What is the role of risk in greening finance and green financing?

An increasing number of financial institutions are rebuilding the structure of their internal risk cycles and ESG reporting to align with ILAAP and ICAAP guidelines. Looking to the future of risk reporting in finance, Suresh Sankaran, Head of Model Risk Governance at Metro Bank, discussed ESG data and risk in his Keynote: What is the role of risk in green finance and green financing?

Sankaran began by comparing ESG to cash as it is not clear whether it should be government, shareholder, regulator or consumer managed. “ESG is the aspiration for the objective functions of the economy, and it’s terribly defined, poorly executed and difficult to measure,” she calculated.

Sankaran noted that it all boils down to capital, and there is a spectrum of capital, from mandatory/regulatory to voluntary. The “end game,” as he puts it, revolves around profitability and pricing structure. Therefore, ESG has implications for risk assessment and management where sustainable competitiveness can be measured through customer differentiation.

“From a risk management perspective, the concept is very simple. We’re cash flow driven, whether it’s market risk, credit risk, liquidity or operational risk, you’re looking at projected cash flows. The risk isn’t terribly sophisticated, but in climate, particularly carbon, we’re talking about net zero in eight to ten years, no emissions by 2050. These long-term structures from a risk management perspective are unknown when you look at the management balance sheet, you’re looking at three and five year horizons, not twenty and fifty years. So you have to have a good understanding of the data going out that long.

He questioned what discount factors are applied when the data is collected, how that data might interact with house prices and mortgage valuations from a climate perspective, and how it might be integrated into regular stress tests.

ESG metrics are not yet useful according to MIT because they are not integrated into the traditional balance sheet management and stress testing framework. To overcome this challenge, Sankaran continued, “Short-term goals can be ALM valuation, liquidity, behavioral factors, and companies can start slowly incorporating climate-related data. So we have to start thinking in terms of how these can be converted into cash flows. There are so many people providing you with data sources, not many people telling you what to do with that data. It’s wonderful to have data, but it’s useless if that data goes nowhere. So, we start thinking in terms of how best to use that data to gain clarity on ESG methodologies. The most critical element is cash flows; everything that is done from a risk perspective revolves around cash flows, and that is done from a climate perspective must result in generating climate-adjusted cash flows.

Moving forward, Sankaran argued that financial institutions should incorporate ESG risks into key risk management frameworks such as ICAAP and ILAAP; the times are coming when going beyond short-term regulation is what’s right for your organization.

Sankaran concluded that regulators are unlikely to become more resilient and that financial institutions need to integrate their risks to act sustainably and accurately reflect ESG risks. He concludes by saying that companies confuse regulatory compliance with financial sustainability when this is often not the case.

“The nature of regulation is iterative. Starting with a first set of regulations, they then have to refine it, fine-tune it and so on. Therefore, the first set of iterative rules is now in play when the regulator establishes the variables related to payments, and these must be underlined in the financial statements, but they have not told you to integrate them with your main stat,” comments Sankaran. “The next stage, inevitably, irrevocably, will be the incorporation of ESG variables into a gap and that will happen; it is inevitable.

Following Sankaran’s presentation, ResponsibleRisk founder Richard Peers led a discussion on how risk compliance and ESG reporting will be addressed in the future.

Responding to a few questions on differential pricing, bank climate stress testing and ESG risk ratings, Sankaran supported the differential pricing structure and says he does not think it likely that ESG ratings will be harmonized in the foreseeable future, especially given the resistance to ESG rating harmonization in the United States.

The upcoming Sustainable Finance Live panel, on how sustainability can be integrated into regulation and risk, covered the impact of regulations such as SFDR, TCFD, CSRD and Green Fintech Taxonomy and how technology can simplify the complexity of existing regulations.

Guillaume Levannier, Head of Sustainable Investment at Lombard Odier Investment Managers, opened this session by championing the ideology of Sankaran’s long-term risk framework and three points that need to change within the sustainable finance industry.

These points included ensuring that investment managers clearly understood the task at hand, went beyond basic definitions and focused on what they do best – conviction in their investments. Also, without a clear definition of sustainable investing, “we can’t play nice.”

Matt Bullivant, director of ESG, OakNorth, explored these considerations and said that “banks need to be aware of the data they have and think about the data in a much more granular way.” He added that companies don’t have extensive experience when it comes to assessing climate change — there’s no precedent, none historical. Therefore, it is of paramount importance to prepare for the unexpected, “for what we don’t already know.”

He added that there is a “danger of chasing regulation”. The financial services industry doesn’t have to worry about achieving goals by 2050, it needs to focus on “what needs to be done between now and 2030 to get to 2050”. While the UK and the EU are lucky to have forward-thinking regulators, it is more beneficial to reduce uncertainty with good intentions and guidance; it’s not just about measuring risk, and industry needs incentives to close the gap.

Adam Webb, COO, risk, ICBC Standard Bank, added to this and joked that while “banks love acronyms,” there are an abundance of classifications, labeling and disclosures. “There are 50 shades of green, but not everything is as green as another.” Providing an overview of all sustainability regulations in the UK and Europe, Webb also highlighted that the UK’s SDR, which focuses on improvements, attention and impact, will come into force in June 2023.

Furthermore, his view is that while SASB, GRI and CDP are all volunteers, there is no interaction. Alongside this, the key regulation that Webb sees emerging is the TNFD, which broadens the scope beyond climate change to biodiversity.

The ISSB, born out of COP25, is also trying to standardize and push forward a framework that is easier to compare. Another regulation to keep in mind for operators in the sector is the CSRD, which was approved by the EU a few days ago and will go into effect in 2024.

Darshna Shah, chief data scientist, ElastaCloud, agreed that there are a lot of regulations, but that also means the industry isn’t starting from scratch. He said there is a “lack of correlation between regulations and there are more frameworks, so we need to apply the data and see what’s relevant.” While it is necessary to find data gaps, this starting point allows every organization to achieve the same level of reporting.

Adrian Sargent, founder, ESG Treasury and CEO, Castle Community Bank, concluded that at the first Sustainable Finance Live event in 2019, there was “real hope that the sector moves beyond regulation. While a large number of players have integrated decisions and capital assessment, “we need to be ready for what’s coming. Things will change often and quickly; as regulations change, we also need to manage legacy portfolios.

“Put it there, rate it, make a judgment and adjust for the future as well,” Sargent said.

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