5th April 2023

ESG as a professional risk

Posted by: Edward Pring

An overview

Environmental Social Governance (ESG) is effectively a framework used to measure the impact a business has on society generally, the environment and how accountable that business is for its actions. The environmental angle is at the forefront of the debate today, with institutions increasingly in the spotlight for actual or alleged failures to comply with external rules and regulations, or by their own strategy.

In respect of the Financial Institutions space, exposure to ESG risks may be overlooked as firms in this space may not be in breach as a first party. However, where a firm chooses to invest third party assets this must also be a consideration. There is growing demand from global investors for transparency and action on the matter, a recent study finding that 75% of investors surveyed think ESG issues should be at the forefront of a company’s business strategy, irrespective of whether to do so may adversely impact that business’s profitability. An even greater percentage of global investors admit that how a business manages its ESG exposure is a key factor in deciding whether to place their finances with them¹.

ESG and Financial Institutions

The UK’s regulatory landscape in respect of ESG risk is tied closely with the regulatory landscape in Europe but the two are not mutually exclusive and in some regard the bar set in the UK is higher than that set by our European counterparts. The UK plans to reach 'net zero' by the year 2050² and although this is very much a base target, it is important firms with stakeholders, shareholders and/or other activities in both the UK and EU are informed of, and compliant with the ever-evolving regulatory landscape aimed at enhancing sustainability and transparency around sustainable investing. The Financial Conduct Authority (FCA) has recently published the findings of its three month consultation in a report, outlining the potential exposures and framework of the latest ESG centred regulatory regime³.

Transparency is a principle that is entrenched within the FCA’s modus operandi, and the proposed Sustainability Disclosure Requirements are designed to make it more difficult for a firm to make “exaggerated or misleading sustainability claims about their investment products” – known as Greenwashing – in turn, increasing transparency⁴. The FCA’s recently released letter entitled ‘Our Asset Management Supervision Strategy’ outlines the potential effects on investor confidence of misleading or inaccurate information and how Asset Managers should review their ESG oversight practices prior to their first Task Force on Climate-related Financial Disclosures (TCFD)⁵. Although there are polarised views as to whether this regulation is fully sufficient in its current form, the UK Sustainable Investment & Finance Association (business members of whom account for some USD20tn is assets) deem the proposed UK regulations to be on par with the regulation current in the EU^6.

Firms with dealings (either directly or indirectly) in the EU will be aware that such regulation is regularly reviewed and a genuine or perceived failure to comply could be deemed a severe regulatory breach. On the 5th January 2023, the Corporate Sustainability Reporting Directive (CSRD) came into force, strengthening the rules about the social and environmental information that companies have to report and now impacts around 50,000 EU businesses (or UK businesses with a EU presence)⁷.

Following the roll out of enhanced requirements of the Sustainable Finance Disclosure Regulation (SFDR), a number of the larger asset managers saw their fund class downgraded from Article 9 to Article 8. Previously to be classed as an Article 9 fund, 80-90% of the fund securities had to be fully sustainable, whereas SFDR now stipulates 100% of the investments need to be fully sustainable. BlackRock, BNP Paribas and Goldman were among a host of firms affected by the new requirement, with an associated GBP103bn+ of assets⁸.

How the insurance market is responding

The growing popularity of ESG investment and expectation for firms to be accountable for their actions and investments presents a number of exposures from an insurers point of view. The insurance market itself has not been exempt, being under scrutiny to take a stance against firms who openly insure non-ESG sectors. The Lloyd’s Market began to cease its insurance of businesses involved in the coal and oil sands sector in 2020 where they derived >30% of their income from such activities⁹.

We are also beginning to see insurers providing specific supporting capacity to risks that stand up well against ESG metrics. COP27 saw progressive conversations from insurers around the idea of ‘parametric’ products as a solution to the increasing frequency and severity of losses resulting from extreme weather. These products would pay out an agreed figure as and when a certain trigger is pulled.

Some US commentators are estimating the value of current and forecast investment into essential tech and infrastructure to get us to Net Zero by 2050, at over GBP100 trillion. Insurance will pay a key part in managing the associated risks in a rapidly evolving landscape¹⁰.

Insurance products to reduce exposure

From our ongoing discussions with insurers on this matter it is clear that discomfort is borne out of a financial institution assuring a certain green or ESG focused investment strategy, without having the proper resources, personnel and systems to confirm it is carried out appropriately.

Claims can arise in a number of ways and, whilst policy wordings differ, most define certain terms in a similar way. The below table analyses at a high level where financial risk insurance products can offer risk management from an ESG perspective.

It is increasingly important to ensure your policy is adapted and modernised to consider regulatory changes and potential third-party liability. We welcome the opportunity to discuss the below and review existing policies to determine these necessities.

Wrongful Act means any actual or alleged:

Definition	Claim arising from	Coverage:
Misstatement	Client material was not checked adequately and contains false information relating to the firm's stance on ESG issues.	Provided it is proved not to have been intentional or fraudulent, a Professional Indemnity (PI) policy will cover the defence costs and subsequent settlement of a claim A lawsuit has recently been brought against BNP Paribas for “ignoring scientific truths”. It may well be the first “climate” lawsuit if its type against a commercial bank¹¹.
Misleading Statement	Client material suggests a firm’s investment strategy is more sustainable than it actually is.
Negligence	An advisor has given poor advice in respect of a business or investment's ESG credentials
Breach of any statute or law’ (including that if a regulatory body)	Investigation for a potential breach of the FCA’s ESG focussed regulation.	Policies are available that respond to both informal and formal enquiries from a regulatory body in relation to the activities of the business.
Breach of Duty	Third party liability of a director/board of directors in their role for a breach of the principles laid out to investors.	D&O insurance will protect the personal assets of the accused directors, paying their individual legal costs. ClientEarth, one of Shell’s shareholders, intends to bring a claim against Shells directors for failing to manage the “material and foreseeable” risks posed to the company by climate change¹².