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The governance of sustainability in large global banks

A report exploring the sustainability progress of 30 European and North American banks shows a need for renewed focus on strategy and risk management. By Stilpon Nestor, Darya Vinogradov-Wouters and Jacob Nolan of Morrow Sodali.
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Banks are at the heart of the global economy as a prime allocator of capital across all economic sectors. They make decisions of systemic importance regarding the kind of growth that is supported by the capital they allocate. Therefore, they have a pivotal role in promoting sustainability across most sectors of the economy. 

In view of their importance, Nestor Advisors examined the governance of sustainability in 30 large European and North American banks. Below we discuss the key findings of this report, which explores how these banks populate, organise and engage their board on sustainability matters, how they deploy reporting lines and decision-making authority, and how they engage with various stakeholders. 

Most importantly, we examine how they integrate sustainability into their strategy, risk appetite/management, and compensation framework.

Strategies

Investors, several firms, and even some capital market (albeit not banking) regulators use the broad category of ESG (environmental, social and governance) to discuss sustainability issues, which we believe to be unhelpful. Its enormous breadth and the lumping of the strategic ‘E&S’ with the organisational ‘G’ encourages inconsistencies and increases greenwashing risk among the resulting noise. We define sustainability as the E&S – the strategic components of ESG. 

A key and recurring theme is that particular stages of ‘sustainability maturity’ in a financial organisation require different governance solutions and result in different governance outcomes. Therefore, directors need to focus on where they are in this spectrum and implement change as they ‘surf along the curve’. Sustainable banking is a journey and its governance is an evolving process.

We identify three drivers of the sustainability agenda in banks: institutional investors, regulators, and the firms themselves. Interestingly, investors seem to play a more significant role in North America while regulation and supervisory expectations are more important drivers in Europe. In the UK, both investors and regulators lead the drive for sustainability in banking. 

Ideally, a sustainability strategy is integrated into the firm’s overall business strategy at every level: purpose and vision, a multi-year business plan, annual objectives of each business and function, and capital allocation. The degree of integration differs according to the positioning of the bank in the maturity spectrum. 

Early on, banks adopt standalone sustainability strategies which are often aspirational in nature and focused on the impact of the institution’s own operations, rather than hardwired to business and risk objectives, cascaded to individual businesses, and informing senior management incentives. As sustainability becomes more embedded in the organisation, there is more strategic integration in the latter areas. 

Risk management

The management of climate-related risks should start with a materiality assessment. However, we found materiality analyses to be generic and broad. Their utility to identify risk is limited and comes with a lot of noise, often lacking prioritisation.

When it comes to risk management, few banks have reached the maturity stage where sustainability aspects are fully integrated into their internal credit ratings – or market and operational risk frameworks. Many of our interlocutors felt that the journey here is just beginning. 

Only 13% of the peers disclose that they include E&S risks other than climate into their formal risk management framework – banks’ and regulators’ focus is predominantly on climate risk. 

Sustainability-literate boards

Best practice boards should look for ‘sustainability literacy’ among their members, instead of appointing E&S ‘experts’ as members. We define sustainability-literate directors as ones that have had significant exposure to E&S challenges during their career as financial, industry, non-governmental organisation (NGO) or academic leaders. According to our own definition of ‘sustainability literacy’, 24% of peer board members fit the bill. 

It is interesting to note that sustainability-literate directors in North America are much more likely to have worked as senior executives in sensitive sectors (59% vs 40% in Europe) whereas, in Europe, literacy stems more from non-business experience in charitable, NGO, policy, or academic sectors (64% vs 41% in North America).

The most common approach to structuring the oversight of sustainability at board level is the creation of an ad hoc board committee on sustainability: 46% of the banks surveyed have established one. It is, however, important to note that the more mature banks prefer to make sustainability a whole board affair, like strategy – 60% of the better performing banks chose the ‘whole board’ approach.

We believe that the establishment of a standalone committee is often the starting point in developing a more comprehensive sustainability risk and strategy perspective. As banks move along the maturity spectrum, the heavy lifting is assumed by management while boards allocate sustainability mandates across existing workstreams and committees.

Senior management

Senior executive organisation on sustainability matters is critical. The transversality of the issues, their novelty, and a certain conceptual distance from the mainstream banking business – mostly a transactional affair – dictate an organisational approach that is (a) broad in its reach, transcending organisational pyramids and silos, and (b) top-down so that it can convey gravitas and the importance of the whole E&S transformation process.

The most common approach is to establish a senior management committee chaired by an executive committee member – in 56% of cases, the CEO. This approach was followed by 54% of peer banks, and 60% of the better-performing ones. 

Ninety-three per cent of peer banks have appointed a head of sustainability (HoS) at group level or equivalent. The HoS’s principal task is coordination across businesses and functions while also having significant input (often, the initiative) in the development of a sustainability strategy – especially in the early stages of the journey. 

Remuneration and incentives

Sustainability was a factor in determining variable executive remuneration in 83% of peer banks – more so among European than North American banks. While Scope 3 climate metrics constitute by far the most impactful area for banks in sustainability, most banks do not currently set compensation-related targets directly linked to such emissions. The average weight of E&S among the factors that determine total variable remuneration is 17%, with more mature banks averaging 22.5%. 

Sustainability is almost by definition a long-term objective but, counter-intuitively, short-term incentive plans are the most popular framework for sustainability-linked key performance indicators, with 80% of peers following this approach.

Reporting

Reporting on sustainability has reached prodigious volumes among peer banks, with the average number of pages in a sustainability report reaching 115. Interestingly, less mature banks publish the largest reports, averaging 142 pages. But volume does not necessarily translate into relevance. The noise might be distracting, making performance-tracking and compensation arrangements related to sustainability non-transparent. 

The lack of standardisation of reporting systems is a significant problem for all market players and explains the multiple standards employed, possibly also contributing to reporting length.

To conclude

Overall, global banks have made significant progress in the sustainability arena. These issues are among the most often debated by boards these days. They are also a top subject in bank director development workshops. Nevertheless, the journey towards sustainability maturity is, for most, only beginning. Boards and management need to systematically focus and measure their efforts toward sustainability readiness in every area, especially strategy development and risk management.

 

Stilpon Nestor is a senior advisor and Darya Vinogradov-Wouters and Jacob Nolan are analysts at strategic advisory Morrow Sodali.

 

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Read more about:  ESG & sustainability , Governance