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How banks should be thinking about ESG

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Environmental, social and governance considerations are rising in importance in banking.

Amelia Pan, managing director in the ESG advisory group at PJT Partners, joins us with thoughts on how bankers should think about ESG as it gains in stature.

A few takeaways from our conversation:

  • Some regulators are proposing that climate reporting by banks be made mandatory, while more front-of-mind on the social side are diversity and pay levels.
  • The ESG transition will require a balancing act to ensure that banks tend to business while embracing and implement ESG-related policies and standards.
  • Setting new environmental and social priorities are part of an economic evolution, but banks thinking about their loans in a climate context is revolutionary.

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Below is a full transcript of my interview with Amelia Pan.

Amelia, some of our listeners may not be familiar with PJT Partners. Could you tell us a little bit about the firm? Maybe also some color on what your role is in providing ESG advisory?

Sure. PJT is a boutique investment bank. We’re relatively new on the scene. We just celebrated our 6th anniversary. We were started by Paul Taubman, who had a long career at Morgan Stanley, and a number of his colleagues. But we’ve expanded from our American beginnings right across the globe, and we now have nearly 300 people in London — this is where I’m based — and colleagues in parts of Asia and all over Europe as well.

Increasingly, the advice that we’re being asked for is on how to respond to ESG expectations. At the same time, we are meeting on a regular basis a lot of new emerging companies that I think will be very important for a transition to the sustainable economy. We’re also engaged in advising incumbent companies about how to structure their capital allocation for more renewable activities, more traditional investment banking advisory as well.

It wasn’t all that long ago that corporate C-suites largely held to the notion that their job was to maximize shareholder value. So no doubt some still feel that way. But the trend is toward a broader acknowledgment that they have more key responsibilities than just share price, and this includes the ESG-related responsibilities you were just alluding to. If you had to point to one or maybe two factors as being the biggest drivers to this new way of thinking at the top of corporations, what do you think those factors would be?

I think if I were to pinpoint a moment in time, I would say that things started to shift in 2018. Obviously, CSR and social responsibility has been around long before then, but I’ve been in the financial markets for 20 years and I think it really hit people’s radar screens when Larry Fink of BlackRock talked about the role of business and society in his annual letter to CEOs and to shareholders that year.

Then in 2019, the Business Roundtable redefined the purpose of the corporation, and also that year at the World Economic Forum, we had the Davos Manifesto, which talked about shareholder capitalism. So all of these events signal the shift away from Milton Friedman’s historic focus on shareholder primacy. Those sentiments were put to the test with recent external events – the global pandemic, extreme weather events and social unrest – which then shone a spotlight on how companies reacted to and supported their stakeholders. And by that, I mean employees, customers, suppliers, communities, as well as their investors, through those events.

So let’s break down ESG, Amelia, into two parts. We’ll put the “E” and the “S” on one side, and we’ll put the “G” on the other. So for investors, the governance part has long been of interest. How well a company is governed, composition of its board, the controls it has in place, and how effective those controls are. It’s a big part of determining valuation and whether to invest in the company. The “E” and the “S” of ESG, do either of them… Have they gained that stature yet that the “G” already has?

I think so. I think we’re starting to see it take more shape, Terry. And investors have been key drivers to get companies to the table on those issues. I think expectations around ESG performance are now commonplace, even in the U.S., which might have been a few years ago seemed to be dragging their heels. I think whereas, five years ago, 20% of Fortune 500 companies were reporting on … issues, now it’s 80%, and the burden of proof has shifted to companies. So a lack of transparency is much a litigation trigger, as too much transparency. That’s certainly true in the case of the “E”, where efforts to make climate reporting mandatory is gaining momentum. I think public scrutiny of company decarbonization efforts has increased and commitments to net zero have doubled in the last year alone.

On the “S” side of things, you asked, we have heard that investor interest in human capital development is much more top of mind than they were before. There are calls for companies to collect and divulge data on diversity at every level of the company, pay level at all levels of seniority, retention numbers, turnover – those issues are much more front of mind for investors than they were before. So attention to a company supply chain, human capital, the culture they’ve built, the size of their environmental or social footprint, has become increasingly important to the achievement of its business strategy and risk mitigation framework.

It seems to me that the environmental aspect of ESG is pretty straightforward and maybe that’s because the issue of climate change is so dire and so dominant within that category. The social part, on the other hand, it feels trickier. More issues to wrangle, it’s more open to subjective and shifting influences. So how do you think about the “S” and the reach of the “S”?

For a long time, we’ve thought about “S” as the squishiest part of ESG. “E” and “S” are much more established, and “S” frankly, is the trickiest to measure. How do you quantify social performance for companies? How do we start to put numbers around human rights? How do you put performance metrics around people feeling safe at work? But decision-makers like investors need useful information to measure performance and understand which companies are changing, adapting, and persevering and which companies are not. We’re starting to hear investors get much more forceful on asking for actual data. Are executive compensation plans tied to ESG targets? Are they tied to diversity targets? How are they retaining their graduate intake of diverse candidates? Are those people moving throughout the firm? So I think we’re starting to see much more focus now on the “S”, and it’s going to be increasingly important in the holistic consideration of ESG for a company.

Mother Nature is kind of the big decision-maker on the environmental side of ESG. But there’s not a similar alpha decider, if you will, and the issues are more varied. Some people, for example, love social media and others might blame certain social media companies for threatening democratic norms. Others, who are, say, pro-Palestinian might want to target companies doing business with Israel. The possibilities are endless, really. So getting wide agreement on an agenda seems like it could be a challenge. So who gets to decide the standards and the priorities for that more subjective, that squishier part, as you described it? That social component of ESG.

The bigger question there is whether a one-size-fits-all approach is the right approach. And this is a debate that’s been going on in ESG for years. There’s an effort underway, to your question, to harmonize reporting questions with actors from the World Economic Forum, and the Big Four accounting firms to the stock exchanges, to standard setters like SASB, but all involved in tackling this question. I think the IFRS Foundation has been taking consultation about an international sustainability standards board. This would create a global baseline of sustainability-related disclosure to facilitate comparability for investment decision-making and really work with jurisdictions to ensure compatibility between this global baseline and their own initiatives. And it really to me all comes down to materiality.

So to your question about is social media force for good or force for evil, or do we support certain political practices or not? It really comes down to what’s material to your business and how do you measure that? Ultimately, there’s some issues like climate, where we need comparable data globally about how it affects companies, and we all need the same metrics to be able to compare a company in Japan to a company in Germany, to a company in the US, in order to make useful decisions. But issues like data privacy and regional banking might not be material to the meatpacking industry, for example, where human capital dynamics might be more relevant. So I think of it like if there’s an ESG related issue that has an impact on your profit and loss on a measurable financial report, like a balance sheet or SEC report, then that’s naturally relevant and should be disclosed.

I’m guessing, Amelia, that you have banking clients and we obviously at BAI we focus on that. So for your banking clients, what are their concerns? What sorts of questions are they asking? What are they concerned about, and what are you telling them?

We do have banking clients and I would say that their concerns fall into three categories. One is frameworks, metrics and disclosures, and this is not unique to the banking sector. We’re hearing this from companies in lots of different sectors all over the world. No one thinks they are where they need to be, regardless of being in an early stage or a later stage. I think that’s because, despite increasing disclosure around ESG factors, banks in particular continue to be challenged by a disparity or lack of robust and granular, forward-looking data for their borrowers and their counterparties. That makes things difficult.

It also makes it difficult to assess and report on their own ESG framework. So while data and taxonomy will likely harmonize around industry standards over time, banks need to prepare for increased data and disclosure demands from their stakeholders, not least of whom are their investors, who are themselves now subject to scrutiny over the types of companies that they hold if they themselves have made a net-zero commitment in all of their portfolios, for example.

The other thing that we hear about from our banking clients is the organizational structure, leadership, buy-in. How do they structure an ESG or sustainability or corporate sustainability function across an organization? How did they get the buy-in and how did they build it into the organization? And finally, kind of aligned with that, is how do we align ESG across all the different parts of the banks? For example, which aspect of climate should banks focus on? Is it lending? The pricing? Changing debt covenants? How do we embed that into the work that we do so that it doesn’t just sit in the corner with the sustainability team, but it is actually part of how you think about your go-forward business strategy.

Earlier this month, a top official at the Fed said that the central bank is looking at creating and analyzing scenarios to gauge the climate-related risk that big U.S. banks face. It sounds like an environmental stress testing scenario, if you will. That idea is still taking shape, so there’s not a lot of specifics to focus on yet, but how valuable do you think that kind of stress testing would be for banks and maybe for the country more broadly?

EY have been running a survey of banks’ risk managers for 11 years with the Institute of International Finance, the IIF. And the results from this year’s survey I think are worth talking about because they came as a bit of surprise. They found that over a one-year time frame, climate risk came out of nowhere to rank third behind credit risk and cybersecurity, and over the next five years, risk officers from bank officers saw climate risk as a top problem that banks are going to have to deal with. So I think that one obvious reason for this is the increase of extreme weather events like the wildfires that we saw this year, the hurricanes, the floods on the East Coast. That can really interrupt banks’ day-to-day operations. But banks are also concerned about stranded assets and the transition risks that will accompany governments’ moves to crack down on emissions, the regulatory risk, litigation risk. I think these stress tests, there were a long time coming, but they are a reality that banks are going to have to acknowledge.

It’s also worth noting that there are opportunities with this new awareness, right? Banks are looking at climate more closely now because there’s a realization that in financial services, we don’t get to a net zero carbon economy without finance. So we’re definitely seeing more dedicated climate risk teams in banks, and they’ve been appointed at very senior levels, reporting to the executive committee, the CEO, and sometimes there’s a board sponsor, and banks are planning a big push on transition financing to enable large corporate SMEs and individuals to go green. So I think once you see innovation in that space at scale, the acceleration will be enormous.

How should we be thinking about the competitive impacts for banks, which are feeling pressure from fintechs and from others coming into the deposits and lending space? They certainly want to keep their customers and that may include customers that are big carbon emitters, for instance. If you choose not to lend to them as a bank, someone else will, and meanwhile, you lose the business and the loan still gets made, the project still gets done. Long term, based on what you’ve been sharing with us seems that businesses, banks, see the writing on the wall. But short term, what’s the incentive for a bank to be a truly early mover on this?

I think that’s a really good question, and that is part of the balancing act that we’re seeing banks and lots of companies thinking through. I would say number one, there’s reputational risk, which academic studies have shown that have had an impact on company valuation. But banks, specifically, I think, are struggling to understand all of the potential unintended consequences of their shift towards more ESG-related business strategies.

So for example, if a bank declines to renew loans on existing coal mines, it might improve its carbon disclosures. But it could also lead to significant social implications, such as mine closures, 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. As long as those assets continue to generate profits for the bank, bank executives will need to balance their duty to finance the ESG transition against their fiduciary duties to shareholders.

Maybe one way of thinking about it is to consider all stakeholders in the decision-making process. Not just shareholders, but also employees, customers, the supply chain, the communities in which they operate, so the broader stakeholder group. Going back to the beginning of our conversation, where we talked about the move towards stakeholder capitalism, maybe the goal should be for all of these people to benefit from any of those bank’s decisions.

I came into this conversation, Amelia, with the idea that truly embracing ESG was going to require a substantial change at the management level. So is that a correct assumption? Are we talking about a major rethinking of how companies are managed or is this less revolutionary and more evolutionary? And where do you start?

I think the starting point has to be that ESG and sustainability initiatives need to be driven from the top. That is where the focus really is these days. Does the board understand the external challenges that the company faces, including climate, including human capital, including the need for a more diverse workforce, and is that integrated into the business strategy? There are some who believe that ESG is 21st-century business. So therefore, it should be part of a board’s fiduciary duties, and for boards who don’t understand how important this is, maybe they’re not up to the task.

Secondly, I think for CEOs and management, ESG needs to be integrated into the business strategy. It needs to be talked about in investor meetings.

And then finally, management needs to empower their team. This kind of shift can’t be done just by a sustainability team. You and I have both seen in the news all these accusations of greenwashing. We know that, as more and more commitments to net zero have come out, for example, or commitments to supporting their employees have come out, there have been just as many accusations that these activities are actually not true or are inauthentic. So I think there’s definitely an evolutionary element to it. Is it revolutionary? Some people who have been working in the climate space and working in the corporate social responsibility space will say that this is not brand new. I think we probably all recognize, those of us who’ve been in the financial sector for decades, that this is a little bit revolutionary, right?

To think about climate as you think about loans is definitely not something that was part of the conversation maybe 10 years ago, five years ago. To think about diversity of your management team, the composition of your board, racial equity as inputs that could affect your company’s ability to drive valuations, I think it’s a slightly revolutionary concept. I think we got a little bit of both in there, and isn’t it exciting to be a part of this right now?

It does seem to be a bit of both, and I suppose that does make it kind of exciting… and at the same time kind of challenging, given the potential complexities involved.

Amelia Pan, head of ESG advisory at PJT Partners, thanks again for sharing your thoughts with us on the BAI Banking Strategies podcast.

Thank you, Terry. It was a pleasure to be here.

Terry Badger is the managing editor at BAI.