How to really be a catalyst in ESG regulations

March 20, 2024 General

Green building

Financial institutions encounter problems implementing the global environmental agreements like the Paris Agreement on climate change and the UN 2030 Agenda for Sustainable Development - even though they have incorporated sustainability goals in their strategy. Which realizations and actions are needed to turn the tables and get ESG implemented?

In Europe, the European Green Deal sets forth the EU's ambitious agenda for achieving climate neutrality by 2050. In a bid to streamline this ambitious agenda, the European Commission has laid down the groundwork for new reporting regulations relating to the Environmental, Social and Governance (ESG) framework, specifically designed to aid in the realization of these sustainability goals.

Banks committed to the cause

Shifting focus to the key orchestrators of this transformation, the financial sector stands out as a pivotal player. In response to this call to action, a multitude of banks globally have stepped forwards to join the Net-Zero Banking Alliance. Their collective goal is to achieve net-zero emissions by 2050. A clear commitment and in line with the European Green Deal. Besides carbon neutrality in institutions own operations, this target entails a rigorous assessment of emissions attributable to their investment and lending activities setting a new precedent for sustainable responsibility in the financial world.

Implementation of ever evolving ESG regulations is very complex, especially for financial institutions. To successfully implement ESG - not just within but also outside the current (finance & risk) framework – one needs to have knowledge of both finance and ESG regulations. Additionally, a quantitative toolbox is required. Currently financial institutions have many finance and risk experts on board with all kinds of capabilities but struggle tremendously finding and keeping the best ESG professionals in the market.

The ECB guide to internal models in its most recent release now also contains climate related risks, even more stressing the relevance of capturing climate related data for companies.

At RiskQuest we have expanded our knowledge in the environmental domain of ESG recently. This ESG knowledge, together with years of experience in financial risk modelling, enables us to operate on the fine intersection of regulation, (climate) risk and modelling. Through several hands-on projects at large financial institutions we gained experience with the intricacies of this relatively new domain. What are the challenges that these regulations present to financial institutions in the coming years and how can RiskQuest help to overcome them pragmatically?

The importance of ESG for financial institutions

So what exactly is ESG? It’s a framework that shows an organization’s sustainability and societal impact. This framework can guide investment decisions, risk management and strategic planning. Each component of ESG has an influence on different aspects of the decision-making process:

• What is the environmental impact of a company? How does it score on factors like greenhouse gas emissions, energy efficiency and waste management - directly and indirectly? These factors are categorized as follows under the accounting and reporting standard:

- Scope 1: Direct emissions from owned sources, such as company factories or buildings.

- Scope 2: Indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by the company.

- Scope 3: All other indirect emissions that are incurred by the company's upstream and downstream activities such as financed emissions.

Social criteria look at how an organization manages relationships with its employees, suppliers and customers. This includes labor standards, human rights and data protection and privacy.

Governance relates to the overall company's leadership, executive pay, audits, internal controls and transparency. Successful governance practices can push the company's reputation and performance while reducing operational risks.

Due to their role as capital providers, financial institutions are uniquely positioned to influence behaviour towards sustainable practices. That’s why it’s important to look closely at their indirect emissions (scope 3) to assess whether they are taking the right steps towards a more sustainable future. Moreover, financial institutions must take risks associated with ESG into account. Environmental risks, for instance, can lead to transition risks (such as risks associated with the change in policies relating to carbon emissions) and physical risks (such as higher frequency of natural disasters).

A more in-depth exploration of these risks and methodology to quantify them are elaborated in our article "Climate risk: how to quantify it?".

Financial institutions no longer have the option to avoid the integration of ESG into their practices. ESG is becoming a necessity for business to maintain competitiveness, manage risks effectively, and align with global sustainability goals.

EU Regulation

Environmental, Social, and Governance (ESG) performance can be evaluated by the regulations, recommendations, and requirements that have been developed by supervisory authorities and task forces. This increases transparency in their sustainability actions and investments and standardizes reporting. The Task Force on Climate-related Financial Disclosures (TCFD) report, initiated by the Financial Stability Board (FSB), offers recommendations on climate-related risk disclosure, becoming an international benchmark for supervisory authorities. To address sustainability interpretation challenges, the EU Taxonomy was implemented, setting criteria for determining sustainable economic activities.

While the TCFD and EU Taxonomy describe essential criteria, the Corporate Sustainability Reporting Directive (CSRD) translates these criteria into practical reporting requirements. Being implemented to streamline and standardize ESG reporting across the EU, the CSRD reports enhance transparency and facilitate informed decision making for stakeholders. In 2024, the CSRD will take centre stage in terms of practical implementation as CSRD eligible companies are obliged to report in 2025 on their 2024 financial book year. Many CSRD-eligible corporations, including financial institutions, are facing challenges. RiskQuest is eager to assist with compliant data requirements and the implementation of a data foundation to store necessary elements.

Interested to learn more about the various regulations? Please read our supplementary blog on ESG legislation.

How can RiskQuest help your business?

The challenges that ESG regulations create are real. Financial institutions need to gather and interpret tremendous amounts of very specific data to meet the ever-increasing number of requirements. On top of this: it all must happen within a limited timeframe AND the ESG requirements are constantly changing, creating the need for institutions and businesses to continuously adapt to new regulations.

This is something many organizations struggle with. They cannot keep up with the dynamic nature of ESG regulations, leading to inconsistencies across departments and strategies. And then there’s the issue of not just getting data but getting the right and reliable data.

This is where RiskQuest excels—by combining years of experience in regulation, risk management, and the financial industry with our recent expertise in implementing an ESG data foundation.

After all, solid reporting starts with a solid ESG data foundation strategy.

At RiskQuest, we recognize the importance of a streamlined ESG data foundation to assist companies in fulfilling their regulatory obligations. Our fundamental service includes modelling activities to address the gaps apparent in our customers' daily reality concerning this new topic. The disclosures that necessitate reporting on a client level involve substantial volumes of high-quality data, and collecting and integrating this data present significant challenges.

Our expertise in data enables us to construct a comprehensive database that aggregates all the necessary data in a single, accessible platform. By implementing our solution, institutions can align their data with their ESG goals and streamline their reporting processes. Download our teaser for setting up a ESG data foundation.

ESG tailored solutions

No institution is the same. From validation of transitional and physical risk models to model development of, e.g., flood risks on mortgage portfolios. RiskQuest is very experienced in creating and interpreting Climate Risk and Financial Risk models and fully equipped to cater to the special needs of your organization.

Interested to know what RiskQuest can do for your business specifically? Please contact Martijn at [email protected] or phone +31 6 23294157.

Ready to develop your quantitative skills, learn from experienced colleagues and talk about your options of becoming an ESG professional at a growing no nonsense Amsterdam based risk management company? Please contact our Recruitment team.