Sustainable Finance Live: What is the role of risk in greening finance and financing green?

Sankaran began by comparing ESG to liquidity in that it is unclear whether it should be dealt with by the government, shareholder, regulator, or consumer. “ESG is the aspirations for the for the economy's objective functions, and it is terribly defined, badly executed, and difficult to measure,” he reckoned.

Sankaran observed that everything dies down to capital, and there is a spectrum of capital, from mandatory/regulatory to voluntary. The “endgame”, as he puts it, revolves around profitability and the pricing structure. Therefore, ESG has implications for valuation and risk management in which sustainable competitiveness can be measured through the differentiation of customers.

“From a risk management standpoint, the concept is very simple. We are cashflow driven, whether it is market risk, credit risk, liquidity, or operational risk, you are looking at forecasted cash flows. Risk is not exceptionally fancy, but in climate, particularly carbon, we are talking about net zero being eight to ten years away, being emission free by 2050. These long term structures from a risk management standpoint are unheard of when you look at balance sheet management, you are looking at three and five year horizons, not at twenty and fifty years. So you need to have a good understanding of data that goes out so long.”

He questioned what discount factors are applied when that data is collected, how that data can be interplayed with house prices and mortgage ratings from a climate standpoint, and how it can be integrated into regular stress testing.

ESG metrics are not yet useful according to MIT because they are not integrated into the mainstream balance sheet management and stress testing framework. To overcome this challenge, Sankaran continued: “Short term focuses can be ALM valuation, liquidity, behavioural factors, and companies can start to incorporate data slowly relating to climate. Then we must start thinking in terms of how these can be converted into cashflows. There are so many people providing you with data sources, not very many people are telling you what to do with that data. It is wonderful to have data, but it is pointless if that data it goes nowhere. So, we start to think in terms of how best to use that data to obtain clarity on ESG methodologies. The most critical element is cash flows; everything done from a risk standpoint revolves around cash flows, and is done from a climate standpoint has to result in the generation of cashflows that are climate-adjusted.”

To move forward, Sankaran argued that financial institutions should be incorporating ESG risks into main risk management frameworks such as ICAAP and ILAAP; that times come when going beyond regulation in the short term is what is right for your organisation.

Sankaran concluded that it is unlikely that regulators will become more resilient and financial institutions need to integrate their own risks to act sustainably and accurate reflect ESG risks. He finishes that companies mistake regulatory compliance as financial sustainability when that is often not the case.

“The nature of regulation is iterative. Starting with a first round of regulations, they then have to refine it, fine tune it and so on. Therefore, the first set of iterative rules are now in play when the regulator sets out payment related variables, and those need to be stressed on balance sheets, but they have not told you to integrate them with your main line statistic,” Sankaran comments. “The next stage, inevitably, irrevocably will be the incorporation of ESG variables into a gap and this is going to happen; it is inevitable.”

Following Sankaran’s presentation, founder of ResponsibleRisk Richard Peers led a discussion on how risk compliance and ESG reporting will be approached in the future.

Answering a few questions on differential pricing, climate stress tests in banks, and ESG risk ratings, Sankaran advocated for the differential pricing structure and expresses that he does not believe it to be likely for ESG ratings to be harmonised in the near future, especially considering the resistance to ESG rating harmonisation in the US.

The next panel at Sustainable Finance Live, on how sustainability can be built into regulation and risk, covered the impact of regulations such as the SFDR, TCFD, CSRD and the Green Fintech Taxonomy and how technology can simplify the complexity of existing regulations.

Guillaume Levannier, sustainable investment manager at Lombard Odier Investment Managers, kicked off this session with an advocation of Sankaran’s long term risk framework ideology and three points that need to change within the sustainable finance industry.

These points included ensuring investment managers understand the task at hand clearly, go beyond basic definitions and focus of what they do best, which is conviction across their investments. Further to this, without a clear definition of sustainable investment, “we cannot play right.”

Matt Bullivant, director of ESG, OakNorth, explored these considerations and stated that “banks need to be aware of the data they have and be thinking about data in a much more granular fashion.” He added that businesses do not have a vast track record when it comes to assessing climate change – there is no precedent, no historic. Therefore, it is of paramount importance to prepare for the unexpected, “for what we don’t already know.”

He added that there is a “danger of chasing regulation.” The financial services industry must not worry about reaching goals by 2050, they must focus on “what needs to be done between now and 2030 to get to 2050.” While the UK and European Union are lucky to have forward-thinking regulators, it is more beneficial to reduce uncertainty with good intent and guidance; it is not just about measuring risk and the industry must incentivise closing the gap.

Adam Webb, COO, risk, ICBC Standard Bank, added to this and joked that while “banks love acronyms,” there are an abundance of classifications, labelling and disclosures. “There are 50 shades of green, but not everything is quite as green as another.” Providing an overview of all regulations across sustainability in the UK and Europe, Webb also highlighted that the UK SDR, which focuses on improvements, focus, and impact, will go live in June 2023.

Further to this, his view is that while the SASB, GRI and CDP are all voluntary, there is no interplay. Alongside this, the key regulation that Webb sees coming to the fore is the TNFD, which broadens the scope beyond climate change to biodiversity.

The ISSB, borne from COP25, is also looking to standardise and bring forward a framework that is easier to cross compare. Another regulation to keep in mind for those in the industry is the CSRD, which was approved by the EU just days ago and will come in to action in 2024.

Darshna Shah, chief data scientist, ElastaCloud, agreed that there are many regulations, but this also means that the sector is not starting from ground zero. She mentioned that there is a “lack of correlation between regulations and there are multiple frameworks, so we must apply data and see what is relevant.” While gaps in data need to be found, this starting points allows every organisation to be elevated to the same level of reporting.

Adrian Sargent, founder, ESG Treasury and CEO, Castle Community Bank, concluded that at the first Sustainable Finance Live event in 2019, there was “real hope that the industry would move forward beyond regulation. Although a large number of players have integrated decisioning and capital assessment, “we need to be ready for what’s coming. Things will change thick and fast; as regulations change, we have to manage legacy portfolios too.

“Get it in there, assess it, make a judgement call and adapt for the future as well,” Sargent said.