the UK are launching climate-risk stress tests for banks. The UAE and other countries in the Middle East are expected to follow suit.