ESG risks are a different type of risks for organisations
ESG risks are very different from traditional risk types, explains Marije Wiersma, from Netherlands-based consultancy firm Zanders. Marije helps financial institutions integrate ESG risks into their risk frameworks. Due to the nature of ESG risks, this is not a simple matter, as she explained when we talked to her on the eve of the Sustainable Finance and Climate Risk Event.
What are the challenges facing EU banks during the integration of ESG risks into their credit risk frameworks?
The nature of ESG risks makes it a complex and challenging process for institutions to comply with ECB and EBA regulations. A different approach is required compared to the more traditional risk types, like credit or market risks. Also, the whole financial industry is still in the relatively early stages of the ESG risk-identification and integration process. So far, the most progress is made on the Environmental pillar of ESG.
How is the nature of ESG risks different?
Impact from ESG factors (to a large extent) still have to materialize. This means that historical data does not have that much use. These impacts also have a long horizon — which means that there is a need to look ahead to the next 30 or even up to 100 years. And, these impacts are non-linear, for example because of tipping points in the climate systems, which leads to additional uncertainty.
Considering these complex factors, where should financial institutions begin in this process?
ESG is a very broad term. The first step for financial institutions is to find out what that means in the context of their portfolios. Meaning which sectors are they exposed to? Which geographies? What mitigating measures do they already have in place which could cover this risk? Identifying the risks and assessing the materiality of that risk is an important first step.
How can you help institutions to start on the path to ESG risk integration?
There is not one plug-and-play solution. As a starting point we use the “non-exhaustive” list of 15 ESG factors defined by the European Banking Authority, such as emissions, waste production and human rights. Then, we map out the transmission channels for different ESG factors.
By this we mean the causal link between an ESG factor and the financial impact on counterparties and invested assets of financial institutions. For example, for emissions, lower creditworthiness of clients could materialize due to higher costs because of a future CO2 tax, or higher investment costs because they must transition to lower-emitting practices. These transmission channels are different for each institution. If a bank has a lot of agricultural loans, then these transmission channels would probably be quite different from the ones relevant for a retail bank. Similarly, an insurance company that focusses on property insurance will also likely face different transmission channels than health insurers.
You mentioned materiality — how do you break that down?
We define the materiality of risk often on two scales: likelihood and impact. For a start, we consider the likelihood that an ESG factor might materialise. For example, the chance of floods, or the chance of the need to reduce CO2 emissions. Secondly, we investigate the potential impact of the ESG factor on the institution’s counterparties: the loans or the investments in the portfolio of an institution. For example, in the Netherlands flooding is an important issue: but perhaps a counterparty is not very prone to this risk because it does not have a lot of immovable assets, so even though the likelihood could be high, the impact could still be low. These scales operate independently of each other.
For ESG risks it is often more difficult to assess the materiality than for traditional risk types because the lack of data and methods. We therefore gather as much internal and public data as is currently feasible. We then assess the materiality qualitatively and where possible quantitatively, together with the portfolio experts of the institutions.
You mentioned that one of the key characteristics of ESG risk is that its impact to a large extend still has to materialize. How can you measure that impact?
One of the difficulties of ESG risk is the level of uncertainty. Only limited useful historical data is available and we don’t know which climate scenario and policy responses might materialize. Scenario analysis, which enables stress testing, is the most important modelling tool that we have right now. There are various climate science-based scenarios publicly available, and they cover quite a range of possibilities.
On climate change this can range from a smooth, event-free transition through to the worst-case scenarios. Even though we don’t know what the probability of each scenario happening is, for a couple of scenarios a financial institution can estimate what will happen to certain portfolio risk-drivers. That gives the institution a sense of how vulnerable or prepared a portfolio is.
What are the similarities between traditional risk management, and ESG risk management?
There is a lot of alignment necessary: it’s important to remember that ESG risk is not a separate risk type. It manifests itself in the existing risks. So, if ESG risk materialises, it will impact your credit risk, or your market risk for example. ESG risk is not a separate column, it is interwoven with the rest of the risk management processes.
And what are the notable differences?
Scenario analysis and stress testing are also techniques that are applied to traditional risk types, but they are also quite reliant on historical data, back testing, or statistical modelling techniques. One major difference with ESG risk analysis is that historical data and knowledge are much less available in ESG risk analysis. Another key difference is between the horizons that are typically used. For example, for probability of default, or economic capital modelling, often one-year horizons are used. For climate-related risk the horizon is much longer.
Is the long horizon over which these risks materialize a well-known issue?
Certainly. It is known as the Tragedy of the Horizon, a concept made famous by Mark Carney, the governor of the Bank of England, in 2015 during a famous speech on climate change and financial stability. To put this over-simply: In order to address these climate risks before it is too late, long-term potential climate impacts should be brought into the present.
What is your view on the tragedy of the horizon, in your role at Zanders?
I think it should not be ignored. Both financial institutions and their clients often have long term financial obligations such as 30-year mortgages or pensions that have to be paid out in 50 years. So, these long-term impacts will eventually also impact financial institutions.
Is the answer down to the financial institutions?
Financial institutions play a pivotal role in the transition to a sustainable economy in their role as financial intermediaries. However, not only financial institutions will have to do the work. There must be support and research from regulators and policy makers. Efforts in that area have already been made for example in the form of the EU Taxonomy and the CSRD. I personally started working on this topic two years ago and an awful lot has changed since then. I expect new techniques and new insights to develop in the coming years. In the meantime, insights and data are two highly important drivers for developing a clearer picture of ESG risk.
What do you hope to gain from the Dutch Sustainable Finance & Climate Risk Event?
I find it very insightful to get together with colleagues from across the risk landscape: financial institutions, data vendors, legal experts, and other market participants to talk about this exciting topic. As there is no standard solution it is good to talk to each other to learn from all approaches observed in the market. It’s a great opportunity to learn from each other as we all try and deal with one of the biggest challenges we all have.