Risk management in the world of conscious consumers
Financial services can change the world.
The business world is changing rapidly. Global megatrends like the push for greater sustainability, changes in how we work and increasingly empowered consumers are challenging traditional business models. And that’s making environmental, social and governance (ESG) goals more topical than ever.
For our recent report, Financial services can change the world by empowering the conscious consumer, we surveyed 3,500 consumers around the world to understand their views on sustainability and the role financial services should play. Across geographies and demographics, we found consumers are becoming more aware of, and are demanding far more, sustainable finance choices.
Almost two-thirds of consumers said they were looking for more sustainable financial products and services, and more than half were more likely to purchase financial products from providers steered by sustainable values. In addition, 93 per cent of respondents expect sustainable financial services to become the norm, with almost half expecting this to be the case by 2025.
Alongside these societal demands, regulation is fast approaching that will force financial institutions to factor ESG impacts into their core risk management practices. And this will open firms up to developing, changing and little-understood risks.
Understanding the risks of the environmental portion of ESG
Rising sea levels, greater storm intensity and increasing urbanisation are clear trends that are making climate change considerations material to organisations and their financial position. Such climate change risks fall into two main buckets – physical risk and transition risk:
In the context of climate change, physical risks are those that arise from natural disasters or changes in climate patterns.
Acute physical risks, such as more severe hurricanes, can lead to financial losses through damage to property and other assets or through disruption to operations and supply chains.
Chronic risks, such as changes in average annual rainfall or temperature, can increase operational costs. For example, extreme heat can damage roads while increased rainfall can change food production patterns.
Transition risks are inherent to the shift to a lower-carbon economy as this demands changes in what organisations do and how they do it. Such transition risks fall into three categories: policy, technology and market.
Governments’ sustainability policies evolve continuously. It’s crucial for organisations to be able to adapt to the changing regulatory landscape or risk falling foul of new rules.
There’s also greater uncertainty in technology development and deployment, which creates both risks and opportunities. For example, when electric cars start displacing oil demand, there will be a risk for oil producers.
As our recent consumer survey found, people are conscious of, and ready for, sustainable financial products and services. This is shifting the market, posing a risk to financial institutions that can’t show genuine and impactful efforts to mitigate climate change.
Monitoring the environmental risks
New approaches to reporting will be crucial to managing both physical and transitional environmental risks. Two global taskforces are helping with this.
Taskforce for Climate-related Disclosures (TCFD)
TCFD, an organisation encouraging financial reporting that reflects organisations’ impacts on climate change, provides a framework for reporting that recommends organisations begin to identify and measure the financial impacts of physical and transition risks. The aim is to promote more informed investment decisions through standardised reporting, enabling stakeholders to better understand the concentrations of carbon-related assets and their exposure to climate-related risk.
Taskforce on Nature-related Financial Disclosures (TNFD)
In parallel to climate risk, there’s also ongoing loss to biodiversity, which brings unprecedented risks for organisations. Having good data on nature enables better nature-positive decision making, which will help solve the global ecological crisis. Building on the success of TCFD’s approach, TNFD is a new global initiative that’s provided a framework for reporting and acting on evolving nature-related risks. TNFD aims to test and deliver this framework by 2023, so organisations can incorporate environmental capital information in their financial statements alongside climate-related risk. This will show how natural capital can affect organisations’ overall performance and how to manage the risks and opportunities that come with this.
How to balance ambitious sustainability goals and risk management
We’ve often seen corporate social responsibility efforts divorced from core business processes, which resulted in sustainability disclosures becoming ambiguous and grandiose. However, global changes and organisations such as TCFD and TNFD are requiring leaders to make a comprehensive adjustment of their risk management setup.
Enterprise Risk Management (ERM) frameworks categorise business risks, predict their impact and likelihood, and measure mitigation efforts. Providing sufficient coverage to climate-related risks and opportunities, as you do with traditional business risks, through scenario analysis and stress testing will allow your organisation to accurately assess their impact.
Stress testing is a comprehensive, forward-looking exercise that assesses future exposure and loss that you can’t extrapolate from past data. It targets the exposure and income sources that are most vulnerable to climate-related risk. The results of stress testing allow organisations to establish the right remediation measures to better respond to the threats that come with climate change.
These approaches will embed the environmental aspect of ESG into your frameworks, driving a more robust, differentiated understanding of sustainability risk and pushing behavioural change. And that will pave the way to achieving your sustainability goals – and being able to prove it.
Root a sustainable development trajectory in data
There’s been a considerable global shift in people’s understanding of sustainability, but sustainability reporting is still often ambiguous. This is an issue because data gives sustainability the tangibility and transparency it needs if it’s to become an actionable priority for leaders – it informs decisions about sustainability initiatives. But data volume, velocity, variety and veracity are key to credibility, and this quality has been lacking.
Once an organisation has defined its sustainability strategy, it needs to identify how to extract data that can support their development trajectory. Organisations can use internal data, such as the carbon footprint of their buildings, and external data to benchmark their development trajectory.
By integrating sustainability key performance indicators and key risk indicators, organisations can measure progress towards targets and the success of their sustainability strategy. This, in turn, can help them develop risk mitigation strategies across corporate asset locations, supply chains and product life cycles.
To achieve the desired state, data management and data governance are key. Organisations that work sustainability data into daily operations and ensure different business areas agree on how to treat, understand and act on data will shift behaviours and increase transparency in sustainability.
Integrating sustainability reporting will provide that transparency, which will build trust among stakeholders and customers. That makes the non-financial risk performance a leading indicator of a company’s long-term success.
A path forward
Sustainable finance is key to remaining relevant in a world of conscious consumers. This means creating a larger selection of green financial products and focusing on broader sustainability goals. In the areas of investment and financing, the financial sector has got off to a good start in the Nordics but maintaining momentum in this space requires a continued focus on technology and innovation, and an understanding of the opportunities partnerships offer.
Our survey found that, in addition to the questionable legitimacy of green financial products on offer, there’s a low level of consumer trust in financial institutions and their commitment to being sustainable. Due to this, it’s necessary to communicate to Nordic consumers the opportunities present and that the sector is delivering on the goals it’s set. Key to this will be the guidance and frameworks set by organisations such as TCFD and TNFD, and empirical evidence based on data.