ESG, banks, and direct and indirect risk

The criteria and strategies related to environmental, social and governance issues, summarised by the acronym ESG (a synonym of sustainability), are always more important in the saving, credit and financial sector.

It is no more just a matter of ethics. Sustainability has become a key factor for the economic development, especially for banks. Credit institutions deal daily with this economic asset and with the deriving risks, both direct and indirect (the difference will be explained below).

ESG is now part of the management of banking risk, for several reasons: the growth in demand of sustainable products, the pressure exercised by European regulators and international rating agencies on banks to assess, manage and measure – with a higher frequency and precision – the risks linked to investments, innovation and research, which increase sustainability. As a consequence, new regulations and new requirements in the reporting process have been introduced, and credit institutions have to face new challenges to be compliant. On the following section, we provide a general overview, then we will focus on banks and ESG.

Definition of ESG

ESG is an acronym which stands for environmental, social and governance: the 3 pillars of sustainability for the European Union, three key factors to verify, measure and support the commitment, in terms of sustainability, of a company or an organisation – including banks and financial institutions.

The concept of ESG was firstly introduced in 2004 by James Gifford, head of sustainable & impact advisory at Credit Suisse. He told many times about its origin “The term was coined when I worked for the UNEP FI, the UNO financial initiative for the environment, in Geneva. We realised that a new awareness about the importance of sustainability was emerging”.

From the Paris Conference to UNO Agenda 2030

In the following eleven years, the sustainability debate has grown, culminating with the Paris Agreement: an international treaty stipulated among the Member States of the United Nations Framework Convention on Climate Change (UNFCCC), on the reduction of greenhouse gas emissions and finance, signed on 12^th December 2015.

Nearly three years later, in November 2018, 195 members of the UNFCCC signed the Agreement and 183 decided to be part of it. Which are its goals? Generally, the Paris Agreement aims at combating climate change and eradicate poverty. To reach these two objectives, the path to be followed goes through the limitation of the increase of the global average temperature at 1,5°C, to reduce risks and effects deriving from climate change, and the introduction of consistency of financial flows to the environmental-protection policies.

Moreover, in 2015 the UNO Agenda 2030 was launched to promote sustainable development: it comprises 17 sustainable development goals (SDG) and it has the merit to steer global economy towards environmental and social goals.

ESG criteria, goals, and strategies

In the previous section we illustrated the key points of sustainability at a global level, but currently, the ESG criteria are a crucial point of the public debate and represent a major driver which guides global decisions, implying short-term commitment of each single undertaking for a sustainable development.

Many undertakings (including banks and financial institutions) choose to adhere to international standards, ensuring their compliance to certain requirements and establishing goals to be pursued in the medium and long term.

In order to reach these goals, undertakings implement a range of strategies on ESG, which relate to different company assets. This is why ESG criteria have become so important: they enable a precise and standardised parameters-based measurement of an undertaking environmental, social and governance performance.

Briefly, invest in ESG assets means addressing capital toward undertakings which respect the environment, support women participation in management bodies, and care about workers inclusion and well-being.

ESG and financial products

The ESG have a direct application in the sector of financial products, which could be classified as ‘responsible’, since they promote social cohesion through the financing of projects and undertaking generating an added value for mankind, culture e/o environment.

According to different criteria related to risk, liquidity and return, savers can choose to invest in savings accounts, term accounts, Sicav or collective investment funds, pension funds, life-insurance policies, or shares and units of non-profit organisations; and also, in private equity closed-funds, real estate funds, asset management companies, ETF, structured products, bonds and certificates of deposit.

The ESG refer to different financial entities: commercial and investment banks, asset management companies, brokers, financial consultancy firms, insurance companies, social rating agencies and index providers.

ESG, banking and financial supervision

The integration of sustainability factors (ESG) in corporate processes and in banks and financial institutions supervisory processes is a strategic priority for the upcoming years. For this reason, the Bank of Italy committed to increase the awareness of the challenges and opportunities – impacting on business models – that could derive from ESG factors and to develop appropriate programmes to evaluate supervision.

The Bank of Italy states that ‘the Basel Committee on Banking Supervision is analysing whether and to what extent the current regulatory framework is fit-for-purpose to appropriately identify the financial risks linked to climate change’. Moreover, ‘the Committee is looking for possible improvement to the First, Second and Third Pillar regulations; among the steps already adopted there is the publication for consultation, in November 2021, of specific Guidelines addressed to banks and Supervisors for an effective management of climate risks’.

Further, it should be noted that the EBA (the European Banking Authority) is developing public disclosure standards and Guidelines to manage ESG risks. The European Commission also proposed a revision of regulations for banks and investment firms (CRR3 and CRD6), to strengthen market disclosure (Third Pillar) and the controls to be implement by intermediaries, to ensure an informed management of risks (Second Pillar).

Referring to the Single Supervisory Mechanism, the Bank of Italy contributes to the assessment of the bank adjustment plans, to meet the expectations of the ECB on climate and environmental risks and to the execution of a climate stress test.

Moreover, the Bank of Italy prepared a first set of ‘supervisory expectations’, referring to the integration of climate and environmental risks in corporate strategies, governance and control systems, risk management framework and disclosure of supervised banking and financial intermediaries. And this last field has been integrated in our Pillar 3 module of the TigreArm suite, which allows for the automatic generation of public disclosures on ESG.

Direct and indirect risk for banks

Risk management is a priority both for banks and financial institutions, but in relation to ESG risk management has to be considered also from another perspective.

First of all, from a ‘direct risk’ perspective, since the environmental, social and governance risk could have a direct impact on the income statement of the banks; for example, when a natural disaster directly affects a building belonging to a bank or one of its branches.

Then, there is also the so called ‘indirect risk’, which refers to clients and stakeholders. For example, when an undertaking has to interrupt its activities due to an environmental damage, with all the deriving economical and financial consequences.

Both these risks cannot be underestimated. On the first one, a bank can exercise a direct control, since the measurement and the management of this risk directly depend on its business and management ability, through the development of strategies and investment business programs, which take into consideration ESG criteria, to protect stakeholders.

In the second case, the position of the bank is more complex. Sustainable finance and credit activities addressed to clients require risk management abilities and stress test also in the field of ESG, which represents a new scope also for credit institutions.

Both for direct and indirect risks, two subsets should also be considered: acute and chronic risks, as well as financial and non-financial risks. The risk scenario is complex and could have a direct impact on the business activities of banks, or an indirect impact on clients, originating a reputational crisis.

The new European Directive CSRD

To meet the need to provide undertaking with uniform standards on ESG, the European Commission mandated the technical institution EFRAG (European Financial Reporting Advisory Group) to set out the principles for sustainability reporting, which will be finalised by 30^th June 2023.

In the meanwhile, in November 2022, the European Parliament approved the new rules on sustainability reporting (Corporate sustainability reporting Directive o CSRD), which expand the scope of non-financial information to be submitted.

The Directive was published on the Official Journal of the European Union on 16^th December: it has to be implemented no later than 6^th July 2024 and it introduces a differentiated treatment, according to the financial year and the size of the institutions (the implementation period will last from 2024 to 2028). Overall, 50 thousand European undertakings should be affected, three times more compared to the current 11.700.

What is it about? With these regulations, the European Union extends reporting requirement to many more undertakings, for three purposes: the first one is to increase the level of transparency related to environmental, social and governance matters; the second one is to combat ‘greenwashing’ and the third one is to strengthen economic sustainability across Europe.

To reach these three goals, the new EU Directive expands the scope of the reporting, including the principle of double materiality, to measure and present the impact of the activities of an undertaking (for example, a bank) on the environment and society, as well as the effects of sustainability factors (ESG) on the economic and financial situation of the undertaking itself.