ESG in Financial Services and Regulatory outlook

The regulatory and legislative momentum behind ESG has shifted and strengthened significantly in recent years. We have seen a major shift from voluntary regulations and initiatives to rigid and binding legislation. Several international groups and initiatives such as the Task Force on Climate-related Financial Disclosures (TCFD) under the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision's (BCBS) Task Force on Climate-related Financial Risks (TFCR) have been working on the development of guidelines for ESG integration in strategies, risk management, disclosure and regulatory requirements with different scopes and mandates.

In Kenya we have also witnessed changes in legislative and regulatory environment with the Central Bank of Kenya (CBK) issuing the Guidance on Climate Related Risk Management and the Nairobi Stock Exchange (NSE) similarly issuing the ESG Disclosures Guidance Manual for listed entities. This rising legislative and regulatory pressure will bolster the attention ESG is receiving and is likely to have the big impact the shift to ESG strategy and focus within our market. As the regulatory landscape develops, unsustainable corporates will lose out on capital and non-compliant sectors will be penalized as a result. In the face of the rigid and ever-changing regulatory environment, banks, insurance companies, as well as corporate and institutional investors, will need to adapt to the new normal in order to remain relevant.

A shift in societal values has given rise to a new generation of investors who prioritize non-financial impacts alongside financial returns. The strongest push stems from institutional investors, who are reacting to increasing pressure from policymakers and stakeholders to incorporate sustainability into their mandates. We have especially witnessed this with Asset managers and Private Equity managers who are experiencing increasing client pressure to incorporate ESG standards into their fund offerings. To meet this demand, Asset managers and PE fund managers have acted; launching new funds with sustainable mandates and repurposing funds.

A wealth of research has disproved the widely held belief that to invest sustainably, investors must sacrifice strong returns. To the contrary, there is increasing evidence that suggests a perfect synergy between performance and sustainability. We expect to see a wider range of products in the future as more corporates turn green, providing opportunities for enhanced diversification. As ESG investment processes become more sophisticated, and the increasing impact and social acknowledgment of sustainability risks further shifts investor sentiment in favour of ESG investments.

The rise of ESG is bolstered by significant societal changes. Public awareness of ESG related risks has brought climate change and sustainability to the top of the global agenda. Society is attributing increased levels of importance to sustainable finance and ESG. COVID-19 has accelerated this shift, bringing the real-life impacts of overlooking ESG factors into the spotlight.

These catalysts are set to usher in the greatest shift the financial services industry; presenting banks, asset managers and even insurers with the opportunity to drive change by playing a key role in mitigating climate risk, promote social inclusivity all backed by good governance practices.

As the ESG revolution fast approaches, institutions must carefully consider what role they would like to play in it. A clear strategic decision needs to be made as to how deeply they would like to embed ESG considerations in their organization. The options range from being a sustainable investment leader, maintaining both ESG and traditional products; or maintain business as usual – complying with regulation but overall sticking to the status quo.

Beyond the above mentioned necessary strategic changes, organizations must also strive to be consistent in their chosen ESG approach to establish and maintain credibility. This calls for a demonstrable commitment to walking the talk by exemplifying the same level of sustainability and ESG consciousness in corporate strategy and philosophy that investors expect from their portfolio companies. They must also walk the talk by upping transparency and thoroughness in internal ESG reporting, as well as by embarking on firmware circulation of ESG knowledge to harmonize their sustainability story.

Institutions will need to make a number of strategic product considerations. They must then decide how to implement ESG indicators in their investment and risk processes, how they will structure and rationalize their fee structures (for Bank) or premiums (for Insurers); and how they will market their ESG efforts to their investor base.

An effective and impactful model of ESG investing is heavily reliant on timely and accurate data – which is a central tenet of benchmarking ESG performance, impact assessment, risk management and even disclosures. To overcome this hurdle, institutions will need to define data sources and take it to transaction level at Know Your Customer (KYC) to ensure they receive accurate and timely data sets and reporting. Secondly, they’ll need to manage their various data sources to ensure sufficiently granular and exhaustive data exists to serve their needs by implementing solid, regulatory-backed ESG reporting strategies and leveraging on third-party data providers. However, considering an immature data market, ESG data for external benchmarking is likely to remain a challenge.

As investors and policymakers alike attribute increasing importance to the assessment and mitigation of ESG risks, institutions will need to rethink their risk management frameworks to comply and thrive. Overlooking ESG-related risks could have serious reputational and financial repercussions. Developing a more resilient structure for risk management involves adopting and implementing expert risk identification and management practices internally and within underlying corporates. ESG risk exposure disclosures will become critical, and institutions will have to reinforce efforts to ensure ESG compliance of not only their institutions, but those of their related entities.

As regulatory requirements relating to reporting and disclosure expand, and investors attribute increasing attention to the ESG metrics of the asset managers with which they invest, it will become increasingly important for institutions to review their reporting processes to ensure their reporting goes beyond minimum reporting.

In order to accelerate the consideration for ESG indicators and risks as well as to successfully respond to an increased expectation of investors for ESG matters, organizations will need to educate their investors on ESG and the interaction with capital flows and financial performance. It will also be critical to build stronger ESG expertise among their employees by upskilling existing staff on ESG principles and strategically scout for and integrate more diverse and ESG-trained talent.