U.S. financial institutions should enhance their compliance with environmental, social and governance (ESG) issues because regulators are watching
With U.S. financial regulators stepping up their oversight of environmental, social and governance (ESG) issues, financial firms would be well-advised to take steps that could ease their compliance once new rules come into force, according to legal and consulting firms.
Upcoming ESG company disclosure rules, for example, are likely to impact decision-making around bank lending and investment practices, leading to a shift away from clients who are not adhering to sustainability objectives and policies, including around climate issues. “Financial institutions should be identifying and quantifying their exposures to high-carbon industries as they determine their strategies for managing transition risk in those sectors as well as developing financing solutions to support clients in the transition to a low carbon economy,” PwC, the consultancy, states in a recent analysis.
What firms might want to consider is whether their lending and investment activities are geared towards clients that have sustainable business strategies in place.
Sustainability focus for bank lending
Environmental activists have fought for years to stop U.S. financial institutions from lending to fossil fuel producers, a battle with few victories. Once new U.S. disclosure rules emerge, however, experts predict the calculus of lending to such companies will shift. This will be particularly true should U.S. firms face regulations similar to those in the European Union, which some believe is possible.
“Sustainability financial disclosure regulations in the E.U. require E.U. financial firms to disclose how sustainability risks are incorporated into their financial decision-making process,” says David Silk, a partner at Wachtell, Lipton, Rosen & Katz. “I think what the banks will ultimately be asked to do at some level is to take account of the sustainability impact of their investments or loans. They should understand, for example, whether for a real estate loan the builder is complying with best practices from an environmental perspective.”
By taking sustainability factors into account in their client relationships, banks may begin to allocate capital according to whether customers are abiding by government policy objectives — a win for both climate activists and investors.
“By creating transparency for investors about what climate risks are, that understanding becomes a moderator of adjusting capital, or making it harder to take on that risk,” says Ilya Khaykin, a partner at Oliver Wyman. “That way of motivating capital would lead to shifts that would ultimately be beneficial for the environment.”
US ESG policies still in formative stage
U.S. financial regulators have been slow to address climate change when compared to jurisdictions such as the European Union and United Kingdom. Only recently, for example, the U.S. Federal Reserve joined the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), an international group focused on climate change risk.
On the securities side, the U.S. Securities and Exchange Commission (SEC) has also treaded water on climate disclosure, due in part to the Trump administration’s stance on climate change. Over the past month, however, the SEC has pivoted quickly, forming an enforcement team to focus on disclosures from public companies related to climate change, investment-advisor activities, and funds dedicated to ESG investments. The agency has also published a “risk alert,” which included findings on shortcomings in ESG practices seen at firms during its inspection process.
In other words, the pace of regulatory reform has quickened. While rulemaking may take time, there are steps that financial firms can take now, ahead of any new oversight.
Banks may require ESG data as part of client reporting mechanism
One possible approach would be for banks to include ESG data as part of the reporting mechanism with borrowers. By requiring greater transparency from borrowers over their third-party relationships, banks could extend their ESG oversight beyond existing customers.
“Eventually the industry might move towards a requirement where you as a client need to demonstrate to me that you are adhering to ESG objectives, and not doing business with known polluters,” says Atul Vashistha, founder of Supply Wisdom and former vice chair at the U.S. Department of Defense Business Board.
As with any new regulation, of course, compliance will require data and metrics. Developing an infrastructure that captures climate-related data is a step that many financial institutions can take now, say experts. In creating such a data infrastructure, banks can look to international organizations like the Task Force on Climate Related Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB) for guidance ahead of regulatory mandates.
“As the industry trends toward more mature ‘investor grade’ climate disclosures, firms will need to make their own investments to develop an ESG reporting architecture that is based on reliable data,” explains PwC in its client note. “This will involve setting clear disclosure objectives; defining key metrics using recommendations from TCFD and SASB; identifying underlying data sources; and embedding climate-related information into their data governance models.”
Data gaps likely to emerge
Still, some experts argue that the lack of clear data standards by regulators makes the task of knowing what banks should collect difficult. There is also the question of whether corporations can provide the data that they are being asked for.
“While certain sectors are more advanced in the granularity with which they disclose climate-related data, disclosure is certainly not uniform across sectors or even within sectors, thereby making the information of use to banks and investors challenging at times,” notes the Bank Policy Institute (BPI), an industry lobby group.
Another important issue is the different needs from regulators. For example, securities regulators appear more focused on disclosures that will allow investors to decide whether to hold or buy a company’s stock. Bank regulators, meanwhile, seem more interested in disclosure for purposes of credit risk analysis and portfolio alignment metrics.