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Why Financial Institutions Should Embrace ESG
Public and regulatory expectations regarding climate change and other environmental, social, and governance (ESG) issues are rapidly changing. The largest banks have made climate commitments pledging hundreds of billions of dollars to sustainable finance. While the larger financial institutions have adopted ESG reporting and practices, this is expected to apply to community financial institutions in the coming years as regulation trickles down to smaller institutions. Due to the speed of change of these expectations, executives and boards in community financial institutions can no longer take a “wait and see” approach and should invest in learning and applying ESG factors in their institution. This article addresses the regulatory changes related to climate change and how those charged with governance can guide their organizations through these changes.
ESG & Climate Change Are Regulatory Hot-Button Issues
The importance of climate risk and other ESG factors was a common topic for regulators during 2021.
In October 2021, the Financial Stability Oversight Council released its Report on Climate-Related Financial Risk, which identified climate change as an emerging and increasing threat to U.S. financial stability. The report includes recommendations for more regulatory action to address this threat. See the Report on Climate-Related Financial Risk on the U.S. Department of the Treasury’s website.
The Securities and Exchange Commission (SEC) has been busy in the past year working on proposed mandatory climate disclosure rules for public companies. The SEC plans to issue the rule proposal in early 2022. It is unclear whether the climate disclosure rules will require disclosure of Scope 3 emissions, which include emissions from certain financed projects.
In an October 7, 2021, speech, the Federal Reserve discussed the development of climate scenario models to assess the effects of climate-related risks on financial institutions and the financial system with differentiation by region and economic sector.
On December 16, 2021, the Office of the Comptroller of the Currency (OCC) issued for comment its draft Principles for Climate-Related Financial Risk Management for Large Banks. Large banks are OCC-regulated institutions with more than $100 billion in total consolidated assets, including national banks, federal savings associations, and federal branches or agencies of foreign banking organizations. The draft climate principles provide a framework with six key aspects for climate-related financial risk management, including:
- Policies, procedures, and limits
- Strategic planning
- Risk management
- Data, risk measurement, and reporting
- Scenario analysis
These are the latest examples of increased regulation that is expected in the coming years to meet the Biden administration’s goals of reducing net greenhouse gas emissions by at least 50 percent below 2005 levels by 2030 and a net-zero economy by 2050.
What Financial Institutions Should Do to Prepare for Regulatory Scrutiny
ESG factors should be seen within the context of strategy and core operations, as ESG factors are enterprise-level considerations. Strategic plans and business models should be evaluated to identify potential threats related to climate risk and other ESG factors. Climate risks include both the direct physical risks of climate change on assets, e.g., a portfolio of mortgages in coastal properties at risk of flooding, and the transition risks, e.g., a concentration of loans in high-emitting sectors. The financial institution’s loan portfolio should be analyzed by industry to determine whether there is a concentration of industries with high transition or physical climate-related risk.
Financial institutions also should plan for how to introduce ESG and climate risk into risk management processes, such as:
- Capital allocations
- Loan approvals
- Reserve allocations
- Portfolio monitoring
Having a strong climate risk management system also can assist financial institutions in underwriting loans for projects related to climate change, such as:
- Energy efficiency
- Renewable energy
- Carbon capture, use, and sequestration (CCUS)
- Electric vehicles and charging stations
Financial institutions should be prepared to discuss climate-related issues and provide documentation of ESG and climate risk considerations with their regulators.
Regulators are soliciting information from financial institutions to gain knowledge of bank and credit union efforts to measure and monitor ESG and climate risk. The primary goal of these efforts is to establish the infrastructure to help make the financial system more resilient to climate-related financial risks.
Recommended Board Considerations
Boards should assess stakeholder ESG expectations, which are likely to vary by financial institution based on various factors, including the expectations of the customer base. Executives and board members should build awareness of ESG best practices and consider how the organization’s strategy can be tied to ESG factors. The board should determine whether the organization has the information and expertise to assess ESG risks. Boards should then have discussions with management regarding whether ESG information is to be reported and what reporting frameworks are to be used and why. The reliability of ESG data and the communication plan needs to be considered. Since executive sponsorship of ESG initiatives is vital to a successful ESG program, the board should discuss what accountabilities are needed to be set for ESG-related performance.
The National Association of Corporate Directors has an ESG resource center specially for board members on its website. ESG reporting questions that directors should consider include:
- What ESG story do our website and our disclosures tell about the organization?
- Does that story resonate with existing and potential investors, employees, customers, regulators, and other stakeholders?
- How does the organization’s ESG messaging compare to that of peers, leaders in the industry, and competitors?
- Is our ESG reporting satisfying the needs of investors, customers, and other stakeholders?
- What is management’s process for engaging and understanding the expectations of ESG stakeholders?
- What are the organization’s ESG initiatives, and who are the executive sponsors for each ESG initiative?
- How and when do the executive sponsors receive ESG performance reports for each ESG metric?
- Is ESG performance integrated with financial and operational performance monitoring so ESG performance gets C-suite attention?
- What are the organization’s controls and procedures for ESG metrics and reporting?
- Is the internal audit function checking the fair presentation of the underlying data?
- Is an independent auditor providing an attestation of the ESG data and disclosures?
On November 8, 2021, the acting head of the OCC issued the following climate questions for bank boards to ask:
- What is our overall exposure to climate change?
- What counterparties, sectors, or locales warrant our heightened attention and focus?
- How exposed are we to a carbon tax?
- How vulnerable are our data centers and other critical services to extreme weather?
- What can we do to position ourselves to seize opportunities from climate change?
A one-size-fits-all ESG program does not exist because every organization faces unique risk and circumstances. Visit our ESG webpage to learn about the four-phase process to develop an effective ESG program.
For additional guidance, contact your BKD Trusted Advisor™ or submit the Contact Us form below.