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Environmental, social and corporate governance and the risks for institutions

World environment

In Depth: Rachel Gordon questions if ESG is all about the optics or are there some real risks to address?

Financial institutions are upping their game when it comes to environmental, social, and corporate governance (ESG). This is because if they do not, they could be facing censure from their shareholders, regulators and their customers. Those who continue to greenwash will do so at their peril.

The FCA is seeking to be on the front foot in this area and early in November, published a substantial discussion paper to coincide with the COP26 Finance Day – the aim was to look at ways investors could put ESG at the heart of their investment decisions.

The regulator is working on numerous ESG-related strands across its business, including appointing its first head of ESG, defining ways to deliver better ESG outcomes for consumers and on how it wants to improve diversity and inclusion, both within its own organisation and across financial services.

The FCA is also working on ways to classify and label investment products so that consumers understand whether they meet their requirements and values – these should be completed next spring. So, ESG is no longer just a hot talking point – it is becoming embedded in the way companies are expected to operate and financial services has particular responsibilities.

Insurance

In terms of the implications for insurers, ESG risks are real and as Sarah Crowther, partner with DAC Beachcroft, says: “The UK is moving towards mandatory ESG reporting and this is riven by investor demand and social inflation. From April 2022, the largest UK-registered companies and financial institutions will be required to disclose their climate change-related risks.

“The FCA’s July 2021 consultation, focusing on transparency around board diversity, tends to suggest that the focus, which has hitherto been squarely on “E”, is shifting towards “S” and “G”. The publication of this data carries with it the risk of claims for ‘green washing’ or even ‘ESG-washing’.  Although ESG disclosures are not yet mandatory in the UK, it seems they are on the horizon which should put ESG firmly on the board agenda”.

The failings and successes of COP26 remain on the news agenda, but the smaller picture is that more clients will want to know what they could be hit with in terms of risk and whether their insurance will cover them.

The UK is moving towards mandatory ESG reporting and this is riven by investor demand and social inflation
Sarah Crowther, DAC Beachcroft

Liz Robinson, director – management risk for broker Tysers, comments: “ESG is a top priority for most financial institutions; there is pressure from employees, clients, investors, shareholders, activists and some governments to shift focus to sustainable investments, practices and outcomes.”

She points out that some institutions are ahead of others: “Some clients are then steps ahead in their policies around a proactive approach into sectors/companies that are trying reverse climate change. Ie, it might not be enough to simply stop investment into polluting industries, there is pressure for FIs to invest in the necessary changes to reverse the harm that has been done.”

She adds: “Underwriters are interested in clients’ outlooks and ESG policies – including the types of clients a bank or insurance company takes on, the type of investments in a fund or whether cryptocurrencies are part of their exposure - due to large energy costs for storing/mining and also money-laundering/black market type exposures.”

Compliance

Robinson continues: “In addition to the environmental related regulation that has/will be implemented, there is likely to be increased regulatory scrutiny, disclosure requirements and compliance associated with ESG for financial institutions.

“For example, the UK government published intentions to mandate Task Force on Climate Related Financial Disclosures TCFD reporting in the next year.  We are likely to see similar requirements from the US, Europe and stock markets. Other non-financial risks are also moving up the agenda – including diversity and inclusion, flexible working, executive compensation, other social issues, such as Black Lives Matter.”

Broadly, she says the three main areas of focus for financial institutions are:

  • Complying with current reporting requirements and creating a framework for those that will be required in the future
  • Creating and implementing an ESG policy and culture across the business
  • De-risking investment portfolios, activities and the client base to avoid those that are seen to exacerbate climate change.

For many, none of the above are easy. But those that fail but themselves at risk of litigation and even whether the costs are picked up by their financial lines insurance, the reputational damage may be hard to rectify.

Litigation

As Naomi Hall, associate with Fladgate, says: “As the litigation funding market continues to grow, so will shareholder group actions increase. Whilst there have not yet been any publicly known claims in England relating to breach or reporting or disclosure obligations relating to ESG, this may be an area for claims in the future, particularly in light of the ESG discussion paper published by the FCA in November 2021, which noted proposals to introduce new rules to introduce new Sustainable Disclosure Requirement and product labelling requirements.

“This may drive ESG related trends under S90A FSMA under which issuers may be liable in respect of published information (other than listing particulars) which contain an misleading statement or dishonest omission in relation to securities. Litigation of this nature is already being seen in the US where Exxon Mobil was sued for allegedly deceiving shareholders by downplaying the risks to its business posed by climate change.“

Meanwhile, James Wickes, partner with law firm RPC, adds: “ESG certainly is becoming a live issue for the asset management industry in particular. Many investors are clear about what is on offer if they choose a particular fund, but when it comes to sustainability, it can be much harder to find out if an investment does meet green credentials. There is a lack of standardisation and definitions and you could get some very big claims in this area.”

When it comes to sustainability, it can be much harder to find out if an investment does meet green credentials
James Wickes, RPC

Progress

But, while more transparency around investment products is being sought, ESG measures are making progress, such as in a number of insurers showing commitment across their businesses such as in net zero commitments and to being fair and inclusive employers – moves that should also bolster share prices and customer confidence.

ESG protection may remain implicit rather than explicit in financial lines’ wordings, but it is very much on the agenda. Nadia Bagijn, head of financial institutions at Travelers, comments: “There is a lot of work going on in this area from both underwriters and brokers. It’s very much a case of knowing  your client – you can have large financial institutions with a strong record in ESG but they could be still lending to or investing in companies that are heavy polluters, for example.

“This is why there is so much talk around greenwashing and so brokers need to sit down with their clients and find out about them, their risks and what role there is for insurance. It is, of course, what many are doing. But this is also not a new area for insurers, carbon trading risks have, for example, have been covered for years, with work in this area being led by JLT, from around 2010.

ESG risks are developing and not just in the climate arena – diversity and inclusion can also have risk implications. We may see insurance having tighter conditions, such as exclusions or reduced cover for bodily injury, emotional distress or discrimination for example. But the right protection will also come with brokers listening to what clients want, taking to underwriters and being clear on what can and cannot be covered.”

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