The topic of ESG risks has made its way into every board room over the past few years, underlying the growing importance of ESG considerations while setting up a company's strategy and risk appetite. Even though efforts to quantify and manage sustainability risks have increased immensely in recent years, more needs to be done to ensure such risks are properly taken into account. We aim to give an outline of an executable approach regarding the integration of ESG risk factors into the existing financial risk management frameworks of financial institutions.
In this whitepaper, we address the challenges of building ESG financial risk management frameworks by focusing on the integrated approach encompassing ESG risk appetite, ESG scoring, ESG financial risks and ESG regulatory reporting. Even though disclosure still remains the main focus of many institutions, we take the forward-looking approach and emphasise that, for an institution to retain its profitability in the long-run, it needs to move beyond disclosure only. We outline how ESG risks can be integrated into risk management processes and decision-making.
Setting risk appetites in alignment with future scenarios
Alignment with the regulatory expectations implies the top-down approach when incorporating ESG risks into an institution's risk appetite. The challenge for the board of directors is to take the forward-looking approach when setting up the ESG risk appetite and integrating it into the company's strategy. To achieve a projection of ESG risk outcomes, two techniques stemming from the scenario analysis can be used: sensitivity analysis and stress testing. While both allow the quantification of future risk, there are differences in terms of time horizons and granularity.
Customised ESG scoring to cover the whole client base
The topic of ESG scoring has already developed into a separate branch of its own. We emphasise, however, that with the multitude of scores already available on the market, there’s still a big gap around the small- and mid-cap companies. We argue that such a gap can be closed by developing an internal bespoke ESG scoring tool tailored for the institution's clients and their portfolios.
Translating ESG scores into classic risk metrics
Bespoke ESG scoring can also be used to identify the relevant shocks for the ESG financial risk analysis. Indeed, the classic metrics of probability of default (PD) and loss given default can be used to estimate the ESG financial risk impact by applying the relevant PD shocks and haircuts to the asset values and using stress testing. This information, together with the bespoke ESG scores, should be built into the exiting credit risk officer processes, thereby allowing the credit risk officers to make decisions based on the quantitative metrics as opposed to the largely qualitative-expert-judgment process that prevails today with regard to ESG risk.
Closing the risk management circle with regulatory-compliant ESG reporting
Regulatory reporting is the step that completes the integration of ESG risks into the financial risk frameworks and is also essential in fulfilling the regulatory requirements and expectations. Building on our extensive experience in audit and interactions with the regulators, we can utilise the best practices for setting up ESG reporting processes. Such an approach ultimately ensures the long-term and future-oriented integration of the ESG risks, which – at its core – supports the institution’s business model while ensuring profitability.
Further information and the results can be found in the full publication.