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As authorities focus more on ESG factors, financial institutions must act quickly to effectively manage evolving sustainability risks.
In brief
- With their potential to threaten financial stability, climate change and ESG factors have come under increasing scrutiny from financial authorities.
- This is apparent from the Monetary Authority of Singapore’s recent formation of a new sustainability group and its Green Finance Action Plan.
- In response, financial institutions must address three key areas to effectively navigate the evolving sustainability risk environment.
In September 2021, the Monetary Authority of Singapore (MAS) announced the formation of a new sustainability group. The group will coordinate the authority’s green finance and sustainability agenda, aimed at strengthening the financial sector’s resilience against environmental risks and developing a vibrant green finance ecosystem to support Asia’s transition to a low-carbon future. It will also identify strategic green finance collaborations with regional and international counterparts and reduce MAS’s own carbon and environmental footprint.
This is certainly welcome news. Regulatory interest in sustainability or environmental, social and governance (ESG) factors is not new: the US Securities and Exchange Commission and Hong Kong’s Securities and Futures Commission have also set up similar task forces or groups to look into ESG-related initiatives.
Managing the impact of ESG risks on financial stability
Central banks and financial regulators now widely acknowledge that climate change and ESG factors can threaten financial stability via physical and transition risks — with financial institutions already reporting significant losses as a result of such risks. Pricing of climate-related risk is still a nascent field and — with its unique and longer-term characteristics — remains a challenge across the board for corporates, financial institutions and financial markets.
Financial authorities recognize that assets generally continue to be mispriced and there is a need for new data, methodologies and disclosures to better understand, size up and manage these risks.
Prudential authorities, for their part, are increasingly focused on the necessity for financial institutions to expedite changes in governance, risk management and disclosure to properly account for climate-related risks and build them into decision-making processes, including capital assessment and allocation.
With MAS’s latest announcement on the sustainability group and the MAS Green Finance Action Plan announced in October 2020, the direction of Singapore’s regulators is clear. The pace of supervisory and regulatory development is expected to hasten with the 26th United Nations Climate Change Conference, better known as COP26.
Similar moves can be expected from regulators in other jurisdictions as well. Countries and regions will move toward greater accountability and transparency, and more will be making commitments to achieve net zero by 2050. There will also be increased legislations mandating sustainable finance for banking, capital markets and non-bank financial institutions.
Three key actions for financial institutions
Financial institutions are sitting up to climate risks too. Many of their stakeholders expect them to support their transition to a zero-carbon economy. The latest EY-Institute of International Finance global bank risk management survey revealed that climate change has topped the list of long- and short-term risks for Asia-Pacific banks for the first time since 2010.
In navigating the evolving sustainability risk environment and regulatory requirements, financial institutions should look into three areas with urgency. First, adhering to regulatory guidelines is key. Globally, it is only a matter of time before sustainability risk management becomes a regulatory imperative, if not already. Financial institutions should not wait for further formal and detailed supervisory guidance, let alone changes in prudential requirements. There are wide variations in how advanced financial institutions are in this regard. The institutions leading the way will set the baseline for peer comparison from supervisory and market perspectives. A defining feature of these financial institutions is their board-level commitment to understand climate-related risk and sustainability considerations and drive them through strategy and into the fabric of how the institution governs the business.
Second, financial institutions need to address the challenge in sustainability-related data, which will be critical to compliance with regulatory expectations and requirements. Having a coherent and robust data strategy is particularly important, given the unique nature of the data required. There will likely be significant gaps in fulfilling regulatory reporting and disclosure requirements. Organizations may have to rely on estimates, best guesses and third-party data providers, and these could pose various reliability issues from an internal risk management and regulatory perspective.
Third, financial institutions must consider broader sustainability factors beyond climate risk. While much attention has focused on environmental concerns (climate in particular), there is a growing emphasis on social factors amid renewed considerations on governance, which in part, is due to reflections driven by the COVID-19 pandemic. In fact, new or planned regulatory requirements are placing a greater focus on these aspects. These include global initiatives like the World Economic Forum working with major accounting bodies to develop frameworks, standards and metrics with respect to sustainability that consider ESG aspects and long-term value creation, in order to foster transparency and comparability in disclosures.
With sustainability rising on the agenda of regulators and other stakeholders, the ability to demonstrate compliance is clearly vital. Yet, reporting to stakeholders is only an end objective. The starting point is arguably more important. How can financial institutions align their strategies with an ESG-centered purpose and execute the commitments, while capitalizing on the opportunity to offer sustainable finance and help other organizations make the transition to net zero?
Summary
Financial authorities are focusing more on climate change and ESG factors as these can threaten financial stability. Financial institutions must therefore prepare themselves to successfully navigate the evolving sustainability risk environment and regulatory requirements in three areas. These include adhering to regulatory guidelines, addressing sustainability-related data challenges and having a wider perspective of sustainability factors beyond climate risk.
How EY can Help
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Supporting organizations with physical and transition risks associated with climate change, and assisting them with market and regulatory changes.
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Through enhanced corporate reporting, EY can support finance teams to meet demands for high-quality enhanced financial and nonfinancial information.
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Discover how EY's strategic transformation services can help your organization drive strategic transformation with long-lasting results.
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