High environmental, social and governance standards are increasingly critical to a bank’s reputation and license to operate. They can also give rise to new revenue streams
With so many challenges facing commercial lenders – digitalization, new competitors, low interest rates, regulation, and more – it is tempting to downplay environmental, social and governance (ESG) issues when considering a large-scale transformation project. Until recently, ESG tended to focus on corporate social responsibility – such as volunteering and community relations. ESG departments existed in a silo, not deeply connected to the bank’s overall strategy, client and product offerings, or incentive schemes.
But there are compelling reasons for embedding ESG standards and practices across all functions in the context of a broader transformation project, and for involving everyone from the C-suite to the local bank branch. ESG is a central driver for the radical, holistic transformation required by European banks and one of the key challenges they must address, alongside credit, cost, consolidation, and technology. More detail on our overall transformation approach and how to address the other key issues can be found here.
Three trends are converging to position ESG as the new litmus test of good banking practices. The first is climate change and the need to finance the decarbonization of economic activities, which promises to open up new areas of activity for banks. The second is reputational, where banks and businesses that do not measure up to their ESG pledges risk being accused of greenwashing. The third is regulation, which will require banks to measure and disclose ESG risks in their loan portfolios and other banking activities, as well as the impact of their activities across a broad set of environmental, social and governance considerations.
For these reasons, we expect ESG standards to become critical to a bank’s reputation and what BlackRock CEO Larry Fink has called companies’ “license to operate” in the coming years.1 Banks that are ahead of the curve stand to gain both competitive and reputational advantages over their peers.
Climate change and COVID-19 are focusing minds on the need to speed up the transition to a low-carbon, more sustainable world. Most advanced economies, including the European Union, have pledged to become carbon neutral by 2050. The EU has also set an interim goal of slashing carbon emissions by 55 percent by 2030, from 1990 levels2 – with its targets now to be enshrined in the new European Climate Law.
At stake is the most radical restructuring of advanced economies since the dawn of the industrial era, and this will require a high level of investment. In Europe alone, meeting the new 2030 emissions reduction target will demand an estimated €350bn of additional investment a year, according to the European Commission3.
As financial intermediaries, banks are at the heart of this economic transformation, especially in Europe where they provide about half of the financing needs of non-financial corporations. They stand to play a major role in facilitating the reallocation of capital toward low-carbon activities while also financing transition activities. This represents a big opportunity for developing new business. Banks that embed ESG across their business model will be better positioned to understand and engage with clients on their own climate risks and sustainable transformations, and secure their business relationships with those clients as a result. This could become a competitive advantage – and a source of new revenue streams.
The reputational risk of falling short is also growing by the day. Banks are facing intense public scrutiny over the impact of their lending practices – on human rights, social cohesion, gender equality, carbon emissions, biodiversity, development, and a host of other ESG topics. Activist investors and environmental groups are tabling an increasing number of shareholder resolutions that single out banks for poor ESG practices.4
One example of the kind of negative publicity banks are at risk of comes from the Rainforest Action Network (RAN), a coalition of non-profits and activist investors, which late last year published a report5 on the climate impact of bank lending practices. It found that in the five years since the Paris Climate Agreement, the world’s 60 largest banks had extended $3.8 trillion in loans to the fossil fuel industry, in many cases contravening their own stated climate policies and commitments.
“No bank making a climate commitment for 2050 should be taken seriously unless it also acts on fossil fuels in 2021 – banks must immediately end support for fossil expansion, and commit to the date by which their fossil financing will reach zero,” the report said.
In addition to climate change and reputational risk, a third reason for making ESG part of an overall transformation project is that a barrage of new climate risk regulations and reporting requirements are about to hit the financial sector – and few in the industry are fully prepared.
European banks were warned by the ECB in November 2020 that most of them were failing to implement meaningful climate-related and environmental risk reporting. On governance, only one-third of banks reported board oversight of either climate-related risks or opportunities. On risk management, only one-in-two banks were able to describe their processes for identifying, assessing and managing climate-related risks. Fewer than one-in-four had tested their loan portfolios against such risks. On KPIs, the ECB noted, “targets are not always supported by relevant metrics.”
The ECB is determined to keep up the pressure on climate risk disclosure. Stress testing of individual eurozone banks will begin in 2022, when mandatory reporting on climate risks in loan portfolios, using a new EU classification or “taxonomy” of sustainable activities, will come into force. “Stress tests… can cast a light on climate risks that currently still lurk in the darkness,” said Luis de Guindos, ECB vice-president6. “It is a vital step in our quest for knowledge on the impact climate risks have on economic and financial stability, which until now has been poorly identified, quantified and understood.”
“It is a vital step in our quest for knowledge on the impact climate risks have on economic and financial stability, which until now has been poorly identified, quantified and understood.”
When taken together, the reputational, regulatory, and business implications of ESG point to its power to transform and reshape business and operating models for banks. All the indications are that ESG will become as significant to the future of banking as successful digital transformation, or building service ecosystems for the new world of open banking. However, for this to happen, the transformative potential of ESG across the bank’s whole internal and external ecosystem must be fully understood.
The first step is understanding that ESG will affect the entire bank:
To set meaningful ESG goals, knowing how far you want to go is crucial. It sets the destination and the direction of travel. Not all banks will want to be ESG leaders; for some, this might not even be practical, depending on the priorities of their customers and the services they offer. These banks will have a less pressing need to develop new ESG-linked products and services, such as green or “climate” bonds, and other sustainability and social issue-linked bonds, in which the borrower’s costs fall if they meet specific environmental or social impact targets. However, they risk falling behind as these types of financial products become more common. Green bond issuance is increasingly popular and reached a record $269.5bn in 2020, a 57 percent increase compared with 2018.8
Banks currently fall into three broad categories when it comes to incorporating sustainability into their overall strategy:
We believe most banks should aim to be strategists. The pragmatist’s approach of doing just enough to satisfy the regulatory minimum still requires a significant investment – in gathering data, implementing risk measurement and management processes, and reporting. Taking the next steps to become an ESG strategist offers more opportunities to capitalize on the initial investment. Done diligently and with conviction, ESG is an opportunity to enhance reputation, reduce lending risk, and potentially improve returns on businesses and activities that may become the new normal going forward.
For example, we were recently engaged in an ESG transformation project for a bank that aimed to be known for being strong on ESG. But it had not adopted a holistic or strategic approach to match its level of ambition. Once the transformation roadmap was in place, we helped the bank establish a sustainable finance advisory unit. This unit is now advising a client in the chemicals sector on how to finance the sustainable transformation of its industrial processes. This in turn has generated demand for the bank’s new ESG-themed products, such as green bonds. By evolving from a pragmatist into a strategist, the bank is now generating new business lines and growth opportunities.
Consistency is what’s important. To be credible, a bank’s strategy must reflect its level of ambition. This comes when ESG goals and roadmaps are integrated into the business strategy. In some cases, business models might have to be adapted to seize new opportunities opened up by the ESG transformation. ESG risks within the bank will have to be mitigated by setting targets, measuring progress, and reporting on them. And as confidence in managing ESG across the business grows, the level of ambition must have room to grow as well.
To be successful, an ESG transformation project also needs the buy-in of the board and C-suite. They must be involved to generate awareness of the scope of the ESG transformation, lend credibility to the project, and bring others onboard. The C-suite must be responsible for driving change, but most departments – Human Resources, Regulation, Credit Risk, Product Development, and Compliance, among others – will be involved.
Each department and business line will have to set its own budget, timeline, milestones, and the results it needs to meet the bank’s overall ESG goals, but the initiatives will be interlinked. All the various parts of the organization must have a seat at the table, in order to drive the transformation together.
Lofty goals, where ESG commitments are not backed up by targets, measurements and reporting, no longer convince shareholders, clients or the public.
At the bank we worked with in the example above, we helped develop the targets and KPIs for the ESG transformation plan. They included:
While EU regulators and bank supervisors are working to produce a common set of standards on ESG reporting, each bank must set its own roadmap and targets, and select the most relevant KPIs to lend credibility to its climate strategy and link it to its business model.
ESG affects every aspect of doing business. A successful ESG strategist will define a roadmap for incorporating sustainability into the bank’s business model and adapt the organization to meet these goals. This involves defining a clear set of KPIs for business units and tracking ESG data to measure success. Banks must also have a strategy for communicating these goals to their stakeholders, including a sophisticated and transparent reporting system. If leveraged correctly, ESG actions and associated data can become a competitive advantage in determining the right pathway to a successful transition.