Sustainable finance - a steep learning curve

Back in June as thoughts started to turn to recovery, Christine Lagarde, president of the European Central Bank (ECB), spoke on the path out of uncertainty and urged policymakers ?not to let this crisis go to waste? as she looked ahead to a 'stronger and greener? society post-pandemic.

The financial sector has just endured one of the most extraordinary periods in living memory. But far from placing sustainable finance to one side, as governments and regulators start to refocus on the future rather than immediate crisis response measures they are embracing it with renewed vigour.

Covid-19 as a catalyst

Climate risk and pandemics act as similar shocks to the financial system. The last six months have highlighted that business sectors are deeply interconnected across borders, that societies of all types and wealth levels are vulnerable, and that the environment is under increasing strain. There is momentum to change the financial services landscape for the better. However, firms need to balance improving their ESG (environmental, social, governance) credentials with the need to survive the impacts of the crisis and manage issues such as credit risk, cost reduction and consolidation.

The search for consistency

Without consistent definition and disclosures, it is difficult for firms to determine the data required to measure ESG risks and exposures or to satisfy reporting and disclosure requirements. Global regulatory bodies have raised concerns about the diverse range of sustainability standards and are calling for consistency.

The EU is the first jurisdiction to enshrine in law a definition of ?E?. For UK-based groups there will be a tension between needing to comply with EU rules and between following the UK's guidance-based approach, which will play out in corporate reporting and disclosures to customers.

Focus on climate risk

The potential financial impacts of climate risk are in sharp focus. Banks are being asked to pay greater attention to climate-related risks within their risk frameworks and stress testing.

Firms and regulators are aware of the significant challenges involved. Quantification of climate risk is complex due to the longer than usual time horizons involved, and methodologies and tools to estimate scale and impact are still evolving.

The scope and breadth of stress tests will undoubtedly be challenging, especially for firms who have not yet begun to assess their exposures. Engagement with key counterparties, focus on gathering better data and creating reasonable assumptions and development of clear and appropriate risk governance practices will be good starting points.

A strategic approach

If this pandemic has taught us anything, it is that sustainability should be at the heart of business models and strategy. Some of the deadlines may seem far off and the underlying details still uncertain but it is essential that firms start now. 

There is no doubt that sustainable finance presents a sharp learning curve for firms, and that there will be many challenges along the way. However, as Sarah Breeden, the Bank of England's executive sponsor for work on climate change, made clear in her July speech, ?imperfection is not an excuse for inaction?.