The third piece in our series on environmental, social and governance (ESG) explores why different departments within financial service firms are now interested in ESG data and solutions – and how to address the resulting challenges
Until recently, financial services firms have largely addressed ESG independently, with little regulatory guidance on how to approach the subject. This is beginning to change, and the incoming EU Taxonomy regulation provides a much-needed classification system and framework for ‘green’ sustainable finance. As part of the EU’s Sustainable Finance Package of regulations, the EU Taxonomy is one of the first examples of formal ESG regulation. This taxonomy will allow regulated institutions to communicate more clearly with one another, their clients and regulators regarding climate change and the environment. With the provisions of the taxonomy due to come into force on 10th March 2021, how firms prepare now to meet those new requirements is crucial to understanding how they can ensure compliance with further ESG regulation in the future.
2021 also sees the EU Sustainable Finance Disclosure Regulation (SFDR) entering into force which focuses on reporting for the asset management community. However, the formalisation of ESG considerations by regulators is only one of many steps being taken to better understand and define the practice within financial services. As the industry adapts and the practice of sustainable investing becomes a norm, institutional investors and asset managers will need to demonstrate how their investments correlate to and comply with ESG targets and how they themselves meet these requirements in order to manage their individual reputational (and possibly regulatory) risk. The big winners will be those who can create a truly holistic approach to ESG across multiple functions and departments in the creation of their products, but also in their ongoing operations. Those who achieve this alongside introducing tools, policies and procedures supported by technology to monitor and maintain the evolving standards, will find an edge over the market.
A Holistic ESG Approach
Attention to ESG related matters has traditionally remained confined to front-office functions, where the data and analysis have been used to inform investment decision making in response to client demand. Yet as we enter the era of regulated ESG, a more holistic internal approach is required. Portfolio companies, institutional investors and asset managers alike need more internal stakeholders from middle and back-office functions such as legal, compliance and even HR to contribute data, analysis and reporting to meet regulatory obligations and stakeholder demand for transparency.
Financial service firms will need to embed ESG considerations into their own company culture and meet the standards set out for investee companies as a means of managing their own reputational risk. Integrating these factors into the fabric of regulated institutions is a matter of governance which will impact new forms of monitoring, data collection and reporting e.g workforce diversity, safety standards, environmental concerns. It will be paramount for firms to instil new policies that ensure ESG considerations and compliance with new regulations are embedded into the decision making in all areas of company culture as failure to do so could not only create significant reputational harm but also a financial risk.
Financial services firms will have to take a more dynamic approach to identifying and monitoring ESG considerations and risk. For example, the disclosure requirements for the EU Taxonomy and SFDR require firms to include ESG related factors in both pre-contractual (e.g. Key Investor Information Documents) and periodic reporting (e.g. Fund Annual Reports) illustrates the need for firms to develop a data management infrastructure to support evolving ESG considerations.
A number of solutions already exist as a means of informing market-facing professionals on what was up until now, data which focused upon the investment decision making process. However, as the regulatory requirements ramp up, a more cohesive and conjoined approach will be required across different departments. What has existed as a largely disconnected and fragmented practice between and within institutions, resulting in the duplication of work and confusion among institutions, will have to be streamlined.
A more structured industry approach will have to be met by collaborative strategies within firms to develop a centralised means of management and interaction between departments that support continuous ESG awareness. In addition to appointing subject matter experts to help facilitate a system that allows front, back and middle offices to remain in dialogue regarding ESG, regulated institutions will need to invest in the right technologies to optimise these processes.
The increasingly coordinated approach to ESG factors across the financial services industry in Europe is still in its infancy. This means that firms will need to consider how these regulations will evolve and prepare themselves by putting the appropriate internal governance frameworks and policies in place. Following that systems and controls will be needed to continually monitor these fast and slow-moving ESG factors, allowing a swift response to changes in sentiment as well as internal and external policy. A proactive approach will result in saving time and money and is likely to enhance an institution’s reputation, providing a future competitive advantage.
We are currently working with regulated institutions advising them on ESG products to help with their regulatory obligations. If you would like to speak to us please drop us an email at firstname.lastname@example.org. Catch up on our other blogs in the ESG series where we address how ESG and RegTech go hand-in-hand, and the current regulatory challenge.