Six key challenges for financial institutions to deal with ESG risks

Understanding materiality

Addressing all ESG concerns at once is impossible even for the most forward-looking and well-intentioned companies. The key to success is materiality. That is, the understanding of which ESG risks are relevant to a company’s sector and overall operating context. A company’s or an investor’s materiality assessment will show which issues are most important to its business and to stakeholders. Industry and geography are two leading criteria for identifying a long list of potentially material issues. The list then needs to be refined and narrowed down to a short list of ‘most material’ issues. How a company or an investor decides to act on their most material issues will be determined by a range of factors, including their risk appetite, but the advice is to be proactive. Material ESG issues may vary, but their influence on the bottom lines of companies and investors is increasingly visible. Doing too little or waiting too long to address the most material ESG issues will result in companies having to play catch-up to their peers and investors potentially seeing the value of their assets being challenged over time. 

Extreme weather events: a highly material E risk for insurers

Extreme weather events such as heavy rainfall, hail, storms and droughts have a high impact on our daily lives and economies. They damage production facilities, disrupt business processes and decrease residential and commercial property values, as well as commodity prices. Climate change is expected to worsen the magnitude and frequency of extreme weather events in the coming decades, also in the Netherlands. Of the extreme weather events since 2012, around seventy per cent can be attributed to climate change. Extreme weather events have a large impact on insurers. When rain, storms or floods become heavier and more frequent, damages will increase and insurance companies will need to pay out larger sums to their clients. According to AON’s 2020 Weather, Climate & Catastrophe Insight report, last decade was the costliest in terms of natural disasters, with the total economic damage and losses amounting to 2.98 trillion US dollars. For Europe in 2019, the costliest disasters were the November flooding in Italy (3.5 billion US dollars), the September flooding in Spain (2.5 billion US dollars) and the spring droughts in Spain (1.7 billion US dollars). Insurance pay-outs peaked, as 845 billion US dollar was paid out by private and public insurers. It is therefore of fundamental importance for insurers to monitor global warming and to anticipate its effects on homeowner insurance products. Navigating this landscape is complex, and data gathered across areas heavily hit by extreme weather events (such as Australia’s ABC Climate Risk Hotspots) shows that many homes will see their insurance premiums double or even triple within decades- and entire geographical areas will become uninsurable.

Global warming also has devastating effects on agriculture, threatening farmers and food production and supply. Higher temperatures increasingly harm agricultural production through extreme droughts, cropland decline and facilitating the spread of agricultural diseases. Moreover, the agricultural sector is also strongly exposed to transition risks, as governments adopt ambitious emission reduction policies targeting agriculture. Insurers must anticipate the effects of reduced crop yields in the future. They may adapt their premiums, insurance policies and require additional certifications from their clients.

Social disruption following Robotics and AI: an underestimated ‘S risk’ for financial institutions

Artificial intelligence (AI) will be increasingly important in enhancing productivity and profitability. AI breakthroughs constantly attract public attention – e.g. robotics development and self-driving cars – and the concern that AI might eventually take over many jobs is becoming an urgent one. In 2018, the OECD estimated that fourteen per cent of jobs in OECD economies are under high risk of replacement by automation, while another thirty-two per cent is at high risk of being replaced partially. The jobs that risk being ‘lost’ are the ones with predictable, routine tasks (e.g. assembly line workers, record clerks etc), and those with a low level of customer interaction (e.g. food service workers, travel booking). In fact, robots performing tasks outside of manufacturing (for example making phone appointments) are already old news. What is worthwhile exploring, from an investor perspective, are the social consequences of these fast-paced developments. Depending on how governments will act on the matter, large-scale job losses could result in structural unemployment and increased inequality. The technology transition has the potential to fuel populist and anti-globalization movements – especially as most of the to-be-displaced workers are already at risk of slipping below middle-class wages. Against this background, shifting investment from human capital to robotics and AI has the potential to fundamentally change societies. Another interesting investment segment is represented by platform technologies that have brought about the so-called ‘gig economy’. The business model underpinning these companies is even riskier from a social disruption perspective, because it causes concentrated job loss and effectively shifts profits from final service providers to platform owners.

In conclusion, the social implications of the technology transition remain a blind spot, and investors need to further explore them. Companies and investors must consider their role in the technology transition and decide how to anticipate or cushion the effects on their employees, sales and markets. Specifically, investors must integrate the effects of technology shifts in their risk management through putting the social implications on their radar for risk identification.