FROM RISK TO OPPORTUNITY: NAVIGATING A COMPLEX ESG LANDSCAPE TO FUTURE-PROOF YOUR BUSINESS

As environmental, social and governance (ESG) issues continue to draw the attention of business leaders, it’s time the financial-services industry reframes its approach to ESG and recognizes the short- and long-term business value of developing agile ESG practices.

Traditionally, corporations have been expected to focus their efforts on financial risks and opportunities and maximizing shareholders’ profits. Other types of risks were considered secondary. Over the past few decades, however, we’ve developed a much deeper appreciation of how interconnected our world is. Companies are inextricably linked to a larger context of factors, and ESG is the acronym of choice for trying to manage this larger picture.

With ESG, there are broad factors at play that are both complex and ambiguous. However, events such as the COVID-19 pandemic and the war in Ukraine offer striking examples of how environmental, social and governance events can converge and have powerful economic impacts on financial institutions. In that regard, it’s not surprising that interest in ESG is exploding. In a recent Forbes survey of C-suite executives¹, sustainability was ranked as the number-one factor impacting business strategy. Interestingly, sustainability had barely registered as a risk during the prior year’s survey. Below are some considerations for developing an ESG strategy and recommendations for mobilizing these efforts.

Uncertainty and uncharted waters

Consensus is emerging that ESG factors have a meaningful impact on business. But when it comes to identifying, measuring and managing these forces, there is concern about how to do it well. BDO reported that² 64 percent of board members don’t believe that their companies’ disclosures on ESG help investors make better decisions.

The result is a bit like trying to fly an airplane while it’s being constructed. Across the globe, a growing number of authorities are asking for ESG disclosures, but most companies are relatively early in their efforts to understand their activities and exposures.

The emerging regulatory landscape changes quickly and is fractured across multiple governmental and non-governmental agencies, all proposing different rules for managing and measuring ESG risk. For instance, there are multiple disclosure frameworks for carbon emissions, competing standards for carbon-based accounting and a slew of proprietary ESG-scoring models that rank companies for institutional investors. It will take years—perhaps decades—for the landscape to fully settle into recognized standards and best practices.

Financial institutions face particularly demanding scrutiny because they are being asked to manage both their corporate activities and the impacts of the loans that comprise their portfolios. According to Claire Nooij at Steward Redqueen, a consultancy that specializes in sustainability and impact, financial institutions are facing three major challenges around ESG:

• They must address the impact of climate change on their lending portfolios;
• They must navigate the friction between setting long-term climate goals in a society that is focused on short-term financial performance;
• They must develop strategies to maintain their clientele as ESG expectations increase.

Understandably, institutions want to delay action until things settle down and become more established after looking at this landscape. But the risks posed by ESG issues are real and significant, and the timeline is short for addressing climate issues.

From reactive to proactive: developing practices relevant to your business

Financial institutions must find a way to operationalize their ESG practices now, which means building a practice that is inherently agile and backed by strong change-management practices. Rather than trying to find certainty in a regulatory landscape that we know is unsettled, the industry’s journey starts by ensuring that institutions are grounding themselves in established ways of working:

• Our actions and priorities around ESG must always be grounded in and follow the core values of our business.
• Our success underwrites our ability to impact the broader world, so we can never lose focus on providing exceptional services. There doesn’t have to be any conflict between the goals of building our businesses and managing those businesses with an eye to environmental, social and governance issues. In fact, these efforts should reinforce each other.
• Do what you say, and say what you do. Don’t grandstand or greenwash, as the ultimate proof of our efforts is in our actions, not our words.

The next step is to reframe the mandate for ESG so that we don’t see it as “something that is happening to our businesses” but as a legitimate opportunity to strengthen and future-proof. Rather than waiting to react to regulators, we can take control by asking foundational questions such as: How can we develop a broader and deeper understanding of the true risks and opportunities that face us? How can we seize this opportunity to make our company, customers and communities better, more resilient and successful?

Finally, we must focus our efforts on the issues that are most important to our businesses, stakeholders and overall strategies. We must focus on the ESG factors that are most material and represent the most imminent sources of risk and opportunity.

For example, nCino is a cloud-based software company, not an industrial manufacturer, so it would be a bad investment of our time and energy to deep-dive into industrial waste-disposal practices. But it is materially important for us to understand how climate change is forecast to impact Atlantic hurricane activity because our headquarters are located on the coast. By focusing on the issues most material to us, we can ensure that the priorities and strategies we put into place provide meaningful ROI (return on investment) in a multitude of ways.

The power to create a better world—and better business results

FIs (financial institutions) are uniquely positioned to turn ESG into something powerful. In 1987, the United Nations (UN) published the “Brundtland Report”, the first major report on sustainability, which defined the challenge in front of us:³ “[h]umanity has the ability to make development sustainable to ensure that it meets the needs of the present without compromising the ability of future generations to meet their own needs.” Lenders sit in the driver’s seat of the global economy. Responsible investment in our communities should mean that we invest in ways that improve that future for everyone by making our communities more equitable and resilient.

So, while the regulatory pressures that drive ESG for FIs are focused on measuring and managing risks, there is a massive opportunity to do even more. Connect the ideas that underlie ESG to the ways in which you are already committed to helping your customers and communities grow and flourish by taking a wider view of what you lend and to whom.

There is substantial evidence that doing good leads to better business results. According to McKinsey⁴:

• Based on a study of 2000 examples, the overwhelming majority show that companies that pay attention to ESG concerns are rewarded with higher equity returns, a reduction in downside risk and higher credit ratings.
• Seventy percent of consumers report a willingness to pay more for a green product.
• Companies with strong ESG practices enjoy higher employee productivity by increasing job satisfaction, boosting recruiting and retention, and enhancing motivation by instilling purpose.
• Eighty-three percent of C-suite leaders and investment professionals say they’d be willing to pay a 10-percent premium to acquire a company with a positive record on ESG issues.

But how do we overcome the challenges of a changing landscape?

No matter how large or small our ESG practice is, we all face common challenges. For lenders, the challenge is to build strong ESG practices and remain compliant without slowing down time-to-market. Technology leaders need to handle the increased amount of data and integrate that into existing workflows while standardizing and automating ESG data collection from different sources. Risk and ESG teams want to ensure compliance is embedded throughout the entire organization and need a clear picture of the sustainability of the overall portfolio.

In fact, how many of us have already wrestled with questions such as:

• How can we build an agile ESG practice that adapts to the changing landscape?
• How can we quickly and efficiently handle the additional data needed?
• How can we understand ESG risk as part of a holistic understanding of exposure?
• How do we make ESG a part of the credit lifecycle and not a set of standalone tools?
• How can we make everyone an ESG expert and not rely on a small group of SMBs?

The greatest challenges to building an ESG practice are maintaining agility in the face of regulatory changes and analyzing the available data. What data is important, and what is the right way to interpret it? How do ESG risks and opportunities translate into something we can represent in financial statements as revenues or losses?

Collectively, we’re working towards these answers, but there isn’t yet a single gold standard. As the landscape of ESG oversight changes rapidly, we’ll need the proper tools to adapt. These tools include:

• A flexible data model and configurable platform for gathering climate and other ESG risk data during the application process.
• A collateral-management system for capturing data specific to types of collateral and assets.
• A covenant-management system that can create and track ESG-specific covenants for specific loan purposes or assets.
• An ability to embed ESG practices into existing lending workflows without creating new silos.

These tools can help financial institutions get ahead of the curve in a rapidly changing environment and build a foundation for long-term resiliency for the business. They will also serve to advance the broader goals intrinsic to the rising shift to ESG while making our businesses stronger and more prepared for the long term.

No matter where you are in your ESG response, it’s crucial to pause long enough to ensure you can connect actions to corporate vision while maintaining a long-term view of organizational needs and objectives. It’s the broader industry’s common purpose to help customers succeed in creating value for themselves or their business and to thereby improve the quality of life for individuals and communities.

We invest in people and businesses so they can flourish, and the funds we can provide profoundly shape our world; it’s time to ensure we’re doing the best work we can for our organizations—and society at large.