Banks have an important role to play on the road to a sustainable world. How do they do this? Ferdinand Veenman, Head of Financial Services, and Marco Frikkee, Head of Sustainability Financial Sector, both at KPMG, discuss the current momentum on sustainability, the complexity of ESG risks and the rapid succession of laws and regulations on this topic. "Taking your calculator out right away will not be possible. First work on your vision, on your story."
"It is about the foundation of the business model of banks,” Ferdinand Veenman states. “The importance of integrating ESG risks into the strategy of banks cannot be overestimated,” he says. "At present, financing revolves around market risks, credit risks and operational risks. This will be joined by this new category, which will have an impact on all of these known risks. Do we all understand the consequences resulting from this? For instance, that we will not only grant credit according to financial criteria, but also based on, for example, the CO2 emissions of the borrower?"
Veenman is doubtful about the answer and the same goes for his colleague Marco Frikkee. "In general, banks are not yet ready for this," he says. "We actually realize that human and environmental risks are real risks – also for the financial position of the bank – but that does not mean that banks fully understand the meaning of these risks right away. However, banks are now more or less forced to learn how to gain that insight.”
The end of non-commitment
‘More or less' forced, as banks have not really taken on this task against their will. Frikkee, "Many banks have already acknowledged the broad social trend towards sustainability. However, there has always been a certain degree of non-commitment and the consequences for the regular banking processes have remained limited." Due to the current urgency of this trend, this is coming to an end. "The momentum is really becoming impressive now," Frikkee believes. "Governments and regulators have started to introduce more and more compelling policies and there can be no question of non-commitment anymore. Some banks have internally kept pace with this development, but others have not which is why they now must take very large steps."
The package of requirements in 2021 is extensive. Both in 2020 and 2021, the European Commission and the ECB in particular have published far-reaching directives and regulations requiring banks to integrate ESG risks into their strategy and business operations. For the time being, the focus in this is on climate change. By March 2022, the major banks must be ready for an ECB stress test for climate risks. “A tricky story,” Veenman thinks. "Banks are now focusing on this short-term goal, while medium and long-term goals are also demanding attention. After all, it is about creating the proper foundations for ESG integration. True, the stress test is complicated, but in the future, when the credit process has to be addressed, things will be even more complicated."
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Different objectives
“The challenge is that legislators and regulators have two different objectives,” Frikkee says. "We see a genuine concern at the ECB about whether banks are aware of the financial risks they face from the effects of climate change, such as floods, which is part of the ECB's job in order to monitor financial stability. On the other hand, banks are now being asked to incorporate ESG criteria into their lending and investment policies. When it comes to climate change, for example, this means that a bank must know how much CO2 borrowers are emitting, now and in the years to come. In fact, it is about banks understanding the extent to which their customers are adequately adapting to the consequences of climate change."
Challenges: data and standards
Achieving these goals is particularly complex for at least two reasons. "Data and standards," is how Veenman summarizes these two reasons. "As far as data is concerned, these are either not available or not of sufficient quality. In other words, quantitative analyses will be difficult to make. What will be the financial risk of 100 tons of CO2 emissions? What will be the economic effect of ending pumping up oil? You can make a model of all that, but there are no experience data available to give that model the reliability it needs."
In addition to this there is also a lack of standards and uniform definitions. The European Commission has pointed this out again in a recent report, stating there is no global agreement on the definition of sustainability and what can and cannot be included in it. The European Union in the meantime as its own classification, the EU taxonomy, but worldwide there are more than a dozen such classifications all containing considerable differences in content.
Veenman, "Banks are now expected to gain insight into ESG risks and to integrate these risks into their risk management. And yet it is not always clear what exactly is meant by these risks, and the data needed to actually measure them are often lacking. “But it is inevitable that banks will have to fully master ESG risk management,” Frikkee adds. "Substantial investment will have to be made as far as knowledge and competencies are concerned."
Flexibility in approach
This obviously has consequences for the approach that banks (can) take. What to do? ”Quantifying at all costs seems not the right way to act in this context,” Frikkee believes. "We recommend banks to wait with the calculations and first of all focus more on the quality of their ESG strategy and ESG objective. Work on the ESG storyline, then the scenarios and then the calculations. Where do you want to be in ten years time? Taking the calculator out right away will not be possible. First work on your vision, on your story.”
Veenman also advocates flexibility in approach. "Accept uncertainties and prepare for a journey where the route is not entirely fixed. This is ultimately a leap of faith. Provide room to experiment, choose an agile approach. This will also allow you to seize opportunities as they arise. And they will certainly come. Everyone realizes that this will be the future: ESG will end up at the heart of the banking organization no matter what. It is therefore important to get a grip on the consequences. Whoever does it first and succeeds in doing it the best way will gain considerable competitive advantages."
