ESG: Rising to the climate challenge
The impact of environmental, social and governance issues is ramping up the pressure on insurers, says Willis Towers Watson
BY: Adhiraj Maitra, director at Willis Towers Watson, and Gareth Sutcliffe, head of the Insurance Investment Solutions Group at Willis Towers Watson
In 2020, environmental threats dominated issues on senior leaders’ agendas for the first time in the history of the World Economic Forum’s (WEF) Global Risk Report. Climate considerations, while naturally and closely aligned with the ‘E’ of ESG (environmental, social, governance) approaches, will increasingly need to straddle insurers’ broader ESG thinking and policies.
The WEF report headline alone is a further sign that the global challenge of achieving a just and orderly transition to a low carbon, climate-resilient economy dictates that climate considerations are pivotal to mainstream financial decision-making across the public and private sectors.
And as climate change has shifted from being seen as ‘society’s problem’, or perhaps a moral issue, financial services businesses, including insurers, have very quickly found themselves thrust into the role of corporate catalysts for change as part of a wider ESG agenda.
From the types of policies and sectors insurers underwrite, to how they make investment returns, how resilient the business itself is to physical, transition and liability risks, how they assess and disclose climate risks, how they reward people, and their attractiveness and fairness as an employer – all increasingly are viewed by stakeholders through a climate lens. And all are becoming crucial factors in the wider ESG rating an insurer can achieve.
Plenty of sticks - but carrots too
What this all means is that if your senior executives haven’t been pressed about your company performance through a climate-focused ESG lens already, then rest assured it is coming - and coming soon.
Indeed, it’s likely that money will increasingly follow those companies with the highest proven ESG credentials, as recognition of the systemic nature of issues such as climate change and a plan to manage them increasingly become key indicators of appropriate risk management and investment worthiness.
Indeed, events that would have seemed unimaginable only a few years ago, such as the chairman and CEO of BlackRock discussing climate risk and referring to a fundamental reshaping of finance, are now becoming the norm.
In July 2020, BlackRock announced in a report on sustainability that it had identified 244 companies that were making insufficient progress on climate risk. 53 had voting action taken against them on climate issues, and 191 were warned they would risk voting action against management in 2021 if they did not make significant progress.
2020 was a particularly active year for climate-related announcements affecting the UK insurance sector, the latest being in November, when the UK joint regulator and government Taskforce for Climate-related Financial Disclosures (TCFD) published an interim report and accompanying roadmap signalling the intention to make TCFD-aligned disclosures mandatory across the economy by 2025, with a significant portion of mandatory requirements in place by 2023.
Looking ahead, there is the upcoming UN Climate Change Conference COP26 meeting, held over from last year, at which international pressure for action on reducing carbon emissions is expected to further grow.
Meanwhile, initiatives such as the Coalition for Climate Resilient Investment, which has the backing of major financial institutions around the world, are taking aim at the pricing of climate risks and climate resilience in investment decision making.
Add to this evolving landscape the idea that Covid-19 may accelerate the broader appetite towards ESG as financial markets look to build resilience to systemic risks, and there is an even stronger case for enhancing ESG response.
Doing nothing is therefore not a viable option. But it’s not all a matter of compliance and enforcement ‘sticks’.
From an investment point of view, for example, there is already substantial evidence of the risk-adjusted return benefits of more sustainable portfolios. Many studies rightly focus on the long term, but there has also been no shortage of headlines highlighting how well ESG-orientated strategies have performed in recent years and during the current pandemic too.
More broadly, there’s a strong argument that companies that embrace ESG, including the climate aspects of it, will be better prepared for the likes of mandatory climate disclosures in due course and reap the financial and reputational benefits in the meantime.
The current ESG landscape
As the worlds of ESG, climate science and finance have come together in recent years, a new language of climate-related financial risk and disclosure has developed.
A framework based on physical, transition, and liability financial risks from climate change, as first set out in a report by the Bank of England in 2015, has become the common climate dictionary.
Physical risks are the direct risks to infrastructure, premises and supply chains that arise from extreme and adverse weather and the economic losses that result. This is where the use of the IPCC scenarios is incredibly useful because they give an evidence-based frame to consider possible futures for risk assessment, asset management and capital expenditure.
Transition risks are the legal, technology, market and reputation costs linked to how organisations adapt, and the speed at which they adapt, to lower carbon and climate resilient economies - such as a shift to alternative sources of energy or more sustainable forms of transport.
Liability risks are the legal costs and damages that result from failing to meet responsibilities for climate risks. These risks could arise from a failure to adapt, mitigate or disclose the financial risks from climate change.
In many ways, these risks are not new per se; they translate into existing categories of financial risk such as credit, market, business, operation and legal risks that insurers have been managing effectively for many years.
But as new sources of financial risk, they do present new challenges, not least the need for more extensive modelling of the natural world and developing a much more granular understanding of the transition to a ‘net zero’ future.
There is no off-the-shelf solution to tackling these challenges. To respond effectively to the various drivers for action - be they from regulation, investors, employees or consumer activism - organisations will need to act in several areas: assessment and quantification of climate risks and opportunities; transition and resilience planning; financial reporting and disclosure; investment and underwriting strategy and its implementation; budgeting and capital management; risk hedging and transfer; and human capital.
Reflecting this diversity of drivers, responding effectively and taking a strategic approach will need to be truly multi-dimensional in nature and will require solutions to managing people, policy, risk and capital that not only continues to create opportunities to make future profits but also which mitigates against activities and events that could have a detrimental effect on reputation and value – or even the sustainability of a business.
For most organisations, an essential first step will be to quantify how they will be affected by, and can affect, the climate change trajectory. As our recent TCFD readiness survey showed, the biggest obstacles that most companies, including those in the financial sector, seem likely to face revolve around climate-related data, analytics and metrics selection in order to understand and report on their position.
Even where insurers are perhaps comfortable with their natural catastrophe modelling capability, the need to develop transition scenarios based on longer-term climate projections will pose completely different challenges. It’s likely to be one of many as climate change continues to test insurers’ full range of ESG credentials in the years to come.