For banks, the future of ESG is now

Financial institutions are under increasing pressure to demonstrate their commitment to climate-friendly business.

Environmental, social and governance issues are becoming increasingly hot topics within the banking industry as institutions adjust their strategies and practices to have more positive ESG outcomes.

As part of a highly regulated industry, banks have long addressed governance issues. In recent years, they’ve increasingly focused on social issues in response to the Community Reinvestment Act, putting particular emphasis on diversity, equity and inclusion.

Now banks are turning their attention to the E in ESG—environmental—as they begin to understand their role in becoming carbon neutral and the impact of environmental considerations on risk within their lending and investment portfolios.

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In May, President Joe Biden issued an executive order that, among other provisions, directs the Financial Stability Oversight Council to find ways to assess climate-related financial risk. The Federal Reserve and the Office of the Comptroller of the Currency are exploring ways to require banks to measure such risk, and the Securities and Exchange Commission is formulating how public companies should disclose ESG-related risks.

ESG strategies are also a focus for institutional investors and ratings agencies, as well as customers and employees, according to Emily Kreps, head of ESG for the Americas at Deutsche Bank. Stakeholders are scrutinizing banks’ investment and lending practices to determine whether they align with society’s values on how to address these critical issues, Kreps told us in a recent BAI podcast.

Banks are also concerned about stranded assets, the transition risks that will accompany governments’ efforts to crack down on emissions, and the risk of regulatory sanctions and litigation by outside parties, according to Amelia Pan, managing director of ESG advisory at boutique investment bank PJT Partners.

“We’re definitely seeing more dedicated climate-risk teams in banks, and they’ve been appointed at a very senior level—reporting to the executive committee, the CEO, and sometimes there’s a board sponsor,” she said in another BAI podcast.

At BAI, we see this as an important issue for financial services leaders, some of whom are now getting together with us to explore what the issues are and how to best approach them.

As a start, banks are looking to various frameworks for guidance, including those recommended by the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures, as well as by the International Integrated Reporting Council and the Sustainability Accounting Standards Board, which recently merged to form the Value Reporting Foundation.

Banks are also delving into their own customer data to customize the recommendations to fit their business models and to assess how their models should evolve over time to meet sustainability goals. The intent is to reframe the investment and lending decision-making process through the ESG lens—and then to determine what metrics should be included.

In addition to minimizing exposure to environmental risks, banks should be treating the E in ESG as a significant business opportunity—such as accelerated investment in renewable energy or investing in industries that are compatible with a low-carbon world, Krebs said.

But it’s a balancing act, Pan conceded, as decisions to limit financing can have unintended consequences.

“For example, if a bank declines to renew loans on existing coal mines, it might improve its carbon disclosures,” she said. “But it could also lead to significant social implications, such as mine closures and unemployment, which in turn would have a massive impact on that market’s retail lending and potential impairments. So it’s much more complicated than just saying ‘we’re getting out of fossil fuels,’ and that’s the challenge.”

Banks will be more successful if they find ways to incentivize positive behavior among customers and help them get to a better place. For some customers, the resulting change in operations may not be a complete reversal, but banks will experience pressure from all sides to at least try to affect behavior with their financing decisions.

Financial services leaders tell us that they expect regulation to advance quickly in this area, so banks need to get ahead of it while refraining from unintentional “greenwashing,” or focusing more on the appearance of sustainability than its reality.

But it’s much more than regulatory compliance. It’s about the broader view of stakeholders versus just shareholders, which includes how employees and customers feel about key components of ESG. Those forces combined, I think, will spur banks to move quickly on adjusting their business strategies to drive meaningful change.

Holly Hughes is chief marketing officer at BAI.

As you’re fine tuning your financial institution’s strategy for the new year, gain insights on emerging industry trends in our latest Executive Report, “A look ahead to banking in 2022.”