What is Environmental, Social & Governance (ESG) and Why Does It Matter to Banks and Other Organizations?

While Environmental, Social & Governance (ESG) has been around for some time and is more prominent from a regulatory perspective in the UK, it has been gaining traction in the U.S. What I have noticed recently, is that hardly a day goes by where there isn’t a piece of news released related to ESG. Even NYS DFS hosted a webinar on financial risks related to climate change. While many industries/sectors face more significant risks, I will limit myself to the financial services sector.

First, I like to think about ESG as being compatible / complementary to Enterprise Risk Management (ERM). We all know what this is by now. In fact, ESG issues have topped a list of risk managers’ concerns in a Deloitte survey of finance executives. Does ESG appear on your risk register?

In essence, ESG is a sustainability model with three prongs and was originally thought to be about non-financial risks. That has changed dramatically as we can see the financial risks playing out from an environmental perspective and the financial risks are higher now for social and governance concerns.

How is Environmental, Social & Governance Defined?

The environmental prong mostly concerns itself with climate change and being a good steward for the planet. More and more, the financial impacts are being weighed, particularly losses sustained from 100-year floods that seem to be happening on a regular basis, the proliferation of extreme weather, and a fire season that is now the entire year in many parts of the country. Just today, I read an announcement regarding the Federal Reserve establishing the Financial Stability Climate Committee. This is in addition to the Fed’s Supervision Climate Committee. We all need more committees, yes?

How many companies have come out with a commitment to be carbon neutral recently? Amazon is currently committing more than a billion dollars toward this effort. Are company executives driving around in luxury V-8 SUVs? This can fit into all three categories.

The social prong is a bit more scattered and bleeds into the governance prong. Mostly, the metrics here are about being a good corporate citizen, socially responsible, and helping to take care of the communities where you do business. What are you doing to make your community a better place to live? Are you a great place to work? This includes Diversity, Equity and Inclusion (DEI) as well as the proper use of social media (you can’t have social media accounts and ignore them).

What are we seeing today from some large companies? Many company residents in Georgia and across the country are coming out against the new voting regulations that are being written or passed in at least 30 statehouses. Major League Baseball just moved the All-star game from Atlanta to Denver. They are trying to get on the “right side” of the issue to signal their concerns around DEI. Corporations have generally lobbied, donated in an effort to make change for things that affect their bottom line industry…this is different.

The governance prong is mostly about board composition (diversity) and corporate culture. In this instance, we need to remember to think about diversity in terms of diversity of skills, tenure, age, gender and ethnicity. Generally, even with great effort, it will end up being your employees and customers that define your culture. The same might be said about your brand. Of course, your organization should have strong entity-wide controls and the “tone from the top” should match what you are trying to convey to the public from a marketing and branding perspective, and always conveying a strong internal control environment.

One thing I see at financial institutions is that they promote a strong internal control environment, yet the heads of Internal Audit and Compliance have titles that might convey otherwise.

Environmental, Social & Governance Examples in 2021

I thought that I might take a minute to provide some examples of the steam that ESG is gaining. Here is a smattering of recent headlines:

• Deutsche Bank is to end global business activities related to coal mining by 2025 at the latest.
• Walmart - As part of its goal to reduce its cumulative carbon footprint by 1bn tons by 2030, Walmart says it has cut 230m metric tons of greenhouse gases from its supply chain in the past three years.
• KPMG has unveiled its blockchain based Climate Accounting Infrastructure (CAI) solution to help organizations measure, report, and offset their greenhouse gas emissions.
• Environmental, social and governance (ESG) issues have topped a list of risk managers’ concerns in a Deloitte survey of finance executives.
• Democrats are planning to use the SEC to impose significant financial disclosure rules on climate risk that would require thousands of businesses including banks, manufacturers and energy producers to divulge information to investors.
• Providing frequent updates about the sustainability of their business is becoming more crucial for finance chiefs, as analysts and investors increasingly rely on this information when evaluating a company’s outlook and its creditworthiness.
• Investors and environmental groups have long been asking banks to curb their financing of fossil fuel exploration. Now some of those groups are urging lenders to also reexamine their relationship with the plastics industry.
• McDonald’s has stated they are taking firm steps to increase the number of women and people from historically underrepresented groups in its senior leadership ranks. By 2025, the company aims to have at least 35% of its senior-director and higher leadership roles held by people from minorities.
• With the help of New York State, 80 farms across New York are working to address the impacts of climate change. Through the Climate Resilient Farming Grant program, $4 million is being awarded to 80 New York farms to reduce their environmental footprints and to "prepare for extreme weather events resulting from climate change."
• Federal Reserve governor Lael Brainard has said that the economy and financial system are already being affected by climate change and said the U.S. central bank is ramping up work to ensure the financial system can deal with the risks that lie ahead of it. “Climate change is already imposing substantial economic costs and is projected to have a profound effect on the economy at home and abroad,”
• Rates for flood coverage are to be revised by the U.S. government on April 1st, as new data suggest premiums need to increase sharply for some homes.
• Budweiser and Stella Artois maker Anheuser-Busch InBev has signed a $10.1bn debt facility that costs more to service if the company falls short on a set of sustainability targets.
• The Securities and Exchange Commission (SEC) has postponed a decision on NASDAQ’s proposal for companies listed on its exchange to be required to meet certain minimum diversity targets or explain in writing why they aren’t doing so.
• Recently in Washington, the House Financial Services Committee held a hearing titled “By the Numbers: How Diversity Data Can Measure Commitment to Diversity, Equity and Inclusion.” The Senate Banking Committee will hold a hearing titled “21st Century Economy: Protecting the Financial System from Risks Associated with Climate Change.”

As you can see, this cuts across industries and the three ESG prongs and there is a lot of momentum.

Why Do We Care About Environmental, Social & Governance?

People are free to believe what they want to believe personally, but if you are at or near the top of the food chain of your company, there are many reasons to care/pay attention. First, the major ratings agencies are scoring publicly traded companies on ESG metrics. This started mostly as a transparency project – are companies being transparent about their carbon footprint and their efforts towards social consciousness and diversity, equity and inclusion. The fact is, this isn’t going away, people are watching, and they are making monetary decisions based upon performance. Studies have shown that large companies that embrace ESG, particularly diversity, tend to outperform the S&P 500. For banks, the focus is not only on their own carbon footprint, but that of their customers as well.

The regulators are also ramping up on ESG and it is best to be proactive. We have seen significant impacts on infrastructure, health and ag productivity, but also on current and future economic activity and asset valuations. Was the power grid failure in Texas something that applies? This happened 10 years ago as well and nothing was done to shore up the infrastructure for prolonged freezing weather. People are a bit more “woke” these days.

Consumer preferences are changing, and one need only to look at the electric vehicle market, organic foods, farm to table agribusinesses, solar, wind, hydro, the carbon credits market, etc.

Sometimes, the best way to avoid regulations is to ensure that we don’t need them. This in an ever-changing regulatory landscape.

All that said, I think there are some misnomers about carbon neutral. If we have 100 million electric vehicles in this country, they will all need to be plugged in. We appear to be a years away from charging all of these vehicles with renewable energy but at least the cars run clean.

What Do Banks Do About Environmental, Social & Governance?

The first thing to do is take some time for introspection. What is the bank doing that fits in the model? What aren’t we doing? How can we tell people?

It’s easy to look at board and senior management diversity and my guess is that your HR Department maintains diversity statistics (I believe you are required to in NYS). Do we provide equal pay for equal work?

Are you actively involved in the community? I hope so given CRA requirements – this is something you can do before you are required to do so to ensure you have the monitoring systems in place? Consider more than volunteer days and NFP board seats, think about financial wellness education in the community. This also creates customers.

Do you have a social media director or at least someone whose responsibility it is to monitor and respond?

Look at what your peer group is doing – get on their websites, read their annual reports. Most of the bankers’ trade groups provide the ability to connect with peer groups.

Are your buildings LEED certified, have you gone paperless (the pandemic certainly forced some productivity enhancements)? Are corporate vehicles electric or hybrid or, at a minimum, fuel efficient? Are there any project investments (affordable housing) in anything that comes under the ESG model for sustainability? Do you provide grants, or lending capital to local Community Development Financial Institutions (CDFI) at a reduced rate?

Review your own website and other publications, are we telling the world what we are doing for sustainability? If you have had some successes in any of the areas, shout it out!

Here are a couple good websites that I have seen:

• Key Bank – has diversity goals and performance published on their website.
• Sound Community Bank – maintains public KPIs for ESG efforts.
• The PeoplesBank – check out the “About” page.

This is not a one size fits all type of exercise. What your institution does regarding ESG will depend on your community, culture and leadership.

Let’s brainstorm together! To learn more about our Risk Advisory Services group, contact Bruce Rumbold at bruce.rumbold@freedmaxick.com and we would be happy to assist.