How Climate Became a Top Priority of Financial Regulators

Financial regulators all across the world are increasingly focusing on climate-related regulations. This focus will necessitate new regulatory standards, processes, risk models, and modifications to risk management frameworks used throughout the financial sector. Recent developments show that this change is not temporary – the steps being taken may change the financial sector at a structural level. These changes will have a significant impact on risk and compliance domains in financial organizations.

Recent Developments

Many recent developments in the government and different regulatory agencies have prompted the increased focus and attention on climate-related risks to the financial sector. The first development is Treasury Secretary Janet Yellen’s announcement that the Treasury will create a Climate Czar position. The new role would be a permanent change to the Treasury’s hierarchy – signifying how important the federal government thinks climate will be for managing the financial industry over the next few decades.

Another significant development demonstrating the success of climate measures is the Federal Reserve Board’s official announcement that it would join NGFS in December 2020. The NGFS (Network of central banks and supervisors for Greening the Financial System) already included over 80 financial supervisors and central banks worldwide.

President Biden also recently issued a new executive order addressing climate risks and clarifying the regulatory actions the government intends to take concerning ESG. Everyone in the financial sector concerned about the future structure of regulations should study the executive order in its entirety. The executive order is broken into six sections, each addressing a distinct area of financial regulations related to environmental sustainability.

The Rise of ESG

These developments have resulted in ESG (Environmental, Social, and Corporate Governance) becoming a prominent topic of conversation in the business world. With good cause, ESG is not a passing trend or a collection of buzzwords that will fade away in a few years. ESG represents a paradigm shift in how businesses are governed and controlled. It can potentially disrupt numerous established business assessments and necessitate the development of new risk and compliance frameworks. As a result, it is critical for anyone working in the compliance and risk arena to grasp ESG and why it has gained such popularity.

The increased adoption of ESG principles – which focus on assessing the true impact of a business on the external environment – means businesses need to be ready to manage new ESG related risks and ensure compliance with rules created from an ESG perspective. ESG is just an umbrella term for the different ideas, strategies, and policies that focus on developing regulatory frameworks that result in a better environment.

ESG will change not just the way the financial world operates but also the way businesses are assessed and valued across the industry. This change will have significant ramifications both of a positive and a negative nature to different firms. Businesses with many negative environmental externalities such as pollution will now see their assessments factoring in the pollution instead of simply focusing on their profits and losses. This is intentional, designed to ensure that more investment is available to businesses that promise better outcomes. Instead of merely creating new laws and making it illegal to do business in the old ways, the government is trying to incentivize investments in greener businesses.

This development will directly affect the financial industry. There are many proposals for creating disclosure laws that will force investment houses and similar financial entities to disclose their investments in environmentally problematic areas such as fossil fuels. Again, instead of simply banning such investments, the government gives people more information and allows them to make their own choices.

The reason that ESG Has not faced many backlashes and has not been politicized is simple; it operates on logic. If there is a factory that creates a large amount of pollution, then someone will pay the price for their pollution. If the pollution is not managed, it will damage the area, resulting in decreased economic output over the next few decades, which is a significant loss. If the pollution is collected and cleaned up by someone else, there will be a high cost for the cleaning operation. What EGS does is that it factors these costs into the business’s current assessment, thereby increasing the accuracy of the value of the business.

Risk and compliance technology will play an essential role in helping businesses evaluate the impact of such regulations and how they will affect policies, processes, disclosures, and much more. Interested in seeing how your organization can automate the detection of emerging risks and create a proactive compliance framework? Get in touch with our experts to see Predict360 in action, the American Bankers Association endorsed solution for risk and compliance management.