We live in a world where environmental, social, and governance (ESG) issues are almost impossible to ignore. Whether it’s because of rapid changes in these 3 areas, heightened awareness, or the Covid-19 pandemic, ESG is now a ubiquitous talking point even within corporate boardrooms. Investors too aren’t too far behind on this trend. In 2021, sustainable funds, which invest based on ESG principles, attracted a record $70 billion in net flows, an increase of around 35% from 2020.
What’s more, the number of sustainable funds and ETFs on the market also ballooned by 70%. So, is sustainable or ESG-based investing just a passing trend or the future of investing? More importantly, if you are a lender or investor, should you care about it? That’s just what this blog attempts to answer.
What is ESG?
Rising sea levels, climate change, employee discrimination, racial or gender inequality, corporate fraud – chances are that you’ve come across one or more of these terms recently. The rise of global movements such as Occupy Wall Street, #Metoo, Black Lives Matter, Farm to Table, and Fair-Trade movements have been successful in etching environmental and societal issues into our collective consciousness. And let’s not forget the Covid-19 pandemic. The worldwide health crisis proved that global disruption is not some dystopian future possibility but a very present-day risk in our interconnected ecosystem. All of this has forced investors to consider the impact of their investments and prioritize long-term sustainability more. This is where ESG comes into the picture. It provides a set of benchmarks or standards that lenders and investors can use to identify more socially conscious companies to align with. Here’s a breakdown of its components:
E – Environmental
Environmental standards measure the direct and indirect impact a company has on the environment. In other words, it measures a company’s carbon footprint. These benchmarks can also be used to evaluate the possible environmental issues a business or industry might face and the steps taken to mitigate these. Some examples of environmental criteria are:
Greenhouse gas emissions
Water and energy consumption
Utilization of renewable energy
Compliance with environmental regulations
S – Social
Social standards focus on the effect a company has on society. It evaluates how a company handles its day-to-day business operations and treats its employees and customers. Some examples of social criteria are:
Employee working conditions
Workforce diversity and equal opportunity practices
Community support and relations
G – Governance
Governance criteria assess a business’s corporate governance policies. It basically puts a company’s internal regulations and practices under the scanner. Some examples of governance criteria are a company’s:
Code of conduct
Transparency, disclosure, and conflict of interest policies
Board member diversity
The past and present ESG landscape
The concept of ESG-based lending and investing has been around for decades. A prime example of this is the 1980s global protest movement to divest from apartheid South Africa. The movement saw corporates, universities, and several US states either cut ties with South Africa or divest their portfolio of companies doing business in South Africa. The economic squeeze resulting from these divestment actions is widely credited to be the driving force that brought the apartheid system down. The 1990s and 2000s saw several ESG frameworks coming to the fore such as the Triple Bottom Line and the United Nations’ Principles for Responsible Investment (UNPRI).
None of these were mandatory, however, and most companies paid attention to these frameworks in name only. As a result, ESG implementation was more of an afterthought, something that companies included only to win moral accolades and tick off a few virtue boxes. Some companies went so far as to indulge in greenwashing - a practice where businesses market themselves as environmentally friendly even when they are not. An infamous example of this is Volkswagen, which ran marketing campaigns that touted its vehicle’s eco-friendly status. In reality, it was fabricating emission test results using sophisticated software instead.
Today, while a lot of companies, including financial institutions, still indulge in greenwashing, the changing risk landscape has ensured that ESG is no longer just a footnote in financing. Economic disasters such as the 2008 financial crisis and the recent pandemic-induced shutdowns have brought third-party risks to the fore. What’s more, ESG-based investments have managed to shrug off their negative reputation of limiting an investor’s profits (more on that in the next section). Consequently, investor participation in sustainable financing is increasing, a trend that is likely to keep growing. Here are a few data points that reflect this:
The number of signatories for the UNPRI has grown from 100 to nearly 5000, an above 40-fold increase
In 2020, ESG criteria were used to choose over $17 trillion in US assets
Sustainability-linked loans have grown over 300% in the last decade or so
Similarly, sustainable or green bonds grew 20 fold to touch $1 trillion in value in 2021
At present, over 90% of banks and insurers monitor ESG
According to a report by GSI Alliance, over 94% of all assets will include ESG criteria by 2030
That said, there is still a lot of scope for improvement, particularly among Private Equity (PE) firms. PE firms account for only around 800 of the 4500 plus signatories on the UNPRI list. Of these, only 50% use ESG criteria to monitor over 90% of their portfolio and only 16 PE signatories disclose the impact of including ESG on their financial returns. In North America, only less than half of the top 20 institutional investors have committed to following an ESG framework. So, there is still a lot of room for growth in this sector.
Should investors/lenders consider ESG?
Now we come to the million-dollar question: Should investors and lenders consider ESG principles while making business decisions? The simple answer is yes. It goes
without saying that ESG factors can’t be the only guideline you use while making financing decisions. However, with the growing emphasis on renewable energy and sustainability, it makes good business sense to include them. Here are a few tangible reasons to do so:
In years past, financiers believed that indulging in ESG-based financing meant forfeiting a part of their profits. This isn’t necessarily the case anymore. There are several studies that show just the opposite. A 2017 Bank of America Merrill Lynch study found that companies with a good ESG track record produced better 3-year returns than those that don’t. Importantly, such companies were also less likely to go bankrupt. Another study by Nordea showed that companies with high ESG ratings outperformed their lower-rated counterparts by as much as 40%. In 2020, an analysis of over 3000 mutual funds and ETFs conducted by Morgan Stanley found that ESG-based funds outperformed traditional funds by over 4%. Of course, only time and more research can truly validate these findings. But it just shows that profits and moral due diligence can go hand in hand.
ESG risks are on the rise. Two decades ago, ESG-related risks such as cyber-attacks, data theft, pandemics, or extreme weather events were fringe risks that no one paid much attention to. Today, such risks feature in 8 of the top 10 risks according to the Global Risks Report 2022. In addition, ESG factors can also act as early warning indicators for future business defaults. And sustainability-driven companies show better performance with key financial metrics such as return on equity, risk-adjusted returns, and sales growth. Given all this, it makes practical sense to include ESG in your financing decisions and your risk monitoring practices.
Reputational and moral returns
It’s no secret that ESG-related disasters can spell financial and reputational trouble for companies. A case in point is the infamous BP oil spill in 2010 that cost the company over $60 billion in cleanup costs, legal fees, fines, and reputational sales losses. The opposite is also true. A study by Unilever found that a third of consumers now buy from brands that have established sustainability and eco-friendly credentials. Consumers and stakeholders alike are now more conscious of their moral obligations and their impact on the planet. And one way for them to fulfill these responsibilities is by aligning with companies that perform their fiduciary duties well.
Along with the reputational and moral bragging rights that come with it, incorporating ESG into your financing also has regulatory benefits. Regulatory pressure in this department is on the rise. The EU-mandated SFDR (Sustainable Finance Disclosure Regulation) that came into effect in 2021 is just one of several new regulations that aim at improving sustainable financing and reducing greenwashing. In the US, the SEC recently put forward a proposal to mandate corporate ESG disclosures. This would make it easier for investors to include ESG data in their assessments.
How to include ESG in your portfolio/investment monitoring and decision making
There are several methods you can use to make your loan/investment portfolio more ESG friendly. Some of the these are:
Exclusionary screening – Also known as value-based screening, this method focuses on excluding companies and even entire sectors that go against your company’s or stockholder’s values and morals. Common exclusionary screens include tobacco, alcohol, gambling, fossil fuels, and nuclear power.
Best-in-class selection – This strategy involves aligning only with companies that have the best ESG record in their sector. Also known as the positive selection, the best-in-class methodology is a good workaround for financiers who want the best of both worlds – financial and moral.
Active ownership – As the name suggests, active ownership involves using your ownership rights to be a catalyst for positive change in the companies you invest in. This may mean holding your counterparties accountable to ESG standards or entering into a dialogue with them about initiating or revising their sustainable practices. An example of active ownership in action occurred in March 2021 when pressure from institutional investors caused British grocery chain Tesco to commit to increasing sales of healthy products and reformulating its existing product line to make it healthier. There are now organizations such as ‘As You Sow’ that help shareholders leverage their ownership to promote better corporate ESG health.
ESG monitoring – ESG inclusion in portfolio management can only be complete when you incorporate it into your portfolio monitoring as well. Given that sustainability risks can evolve rapidly (as witnessed by the Covid-19 pandemic) and that ESG metrics have a predictive quality to them, integrating them into your risk monitoring practices is as vital as your initial due diligence. This will allow you to quickly identify emerging ESG-related risks and trends. And the sooner you identify these, the better you can minimize the fallout from them.
How TRaiCE can help
When it comes to risk monitoring, ESG, or otherwise, timely data is of the essence. Relying only on historical information leads to uninformed decision-making. In addition, analyzing ESG data essentially means analyzing non-financial data. The good news is that today, there is plenty of timely non-financial data available in the digital world. The bad news, however, is that it is vast, unstructured, and notoriously hard to measure. This is what makes ESG monitoring such a laborious task. TRaiCE overcomes these common hurdles with its ability to gather, process, and quantify vast amounts of digital data, giving financiers the ability to incorporate financial and ESG metrics into their decision-making. In addition, the platform has an Early Warning System that can be customized to deect sustainability-related red flags for better ESG risk detection and analysis. The TRaiCE team is also working on creating a sustainability index that financiers can use to gauge the ESG compatibility of the companies they want to invest in or lend to. So, watch out for that!
Financial institutions and institutional investors have an active role to play in making the world a better place. Financial inclusion and responsible financing are two ways to do just that. Today, including ESG criteria is not just a trendy undertaking but an essential practice both in terms of business risk and opportunity. With governments, customers, and stakeholders clamoring for change, it could even prove to be a competitive advantage for you to do so. This will however require that you invest in intelligent systems that can access and keep track of all the changes happening in the world of sustainable finance.