Exploring ESG’s impact on investment returns and financial disclosure of climate-related risks

This article is part two of a three part series on ESG in the insurance industry. Read part one here.

We previously defined ESG as the environmental, social and governance nonfinancial factors that are considered in the investment decision-making process and corporate strategy development. These factors are broad and include a range of financial risks and opportunities.

ESG environmental factors center around making socially responsible investment decisions in companies investing in and supporting environmentally friendly products and services. Greenhouse gases, renewable energy generation and usage, land and material resource use, water management and waste are most considered when investing. Social ESG factors center around human capital, child labor, working conditions and employee relations. Governance factors include decision-making actions and policies impacting the business, diversity of board composition, executive pay, financial statement and disclosure transparency, political lobbying and bribery and corruption.

Investors are increasingly seeking sustainable investment opportunities and analyzing a corporation’s ESG performance. Morgan Stanley’s Institute for Sustainable Investing identified four practical steps to guide the development of a sustainable investment strategy. It’s recommended that the strategy start by identifying and clarifying motivations to incorporate sustainable investing and developing an investment philosophy. Next, identify implementation approaches that reflect the investment philosophy that include screening investments, integration, themes, impact, and engagement. Then, define the investment strategy to apply the approach within the investment portfolio. Finally, design the operational model with the appropriate governance that supports implementation of the strategy.

ESG’s impact on valuation and performance is evidenced in ESG rated investments. According to Morgan Stanley’s Institute for Sustainable Investing, sustainable equity funds and sustainable taxable bond funds outperformed their traditional peer funds in 2020 at the height of the pandemic. Embedding ESG factors into investment decisions improves market sustainability, leads to better societal outcomes and has historically yielded above-market returns.

Corporate valuations and ESG ratings are becoming top of mind for management teams and boards when considering their capital raising and investment strategy. It’s also affecting their response to shareholder activism and their formulations for executive compensation. ESG ratings typically use quantitative data and qualitative analysis, and the resulting scores quantify environmental risks and measures long-term exposure to those risks. Good ESG rating scores, based on a rating agencies’ models, indicate low risks. Ratings should be reviewed relative to the industry and rating agencies’ methodologies. Ratings differ though, as agencies use various methodologies, criteria and factors to assess performance within ESG factors.

One major risk factor impacts all pillars of ESG: climate change. Climate change naturally falls in the environmental pillar; however, it also impacts social and governance pillars. Transitioning to low-carbon emissions and management’s attitude toward aligning climate outcomes are relevant risk factors, as well. The geographic location of an organization, products and lines of business, and operations each have financial climate risk implications.

Managing and assessing financial risks associated with climate change has become a top priority of the National Association of Insurance Commissioners (“NAIC”). To promote uniformity in filing and regulatory requirements, on March 21, 2022, the NAIC’s Climate and Resiliency (EX) Task Force adopted the revised NAIC Climate Risk Disclosure Survey. The survey is a non-confidential, voluntary risk management tool designed to assist regulators in reviewing an insurer’s self-assessment of their climate-related risks that attempts to build upon the four elements of the Task Force on Climate-Related Financial Disclosure (TCFD) to align climate risk frameworks. The four core elements include risk management, governance, strategy, and metrics and targets. Insurers are expected to describe financial impacts and implications on business operations in these core elements when assessing climate-related risks. The NAIC set an expectation of 2023 for insurers to address the survey.

Also on March 21, 2022, the SEC issued proposed rules to enhance and standardize climate-related disclosures for investors. “The rule changes would require registrants to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements.” This rule establishes “consistent and clear disclosures for climate-related risks relating to governance; identification of risks and the material impact on business and financial statements; the effect of climate-related risks on strategy, business model, and outlook; and the impact of events and transition on financial statement line items.”

Have you established processes and procedures to assess ESG risks and climate-related risks to determine appropriate financial disclosures? ESG frameworks and financial disclosures will continue to evolve as regulatory requirements are expected to be implemented within the next 2-3 years. Investors, customers, regulators and other stakeholders are pushing for more information around sustainable investing and data that measures ESG risks and opportunities. Are you prepared to implement the recommended ESG disclosure surveys?

This article is part two of a three part series on ESG in the insurance industry. Read part one here. Stay tuned for the last post in this series on ESG where we will discuss its impact on other corporate decision-making processes.

For more information on these topics, or to learn how Baker Tilly’s insurance industry Value Architects™ can help, contact our team.