ESG evolution – Navigating the regulatory challenges in financial institutions

It has been six years since the Network for Greening the Financial System (NGFS) was formed, and today it represents the views of 129 regulators and central banks. The work of NGFS has been fundamental in driving the development and implementation of climate risk ?and green finance related regulations. Furthermore, with over 50 publications, NGFS has played a pivotal role for financial institutions, offering guidance and assistance in shaping the industry best practices and providing a window into possible futures through its creation of climate scenarios. Over the years, regulatory developments have materialized on multiple fronts and in different regions, largely influenced by this work of NGFS, encompassing risk, disclosure and green finance. Also noteworthy is the arrival of the Corporate Sustainability Due Diligence Directive (CSDDD) in Europe, signaling a shift towards firms bearing increasing liability for their climate inaction. While the financial sector is temporarily excluded from its scope, this is still subject to review and change.

"Capital requirement is the nuclear option for the regulator to push banks into action".

SOURCE: DAVID CARLIN, UNEPFI HEAD OF CLIMATE RISK & TCFD

Another ongoing major regulatory debate focuses around climate risk and capital requirement: whether climate risk should be a separate pillar 1 risk with its own risk-weighted asset and capital requirement, or should it be rather included in the current risk categories, and/or should there be a capital relief for greener assets. Once resolved, these issues can lead to significant impact on how financial institutions respond to climate change.

Simultaneously, ESG began its journey as nice-to-have, initially surfacing as awareness in banking discussions, progressively evolving into formalized expectations and influencing demands from local regulators, investors, customers and policymakers.?

All in all, we have seen an unprecedented wave of regulations, policies and disclosure requirements, already causing lot of headaches for firms. And there is still more to come, as a number of requirements are going to kick in during the coming years.

During a Qorus event 'ESG evolution: Navigating the regulatory frontier ' in December, we discussed with our experts and participants their views on the current regulatory landscape, how banks can effectively address the regulatory requirements and what can we expect going forward.?

The collective sentiment from our audience aligned with the view that current regulations are insufficient, emphasizing the need to advocate for more proactive measures from firms.

The application of the current already extensive regulatory framework is not uniform across all regions. In Europe, we benefit from a robust regulatory framework. However, this consistency is not mirrored globally, despite sustainability being a global concern, not exclusive to Europe. Maybe the focus should shift from needing more regulation to facilitating better regulation. The emphasis lies in uniformity – when discussing materiality or risk, a shared understanding should prevail. This involves standardizing definitions, enhancing the clarity of sustainability reporting, and aligning trajectories.?

Taking disclosures as an example, the overview below covers some of the key areas addressed by different disclosure frameworks, highlighting their relationships, differences and key features. ISSB is more principles-based, emphasizing financial materiality, while CSRD is more rules-based, specific to individual standards, and focuses on double materiality. The SEC and FCA are expected to provide guidance in line with ISSB.

There is a shared call for increased clarity in regulations. While current climate regulations are appreciated, the need for a global focus on regulatory clarity is emphasized. For example, comprehensive cataloging of expected risks, clear guidance on framing methodologies, and tools for climate and broader environmental risk management are identified gaps in current regulatory frameworks. Addressing these gaps will contribute to a more transparent and effective regulatory landscape.

Furthermore, the emphasis is on the need for policy, with regulation sometimes serving as a secondary solution. A direct approach is crucial, involving government action and policy implementation to create market conditions. While reporting is essential, the focus should extend beyond, with a call for more comprehensive government intervention to drive the necessary changes.

Regarding the regulatory requirements, banks are grappling with numerous challenges. According to Adlen Bouchenafa , Partner, Director of Sustainability at TNP Consultants , efficiently navigating ESG regulations requires a nuanced analytical approach focusing around four key pillars: ??

• Robust understanding of ESG risks and sustainability patterns at all levels of the organization. Comprehensive education is crucial, not only for internal stakeholders but also for clients, enabling them to navigate the swiftly evolving regulatory space. It entails continuous monitoring, keeping pace with regulatory changes, identifying exposure levels, and conducting gap analyses.?
• Finalization of an ESG strategy. Some institutions still grapple with clarity in this regard and must transition to a more operational phase in delivering and executing their strategies.?
• Proactivity is paramount. Banks must anticipate and address material ESG issues promptly, avoiding the pitfalls of playing catch-up. Waiting too long could prove detrimental. A proactive stance is essential to stay ahead of regulatory changes and demonstrate adaptability.
• Lastly, banks must balance short-term and long-term objectives, adopting a step-by-step approach. Quick wins are vital to showcase the efficacy of their strategies, reassuring stakeholders and validating their approach.

Effectively leveraging data and analytics for efficient compliance is becoming one of the main areas which can support banks in addressing the regulatory challenges.

The work of the NGFS has prominently centered around data as a primary focus. Within this domain, the NGFS has articulated recommendations for how supervisors can positively contribute to this crucial aspect.

In essence, the supervisory perspective not only influences the presence and availability of data and tools but also dictates their application and purpose. The regulatory landscape serves as a catalyst, steering the financial industry towards a more sustainable and transparent future.

Utilizing data not only guides bank’s business strategies but also provides a comprehensive view of the transitions banks facilitate for their customers.?

2024 – we will be building the plane while flying.

SOURCE: Ruben Audenaert, DATA DRIVEN SUSTAINABILITY, KBC Global Services?

Reflecting on the discussions above, it's evident that 2023 has been characterized by the release of regulatory guidance. Looking forward, 2024 is anticipated to be a crucial phase of implementing that guidance, bringing forth a set of challenges and opportunities. The focus will extend to data management, introducing new scales and scopes, particularly in the non-climate aspects of ESG.? In essence, 2024 embodies a year of dynamic action – building and flying simultaneously – to ensure the continuation of banks’ established practices while laying the groundwork for a sustainable and adaptive future. It necessitates a strategic blend of existing practices, innovative data sourcing and a forward-looking mindset to meet both reporting obligations and guide our business toward enduring success.

This Article was written with the support of Qorus and published at their Sustainability & Regulation Community site here .