Environmental, Social and Governance (ESG) factors are increasingly driving business decisions across the world. While there has been an emphasis on developing governance framework for a long time now, companies are now incorporating environmental and social factors in their business strategies. Banks, which are part of broader business ecosystem are also not left behind. After all, they fund businesses, hence it becomes their responsibility to ensure that ESG framework is adopted by borrowers for overall sustainable growth. This takes us to the key question, “How do ESG factors impact bank?”. The answer to this question is interesting and needs detailed investigation. Here are some of the interesting aspects of analysis done by many institutions, regulators and other stakeholders.
Risk in banking and ESG factors: Banks are bound to get impacted by the ESG factors. The European Central Bank (ECB) in its paper, “Guide on climate-related and environmental risks” has detailed out how climate related risks can impact banking system. As per ECB, climate change and environmental degradation are sources of structural change that affect economic activity and, in turn, the financial system. According to ECB, climate-related and environmental risks are commonly understood to comprise two main risk driver-1) Physical Risk and 2) Transition Risk.
The ECB describes physical risk as the financial impact of a changing climate, including more frequent extreme weather events and gradual changes in climate, as well as of environmental degradation, such as air, water and land pollution, water stress, biodiversity loss and deforestation. Transition risk refers to an institution’s financial loss that can result, directly or indirectly, from the process of adjustment towards a lower-carbon and more environmentally sustainable economy, according to ECB.
So, how can environment related factors impact business of lending and various risks which are faced by banks? Let us look at a risk like credit risk. How will credit risk increase for a bank because of environment and climate related factors? It is known that banks work on probability of default (PD) calculation while working on credit risk calculation. Similarly, they also evaluate Loss Give Default (LGD) when the calculate credit risk. LGD is the amount of money that will be lost if a borrower default. PD and LGD along with some other factors help banks arrive at capital reserve that they need to keep. The ECB report points out that PD and LGD of exposures may get impacted by environmental and climate factors. The ECB says , “The probabilities of default (PD) and loss given default (LGD) of exposures within sectors or geographies vulnerable to physical risk may be impacted, for example, through lower collateral valuations in real estate portfolios as a result of increased flood risk.”
The transition risk may also be faced by the banks in the similar way. As per the same ECB report, “Energy efficiency standards may trigger substantial adaptation costs and lower corporate profitability, which may lead to a higher PD as well as lower collateral values.”
But the risks to the banks because of environmental and climate related factors are not just confined to credit risk. It also spills over to other risks such as market risk, operational risk and other risks which banks monitor as part of their risk management factors.
Marco Sindaco in his article (S & P Global Market Intelligence, dated 27-Oct-2020), “The Evolution of ESG Factors in Credit Risk Assessment” has stated, “Today there is increasing evidence that ESG factors can affect credit risk and investment performance, and ESG considerations are gaining prominence within investment and risk management groups. After all, mismanagement and poor governance can contribute to credit rating downgrades, and environmental and social issues can lead to reputational, legal, and regulatory risks that may result in negative financial consequences for companies.”
Reducing Risk and steps required: Managing ESG related risks is very important for the banks. There are many steps that can be taken in this regard. The first step obviously starts with understanding these risks. Business strategy need to be aligned to these risks and as mentioned by ECB , institutions are expected to integrate climate-related and environmental risks that materially impact their business environment in the short, medium or long term.
The Reserve Bank of India in its annual report 2020 has pointed out that “Given that the impact of climate change on India is expected to be one of the severest globally, the need for an appropriate framework to identify, assess and manage financial risks arising out of climate risk has become an imperative. Central banks and regulators need to provide leadership in the propagation of the ESG principles through the standardisation of the ESG investment terminology, design of a standard disclosures format for firms, and by incorporating ESG principles in financial stability assessments.”