Planning for environmental and social risk management

By now, environmental and social risk management (ESRM) has become engrained in the processes many banks and other financial institutions use to manage risk and mitigate the potential for environmental and social (E&S) adverse impacts. Their rationale for adopting such programs is typically twofold: 1) they understand that failure to address such risks could affect their customers’ future revenue streams and ability to meet their financial obligations; and 2) they recognize that stakeholders are demanding increased transparency and engagement around how banks and other lenders are accounting for those risks as gatekeepers of capital. 

Importantly, the identification of potentially significant environmental or social issues doesn’t rule out a business relationship. In many such cases, the financial institution works with the client to better understand the E&S risks associated with the client’s operations and their implications to establish appropriate safeguards that protect their mutual long-term interests. Therefore, ESRM not only makes strong business sense from a credit, operational, and reputational risk perspective but also supports the communities and the environment in which the client operates. 

Recent pieces of legislation passed at the state government level have sought to address ESRM practices that some perceive as amounting to discrimination against industries often associated with high E&S risk. Dubbed “fair access” laws, they seek to prevent financial institutions from considering environmental, social, and governance (ESG) factors in financing and investment decisions, based on their reading that such practices can unfairly discriminate against certain commercial industries. 

This article reviews these new laws against the backdrop of ESRM becoming a standard part of due diligence and proper risk management in financial institutions. It also provides guidance on how financial institutions can defend their E&S risk decisions by highlighting the individual, quantitative risk analysis that forms the basis of leading ESRM programs.

ESG in finance: Banks caught in the middle

In 2020, the Office of the Comptroller of the Currency (OCC) proposed a “fair access” rule that would prohibit banks from discriminating against commercial industries, taking aim at banks that had ESG policies that restricted their ability to do business with certain industries due to climate or other concerns. 

The proposed rule prompted legal challenges and was put on hold the following year by the next US administration. Nonetheless, it inspired legislation at the state level that sought to protect local industries. These new fair access laws passed by select states may contradict disclosure mandates around the reporting of E&S risks in other jurisdictions. The Corporate Sustainability Reporting Directive (CSRD), for one, requires more than 50,000 global organizations to disclose details around how they are managing E&S risks within their value chains. 

Meanwhile, a study commissioned by the Oklahoma Rural Association estimates the state has experienced a 15.7% increase in its municipalities’ borrowing costs due to its Energy Discrimination Elimination Act (EDEA), adding nearly $185 million in additional expenses as of April 2024. It concluded that EDEA and similar laws passed in the state “are burdening taxpayers and hampering investment in and development of critical public projects.”

Engraining green finance in normal risk management

At the crux of the issue is how banks and other financial institutions incorporate E&S impacts as part of their regular risk management policies and practices. Many state bills and regulations reveal suspicions that banks are routinely and categorically deciding not to engage with certain companies based on the industries in which they operate. 

However, in some instances, extending credit or some other financing solution to a potential client in an at-risk industry or activity, irrespective of its environmental or social record, ignores factors that could affect its ability to make good on its obligations. 

In their ESG disclosures, banks regularly outline their thinking about lending to businesses in high-risk sectors. A large US bank points out that it lends to companies in sectors that are associated with E&S risks, but not before carefully assessing the impacts and working with the client to “apply a clearly defined set of international standards and good practice to mitigate and manage environmental and social risks and impacts.”   

ESRM due diligence is therefore vital to understanding risk—when such risk is mismanaged, it is a driver of other risks, from credit to operational to market risk. Because of this, there’s a strong argument that such evaluations fall under exclusions to the new fair access laws because they are part of routine due diligence and performed on a case-by-case basis.

Taking an evidence-based approach to ESRM

Given all the uncertainty around fair access laws and which ESRM practices will be exempted or not, banks and other financial institutions should work to make sure their programs can hold up to increased scrutiny. In our support of financial services clients in establishing and evolving ESRM programs, we emphasize they adopt the four following principles:

ESRM as a meaningful force

We believe a properly designed ESRM program can prove its worth as an objective and meaningful force for positive change. The increased knowledge and understanding of E&S risks and impacts that ESRM programs provide allows leaders to make better decisions on individual transactions but across the board from a strategic perspective.

For those benefits to be fully realized though, industry participants need to lean in, engage, ask questions, and increase their understanding of how their clients or prospective clients are managing their E&S risks. If this happens at large, ESRM will come to be seen not as a toggle switch for automatic denials, but as a mechanism for identifying those companies that need more help than others when it comes to transitioning to more sustainable and equitable business practices.