ESG reporting: Improving performance and perceptions
Environmental, Social and Governance (ESG) factors, which relate to ethical and sustainable practices, have recently risen to prominence within the financial industry. Led by the existential threat of climate change, financial crises and demographic shifts, investors have become acutely aware that ESG factors impact asset values. ‘Climate value at risk’ of global financial assets is estimated to be US$2.5tn alone.
Given this backdrop, ESG assets are on the rise. More than 25% of global assets under management are invested in accordance with ESG principles and the signs indicate that this will continue to grow. A recent survey conducted by Morgan Stanley showed that ‘84% of asset owners are at least “actively considering” integrating ESG criteria into their investment process, with nearly half already integrating it across all their investment decisions.’
This represents a new paradigm for the industry. As such, there is an increasing appetite from the investor community for decision-useful data on how organisations are performing against ESG factors. Organisations have a vested interest in reporting this information given that improving performance against ESG factors is beneficial for overall company performance. Research undertaken by MSCI has shown that high ESG-rated companies tend to have higher profitability, lower expected cost of capital (higher valuations), and lower idiosyncratic tail risks to their stock price. Activities once seen as a moral crusade to enhance perceptions now carry significant implications to the bottom-line.
For banks, in addition to ethical considerations and financial opportunities, the unrivalled position that they are in to set standards and influence ESG considerations across the globe is a key force to drive ESG reporting forward. Through lending and advisory decisions, banks can shape the direction of industries and increase the resilience of business models against the regulatory and consumer trend changes that are coming from a more “sustainability-conscious” society.
Banks have bought into thisESG factors are increasingly disclosed in annual reports with standalone publications produced by some institutions (e.g. Barclays and UBS). Typically, reported ESG performance covers four key areas:
- Strategy: How ESG factors are considered within the organisation’s business model and strategy
- Governance: How ESG factors are managed, escalated and accounted for within the organisation
- Risk Management: How ESG factors are integrated into the transaction review process, supply chain management, and financial and non-financial risk analysis
- Metrics & Targets: How performance against defined ESG metrics and targets is tracked in the organisation
In Q2 2018, BCS Consulting conducted a review across 16 leading banks to evaluate the quality of ESG external disclosures in the banking sector. The review highlighted that, in general, banks acknowledge ESG oversight at group board level, explain ESG relevance to their business model and set targets to enhance ESG considerations.
Leaders included the following within their disclosures:
- Clearly defined ESG review processes with linkages to senior management and board level committees
- ESG action plan and progress tracking against priorities
- Areas for improvements in ESG performance and detailed mitigating actions
- ESG targets, metric tracking and third-party data assurance
These encouraging signs indicate that senior decision-making processes across organisations include ESG considerations. However, reporting maturity ranged across the banks reviewed (see Figure 1).
Of the four key ESG reporting areas, Risk Management is identified as the least mature across all banks (see Figure 2). More than half of the banks assessed do not disclose the amount of assets linked to high environmental impact sectors, evidence that the bank is integrating ESG considerations in new transactions, or evidence the use of ESG ratings tracking (such as RepRisk, Sustainalytics or MSCI) within their risk management framework. Additionally, no bank discloses climate scenario analysis to assess value at risk under a variety of carbon pathways.
The importance of providing these disclosures lies in enabling better evaluation of risks and exposures which leads to a more efficient capital allocation across differing time horizons. The challenge here is for organisations to gather the right data and have the frameworks in place to realistically assess the impacts of ESG factors on their business performance.
Climate change is arguably the largest and most complex issue organisations face and need to incorporate into their Risk Management frameworks. An industry example of implementation on this front is a pilot project to assess the risks and opportunities from the physical and transitional impacts of climate change. In line with the Financial Stability Board’s Task Force for Climate Related Financial Disclosures (TCFD), a working group of 16 banks used climate change scenarios and methodologies to evaluate impacts on key credit risk metrics across their loan portfolios. Results from such analysis provide an enhanced assessment of risk and support more informed business decisions to improve organisation resilience and ultimately long-term shareholder value. Further, incorporating results within ESG reports enhances transparency making for a more efficient and stable financial system.
Getting this right is no small task and requires coordination across many functions (from Risk, Finance and sustainability SMEs) and senior leadership support. TCFD presents an opportunity for the banking sector to put in the extra, necessary focus on environmental issues and embed risk management approaches across all ESG factors.
Enhancing ESG reporting frameworks, with associated risk management practices, is not only the right choice from an ethical perspective, it’s also the right choice for the long-term sustainable financial performance.
 Dietz, Bowen, Dixon & Gradwell, Climate value at risk of global financial assets, Nature Climate Change, April 2016
 Morgan Stanley Institute for Sustainable Investing and Morgan Stanley Investment Management, Sustainable Signals survey, June 2018
 MSCI, Foundations of ESG Investing Part 1: How ESG Affects Equity Valuation, Risk and Performance, November 2017
 UNEFPI, Navigating a New Climate, July 2018; UNEFPI, Extending Our Horizons, April 2018