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Financial institutions at risk of ESG non-compliance

Financial institutions ill-prepared for new EU ESG reporting requirements

Financial institutions at risk of ESG non-compliance

Under the EU’s Sustainable Finance Disclosure Regulation (SFDR), which aims to prevent greenwashing; increase transparency for sustainable investments; and improve transparency around sustainability claims made by financial market participants, financial institutions face significant compliance costs related to data compilation and reporting requirements, according to Andie Wood, vice-president, regulatory strategy at Workiva.

The new regulatory requirements, which will apply from January 1, 2023, will require financial institutions to collect large amounts of standardised data to report on their sustainability impact to allow investors to distinguish and compare investment strategies across the EU, explains Wood.

“Added to this, [financial institutions] must consider the cost of non-compliance if they are not ready on time, as well as the risk of losing customers and investors as a result,” she says.

Wood points out that many financial institutions are simply not prepared for the flood of new EU ESG regulatory requirements.

“Financial institutions are being impacted by ESG compliance and reporting in relation to a range of activities from the advice they provide to investors to their behaviour and governance,” she says.

Nigel Green, CEO at financial advisory group deVere, agrees that the level of EU regulation will prove both onerous and costly for financial institutions.

“The EU has arguably the strongest regulatory framework in the world when it comes to greater transparency in the sustainability of investments,” he says. “However, it means that these financial institutions have credibility with clients who are looking for profits with purpose through these types of investments. In addition, it means that clients have greater levels of protection.

“The escalating climate crisis has put environmental concerns front and centre, but now we need regulators to help shore up the sustainable investment providers to ensure the avalanche of private money is not cut off at this critical time.”

Green believes that greater harmonisation of sustainability reporting regulation is vital.

“We need joined-up thinking on a global level to tackle a global issue,” he says. “This means internationally approved, enforceable anti-greenwashing rules. Failure to do so will severely compromise the mission.”

Complexities and risks

Wood explains that the complexity of ESG compliance and reporting for financial institutions operating in the EU area is so great because they have “two sides of the coin to deal with” – meeting disclosure regulations under SFDR, as well as rules governing the advice they give to investors looking to invest in sustainable investment products under the EU Taxonomy.

“One of the biggest challenges financial institutions are still trying to resolve is having to integrate their own financial data with external corporate ESG data (non-financial data) on the sustainability of companies they have invested in,” says Wood.

In the first instance, many financial institutions are experiencing difficulties gathering their own sustainability data, which comes from multiple departments within their own organisations.

“Each department within a financial institution, from portfolio management to risk management, has to become more focused on getting the ESG information and data required from within their respective departments,” says Wood. “There is a huge amount of data involved, which calls for a massive collaborative effort between these departments, which are not always used to working together.”

Then comes the added challenge of gathering data on, and reporting on, the ESG credentials of the companies financial institutions have invested in.

“The new requirements even call for changes in risk management to deal with issues such as understanding how a company the financial institution invests in might be affected by climate change,” she says. “There is also transition risk – the risk involved when a financial institution moves investments made in one industry into another industry.”

Pooling together the vast amounts of ESG data required has not been made any easier by financial institutions’ reliance on disparate legacy systems.

“It has been very difficult to adjust legacy systems in time to bring in more data,” says Wood, “Financial institutions now have to bring in non-financial data on, for example, the carbon emissions of companies they have invested in and the cost of those emissions – this type of data has not been historically collected by financial institutions.”

She also points out that financial institutions are under significant pressure to prove both their ESG adherence and provide sustainability data to stakeholders such as shareholders and investors, as well as regulators.

“One of the biggest challenges financial institutions face is that more investors are now asking portfolio managers for sustainability data directly. Moreover, where a financial institution is giving advice on an investment product, it is obliged to ensure the suitability of the product for the investor based on that investor’s sustainability preferences,” says Wood.

“Investors are setting the parameters now.”

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