HOW BANKS CAN MEASURE HIDDEN ESG RISKS?
Banks and other financial institutions are increasingly accounting for environmental, social and governance (ESG) factors in their portfolios. A particular area of focus has been on the environmental component, especially around decarbonization. Adopting a strategy focused on ESG or decarbonization, however, is easier said than done – in part because the strategy is only as good as the data that informs it. Major publicly traded companies publish key metrics in their sustainability reports, but these reports are not standardized.
And many smaller firms don’t hire sustainability experts, don’t know how to measure or disclose ESG, or don’t see much business value in ESG metrics.
The standardization we expect in financial reporting has not yet emerged in ESG reporting, although there’s increasing maturity for narrow subtopics such as carbon footprint measurements. The lack of standardization creates a significant challenge for banks that have limited options for understanding the ESG impact of much of their portfolio.
For example, a bank that wanted to offer tiered pricing for credit based on ESG metrics would encounter two key problems. First, many companies don’t know how to properly measure ESG metrics and might misunderstand their true impact. And second, without an accepted and auditable standard, the risk of intentional “greenwashing” by companies to gain access to preferential rates increases dramatically.
Banks aren’t the only institutions with insufficient data. As more companies begin to create sustainability reports and measure their Greenhouse Gas Protocol Scope 3 impact (which includes metrics covering their full value chains), many will field a wide variety of requests from different sources.
Some have looked to ESG ratings agencies for solutions to this problem, but those organizations tend to use human-intensive ratings analysis that isn’t scalable. And agencies often don’t agree on these ratings due to the inherent challenges of measuring ESG. One study found that the correlation among various ESG ratings was just 30%. In contrast, credit ratings had a 99% correlation rate.
One thing is clear: The solution will be larger than any one lender. While regulatory action will eventually be a driver, banks that begin this journey now will be better positioned to capitalize on future trends. There are several steps that market participants can take to move forward on ESG data right now.
First, banks can form consortia that standardize data collection and educate businesses on how to estimate their ESG metrics. Even without a formalized reporting and audit infrastructure, we can lay the foundation by providing an accessible framework—one that can be leveraged for other uses, such as Scope 3 impact calculations.
While many expect that sustainability reporting standards will be driven by regulators, it’s important to remember the example of financial accounting, which arose from private industry’s need to raise capital and was standardized starting after the Great Depression. Nonprofits and the U.N. have laid the groundwork for much ESG reporting, but private actors can take the next step rather than waiting for regulations.
Second, data vendors can create a more efficient reporting system by enabling companies to efficiently share their data once they have created estimates. Companies that do not have full-time sustainability reporting staff will need an easy way to share relevant ESG metrics, and data vendors can also offer some level of assurance to the market by performing “reviews” of a sample of reporting companies each year to discourage ESG fraud.
Third, banks and other stakeholders can leverage the data that is available. Despite significant limitations, there are ways to obtain some understanding about certain ESG risks.
One example is the use of satellite imaging technology to gather data about real estate or land, a useful tool for understanding physical climate risk. Another strategy is to use proxy data—examining the typical ratings for a company of similar size, industry, and location to develop a rough estimate. This strategy is useful at the portfolio level for banks that work with a large number of smaller companies.
As ESG factors become more critical to success and the economy broadly moves toward decarbonization, banks and lenders cannot simply rely on their own expertise or wait for other players to lead the way. Even the deepest knowledge of market dynamics is inadequate when the data is thin or missing. Players need a creative new approach—together with a degree of cooperation—to take advantage of the new opportunities that ESG presents.