Integrating ESG into your Risk Management Framework – are you prepared for the challenges?

Through a series of blogs we will be discussing the challenges CRO’s have with integrating ESG into their Risk Management Frameworks and what steps and actions they can take to help overcome these challenges. As part of this series, we will also be covering elements across a number of themes including conduct, prudential and governance considerations.

Key Takeaways

• Client demands, increasing regulatory and political expectations are increasing the drive and desire for firms to integrate ESG risk into their risk management frameworks.
• Integrating ESG risk into the risk framework will be key to managing greenwashing risks and the associated reputational risks that can crystallise as a result of accusation of greenwashing.
• As a risk type, ESG risks are pervasive risks and extend into many existing risk classes, holistic integration of ESG risk into the risk management framework will be key to managing them appropriately.
• CRO’s should challenge themselves on whether existing frameworks are robust enough to address both the transition to net zero and an industry increasingly geared towards more sustainable finance.
• As with any new risk type, integration success is better enabled through a mature risk management framework; as firms move to integrate ESG risk they will need to consider how they will drive consistency in the management of ESG risk across the business.
• Working collaboratively with the business will be key to ensuring a successful integration of ESG risk into the risk management framework as well as driving consistency on the approach to risk management.
• The starting point for integration should be to define ESG risk as this will the foundation for identifying which components of the framework will need to change or can be leveraged to support the sound management of ESG risks.

Growing Importance of ESG within Asset Management

The evolving global landscape of ESG regulation, new products and increasing regulatory expectations, in addition to increasing expectations from investors, asset owners and corporate boards to transition towards a more sustainable future for the asset management sector is a well-known feature of the industry and one which continues to be of strategic importance for firms and the industry as a collective. The recent publication of the Sustainability Disclosure Requirements (SDR) consultation by the FCA and the EBA publication of the integration of ESG risks in the supervision of investment firms serves to emphasise that this is a continued priority for the regulatory agenda.

Against this backdrop, many firms are continuing to struggle to prove that they have incorporated consideration of ESG throughout their operating model and being able to demonstrate not only that they can meet the regulatory considerations around ESG, but equally the expectations of clients, shareholders and their own strategic statements (e.g. commitments towards net zero). Failure to do this creates material emerging greenwashing risks that have the potential to cause significant reputational damage to firms, just as regulators are becoming increasingly active in this area and investors and shareholders are firming up commitments to positive sustainability contributions.

As a sector, asset management serves a pivotal role in facilitating the ESG ambitions and preferences of both institutional clients and the broader retail market. It is therefore, essential that firms consider whether they are appropriately set up to serve these evolving client needs both from a business perspective, and ensuring that the associated risks are appropriately managed.

Challenge of Integration

The impact of ESG factors is one that extends into virtually all existing risk classes which firms are typically geared towards managing. Coverage of certain risks within the ESG bracket can be more advanced than others – for example firms are typically more mature in their embedding of corporate governance into their existing risk management approaches. However, an aspect that continues to challenge firms is the holistic integration of ESG-related risks into the risk management framework.

One source of challenge will be the pervasive nature of ESG risks when considered through an enterprise lens. ESG risks can act as a causal driver of existing risks and can impact firms reputationally or attract regulatory scrutiny in the absence of being managed effectively across all areas of the business. Interventions will therefore be needed across all risk domains in order to demonstrate, both internally and externally, that ESG risks are appropriately managed across the business.

As with integrating any new risk type, a key driver of success is the level of maturity within the risk management framework. Where gaps already exist, these will present challenges for demonstrating the effectiveness of the overall framework to support the sound management of ESG risks. As firms start to move ahead with integration plans, there are common pitfalls that firms should be aware of. Past experience has shown that implementation can be inconsistent across the business, management of boundary issues is important as the concepts around ESG risks solidify over time, and challenges can exist around clarifying and preventing blurred lines from emerging within roles and responsibilities for new and emerging risk types.

Achieving a level of consistency in the management of ESG risks, given the range of client needs and preferences, and enabling this through the various components of the framework is also a crucial challenge that firms will need to overcome. This challenge becomes even more pronounced where asset managers are embedded into extended groups where asset management does not form the principal business focus and where “house views” of ESG risk do not always account for the nuances of an investment business.

What Firms Should be Looking to Do Now

As regulatory and investor expectations continue to grow in this area, firms should look to address these challenges by holistically considering how to integrate ESG into their existing risk management frameworks and challenge themselves on whether existing frameworks are robust enough to address both the transition to net zero and an industry increasingly geared towards more sustainable finance.

Boards and senior management are increasingly looking to Chief Sustainability Officers and Chief Risk Officers to work together to define an approach for managing ESG risks. For many firms, this will require considerable transformation effort, and will require a collaborative approach and buy-in across multiple areas of the business where ESG risks are likely to materialise. In many instances, this will need to be supported by a cultural shift at all levels of the organisation towards a mindset of managing ESG risks through day-to-day activities.

The starting point should be to define ESG risks as they relate to the organisation and find an appropriate home for these risks within existing frameworks through a common language and understanding. This will set the foundation for integration and identifying which components of the framework will need to change or can be leveraged to support the sound management of ESG risks. The result of keeping on the path of integration is a business that is more resilient to the emerging environmental threats and more capable of anticipating and responding to the significant societal shifts that come with a transition to a more sustainable world.  In our next blog we will address a number of considerations around the incorporation of ESG risks into firms’ risk taxonomies and the alignment of risk strategy with the sustainability objectives and aspirations of the firm through their corporate strategy.