Transcript: Series 2 Episode 1: Finding purpose through ESG

Andrew Strange: Hello everyone and welcome to the second series of our Risk & Regulation Rundown podcast. This is a monthly podcast, where we discuss the latest risk and regulatory developments affecting our industry, some insights from our work with clients, and our perspective on industry talking points. I’m Andrew Strange, a Director in PwC’s Financial Services Regulatory Insights team and your new regular host. As last month, we are recording this remotely, so please note the sound quality might not be quite as good as usual.

In this episode, we are discussing sustainable finance and the environmental, social and governance agenda, better known as ESG. I am delighted to be joined by Elizabeth Stone, PwC’s Asset and Wealth Management Leader; and Emma Cox, PwC’s Head of Purpose and Sustainability and Climate Change Leader.

Sustainability has been high on financial services firms’ agendas for some time now. In the current situation, we are seeing ever stronger regulatory and commercial incentives for firms to take action.

Firstly, Elizabeth, do you want to start by outlining what we actually mean by ESG?

Elizabeth Stone: Thanks Andrew, and that’s a really good question to start with, because there are so many different terms and acronyms being bandied about, so I think it’s important to set the scene of what we mean.

ESG is essentially referring to a company’s credentials on environmental, social and governance issues. The ‘environmental’ is heavily, although not exclusively, focused on what companies do to manage their impact on the climate. ‘Social’ is very broad, but includes things like how companies treat their staff, their approach to diversity and inclusion, the extent to which they have a bigger purpose in society, so beyond simply making a profit, and how they tackle social problems. Then finally, ‘governance’ should be thought about as the framework that underpins the ‘E’ and the ‘S’. So, how is a company controlled and run, what’s its approach to executive pay, what’s its board structure, and how does it approach things like culture, codes of conduct, and its supply chain management.

When we think about ESG in a financial services (FS) perspective, one of the critical points to note is that we are not just thinking about the financial services firm’s own ESG performance, but also the ESG credentials of organisations that that financial services firm has exposure to. In an asset management context that could be the underlying corporates that the funds invest in, or from a banking context it could be who the bank lends to.

One of the key challenges for financial services firms is how they then might reconcile their own ESG performance or viewpoint with those of the other organisations that they touch with their supply chain, lending or investing.

Andrew: Thank you Elizabeth, that’s really interesting, and much broader than the regulatory world that I come from. What are the main drivers that are actually prompting firms to focus on ESG issues at the moment?

Elizabeth: Andrew, there are probably three main drivers that we could think about. Firstly, obviously regulation and policy. Policymakers and regulators internationally are increasing their focus on how to ensure that sustainability considerations and concepts are embedded across the wider financial system.

Secondly, public attitudes. Everyone will be very aware of recent movements like Extinction Rebellion and Black Lives Matter, and the changing public attitudes towards ESG issues. This manifests itself as increasing pressure by customers and employees on companies to adopt ESG principles.

Then finally, investor demands, again partly as a consequence of movements like Extinction Rebellion and Black Lives Matter, but also, I think we are seeing a generational shift. Younger generations are more focused on wanting to invest their money in companies with positive ESG credentials.

If you take all these factors combined, what it is doing is causing business leaders to really focus on ESG. Our recent CEO survey that PwC does globally, shows that chief executives are much more likely now to recognise the benefits of investing in climate change initiatives than they were a decade ago. For example, our most recent survey showed that 25% of CEOs strongly believe that climate change initiatives will lead to significant product and service opportunities, but ten years ago that percentage was only 13%. The other more recent factor is that we’ve seen the impact of COVID-19 really amplify the ESG agenda, and actually shift the balance of some those drivers in driving the agenda towards ESG.

Andrew: I was going to ask about COVID-19, because you’re right, it must be having an impact. What are some of the ways that it is impacting trends at the moment, Elizabeth?

Elizabeth: Andrew, there are probably two ways to think about the impact of COVID-19 on the ESG agenda. Firstly, short-term and then the medium-term consequences. From a short-term perspective, there are probably three key impacts that we are seeing. Firstly, the collapse in global economic activity has brought greater credibility to the ‘disorderly transition’ climate scenarios that regulators and industry have been considering. Where there has been scepticism before, people have actually seen what can happen.

Secondly, the sharp downturn in demand for energy, we think that this could accelerate the devaluation of certain assets and heighten the risk of them becoming stranded assets. While this is not a new issue, it has obviously been identified as a key concern for quite some time, we do think that the COVID-19 crisis could accelerate this change, and therefore increase significant risks to firms’ balance sheets.

Then the third impact is really around that greater focus on corporate social response to the crisis. Corporates have really been exploring through this crisis how they can respond and adapt their business models. We have seen numerous examples of how they have done that. Car manufacturers shifting to production of ventilators, fashion houses shifting to production of PPE, for example.

The other short-term and medium-term factor to bear in mind is that also regulators will be paying close attention to how all of these types of ESG issues are amplified by COVID-19 and handled by the industry, and we certainly expect that the regulators will be looking at how FS firms have met regulatory requirements in the context of ESG and COVID-19.

And Andrew, in the medium-term, as governments grapple with the economic consequences of the pandemic, we know that they will be exploring options to help boost economic growth. What we envisage happening is this renewed importance placed on sustainability will influence the nature of any future economic recovery, and that the financial services sector has a really key role to play in any ‘green recovery’, not least of all ensuring that sufficient funding is available, and can be mobilised to support that sustainable growth. There have been a number of industry associations such as TheCityUK, who have already highlighted this point. Against this backdrop, financial services organisations can expect sustainable finance to move even further up the agenda both from a policymaker and a regulator’s perspective.

Andrew: Thank you, Elizabeth, I was nodding strongly there, difficult in these social distanced times, but that greater focus on social issues, the ‘S’ in ESG is certainly something we’re seeing a focus on. Emma, can you talk us through what’s driving that increased focus, and how you are seeing firms responding to that?

Emma Cox: Andrew thank you, and very interesting to listen to everything that Elizabeth has been saying, and I really agree with everything that she has touched on. The ‘S’ in ESG, which is the social side, one report referred to as the ‘ugly duckling of ESG’. It was the one that used to get left out more, with much more focus on the ‘E’ and the ‘G’ side. That is probably because a lot of the things in the ‘E’ and the ‘G’ side are easier to measure, and on the social side it’s harder. It’s the things Elizabeth was talking about, it’s about human rights, it’s about health and safety, it’s about responsibility for your customers, it’s about labour standards, all those sorts of things. But those are things that people really care about.

What the pandemic has done, in particular, is throw a much sharper focus on the need to understand businesses’ social responsibility. We came into the pandemic with trust in business at a pretty low ebb. What we’ve seen through the pandemic is a real positive reaction to companies, banks, institutions that get it right, that really put people at the centre of it. The social bit is a very human-centric metric, and if you get it right, it really helps to build trust. But the metrics are quite difficult sometimes to actually measure and disclose, but we’ve been getting better at doing that.

The other thing that’s been getting called out on the social side is a real need for authenticity. Where companies make grand-standing comments, they really get called out for it, and you see much higher standards being applied by a broader range of stakeholders. This isn’t just about companies reporting to either their shareholders or investors. We are seeing really the rise of this much broader stakeholder capitalism, and the ‘S’ bit takes in a lot of those other types of stakeholders. And they’ve got much more of a voice now. Things like social media really have an impact on people’s lives. So then you see things like the big platforms being called out if they don’t take action on things people don’t like, like hate speech, for example.

The Black Lives Matter movement, which has been an incredibly powerful movement, that has really touched the lives of many people, is making a lot of companies reassess their inclusion and diversity approach, and their approach to things like mandatory gender pay gap reporting, for example. I think we’ll see a lot more companies taking positive action to get ahead of the curve, show themselves as good societal citizens, to make bigger and better disclosures.

It’s a period of change, and this broadening out of stakeholders that have different influences on the way that companies behave, report, take decisions, etc., can really have an impact on the way that business gets trusted in the future, and really can actually up the profile of ESG. That’s because what we are seeing is that the ‘S’ is often the bit that unites the ‘E’ and the ‘G’ together, because it’s where things actually get played out in people’s lives, it’s the real human part of it.

Andrew: Thank you, the way the ‘S’ links the ‘E’ and ‘G’ is really interesting. That’s been a really helpful overview of the main issues, and it would be great if we can just talk in a little bit more detail about some of these points now. Elizabeth, you mentioned regulation earlier as one of the key driving forces for the ESG agenda in financial services, an area close to my own heart. What are some of the key regulatory considerations and upcoming initiatives that should be front of mind for firms?

Elizabeth: Thanks Andrew. Broadly speaking, and I think I touched on it earlier, regulators basically want to see how ESG risks are integrated across the financial system. For financial services firms, this means assessing and managing risks across their whole business and their operating model, and not just their balance sheet.

Touching then on regulation, it’s almost a question of where do you start and how do you keep up, because it is so far reaching, but perhaps just picking up firstly on climate risk in banking and insurance. We know that the PRA plans to carry out biennial stress tests to test the resilience of the largest banks and insurers on the risks associated with possible climate scenarios. There’s also been a couple of very recent developments. At the end of June, the Climate Financial Risk Forum, which is chaired by the PRA and the FCA, published its guide to help the industry address climate-related financial risks. Then, very recently, on the 1st of July, we saw that the PRA published a Dear CEO letter on managing climate-related financial risks. It set out in that letter its feedback on progress so far and the next steps for implementation. One of the key points it made in that letter was that material near-term improvements are required in a number of areas, and it set a deadline for the end of 2021 for the embedding of approaches to managing climate risks.

Then we have the Task Force on Climate-related Financial Disclosures, abbreviated as TCFD, which also focusses on climate risk. It has issued recommendations for listed companies, both financial services organisations and non-financial services companies, to disclose how they manage climate-related financial risk. It is important to note that the FCA is currently consulting on how to incorporate these recommendations into its rulebook on a ‘comply or explain’ basis.

In the asset and wealth management sector, there has also been a lot of focus on how firms integrate ESG risks into their investment approaches. A couple of examples, as part of its sustainable finance action plan, the EU is introducing the Sustainable Finance Disclosure Regulation (SFDR). That will require asset managers, asset owners and wealth managers to be more transparent as to how they assess the ESG risk profile of investee companies when they determine their underlying investments. The SFDR will also introduce new reporting on the sustainability performance of funds, where they have a specific sustainable investment objective.

But it’s not only new regulation, we are also seeing proposals from the EU to ‘mainstream’ or embed ESG principles into existing financial services regulation such as MiFID II. The changes proposed to MiFID II, for example, would require investment firms having to consider ESG issues when meeting obligations on product governance, suitability, and conflicts of interest.

One other important point that I think is very essential to consider is that firms’ ability to robustly meet all these various regulatory obligations does really rest on access to high quality and granular data on the ESG credentials of the companies they have exposure to. But what we are seeing is this is a real challenge, because quite often that data is not available at the required standard that firms need, and actually the PRA touched on this point in its recent Dear CEO letter. It recognised explicitly that data limitations mean that firms may not be able to embed an end-to-end state analysis of climate-related financial risks within their capital frameworks by the end of 2021.

Andrew: Thanks Elizabeth, that’s a really packed regulatory agenda. It is interesting to hear about the global approaches, the European approaches, the approaches of domestic regulators, and the way that they link together. But the sustainable finance agenda itself is about probably more than that; regardless of regulation, FS firms are thinking about their reputation, purpose and strategy, and the role, as you said Emma, they can take in tackling things like climate change and social issues Emma, do you want to talk a little bit more about what financial services firms are thinking about in that regard?

Emma: Thanks Andrew, and I feel quite daunted by that list of regulatory changes that Elizabeth just set out, but one of the things that makes me actually quite optimistic about the way that the FS sector as a whole is reacting to these bigger issues, is the way that they are really picking up on purpose. Purpose has become a real buzz word in the last year or so, but it’s actually through this crisis been shown to be something that’s not just skin deep, it’s really in the psyche and the culture of organisations. I’ve been particularly impressed by how banks have really thought about their purpose during this crisis, and actually that has acted interestingly as a real accelerator of focus on ESG and these bigger picture issues.

They are not doing it either just because of regulation, although the FCA published a paper on driving purposeful culture. A lot of it is actually firms really proactively exploring who they are, who their stakeholders are, what the changing expectations are. And actually we’ve seen leading banks declare themselves purpose led, with some really macro objectives and priorities as to how they can influence on financial literacy, for example, on SMEs, but also on climate change and on net zero, and their role as lenders in that process. That is really interesting, and quite a change from where we were even a year or two ago. The whole ESG agenda has really come into the spotlight and so again you are seeing certain asset management companies really upping the level of integration of ESG in their investment decision making, talking about it, challenging others about it. It has really become very much more mainstream rather than peripheral.

I do think, purpose has been a driving force in helping companies think about this and think about the part that they have to play. It is not something now that is just put off on the one side. I was having a conversation recently with a FTSE100 Chair, and he said that in every one of their shareholder roadshows, ESG and their ambitions in relation to ESG had come up in every single one of those meetings. Again, that’s quite a sea change. It makes me, as I said, quite optimistic about the level of impact that the financial services sector is going to have on some of these really big issues that actually we’ve got to tackle as a society.

We’ve seen, for example, a number of high-profile companies setting out their net zero ambitions during this pandemic. The financial services sector has got to think about how it deals with financing recoveries, what decisions it is going to make. I think actually, we’ve got almost an acceleration coming out of this crisis, rather than a slowing down. So I am quite optimistic that banks are going to really play their part in these difficult questions.

Andrew: Thank you Emma. It’s interesting, you mentioned net zero, and clearly there is an entire ‘green recovery’ agenda that we are looking at now as well. What do we actually expect to see from policymakers and regulators on the sustainable finance agenda as we move into that stabilisation and then into the recovery phase of the crisis? Emma, I’ll come to you first if I may.

Emma: Thanks Andrew. I think we are going to see a period of quite rapid announcements in the coming days and weeks as we go through into the summer, because there is quite an expectation that the Government will put ‘building back better’ and a ‘green recovery’ right at the heart of its policy space. Indeed, at the time that we are having this conversation, we are expecting some announcements from Government coming up this week, in early July. Obviously, the UK was one of the very first to issue its own net zero target for us as a whole, and we were very proud and pleased to be hosting COP26, which was meant to have been in Glasgow this year but has now been delayed to November 2021 instead. I do think that actually we will see a lot of action in the run up to COP26. That will be not only political action, but also action by investors, by companies, and by banks.

We’ve seen actually corporates really wanting to play their part in driving a ‘build back better’ type of recovery to COVID-19. We saw some 200 leading UK businesses, including ourselves PwC and many large financial services companies, writing a letter to the Government, encouraging them to use the recovery to accelerate that net zero transition. You see the former governor of the Bank of England, Mark Carney, coming out time and time again underlining the importance of action now on climate and the risks that lack of action will pose. And you see a really increasing number of businesses publishing their own net zero plans, and that ramping up of ambition is forcing it to become almost a competitive issue.

I think the FS sector has a real role to play in the recovery as an enabler of financing across all sectors of the economy. A lot of sectors are going to have suffered enormously, some actually are vital during this crisis, and have done better, but how the FS sector behaves, and how it can help direct money to those in need of it, I think has a real opportunity to build trust in the FS sector. If we can get it right, we could end up with a ‘new normal’, broader form of stakeholder capitalism with an increased level of trust between business and policy makers, regulators, and society at large. That will help on those really important agendas of net zero and of levelling up as we come out of the crisis.

Andrew: Thank you, that’s great. Elizabeth, is there anything you’d like to add?

Elizabeth: Andrew, the only point I will add is that I would hope to see, picking up on some of the points Emma made about purpose and trust, that the policy focused on ‘green recovery’ will accelerate the debate around using prudential policy levers and tax measures and incentives to actually achieve sustainable objectives and help businesses to do so. For example, could we use a favourable VAT regime to foster more ESG investments. Some really concrete measures that will incentivise and help industry to ‘build back better’.

Andrew: Thank you Elizabeth. Well you said there about concrete measures, so to finish, I’d like to ask you both for a key takeaway message for our clients and firms. Is there a practical step that firms should be taking to progress on some of the issues we’ve discussed, or a key question they should be taking away to ask themselves? Emma, let’s start with you.

Emma: I guess you won’t be surprised, given my focus on purpose and the power of purpose, if I suggest that if you are sitting there in a company (a bank, or an asset manager) thinking how do I take this forward, think about what your purpose is as an organisation, and then think how that drives down into your ESG agenda. And think how you can really use this opportunity to challenge how you can do more on each of those of E, S and G lenses, and how it links to your strategic decision making. Is it really properly baked in to all those important processes, strategic decisions, and actions that you take, or is there more that you can do to really push that forward? Because I think if you get it right, there is a real opportunity to both drive positive change, but also to inspire and motivate all the people who work in your company and your customers, and that in itself should drive a virtuous circle of success.

Andrew: Sounds great. Elizabeth, what do you think?

Elizabeth: I think, just picking up on the point that Emma made about strategic purpose, but also the regulators’ key agenda, which is that end-to-end integration. Organisations should be challenging themselves or asking themselves the question, how truly is ESG embedded in their organisation from an end-to-end, bottom up, top down process? And are they really meeting in the middle with that cultural strategic piece with what’s going on at the very granular level across all parts of the business model of the organisation.

Andrew: Thank you Elizabeth, and to you too Emma. That’s been a really interesting discussion. I’m struck by both the breadth and the interconnectivity of the issues we’ve discussed. It’s clear these issues are going to remain high on firms, regulators and policymakers’ agendas for the foreseeable future.

I hope you’ve found this helpful, please do feel free to share this podcast with your colleagues and subscribe to future episodes, and I look forward to being back next month with another episode.