ESG and Prudential Considerations

Environmental, social and governance (“ESG”) risk is unique in the challenges it presents, and a well-executed risk framework can help to determine and manage the most critical risks. Given the increasingly widespread and complex nature of ESG risks at both group and entity level, firms are having to consider how to address these risks. Clients, both institutional and retail, have created demand for ESG products and solutions, requiring material changes to the way investment firms operate. However, firms may have challenges with isolating and quantifying the impact of ESG risk on a standalone basis or as part of existing risks.

Asset owners require capability to support their own ESG commitments, including, for example the provision of specialised data and reporting. Investment firms are increasingly responding to the broader Sustainable Finance agenda by making corporate-level ESG commitments, ranging from Net Zero or carbon negative approaches to diversity & inclusion, gender pay gaps and employee working conditions. Each commitment can require material changes for example in relation to focus on product re-design, accurate data, reporting and operational change. This can directly impact a firm’s ICARA and can become a theme throughout a firm’s risk management framework (“RMF”) and capital planning.

Increasing levels of regulatory input and scrutiny around ESG heightens the potential regulatory risk for all firms, as they look to simultaneously pioneer market trends and stay ahead of the regulatory requirements in this space. A fast-evolving global ESG regulatory landscape means that asset managers and asset owners are being subjected to new and sometimes complex requirements. In addition to potential opportunities from corporate strategies around ESG, Operational teams will also need to be aware of potential challenges and risks related to the transition from initial ESG commitments through to the actual implementation and embedding of (new) ESG business or operational processes.

Risk Management Framework

ESG strategy, business strategy and risk appetite will need to be aligned and inform each other. In order to adequately assess and mitigate ESG risk, ESG risk needs to be considered within an organisation’s strategy and risk framework, including areas such as the risk taxonomy and risk identification processes.

A number of risk management areas may need to be enhanced to facilitate effective delivery of ESG objectives, including (for example):

• Governance: Senior management and Board level engagement, with clear allocation of roles and responsibility for the oversight, identification, monitoring and management of ESG risks.
  
• Competence and capability: Relevant staff across the firm having the skills, knowledge and expertise to manage ESG risks. This can be through up-skilling those in the business or bringing in Subject Matter Experts (“SMEs”).
  
• Compliance with Regulatory Requirements: Compliance with requirements for investments, and disclosure regulations on providing investors with information on the sustainable credentials of financial products.
  
• Reporting: Consideration of sustainability risks when establishing, implementing and maintaining effective reporting within the firm and with third parties.
  
• Internal Capital Adequacy and Risk Assessment (“ICARA”): Identification, assessment and mitigation of ESG risks as required, and to the extent that these risks are considered to be material, as set out within the FCA’s MIFIDPRU rules.

A key challenge for firms is to ensure that the consideration of ESG risks within the ICARA process aligns to the RMF, in order to achieve a holistic assessment. The latter may also require input may be required from teams that would not typically be involved in the ICARA process, given that the risk type is in its early stages of definition and management.

Own Funds, Liquidity, and Stress Testing

From business model and strategy analysis to the Overall Financial Adequacy Rule (“OFAR”) assessment, ESG risks can filter through and have an impact on the firm’s capital and liquidity positions. Firms should remain cognisant that the impact of ESG factors is one that could extend into virtually all existing risk classes which firms are typically geared towards managing, including capital and liquidity (also refer to our previous blog on ESG integration in the RMF for further detail on this).

Although ESG factors and risks may impact minimum rules-based capital requirements, for example through changes in asset values which may result in changes to k-factor inputs, firms will need to consider whether any additional financial resources are required to mitigate these risks under the ICARA. The key challenge for firms from a capital and liquidity perspective is likely to come in the form of increased and more complex data requirements to measure ESG risks, as ESG data itself is not always readily available within the market.

Firms should also examine whether their current approach to stress testing under the ICARA process adequately encompasses the assessment of exposure to ESG risk. Firms should check that their approach considers the various components of ESG risk they have identified. For example, some elements being considered by firms include sustainability, climate, rights of workers, diversity and stewardship. The incorporation of ESG risk into stress testing can provide challenging for firms especially as both the outputs and inputs from stress testing are typically limited by the availability of ESG data and metrics. There are also challenges for firms that are more advanced in their ESG measurement, for example consideration of stress testing methodologies to account for certain risks e.g. climate risk, which are expected to occur over a longer time horizon.

Key Takeaways

Regardless of the size or complexity of investment firms, there is an increasing expectation from regulators, customers and other stakeholders, to ensure adequate consideration and integration of ESG as part of a firm’s strategy and key decision-making processes. As an evolving risk, ESG is likely to require clear, well defined and embedded arrangements to ensure effective compliance and management. The onus on setting clear targets, measuring progress and reporting in a clear and transparent manner is increasing, with governing bodies and regulatory powers looking to industry for best practice.

• Integration of ESG risk considerations into firm’s RMF and risk appetite may require input and challenge from various levels of the organisation to ensure overall completeness and effectiveness. Senior management and board level engagement, with clear allocations of roles and responsibilities is essential for the management, oversight, monitoring, reporting and disclosure of ESG risks and for a holistic assessment to be carried out under ICARA.
  
• The impact of ESG factors and risks may need to be considered across a number of ICARA elements including the business strategy, business model analysis, harms assessment, capital and liquidity risk exposure requirements, stress testing and wind-down planning.

In our next blog we will address a number of considerations around the incorporation of sustainability risks into firms’ risk taxonomies and the implications of this across firms’ approaches to integrating sustainability risk into the broader risk management framework

If you have any queries, please do not hesitate to contact any member of our IM&W Prudential team.