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Turning the world from brown to green - the ESG revolution

Andrew Evans
23/03/2021
The financial services sector is changing. ESG, once seen as a very niche element in financial services, is becoming more prevalent as banks and other financial market participants feel the pressure from employees, customers, investors and regulators.
  

What is ESG?

Environmental, Social and (Corporate) Governance.

It refers to an organisation's commitment to do more than just make a profit and instead, to actively strive to contribute to the environment or social causes and to conduct themselves responsibly. ESG are the three central factors in organisations creating and maintaining long-term sustainable value that is measurable, and in the ethical impact of an investment in a company or a business.
 
 

How has it come about?

It has been growing in influence for many years, driven by the united demand from employees, investors and customers for companies to take more proactive steps against climate change and social injustice. The public is now requiring banks, pension funds and investment managers to invest their savings in sustainable options e.g. sustainable natural materials, water conservation, C02 reductions or in advancing social issues such as diversity in the workforce and leadership, human rights and poverty reduction; and to take positive action on corporate governance issues such as anti-corruption, capped executive compensation and board composition.

Environmental sustainability is extremely important to millennials and the generations that have followed. Consumers want to buy from responsible companies and employees want to work for them.
 

Why is it important?

ESG is important because there is now a groundswell of public opinion in favour of a greener and more environmentally sustainable economy and governments are taking notice and adopting green agendas.

For example, the 2030 Agenda for Sustainable Development adopted by all United Nations Member States in 2015, provides for a shared blueprint for peace and prosperity for people and the planet, now and into the future.

At its heart are the 17 Sustainable Development Goals which are an urgent call to action by all countries in a global partnership. The UK has agreed a legally binding commitment to deliver net-zero greenhouse gas emissions by 2050 with Scotland's target being 2045. In November 2018 the UK Government published a Ten Point Plan for a Green Industrial Revolution. The plan will mobilise £12 billion of government investment, and potentially three times as much from the private sector, to create and support 250,000 green jobs.

In this scenario companies are required to support public institutions, in order to accelerate sustainable development.

Banks are embracing ESG with Goldman Sachs committing to spend US$750 billion on sustainable finance over the next decade and Bank of America pledging US$300 billion to sustainable investments. Very senior decision makers made these commitments in these banks. Furthermore, one third of the largest banks globally have signed up to the Principles of Responsible Banking which sets out a framework for a sustainable banking system under which banks adopt a strategy and practice aligned with the vision society has set out for its future in the UN's Sustainable Development Goals and the Paris Climate Agreement.

It follows that companies, pension funds and banks can no longer afford to take a 'wait and see' approach. Banks and others need to consider the ESG expectations of their key stakeholders and understand what their regulatory and supervisory authorities might require by way of targets and expectations. Banks and other financial services firms need to embed ESG in their strategies.
 

The ESG Criteria

Let's examine the criteria in more detail.
 

Environmental Criteria

Here we are looking at a company's performance as a steward of nature, the environmental risks they face and how these are managed. The criteria might include: pollution, climate change, carbon emissions, energy efficiency, biodiversity, deforestation, resource scarcity and waste management.
 

Social Criteria

Used to examine how a company manages relationships with relevant stakeholders including local communities, supply chains, human resources and others, and their impact on communities, social criteria might include: human rights, community relations, gender and diversity, employee engagement, labour standards including health and safety, consumer safety and consumer satisfaction. For example, does the company ensure that its suppliers uphold the same values as it upholds? How does the company contribute to the local community, and does it encourage employees to perform voluntary work there? Do the company's working conditions show a high regard for employee's health and safety?
 

Governance

Governance covers such issues as executive pay, audits and shareholders' rights. This criteria includes board composition, executive compensation, audit committee structure, bribery and corruption, tax transparency, compliance, lobbying and whistle-blower schemes.

For example, investors might be concerned that the company uses transparent accounting methods and stakeholders are given the opportunity to vote on important issues, that conflicts of interest are avoided in the choice of board members, that political donations are not misused to obtain unduly favourable treatment and that the company does not engage in illegal or unethical practices.

No single company will meet all the criteria in every category, so each needs to decide what the most important criteria are and their priorities. This approach reinforces the sustainability strategic value for companies.

Investors might wish to limit their investment in companies involved in coal mining, nuclear power or weapons and avoid companies with recent controversies in the workplace involving discrimination, corporate governance or animal welfare. The benefit to investors in following ESG when making investments could include avoiding companies with risk factors such as BP's 2010 oil spill and VW's emissions scandal.
 

ESG Lending

Loans are a unique way for borrowers to demonstrate and communicate their commitment to sustainability.
ESG loans are typically loans where the margin is tied to the borrower meeting certain KPIs linked to ESG criteria. If the criteria is met the borrower receives a small discount to its loan pricing and, if it is not met, it is likely that a premium will be added.

The LSTA (Loan Syndications and Trading Association in the US), LMA (Loan Market Association) and APLMA (Asia Pacific Loan Market Association) published Sustainability Linked Loan Principles in March 2020. This comprises a high-level framework identifying four core components for ESG loans being:

1. The relationship of the sustainability performance targets to the borrower's overall strategy
2. How these targets are set
3. How information is reported on these targets
4. The recommendation for external review

To be successful, an ESG loan needs to fit into and complement a borrower's existing sustainability strategy. When structuring an ESG loan focus on the sustainability and performance targets is essential. They need to be identifiable, ambitious, meaningful to the borrower's business and readily measurable.

In the post covid world and once the banks have sorted out the transition from LIBOR, ESG will become increasingly important. One can expect to hear a lot more from regulators, oversight authorities and policy makers about the need for greater adoption of ESG. They already recognise that transitioning to a low carbon economy will create additional complex issues for financial services firms.

Supervisors and regulators are working collaboratively in groups on ESG. In 2017 the Network for Greening the Financial System (NGFS) was created, and now comprises 83 central banks and financial supervisors, which aims to accelerate the scaling up of green finance and develop recommendations for central banks' role for climate change. They are looking to share best practices around key systematic challenges e.g. integrating climate-related risks into financial monitoring and micro-supervision.

The Financial Conduct Authority (FCA) at the Green Summit in November 2020 outlined stricter rules on climate risk reporting to align with the recommendations of the global Taskforce on Climate–related Financial Disclosures (TCFD). From 2023, all premium listed UK companies will be required to comply or explain against the TCFD's requirements which are likely to be tightened further in 2025.

It is likely that investors will continue to ramp up pressure on banks to lend to sustainable activities as well as wishing to see a return on their investment. Interestingly ESG loans outperformed the market in the first quarter following the covid outbreak.

Banks are also starting to feel pressure from their customers and the public at large. Customers want to bank with bankers that reflect their views and beliefs. The younger generations, in particular, are said to be choosing where to bank based on ESG credentials.

Financial services companies including JP Morgan Chase, Wells Fargo and Goldman Sachs publish annual reports that contain a detailed review of their ESG approaches and bottom line results.

Banks face the challenge of transitioning to finance greener and more sustainable companies and investments, but this cannot be done overnight as their existing book of business will be tied significantly to 'brown assets'. Banks will need to find a balance between the duty to finance ESG green assets against their duty to shareholders to return a profit. Also, declining a loan to brown commerce could have adverse social consequences such as plant closure and unemployment.

Although covid has clearly slowed progress with ESG, it is clear that banks to continue to adopt the ESG agenda. New products are being developed and commercialised and wealth managers are looking at ESG-driven investing. Retail banks are developing new sustainable banking and investment products and services including green home-improvement loans and carbon neutral banking and sustainable exchange-traded funds. Capital markets are also looking at 'green underwriting'. Customers are already able to choose from a variety of ESG linked funds, bonds and assets.
 

Conclusion

The green industrial revolution is well on its way and banks, pension funds and investment managers need to embrace it. Post covid, ESG offers an exciting opportunity for the financial services industry to be part of a new vision where the sustainability of the planet, social fairness and good governance will be the guiding light.

 

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