Leveraging ESG risk governance to your competitive advantage

Such are the environmental and societal changes sweeping the world that addressing and managing ESG (environmental, social and governance) risks is no longer optional. With record-breaking heatwaves, deadly floods, disrupted supply chains, pandemics and the reignition of geopolitical conflicts in Europe and the Middle East a constant threat to economic and social stability, companies are now under increasing pressure to incorporate the evaluation of these risks and exposures into their existing financial risk management frameworks.

This also applies to the financial industry. The interesting thing about the way ESG risks affect this sector is that they can impact any traditional financial risk category to which financial institutions are susceptible. The EBA, for example, defines ESG risk as “the risk of any negative financial impact on the institution stemming from the current or prospective impacts of ESG factors on the institution’s counterparties or invested assets; ESG risks materialise through the traditional categories of financial risks.” The Swiss financial regulator FINMA has evolved a concept of “nature-related financial risks”, defining natural risks as “risk drivers that can be reflected in existing risk types at institutions through various transmission channels such as nature-related financial risks, in particular in credit risks (including counterparty credit risks), market risks, liquidity risks, operational risks (including legal and compliance risks), insurance risks, business risks or reputational risks.” In a nutshell, ESG risks in general, and nature-related risks in particular, can have a detrimental impact on just about any aspect of a financial institution’s business and performance.

Here a just a few examples to illustrate this. Liquidity/treasury risks can result from higher withdrawals following natural disasters, while unanticipated or premature write-downs due to stricter environmental regulations can lead to stranded assets. ESG ratings can affect credit risk, influencing risk management at both the product/service and portfolio levels. Investing in companies operating in “higher-risk” areas like carbon-intensive industries can increase an institution’s investment risks. Changes in regional commodity markets and shifts in market sentiment can influence market risks and opportunities. Greenwashing or false green claims can lead to brand and reputational damage, negatively impacting ESG ratings and financial performance. Environmental, social or governance shortcomings such as social controversies or governance scandals can pose reputational risks and erode stakeholder trust.

As businesses in general and financial institutions in particular grapple with the requirements of growing ESG-related regulation at the national, European and global levels, they’re well advised to build ESG risk management into their risk management framework. We’re already seeing risk management frameworks evolve to comply with regulatory developments but also to maintain a strategic fit.

At PwC we advise clients to adopt an ESG risk management framework consisting of five steps, all of which are planned, implemented, checked and adapted on an ongoing basis:

We have a number of recommendations to help companies turn ESG risk into opportunity:

• Make ESG risk subject to board oversight and governance to foster a culture of continuous improvement.
• Keep it strategic, proactively aligning risk management practices and reporting frameworks with evolving international standards to enhance organisational resilience and agility, stay ahead of the curve and gain competitive advantage as a leader in ESG risk management.
• Build ESG risk around business strategy, making ESG risk governance something that enables and enhances business rather than a regulatory compliance and/or philanthropic exercise.
• Treat risk as a tool for realising opportunities, fostering innovation and technology to create competitive advantages and enhance risk reporting and overall risk governance, and making the organisation more agile and resistant.
• Build capacity and provide training, investing in ESG risk management expertise at all levels and across all lines of defence.
• Collaborate to share risk and gain upside, adding value by building common understanding and sharing best practices on ESG challenges with industry peers, government agencies, NGOs, academia and other stakeholders.

Increasing regulation at the national, European and global levels in response to growing environmental and social risks is forcing companies, including players in the financial services industry, to build ESG risks into their risk management frameworks. Done intelligently, this can boost an organisation’s agility, resilience and reputation – and ultimately the value it adds for all its stakeholders.