Financial services firms must evolve their mindsets to both manage risk effectively and to ensure that the industry meets sustainable goals, according to Sandy Trust, sustainable finance consulting lead at EY and deputy chair of the IFOA’s Sustainability Board.
Trust believes a lot of traditional risk models are based on looking backwards, focusing on what has happened in the past with equity returns, interest rates and so on, and using them to make assumptions about what will happen in the future.
Given the unprecedented nature of physical climate change and the scale and pace of the energy transition, basing a capital, investment or risk management strategy on past performance is, he claims, akin to standing at the stern of the Titanic, “looking backwards and saying, ‘This has been a fantastically peaceful voyage hasn’t it?’”
FS firms now need to develop strategies based on looking forwards, to enable them to plot a course through the disruption that is coming faster than some may realise, with numerous potential tipping points in both the physical and transition spaces.
“It is a really fundamental shift for organisations to understand that the traditional approach to risk management may no longer be valid," he says.
This introduces the importance of analysing future scenarios, thinking about what could happen and starting to plot a course that delivers both financial results but also the sustainable outcomes that society needs.
For example, EY has carried out work to estimate how and when we might see tipping points in the energy transition, relating to cost parity of EVs or localized power generation. They highlighted in their recent Megatrends report that the planet is also moving from a linear warming period to one of exponential climate impacts. Overlay that with global demographic shifts, policy changes and technological developments and the picture becomes complex.
But this is a big shift in mindset for some in financial services and there remain significant cultural and behavioural impediments to change in some quarters, partly because of the complexities in comprehending the risks that sustainable finance is seeking to address, partly because people are still coming to terms with the responsibility of the financial sector to deliver sustainable outcomes as well as financial returns.
“For many, sustainability simply hasn’t been in the job description - their purpose has been to deliver financial results. That’s now changing and rapidly - with for example the DWP hinting it may start to regulate on Paris alignment and we’re seeing a range of major financial institutions now moving on this, starting to embrace a broader responsibility or corporate purpose."
“On the risk side, it is incredibly difficult to understand the earth’s system itself, how quickly climate change is going to happen and what instabilities that could trigger - it’s a complex adaptive system and modelling all the interactions is a real challenge” Trust says.
“But the data, systems, models and processes are improving all the time - and we mustn’t let perfect be the enemy of good here - there is certainly sufficient data to make more informed decisions today.”
How these and other concerns relating to profitability of sustainable instruments are addressed will be some of the issues that define the movement in the years ahead.
For some, the perception that an ESG-orientated investment or risk management strategy will be complicated and costly remains quite culturally embedded. But it is clear that major change is coming as sustainable finance becomes more embedded - firms and individuals who fail to recognise this risk far more than their reputation if they are slow to react.