ESG matters for Financial Services

ESG-related matters are requiring an increasing amount of attention from asset owners and managers. Some of the most common ESG topics the sector is focussed on include:

1. Understanding the potential impact on investment returns of ESG-related factors
2. Developing and consistently embedding responsible investment policies linked to key initiatives such as the UN’s Principles for Responsible Investment and the FRC’s Stewardship Code 2020
3. The introduction of mandatory disclosure and reporting requirements at entity level, such as TCFD
4. Product-level disclosure requirements such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and the FCA’s Sustainable Disclosure Requirements (SDR) expected by the end of the year
5. Collating and reporting on GHG emissions data from investments.

ESG challenges for asset owners and managers

Common industry-wide challenges exist across all the above considerations. Our Financial Services ESG Advisory team has experience supporting asset managers in navigating these challenges and many more, whether you are just starting on your ESG strategy journey or are more advanced and are seeking advice and/or assurance to progress to the next stage of development. 

The Dear CEO letters from the PRA in October 2022 and January 2023 to CEOs of PRA-regulated firms reinforces the regulator’s expectations in respect of climate-related financial risk, which includes the PRA’s reiteration in that, by now, all firms within scope of their Supervisory Statement (SS) 3/19 must be able to demonstrate how the expectations are being met. The most common weaknesses identified in the sector are governance and oversight, engagement, and data management.

The above requirements extend to international Banks and UK branches of international Banks operating in the UK, as they are covered by the PRA requirements and should have climate change risk management controls in place.

ESG challenges for banks

The most common weaknesses identified are:

• Governance and oversight: There is increased scrutiny on the responsibilities of the designated Senior Manager Function (SMF) for climate, with roles and responsibilities clearly set out. From a business strategy and process perspective, Management need to be able to show how the results of scenario analysis have been considered when making key decisions. The Board must be prepared to report on how they have exercised their oversight and challenged responsibilities.
• Stakeholder engagement: The expectation is that firms should develop a counterparty engagement strategy to inform them on how they manage climate risk exposures, for example when developing new products and services. This will aid firms in understanding exposures and building data whist encouraging others to improve their current approach.
• Data management: Data availability has been identified as a key barrier for firms in measuring their climate risks. The PRA expect firms to set out an approach to identify the gaps in their climate data, and to have a plan to close those gaps. All firms should have contingency solutions in place using appropriately conservative assumptions, judgements, and proxies and should be more focused on bolstering quantitative data availability.

Overall, four years after the publication of the Supervisory Statement 3/19, the PRA expects banks and insurers to be able to demonstrate sufficient embeddedness of climate risk management controls, as well as strategies to overcome identified barriers. Firms not meeting these expectations face having to explain their position to regulators, upon their request.

In the UK, PRA regulated firms were required to have fully embedded an approach to managing climate-related financial risks by the end of 2021.

Risks that were once on the long-term horizon are now within close distance leading to increased attention particularly on the underwriting footprint, the investment portfolio, and insurer’s role in society. Therefore, assessing both the risk exposure and the ability to influence positive change is crucial. As a result, the concept of sustainable insurance is gaining prevalence as a strategic approach that covers identifying and assessing risk to managing and monitoring key performance indicators and exploring new opportunities associated with ESG issues, improving business performance.

In addition, since 2020 Lloyds have increased their ambition to become a truly sustainable market-place and to achieve net-zero carbon emissions by 2050. Lloyds expects each managing agent to implement an ESG strategy and framework that is fit for purpose for their business, and their 2022 ESG guidance sets out best practices on developing sustainable underwriting and responsible investment strategies.

ESG challenges for insurers

Some practical challenges we see for insurance and reinsurance firms with implementing climate risk regulatory requirements include:

• Depending on whether insurance firms are viewing climate risk from the perspective of insurers, or as investors/allocators of capital, these can drive different considerations and responses, as well as the need for different underlying processes and controls to support these responses.
• What is a proportional approach? A key theme. The physical and transitional risks associated with climate change have and will impact insurance firms differently depending on their business models and activity. However, regulators globally are stressing the importance of having conducted the relevant risk assessments and preparatory work to support current conclusions in terms of climate risk assessment and to be able to respond to changing climate risk profiles and impacts over time. Proportionality largely depends on the risk levels identified. Comparable to financial crime requirements and expectations, if claiming your business is at low risk of climate change, there is a need to evidence and prove how that conclusion has been drawn.
• Commercial strategy and getting the balance right. For example, requirement around executive pay, remuneration, and incentives, may be commercially sensitive, and there is a trade-off to consider between commercial sensitivity and regulatory compliance.

Payments 

In 2023 the FCA asked payment firms to consider ESG risks. Firms authorised or registered under the Payment Services Regulations 2017 (“PSRs”) and the Electronic Money Regulations 2011 (“EMRs”) such as Payment Institutions (“PIs”), Electronic Money Institutions (“EMIs”) and Registered Account Information Service Providers (“RAISPs)”) should familiarise themselves with the FCA’s ESG Strategy and ensure that their firms have appropriate governance arrangements for complete and careful consideration of material risks and opportunities.

This requires at the very least an ESG materiality risk assessment that investigates exposures as a result of climate-change negative impacts and a lack of diversity, equity and inclusion in the firm.

The output should become a plan to develop strong governance to support ESG objectives and promote diversity and inclusion. The plan should be made available to the FCA upon their request so firms should make sure they are prepared to avoid being caught off-guard. We expect the sector will be further regulated in the future.

Lager corporates and listed companies

Where financial services firms are either listed companies, or larger corporates this can bring firms not otherwise covered by the ESG reporting requirement into scope.

Larger firms are defined as those with more than 500 employees and operating income of more than £500m. They need to report on how they are managing their climate-related financial risk in accordance with the Companies (Strategic Report), Climate-related Financial Disclosure Regulations 2022 and the Limited Liability Partnerships. This requires them to have implemented climate change strategies supported by climate change risk management frameworks.

For asset managers and owners that are FCA regulated as the as per their ESG Handbook, they also need to report on their arrangements for managing climate-related financial risks. Initially the FCA requirements covered just listed entities, but was extended to larger regulated financial institutions, including asset managers with AUM of more than £50bn for the financial year beginning 1 January 2022, and extended to asset managers with more than £5bn for FY’s beginning 1 January 2023, to be reported by 30 June the following year.

To clarify, these requirements are slightly different to the Companies Act requirement which requires the TCFD report to be included within a firm’s annual report.

In addition, as indicated in the PRA’s Supervisory Statement SS 3/19, regulated firms, not in the scope of the above listed reporting requirements, are also expected to engage with the TCFD framework and report accordingly.