ESG Risk: The Regulatory Challenge

This second piece in our ongoing series on environmental, social and governance (ESG) looks at the challenges and developments surrounding ESG data and disclosures. 

The relationship between corporate resilience and value has never been more apparent in the financial services industry. Environmental, social and corporate governance (ESG) factors have proved accurate in predicting resilience despite a fragmented set of frameworks and standards. Until now, non-financial risk factors, ESG frameworks and the associated data have generally been established by the collective efforts of industry collaboration, NGOs and other interested bodies. Policy-makers and regulators are now engaging more closely, as the financial impact of climate change risks is better appreciated and understood and as the need for a more standardised approach across the financial industry is becoming more urgent.

Risks & Opportunities 

As ESG data and the related risks increasingly influence decision making in capital allocation, firms will soon need to approach ESG risks and disclosure with the same discipline and rigour of financial accounting. Managing, mitigating, and reporting on risks such as the way climate change may impact mortgage-backed securities, puts firms in a better position to manage future financial risks. ESG considerations cover a wide berth, from compliance with the law and regulations to data privacy and human rights. This broad scope and the increasing prominence of social and corporate governance factors on investment outcomes requires new forms of due diligence and monitoring, that produce authentic, structured data on performance, in order to help firms satisfy socially conscious investors, and deliver shareholder value.

State Street assessed how company actions such as employee management during the global health crisis impacted stock performance. Companies that received positive public attention also experienced greater investor money flows. Thus in order to create value for shareholders and investors, financial services firms must adopt approaches, develop tools, and provide services that account for and acknowledge ESG risk factors in their products and processes. 

Global Standards

Identifying which considerations qualify as ESG factors today are still based on a widely fragmented set of frameworks and standards. Firms need to capture and evaluate data from a range of sources, and while standards such as those set by the Sustainability Accounting Standards Board (SASB) and MSCI’s Global Industry Classification Standard (GICS) are widely regarded, their metrics diverge. Easily comparable disclosure requirements and reporting frameworks are needed to support the acceptance of ESG within firms and across the finance industry. Without an agreed industry standard these efforts are being frustrated. This is a key challenge for firms, as ESG data and reporting lacks the infrastructure needed for the collection of relevant and comparable data that would inform decision making and disclosure. 

An ESG standard within the financial industry is required to create benchmarks that will establish credibility and maintain accountability in this new area. A globally agreed ESG equivalent to the International Financial Reporting Standard (IFRS) used for financial accounting will also pave the way for technological solutions that provide ESG data and support in a manner that is scalable and cost-effective. We are beginning to see some convergence, for example, the incoming European Taxonomy Regulation will establish a framework for the environmental component ESG, providing financial services firms with a common language through which companies can identify to what degree economic activities can be considered environmentally sustainable. Additionally, the European Supervisory Authorities are specifically drafting rules on ESG disclosures required under the EU regulation on sustainability-related disclosures in the financial services sector (SFDR). Both are widely applicable across market participants and begin to form the common standards and frameworks required to aid the development of the ESG market.

Conclusion 

Conversations around ESG have steadily gained momentum since 2019, with Covid-19 intensifying the focus. The push among European regulators to establish market mechanisms that require integrating ESG considerations into numerous aspects of financial services speak to this. In true ESG fashion, it appears that the taxonomy is being developed to aid the delivery of societal objectives, relating to the environment and human rights, in addition to providing an industry standard and benchmark. These changes illustrate how emerging industry trends and practices should not be ignored, as with the right support they often become regulatory requirements. Financial services firms will need to allocate resources and prioritise ESG efforts if they have not done so already. Thankfully, the advent of internationally agreed frameworks and standards will create the parameters from which innovations and technological solutions can be developed to support sustainable economic growth whilst mitigating ESG risk.