Key challenges for financial service institutions to integrate ESG risks

ESG (environmental, social, and governance) risk management focuses on the risks arising from those environmental and social changes that affect the performance and business operations of a financial services organization. Sources of ESG risks are commonly classified into two different categories.

Physical risks arise from the direct impact of environmental events on the existence of assets, like floods, droughts or rising sea levels.

Transition risks come from the transition to more sustainable economies. Economic, social, political and legal changes can cause significant changes in asset values and feasibility, consumer and industry demand. These could also have subsequent impacts on the viability of a business or entire business models, shifting to more renewable energy sources, electric vehicles or even a more vegetable-based diet.

According to Dinh Hong Hanh, Partner, Financial Services Leader, PwC Consulting Vietnam, in the financial services industry, sustainability plays a significant role through various factors: strategic opportunities, external expectations (investors, shareholders, customers), industry standards and listing rules, disclosure and transparency requirements, regulatory requirements, and ESG risks. These are the driving force of a sustainable transformation in the financial services industry. These events and developments typically affect banks' financial risk areas, including credit risks, market risks, liquidity risks. In addition, the non-financial risk areas are also significantly affected. These include operational risk, strategic risk, reputational risk, legal risk and other risks.

Dinh Hong Hanh, Partner, Financial Services Leader, PwC Consulting Vietnam. Photo courtesy of Hanh

Banking supervision on ESG risk

The banking supervisor in Vietnam has been active to promote new regulations in ESG space, which is an important motivation for the banking sector to embark on the ESG transformation journey. A draft circular guiding the implementation of environmental risk management for credit institutions and foreign bank branches has been recently issued.

In 2018 the State Bank of Vietnam issued the Environmental and Social Risk Assessment Manual for 10 economic sectors in credit activities in the first step of a process to integrate ESG criteria into banking regulations.

Bank supervisors in Vietnam have also shown considerable effort in integrating the region's ESG transformation journey. A draft circular guiding the implementation of environmental risk management in activities of credit institutions and foreign bank branches was recently issued.

However, the implementation of ESG criteria into existing business models and activities of credit institutions is still in the early stages. Credit institutions face many difficulties in assessing the environmental impact and associated risks of their conventional investment and lending portfolios.

Key challenges

According to Antonie Jagga, Partner, Financial Risk Management Leader, PwC South East Asia Consulting, financial services institutions are likely to face a number of challenges when implementing an ESG risk management strategy.

Antonie Jagga, Partner, Financial Risk Management Leader, PwC South East Asia Consulting. Photo courtesy of Antonie Jagga

First, the risks involved need to be adequately foreseen. This means that before identifying material risks, credit institutions can break down their portfolios into specific areas to assess and measure risks. In-depth analysis and portfolio assessment associated with core business activities will help an organization focus resources and time on key issues that are at risk of being negatively impacted.

Second, the ESG strategy needs to be transformed and integrated into the ecosystem of the organization. ESG strategies and policies should be integrated into the existing process rather than developing a parallel process. For example, incorporating ESG factors into the credit assessment process will help credit institutions anticipate ESG risks before undertaking credit granting activities.

Third, it is necessary to regulate the management of stakeholders, implement communication and training on ESG in the organization. Training ESG risk assessment skills for appraisal staff in credit granting activities is an example of a good approach in ESG risk management of credit institutions. In addition, the proper allocation of resources and assignment of responsibilities will also ensure that the credit institution has sufficient capacity in managing ESG risks.

Another significant challenge is the collection, management and use of ESG data to establish a risk assessment model. Data collection is essential for credit institutions to successfully identify and assess ESG risk and integrate ESG into the risk model. For example, information about a customer's greenhouse gas emissions or the location of their production facilities allows credit institutions to assess physical and transitional risk.

Fifth, ESG commitments need to be formulated and publicly disclosed. Each financial institution may at some point need to show why and how they have handled their ESG risks and how to take advantage of ESG opportunities.

The final challenge is how to integrate ESG into the organization's existing risk management processes. Existing policies and procedures need to be aligned with the ESG risk management strategy. For example, a process should be established to find the linkage between physical environmental and social aspects of risk, the respective potential financial impacts for existing risk categories, and the estimated timeframe of these financial impacts.

Addressing these challenges will open up new opportunities for financial service institutions beyond just complying with ESG regulations, which will uphold the organization's objectives of creating long-term and sustainable value.