The pervasive value of sustainable regulations for financial services

If one sector has emerged at the heart of business efforts to confront climate change it is financial services. That goes a long way to explain the deluge of policy-making, regulation and guidance affecting banking and insurance firms as watchdogs and politicians search for measures to counter global warming.

Financial services boards and executives have much to consider as they work to comply with policies designed to persuade them to consider their own environmental impact and that of the innumerable counterparties they work with. It is a daunting prospect made all the more imposing by the frequency with which new demands emerge.

“It is definitely a challenge to understand and remain up to date with the regulatory landscape and how firms need to respond, “ says Phuong Gomard, a Partner in the Financial Services Consulting team at Mazars. “Every day it seems more announcements are released.”

“While the task is enormous there is a way to manage regulation that not only ensures firms are compliant but also enables them to develop some essential value from the process.” 

“For most it will be a transformational project that means change and potentially innovation. But there is a way through.”

Regulations

While many announcements and regulations have come in the last two years, there are a few that have had a striking influence. The Prudential Regulation Authority has written a letter to CEOs in financial services setting out its expectations on managing climate-related financial risk. The Bank of England, in the most recent Biennial Exploratory Scenario, also sets out to test the risks presented to banks and insurers by climate change. 

Elsewhere, the UK Treasury has written a timetable introducing mandatory use this year of the TCFD (Taskforce for Climate-related Financial Disclosures) reporting framework by financial services firms.

Tracking all the regulations out there and managing the compliance process can be hard. “Market participants obviously face a risk of not being prepared or failing to anticipate how the regulatory landscape may evolve,” says Gomard.

The OMFIF/Mazars Sustainable Finance Policy Tracker is an online tool offering live updates on regulatory developments that keeps tabs on what’s going on and who it applies to.  “The tracker can help firms stay up to date on which policies apply in their jurisdiction. It also lets firms know what’s happening in their neighbouring jurisdiction, which can be a guide to what they can expect next.”

Risk identification and assessment

Managing the process can be smoothed by establishing some fundamentals in the way firms assess their exposure to climate change. Firstly, firms should ensure they have a solid definition of what climate change means for them, and, secondly, by tackling a risk assessment from the “bottom-up”.

It may seem intuitive that boards and management start the risk assessment process, but Gomard says a bottom-up approach is more likely to be “comprehensive”. Taking this perspective entails front-line and operational staff working their way through products and transactions to see where climate change may play a role in exposing a firm to risk. 

That includes not only physical risk (eg. extreme weather events, fires, soil erosion etc), but also the transition risk (eg. government decision making, legal changes, consumer preferences, technology advancement).

Working bottom-up is key. A top-down approach could mean missing essential risks known only to stakeholders at the sharp end of a firm’s operations. “Every communication or guidance that comes out starts by calling on the board to get its collective head around climate change,” says Gomard.

“Boards can only make the right decisions if it receives the right management information from the front line.”

Working bottom-up also means front-line staff are effectively training themselves to continue identifying and assessing looming climate threats into the future, an essential element in any organisation, as governments continue to push for huge reductions in carbon emissions.

Challenges

While bottom-up may sound straightforward, the task is significant. Large financial services firms will have numerous and diverse products and services connecting to a countless number of counterparties. Pertinent data is essential but not always at hand so acquiring the right information is critical. Boards will also need the right metrics to measure and monitor so they can develop a full picture of their climate change exposure. They will also need the skills and capability to understand, process and act upon the climate data they receive. 

“It is inevitable that firms will encounter some, or all, of these challenges when managing their response to sustainability-related regulation,” says Gomard. “They should be prepared in advance.”

While the effort to grapple with the compliance challenge is substantial it should not be viewed as a “tick box” exercise: there is value to be had from working through the process in depth. 

“Financial services has the opportunity to be part of a global movement by financing projects and innovation that will be in demand to counter climate change. Acting in a timely manner could give financial services firms a significant upside,” says Gomard.

“For an industry that has had a very bad press in the last 10-15 years, there is a chance to rebuild its reputation through defining its purpose with sustainability at its heart.”

“Financial institutions have also struggled to recruit the best people. An enhanced reputation through a well-defined purpose can only help in the drive to attract the highest quality candidates.”

Compliance with the huge array of climate-related regulations now in play across jurisdictions can be managed if the process is built on a solid foundation of climate risk assessment. There are challenges, not least accessing the right data and the boardroom skills needed to use it. There is value to be had if it is managed well.