Embedding ESG into banks’ strategies

in Advisory, Industry Insights, 31.07.2020

This article was originally published on kpmg.com by Mr. Steven J. Hall, Partner, Financial Risk Management, KPMG in the UK, Niven Huang, General Manager of KPMG Sustainability Consulting Co., Ltd., KPMG in Taiwan, Julie Patterson, Wealth & Asset Management, KPMG in the UK, Arnaud Van Dijk, Senior Manager, KPMG in Canada.

In the ‘new reality’ that will follow COVID-19, sustainability will be the mantra, Are banks ready?

In just a matter of weeks, COVID-19 changed the dynamics of the global economy. As the crisis unfolded, many businesses and investors shifted their focus from profits to people; human impact became more important than economic impact. Issues related to human equality, access to health services and societal welfare topped the agenda. It quickly became clear that the environment and social issues have a deep and direct influence on economic stability.

At the same time, the economic contagion that followed seems to have infected the carbon economy the hardest. Oil prices plummeted on historically low demand. Carbon-intensive industries — everything from airlines to mining — either shut down or greatly reduced operations. Cars remained parked in driveways.

For a time, the immediate health and economic crisis pushed the sustainability agenda to the back-burner. However, our view suggests that — in the ‘new reality’ of the post-COVID world — environmental, social and governance (ESG) will increasingly become central to the economic equation.

Pressure for sustainability rises

As the world starts to look to the future, expect regulators, oversight authorities and policy makers to become more vocal about the need for greater adoption of ESG. They recognize that moving towards a low-carbon economy will create additional complexities for financial services firms. And they are worried that banks are ill-prepared for the types of prudential and conduct risks that could arise — both in terms of the direct risks (i.e. the physical impact of climate change on assets) and the transition risks (i.e. the challenges inherent in a wholesale move towards a low-carbon economy).

Investors will also be ramping up pressure on banks. In part due to the increasing recognition that ESG factors, and climate change in particular, represent material risks that must be managed.

Investors also want to ensure they can continue to earn a return on their investment. Interestingly, recent data suggests that ESG-related funds outperformed the markets over the first quarter of the year — when the COVID-19 economic crisis started. The MSCI World ESG Leaders Index, for example, outperformed the regular index by 1.36 percent on the quarter. According to Morningstar, 70 percent of responsible investment funds outperformed their peers in the first quarter1.

At the same time, banks are also starting to feel pressure from their customers and from the public at large. Customers want to bank with a firm that reflects their views and beliefs; younger generations, in particular, are said to be choosing their bank based on their ESG credentials.

Facing the tough questions

Bank CEOs know they need to act. In fact, in a global survey by KPMG International in autum last year (before COVID-19), almost three‑quarters of banking CEOs said they believed their future growth will be largely determined by their ability to anticipate and navigate the shift to a low-carbon, clean-technology economy2. However, most are struggling to come to grips with what that really means for their bank going forward.

Take the transition risk, for example. Bank executives understand the “new reality” will require them to pivot their finance towards greener and more sustainable companies and investments. But they also know they can’t just flick a switch; they still have significant books of business wrapped up in loans and instruments to ‘brown’ assets. As long as those brown 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.

Banks, regulators and politicians are also struggling to understand all of the potential unintended consequences of their shift towards more ESG-related business strategies. Declining to renew loans on existing coal mines, for example, may improve a banks’ carbon disclosures. But it could lead to significant social implications as mines close and unemployment grows (which, in turn, would have a massive impact on that market’s retail lending and potential impairments). Having the experience, insight and data to map all those potential consequences is proving to be a challenge.

The leaders move forward

Many banks were already moving down the path towards greener finance. The quantum of ESG-related announcements coming out of banks before COVID-19 were staggering. Goldman Sachs, for example, announced they would spend US$750 billion on sustainable finance over the next decade. Bank of America has pledged US$300 billion to sustainable investments3. Virtually every large global bank has made some sort of commitment — both financial and otherwise.

What is notable about these announcements is not just the sheer size of the commitments. It is who is making the statements. The Goldman Sachs pledge was made by David Solomon (the global CEO). At the Bank of America it was the Vice Chairman of the global bank. The point is that the leaders are making ESG a CEO-level and Board-level mandate; they are elevating the issue to the highest levels of the organization.

While COVID-19 may have slowed progress somewhat, it is clear that banks continue to embrace the ESG agenda. New products and new models are continually being developed, tested and commercialized. Wealth managers are moving towards ESG-informed investing; retail banks are creating new sustainable banking and investing products and services, such as green home-improvement loans, carbon neutral banking and sustainable exchange-traded funds (ETFs), aimed at millennials; and capital markets are moving towards ‘green underwriting’. Many bank customers (commercial and retail) can now choose from a variety of ESG-linked funds, bonds and assets.

Commercial banks are also creating new products and testing new models. For example, UK firm, Britvic, recently refinanced its GBP400 million (US$520 million) loan facility with several commercial banks through a sustainability-linked deal that offers the company lower rates if they meet their various ESG targets4. It is certainly not the first loan to be linked to sustainability criteria. And all signs suggest it will not be the last.

Interestingly, the leading banks also seem to recognize that this is an issue that requires industry-wide (indeed, financial system-wide) collaboration and response. And they are working with a range of organizations to progress key aspects. A third of the largest banks globally have signed up to the Principles for Responsible Banking. Many are participating in regulatory discussions around taxonomy and green finance.

Supervisors and regulators, in turn, are also working collaboratively in groups. The Network for Greening the Financial System (NGFS), a group of central banks and supervisors, was created to share best practices around key systemic challenges (such as integrating climate-related risks into financial stability monitoring and micro-supervision).

Taking ESG seriously

While some big questions and uncertainties exist, it is clear that bank executives can no longer afford to take a ‘wait and see’ approach. Public and regulatory expectations are rapidly changing and the most competitive banks are already moving to take advantage of that situation.

So what should banks be doing to embed ESG into their strategy? KPMG member firms’ work with banks and other organizations across the financial services ecosystem suggest there are four key actions that bank executives should be addressing today.

  1. Understand your current baseline. More than simply quantifying the financial risks and probabilities, banks should create an understanding of common ESG expectations of key stakeholders and build awareness of leading ESG practices, in particular amongst senior management and board members. This includes taking time to understand their current practices and exposures, including whether they have the right data, the right capabilities and the right processes to monitor and manage ESG appropriately going forward.
  2. Know what’s expected. While regulatory and supervisory authorities are exploring approaches as to how they might provide specific targets or expectations, bank executives should be talking to their regulatory authorities to understand what is expected of them and how those expectations may change over the short to medium-term. They should also be working proactively with their regulators and authorities to seek out facts, develop standards and identify solutions.
  3. Put it on your risk radar. For many banks, ESG factors remain a reputational risk. But they need to be more than that. Bank executives (and particularly boards) should be ensuring that ESG risks are a lens through which all decisions are made, especially in relation to credit and valuation risks in their portfolios, reflecting the strategic nature of these risks.
  4. Develop a strategy. ESG risks cannot be managed off the side of a desk. It requires banks to develop a robust strategy that is integrated into the overall business strategy for the organization. While the strategy must retain a level of flexibility, it must also be actionable and measurable.

Embrace it

The impact of COVID-19 makes it clear that banks must act to embed ESG into their strategies now if they hope to remain ahead of public and regulatory expectations. The reality is that many leading banks are already taking advantage of the ‘upside’ to execute a strong and integrated sustainable finance strategy. Those who lag behind face not only increased regulatory and public scrutiny but also constrained growth.

The bottom line is that banks can no longer afford to ignore ESG. Indeed, they must embrace it.