ESG Trends in Risk Management

Climate change, environmental justice, and governance practices top the list of ESG trends to watch for risk management teams within financial institutions.

ESG trends to watch: Meeting the risk management demands of corporate leaders

Environmental, social, and governance (ESG) issues have become a strategic priority for corporate executives and boards in the United States and in many countries around the world. Business leaders face increasing pressure to adopt a broader, more inclusive stakeholder strategy — addressing an interconnected set of issues that affect all areas of operations.

At the same time, risk management professionals need to ensure that customer due diligence (CDD) and know your customer (KYC) workflows satisfy the new demands of leadership.

ESG covers risks that include protecting workers’ rights and promoting ethical labor practices to diversity and inclusion efforts, privacy and data management, and the transition to a low-carbon economy. Climate change remains among the most pressing concerns and has proven to be far more challenging to tackle than many other financial risks.

While government leaders from the world’s major economies work toward adopting a global framework for addressing the climate crisis, it has become increasingly clear that protecting our planet and sustainable economic growth must go hand in hand. Given the complex nature of ESG risks for financial institutions, effective governance may be the most critical element in managing the environmental and social issues of the 21st century. 

Corporate executives prioritize ESG risk management

The Black Lives Matter protests following the killings of Ahmaud Arbery, Breonna Taylor, and George Floyd have forced business leaders to recognize that pursuing social justice is essential for healthy economic growth. Deriving profits for shareholders is no longer enough. Communities focused on justice and sustainability have called on C-suite executives to take actions that benefit customers, employees, and other constituents, rather than just seeking ways to maximize shareholder value.

Consumers and investors expect companies to respect human rights, practice corporate transparency, and promote diversity and inclusion initiatives that improve business performance and lead to broader economic development in local communities.

According to a recent Barron’s survey, nearly 60% of American consumers want companies to take positions on racial discrimination and social justice. Moreover, roughly half of the respondents say they research how brands react to social issues.

A PricewaterhouseCoopers survey, “Pursuing growth in 2021: The C-suite focuses on a rejuvenated workforce and building trust,” finds that improving business performance on ESG factors — and telling that story to a wider audience — is the key to building and maintaining trust with stakeholders.

Among financial services leaders, 53% are considering actions over the next year that include deals or investments related to ESG factors. As stakeholders call for corporations to take more meaningful actions to combat climate change, 43% of financial services leaders plan to increase company-endorsed public statements on social and environmental issues.

Leaders across a wide range of industries are stepping up their efforts to address ESG concerns. In May 2021, as the global health technology firm Philips marked its 130th anniversary, it issued a statement promoting the commitments enshrined in its new five-year ESG strategic plan, a key part of its target to improve the lives of 2.5 billion people by 2030.

ESG reporting requires clear standards for climate change disclosures

As a growing number of corporations integrate ESG factors into their decision-making processes, the interconnectedness of ESG issues has become a focal point of both private and public sector leaders. The Biden administration recognizes the deep and often complicated connections between environmental policies and social factors — putting environmental justice at the center of its climate change initiatives.

The Environmental Protection Agency (EPA) recently released a report that found climate change disproportionately harms marginalized communities that “are least able to prepare for, and recover from, heat waves, poor air quality, flooding, and other impacts.” According to the report, Black and African American people are 40% more likely to “live in areas with the highest projected increases in extreme temperature-related deaths.”

The climate crisis has also become a concern for The U.S. Securities and Exchange Commission (SEC). Recently, the agency requested public input on climate change disclosure requirements as it prepares to update the climate change reporting guidance issued in 2010. The goal is to develop “a more comprehensive framework that produces consistent, comparable, and reliable climate-related disclosures” upon which investors make investment decisions.

The lack of clear standards governing climate-risk data disclosures remains a problem for U.S. financial firms. In An ESG Reckoning Is Coming, the authors argue that companies should be required to report clear, standardized, and easy-to-understand ESG metrics. To this end, the Big Four accounting firms have issued a set of metrics for companies to use for ESG reporting as part of the financial reporting process.

As consumers and other stakeholders demand environmental justice and the protection of human rights, companies that practice corporate transparency and adopt ESG strategies focused on achieving more equitable and sustainable growth are well positioned for the future.

Governance is critical to managing ESG risks

Corporate governance policies play a critical role in helping firms manage environmental and social issues. Governance informs the policies, processes, and controls companies implement to maintain regulatory compliance and promote transparency. Core elements include the role and makeup of the boards of directors, shareholder rights, and the mission of the corporation.

In the summer of 2019, the Business Roundtable released a Statement on the Purpose of a Corporation, signed by hundreds of CEOs who have made a commitment to lead their companies for the benefit of all stakeholders, including customers, employees, suppliers, communities, and shareholders.

In addition to focusing on transparency and business integrity, companies in the financial services sector must also implement strong KYC and CDD processes that identify and prevent a wide range of illicit activities, including corruption, money laundering, and bribery. Failing to do so may expose the firm to costly fines and damage the company’s reputation and brand.

In recent years, shareholders and nonprofit organizations have filed an increasing number of lawsuits to hold corporations accountable for poor governance practices. False, deceptive, or inaccurate claims about environmental sustainability can also trigger ESG lawsuits.

Best practices for implementing an ESG risk management strategy

Comprehensive ESG due diligence is critical to doing business in the 21st century. Implementing best practices to mitigate ESG risks can help firms create value for stakeholder communities in the long term, enhance corporate transparency, and pursue sustainable economic growth.

1. Focus resources on specific ESG risks that are tied to core business activities.

ESG covers a wide range of issues. When performing due diligence on a company or individual, risk management teams must develop a strategy that informs the specific set of issues on which they will focus their time and energy.

2. Integrate ESG risk management into existing due diligence processes.

Data collection is resource intensive and requires interpretation. Rather than creating new processes to identify and assess ESG risks, financial services firms can use existing CDD and KYC processes to collect and process ESG data and deliver a more streamlined customer experience.

3. Incorporate ESG factors into each stage of the risk management framework.

Risk management teams must stay informed on ESG policy developments and adapt due diligence processes as risks and opportunities evolve.

4. Train risk management teams on identifying and assessing ESG risks.

Effective training is the key to a successful comprehensive ESG due diligence strategy. Teams must learn how to successfully integrate environmental, social, and governance factors into risk modelling.

5. Perform ongoing monitoring of ESG risks.

Ongoing monitoring throughout the life of the contract allows firms to continue collecting and analyzing ESG information about companies or individuals. The age of the 24/7 news cycle requires a 24/7 monitoring solution that includes a close evaluation of financial transactions, operations, and adverse media.

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