In a data-driven world, how well can you measure sustainability?

With more companies committing to a net-zero economy by 2050, financial services firms must lead in developing data and reporting standards.

In brief

• Emerging data standards and reporting frameworks will help financial services institutions realize their sustainable finance strategies.
• With trillions of dollars in necessary investments and huge profit opportunities, clear metrics are critical to measuring progress to a net-zero economy.
• Higher-quality data, more robust stress-testing and scenario modeling and transparent reporting are the right next steps for the industry.

The powerful momentum behind sustainable finance shows no sign of abating. Rather, it’s picking up. More and more global financial institutions are lining up behind the United Nations Environmental Program Finance Initiative (UNEP FI) principles of responsible banking, insurance and investments. The concept of stakeholder capitalism continues to drive strategic decision-making with many global companies pledging their support.

Increased regulatory activity is another contributing force, especially relative to reporting on metrics ranging from carbon emissions to diversity and inclusion, as well as climate regulations targeted at financial institutions. Even the challenges from COVID-19 have done little to slow or constrain the financial service industry’s commitment to sustainable finance – indeed, in areas like ESG investing, COVID-19 seems to have accelerated prior trends.

What is Sustainable finance?

EY defines sustainable finance as any form of financial service that incentivizes the integration of long-term environmental, social and governance (ESG) criteria into business decisions, with the goal of providing more equitable, sustainable and inclusive benefits to companies, communities and society. Embedding ESG concepts into investing is perhaps the highest-profile manifestation of sustainable finance, alongside the rising prominence of stakeholder, or inclusive capitalism.

However, most financial institutions are only now gaining a full understanding of the risks and opportunities related to sustainable finance, and climate change. EY’s Sustainable Finance Index illustrates the global financial services industry’s progress toward a more sustainable future and how far it still has go in making its ESG impact transparent and measurable.

Financial services firms have an essential role to play in the decades-long transition to a low- or no-carbon economy. There are literally trillions of dollars of investments required. The International Energy Agency estimates that $3.5 trillion in annual global investments are necessary to build the infrastructure for a green economy.¹  EY analysis has found that the ten largest European banks, as measured by assets, have publicly committed to providing nearly $1.5tn of green finance by 2030.

Huge profits are on the table, too. Some analysts have likened the scale and scope of opportunity to the industrial revolution. Mark Carney, former head of the Bank of England and now a US Special UN Envoy, has called the greening of the economy “the greatest commercial opportunity of our age.”

The first article in this series on sustainable finance outlined the need for a four-point strategy to take advantage of the enormous commercial opportunities. This article highlights other critical steps – including data standardization and collection, scenario and risk modeling, and the creation of effective reporting mechanisms – to mobilizing and measuring the results of those strategies.

Based on EY’s engagement with industry leaders and stakeholders across multiple industry working groups, we view the following three steps as critical for banks, insurers and asset managers seeking to take effective action based on their sustainable finance strategy.

1. Engage and collaborate on data standards to drive systemic change

Financial institutions will require more trustworthy data than they have today to better assess the ample investment opportunities. Clearly, there is plenty of data available – especially relative to current carbon emissions and future targets – and from a range of sources. As the latest EY Global Climate Risk Disclosure Barometer confirms, the quality of the data – rather than the quantity – is the issue. It is often inconsistent and difficult to translate into meaningful analysis, modeling and reporting. Many financial services firms still lag in disclosing on their risk exposures and risk management approach, reflecting the dearth in quality data.

Higher quality and more consistent data will help investors understand what they are investing in. Another recent EY study of institutional investors found increasing dissatisfaction with information shared about ESG risks and that non-financial performance and risks play a pivotal role in investment decision-making. That’s why banks, insurers, and asset managers should engage in industry efforts for increased standardization across myriad reporting frameworks. Meantime, firms have been innovating on what they disclose. For example, some firms have begun applying the principles of impact-weighted accounting to track the effects of climate change on their financial performance.

The Taskforce for Climate-related Financial Disclosures (TCFD) has become the go-to standard for climate-related financial reporting, with more than 1,000 supporting organizations from 55 countries. TCFD is working actively to fill the gaps in current reporting relative to climate change strategies, governance, risk management and target setting. As recent EY analysis makes clear, there are definite benefits, (e.g., stronger risk management, improved modeling capabilities, and more consistent communication) that come from implementing the TCFD recommendations. EY worked with the Institute of Finance and UNEP FI to publish a TCFD playbook to provide clear and comprehensive guidance to financial institutions on how to develop a TCFD report to move from initial to advanced reporting.

Financial services leaders can provide input to refine TCFD recommendations. They can also contribute to the development of TCFD-compliant listing requirements and participate in coalitions supporting mandatory disclosures, which appear inevitable. The recommendations of the Climate Financial Risk Forum also bear watching. This collaboration between the Bank of England, the FCA, and private sector is focused on defining and sharing best practices for data consistency.

Similarly, as noted above, UNEP FI has released principles for responsible banking, insurance, and investment. These principles aim to “embed sustainability at the strategic, portfolio and transactional levels, and across all business areas” and “help the industry to demonstrate how it makes a positive contribution to society.” They clarify the common ground firms can find in terms of analyzing their impacts on people and the planets, setting and implementing sustainability targets, and reporting on progress.

The regulatory context is also changing quickly. A recent IIF paper highlighted the need for a “harmonized and sound policy and regulatory framework that ensures clarity of purpose, protects consumers, supports market development, and facilitates transition in key economic sectors.” Financial service firms can and should help in designing that framework and thus must engage as they did in the development of reforms after the financial crisis.

Boards and senior leaders are recognizing that emphasis on transparency and accountability means they may have to share data more openly and rely less on proprietary models than they are otherwise inclined to do. Such collaboration will be necessary to overcome regulatory fragmentation and achieve systemic change.

What financial services firms should do now:

• Understand current sustainability initiatives and how they are being measured
• Identify the data and information to be collected to meet reporting standards, as well as necessary process changes and governance structures
• Identify opportunities to engage with working groups and demonstrate leadership in key areas

2. Build stress tests and scenario models for the near and long terms

Better and more consistent data enables more robust stress testing and scenario modeling, another critical step on the path to sustainable finance. Beyond framing the full scope, extent, and urgency of the challenges and risk ahead, such modeling is essential to finding the right strategic balance between risk and reward. Opportunities should be identified.

Modeling frameworks should be adjusted to reflect nearer-term impacts from climate change. Focusing the modeling lens on one-, three- and five-year horizons reflects the reality that extreme wildfires, floods, and superstorms can no longer be viewed strictly as once-in-100-years phenomena. Indeed, they are happening today around the world with more severe consequences every year. Models should account for a range of physical impacts, as well as the potential of another pandemic, massive cyber-attacks, and/or widespread geopolitical disruption playing out against the backdrop of climate shifts and natural disasters. Nearer-term models are critical inputs as companies devise their strategies in the coming months.

These shorter-term impacts should be coupled with longer-term factors and scenarios; after all, the journey to carbon neutrality will take decades, as will the journey to gender and racial equity.

Because the risks and potential responses are complex, top-down macro models must be supplemented with bottom-up views. It’s worth noting that, given the unprecedented nature of the threats, historical data is of limited use. Even the insurance industry, with its unsurpassed data sets and risk insights, will be challenged to model effectively. After all, what was once a one-in-one-hundred-year event now seems to occur frequently.

Modeling for transition risks should factor in different rates of adoption. For instance, what are the likely effects of gradual, but steady, annual progress during the next decade as compared to a scenario where little to no action takes place through 2025 when a sudden rush of initiatives is launched? Sector-specific models will explore how quickly renewable energy sources replace fossil fuels and how soon the infrastructure for all-electric vehicles can be put in place.

The bottom line is that risk modeling teams must think bigger, broader, and more creatively in framing the potential impacts of climate change. Companies must balance near- and long-term impacts and use modeling to show impacts across the years.

What financial services firms should do now:

• Ensure models strike an appropriate balance between near-term and long-term scenarios
• Use modeling outputs as a key input to shaping strategy and refining metrics
• Apply scenario analysis to all key links across the value chain

3. Report and disclose openly and efficiently

The adage that “what gets measured gets managed” will certainly hold true in the realm of sustainable finance. Financial institutions should engage with industry efforts to develop more detailed, accurate, and standardized reporting. The goal must be to provide better insight into the efficacy and progress of company transition plans, with clear links between disclosures, reported metrics, and company strategies. Choosing the right metrics will allow senior leaders to tell credible and convincing stories to financial markets – clarifying why sustainability matters and how the firm is working toward it.

The TCFD standard provides a strong foundation on which to build. The Taskforce’s most recent status report noted the significant progress in the last few years, but stated bluntly that current disclosure “is still insufficient for investors.” Other groups – including the Climate Action 100+, a group of institutional investors with more than $40 trillion of assets – is also pushing for fuller disclosures.

All signs point to mandatory reporting in the years to come. It is likely that central banks and regulators will follow TCFD’s lead, which means the financial services industry would do well to proactively engage to set these standards. Indeed, some regulators, like the UK, are starting to mandate TCFD disclosures. The reality is that most companies are doing more than they report on. Thus, the initial focus for many firms will be on more effective coordination and communication of existing efforts, rather than standing up entirely new reporting efforts and initiatives.

Forward-looking firms are aligning their sustainability metrics into emerging long-term value frameworks. The concept of long-term value has emerged alongside calls by some prominent leaders for a clearer articulation of the social purpose of business, as well as the definition of more comprehensive valuation metrics related to purpose. These long-term value frameworks are at the heart of stakeholder, or inclusive, capitalism. The EY-led Embankment Project for Inclusive Capitalism (EPIC), which involved 31 asset managers, asset owners and companies, created a market-validated framework for measuring long-term value around four focus areas: human talent, consumer needs, societal and environmental concerns, and corporate governance. Sustainability strategies and goals are a natural fit.

What financial services firms should do now:

• Analyze current disclosures and compare them to proposed standards
• Ensure that metrics are incorporated into holistic “stories” that senior leaders can share with investors and other stakeholder groups
• Assess how sustainability metrics fit into broader frameworks for long-term value creation and measurement

The time is now, not tomorrow

Some industry stakeholders take the position that climate-related financial risks could result in the next global financial crisis. That’s why the time is now to set the rules for data standards and reporting and develop both the necessary risk management plans and investment strategies. The regulatory actions were taken after the last global financial crisis certainly helped the industry navigate the COVID lockdowns. Climate change calls for an even higher degree of advanced preparation.

The good news is the world’s largest and most important banks, insurers, pension funds, and asset managers have moved out of “wait-and-see” mode and actively support and deliver increased transparency about climate-related financial risks. But even as the industry steps up, there is a great deal of work to do if sustainable finance is to become reality and businesses around the world are to realize its potential. Much collaboration among many different stakeholders will be necessary. Many difficult questions must be answered. Data will be sourced, aggregated, acted upon, and disclosed. For all the uncertainty, one thing is clear – very interesting days are ahead for those firms pursuing sustainable finance.