Financial firms face difficult choices on ESG compliance

Lately, it feels as if the environmental, social and governance ante is constantly being raised.

Across the financial industry, institutions are not only facing impending regulatory pressure but also heightened interest from investors, shareholders and the average consumer. News coverage focuses more and more on storms and weather patterns of increased severity. Commercials aired during major sporting events no longer predominantly advertise the flashy lines and off-road capabilities of cars and trucks, but also stress the sustainability practices of automobile manufacturers.

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Even the war in Ukraine has thrust ESG more to the forefront, with soaring gas prices emphasizing the need to transition to a net-zero carbon economy — not only for the sake of the planet, but to reduce the West's reliance on volatile countries for energy supplies.

Then, of course, there is the Securities and Exchange Commission's recent publication of its proposed Climate-Related Disclosures for Investors in March 2022, the culmination of a rapid-fire rollout of recommended climate-focused regulatory guidance issued by several U.S. regulatory agencies since November 2021. Obscurity regarding what future climate-related regulatory expectations may look like is diminishing, but the number of questions about when and how financial institutions can possibly align with the aggressive reporting requirements the SEC and other agencies propose is rising exponentially.

After months analyzing the SEC's proposed disclosure rules, many across the financial industry have concluded that the guidance is both overly prescriptive and premature. The financial industry is already heavily burdened from a regulatory perspective, and there are broader concerns that banks will be expected to carry the load in lieu of formal climate change-focused public policy and legislation. As always with ESG, there seem to be more questions than answers.

The financial industry may be wise to move cautiously when it comes to aligning with early climate change regulatory guidance. Climate change-related risks are being felt more and more keenly with every drought, forest fire or Category 5 hurricane. Annually, the United States typically sustains approximately $120 billion in climate change-related damage. That being said, the more extreme effects of climate change will likely gradually materialize over time — which makes it extremely challenging to predict with any sense of accuracy when and where potential resultant shocks to the financial system may occur.

The physical risks associated with climate change are one thing, but there are also potential transition risks that may result from increased market volatility stemming from the introduction of new green technologies or destabilized or stigmatized sectors as an attempt is made to segue to a net-zero carbon economy. Will the SEC's rigid reporting guidelines for Scope 1, 2 and 3 greenhouse gas emissions really make a dent in all this uncertainty?

The SEC has been careful to stress that investors are driving the demand for greater transparency into greenhouse gas emissions reporting. Therein lies the rub for financial institutions. An argument can be made that there is a political element thanks to the current presidential administration and that resultant proposed regulatory guidance has been a logical outcome of that directive. Holding out for a change in presidential administration may not solve all of the financial industry's headaches, though, when it comes to climate-related disclosures. Institutions still answer to their shareholders, investors and consumers, and the trend toward ESG will not abate anytime soon, thanks to the galvanized interest of younger generations.

The meek will not necessarily inherit the earth — millennials and Gen Z will — along with the wealth accumulated by their baby boomer parents and grandparents. These same younger generations, now jaded after the COVID-19 pandemic and increasingly vocal in their discontent, will predominantly steer financial investment strategies in the future. Whether the SEC's guidelines go through and in what manner, financial institutions will still be expected to disclose, formally or informally. Even with finalized regulatory expectations still mainly theoretical, an increasingly aware public is already demanding that financial institutions provide transparency and clarity regarding their ESG/climate opportunities and exposures.

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Lack of formal climate disclosure requirements also will not protect financial institutions from climate risks inherent in their business strategies, portfolios and locations. One way or the other, it is likely that financial institutions — along with everyone else — will pay the price for climate change. It is simply a matter of when. Do financial institutions want to pay the upfront costs (which will be significant) to establish internal mechanisms and work streams required to facilitate and align with regulatory expectations? Or would they prefer to bleed revenue over time (which may prove more significant) as climate-related physical and transition risks come to fruition?

The SEC's proposed Climate-Related Disclosures may not be ideal. At this time, they introduce more challenges than solutions, but they should be viewed as what they are: a first step. It is true that financial institutions alone cannot solve the existential threat of climate change — but they can aid in driving safer and sounder practices that help prepare and stabilize the broader economy for the trials to come. A benefit of the SEC Climate-Related Disclosures and other evolving regulatory guidance will be their role in helping the financial industry start wrapping its mind around where future exposures lie — and how they can be headed off or reduced.

Sooner or later, climate change risks will catch up with the financial industry. If the SEC and other regulatory agencies do not drive more immediate climate change focus, then consumers and simple circumstance will in the long run. This moment presents an opportunity for the financial industry to lead, to partner to perfect regulatory guidance in order to evolve more meaningful, effective, robust and achievable reporting and risk identification.

First steps, by definition, are often painful — but they are also necessary. The SEC and other regulatory agencies have raised the ESG ante. Financial institutions will need to find a way to chip in before the stakes are raised even higher.