ESG Risk Integration Challenges

From Open Risk Manual

Definition

There are a number of challenges facing the integration of ESG risks into institutions’ management processes and their supervision (see Figure 8). The following are the most often cited.[1]

Level of uncertainty

the timing and effect of policies and related regulatory interventions, whose specific implementation is largely the responsibility of the governments, are hard to predict, as are the timing and effect of physical risks.

Insufficient data

The scarcity of relevant, comparable, reliable and user-friendly data, is another major challenge that limits the understanding of the potential impacts of ESG risks on the performance of financial assets. Whereas ESG data for large corporates are considered to be increasingly available, such data for counterparties such as SMEs, local and regional governments, and companies from developing or emerging markets, are scarcer. Further, it remains challenging to translate the available ESG data into expectations for the financial performance of a counterparty. The fact that ESG data are currently mostly only available on an annual basis (i.e. through companies’ annual sustainability reporting), can further complicate an accurate assessment of ESG risks, as such risks could significantly increase or decrease over a one-year time horizon. More consistent and coherent ESG-related reporting by companies could help to enhance the quality and availability of ESG data.

Methodological constraints

Most of the risk management models are based on the use of historical data (i.e. historical experience) to estimate current or future risks. ESG factors are frequently not reflected in these data. For example, it is difficult to take ESG risks into account when calculating risk parameters such as the probability of default (PD) of borrowers or loss given default (LGD) using the existing methodologies. Other methodological constraints include translating ESG risks into financial risks, understanding their impact on the resilience of business models and the lack of a harmonised definition of the full range of sustainability-oriented activities.

Time-horizon mismatch

The mismatch between ‘traditional’ management tools and the timeframe for the materialisation of ESG risks particularly, the full impact of environmental factors often develops over decades. As an example, climate scenarios usually analyse possible climate pathways until the end of the 21st century. The transition to a carbon-neutral economy is scheduled to happen gradually over the next 30 years. In contrast, the strategic planning horizons of institutions and risk management frameworks are traditionally much shorter, as they largely reflect shareholder pressure or macroeconomic factors. (See Tragedy of the Risk Horizon)

Multi-point impact of ESG risks on institutions

Given that ESG risks can impact different financial risk categories, they can impact the financial position of institutions in multiple ways. For instance, the physical deterioration of areas in which some economic activities (e.g. agriculture, construction) operate may lead to higher credit losses, if an institution is exposed to those activities via loans or bonds, or losses in market value, where the exposure is in the form of financial instruments. The necessary and politically agreed transition towards a more sustainable economy in general, and a carbon-neutral economy in particular, may also negatively affect existing business models. Credit and market losses translate into impacts on the capital adequacy and, thus, prudential soundness of an institution. Moreover, when credit rating agencies include ESG risks, the credit ratings of vulnerable corporates could be downgraded resulting in higher risk weights of affected exposures under the standardised approach. In addition, when ESG risks impair the valuation of collateral, this can increase the LGD. ESG risks can also cause an outflow of capital, for example, after a Natural Disaster. With regard to the costs of capital and funding, investors and depositors are likely to discriminate increasingly against institutions that disregard the negative effects of ESG factors. The impacts should therefore be assessed as elements inside each of the financial risk categories, as well as across these categories.

Non-linearity

Most ESG risks, especially those related to environmental risks, are non- linear in nature. Both physical and transition risks can create complex chain reactions and cascade effects, which in turn could generate unpredictable environmental, geopolitical, social and economic dynamics. This means that, for example, when (detrimental) events such as increases in local or global temperature occur, their impact is greater in relation to the instantaneous magnitude of the event itself and over time.


References

  1. EBA Report: On Management and Supervision of ESG Risks for Credit Instituions and Investment Firms, EBA/REP/2021/18