Financial services face a double whammy of ESG challenges

Banks, Insurers, Asset- and Wealth- managers are today facing two-pronged ESG challenges, explain Mukund Rajan and Jeroen Crijns, Amsterdam-based partners at Strategy&, PwC’s global strategy business. Financial services companies are simultaneously tackling short-term practical concerns and deeper, business strategy questions all sparked by the current focus on ESG.

What are the main challenges you see customers currently facing with relation to ESG?

Mukund Rajan: Many financial services companies have recently been occupied dealing with the sheer volume of compliance and regulatory burdens coming their way. That is a very “here and now” issue. In the insurance sector, for example, several extensive regulatory programmes are all colliding at the same time: each with fixed deadlines. This has put staffing capacity pressure on organisations and little headspace to think about the longer-term strategic implications. The practical side of finding people to parallel process these legislatory obligations has also been quite considerable. Whilst this intense 12-to-18-month period has also resulted in everyone now being acutely aware of what needs to be done in terms of complying with ESG regulations, it is just a first step and much remains to be done.

Should financial services companies be looking at ESG from a wider perspective?

Mukund Rajan: They are starting to. As well as dealing with the regulatory practicalities, financial services companies are starting to ask themselves a deeper question: “will ESG be the factor which transforms our business models and becomes embedded in our strategy so we can capture value in the future”

And what is the answer to that question?

Mukund Rajan: I’m not sure if it’s one single answer for all, but there are certainly new opportunities created by ESG. If you read the annual reports of the leading 20 or 30 banks or insurers there is very little in terms of differentiation regarding their stance on ESG. As far as we see, few major financial service companies are taking on the challenge of developing a new ESG proposition at scale. There are some smaller players who are doing that, but not in terms of the big global names. We believe there is an early-mover advantage to be had there. Right now, I think retail customers are choosing products, be that insurance, mortgages and so on, purely based on cost and convenience. But that may not be the case forever.

Jeroen Crijns: Companies need to have an authentic proposition to put in the market. It is very important that their ESG strategy is not just focussed on ticking the boxes for regulatory purposes. The regulations coming out of the EU Green Deal are a good example: it is going to cost companies a lot to comply with those regulations. This will likely force companies to develop numerous capabilities in order to comply. But it is the companies which take those capabilities, embed them in their strategy, and use them to drive the transformation to reshape their business models which will also capture the benefits and advantages of the ESG opportunity. This should not just be seen only as a regulatory compliance exercise. The economy is about to go through a huge transition, and this will provide a lot of new opportunities for those who do not just see this process as a cost to comply.

Do you have a specific approach to understanding and managing ESG opportunities on behalf of your clients?

Mukund Rajan: We do not think of ESG as being a separate set of challenges which businesses face. The direction of travel is clear, and it will only become more inter-twined with the strategic priorities of financial services players. ESG must be a critical component of whatever growth and business plans your business has. The way we think about this is very capabilities-based. We start by asking “what is your right to win?” By that we mean: “why would a customer give you their business over someone else?”. And ESG must be a component of the answer. The next step is to pinpoint what the required capabilities are, and be clear on how best to differentially invest in them to capture value. This method for building such capabilities is consistent with how we at Strategy& have helped many of our clients tackle broad business challenges such as growth, productivity, and customer centricity.

Jeroen Crijns: Our customers today face a dilemma. The short-term demands for quarterly earnings, versus the much longer-term needs for ESG resilience. It is often a case of asking companies how much they invest in a more sustainable business model, or offering more sustainable products for the longer term, versus focus on the short-term financial result. This discussion is complicated, but it appears to be shifting. With a recession looming on the horizon, we see that our clients are becoming more careful. There is more cost pressure, so they are reviewing all investments. Therefore, this includes investments into ESG transformation.

So, you see the threat of ESG budgets being cut?

Jeroen Crijns: This remains to be seen, and it could go both ways: for example, we all see that energy prices are skyrocketing. Therefore, anything which lowers energy consumption or is a potentially cheaper energy source, is suddenly on the table. So, there is quite a bit of movement in terms of the focus areas and how value is being created. However, having said that, high inflation also means there is naturally increased focus on the short term.

What does the ESG landscape look like within financial services?

Mukund Rajan: The focus of some of the regulatory items to date lead to a strong focus on the Environment and — specifically — de-carbonisation. The “E”, rather than the “S” or the “G”. Many of our clients are starting to think about how to separate these three distinct elements. There is a de-carbonisation lens, however there are also a lot of other possibilities within the S and the G that may not have been fully tackled when only looking through the E-lens.

Jeroen Crijns: And the E-lens itself is also broader than just de-carbonisation. There has been a lot of developments around biodiversity, water usage, and other environmental topics which are still less developed than the well-known CO2 footprint.

How can financial services companies execute prudent ESG risk management?

Mukund Rajan: Climate risk is often top of mind because we see the pictures when there is a hurricane in Florida or flooding in Pakistan. What is less well understood is “how do companies become more sustainably managed over time?” How can companies evolve their internal decision-making, management and governance procedures to keep one eye on the longer-term horizon? That is the big challenge for companies.

Jeroen Crijns: Risk is a strategic element which ties into value creation. To be able to manage the risks associated with ESG, it is important to properly understand them. This shift will help to steer companies in the direction of taking these risks into account in the correct way and help them to articulate and quantify the value creation narrative associated with this understanding. It is early day for many of our clients when faced with this issue.

Are there exceptions to this among your clients?

Jeroen Crijns: International insurers are one clear exception. Take the physical climate risk such as flooding: there are some insurance firms which have scenario models based on flooding risk and they have also actually started to build alternative business models which do not necessarily involve taking that risk on, but instead advising local communities about how to manage these risks. That is very interesting. But many banks, for example, are still very much struggling with ESG risk management: for example, when it comes to the risks associated with financing their own customers. For many clients, it is early days.

How can companies become enduring champions on sustainability?

Mukund Rajan: The enduring champions will be those that re-architect their businesses. They make conscious decisions to worry about what happens 3, 5, 10 years from now, and shape their plans around this. We believe the winners will be those that can get a clear orientation towards their proposition and capabilities but do that with a long-term view by saying “we are building something that will endure”. For example, I think Mastercard does a great job in the way they include many of their staff into their pension schemes to set them up for financial security later in life. This effectively says: “I am going to worry about the bottom line but not necessarily at the expense of ensuring financial inclusion for my staff.”

What do you both hope to gain from the Sustainable Finance and Climate Risk Event?

Mukund Rajan: What I would like to hear from is the challenges they are facing in terms of practical challenges and taking the ESG agenda forward. I also hope that we walk out of there with agreement on the need for a bias towards action.

Jeroen Crijns: For me the most interesting part will be to hear more on best practices around risk quantification. I do believe that the traditional way of quantifying risks may not work, as this covers a lot of new business models, new technologies. And to have conversations around how different players are finding out emerging solutions. I would be interested to see if there are any common direction which can be distilled from that.