The banking industry is waking up to the importance of meeting – and being seen to meet – environmental standards. But progress will be limited until universal definitions and standards can be agreed. Silvia Pavoni reports on the various initiatives in progress.
Studying a sustainability report is fascinating. Specialised rating agency Sustainalytics granted The Banker access to its analysis of a UK lender, in which indicators such as business ethics and the integration of environmental, social and governance (ESG) metrics in lending and investment decisions are assessed. The UK bank scored poorly on both. How would yours do?
Posing this question matters. Often viewed with scepticism or, worse, ridiculed as empty slogans, companies now ignore ESG considerations at their peril. Climate change, raw material scarcity, diversity and more generally a public push towards a fairer society are reshaping the rules of corporate success, and, therefore, what it means to sustain that success.
“Take the #MeToo movement, for example: 15 years ago people were concerned about [sexual harassment] but it wasn’t perceived to be material,” says Brace Young, partner at asset manager Arabesque and a former partner at Goldman Sachs. “Today it is influencing stock prices.” Arabesque captures non-financial information that may move markets and the company was set up with the idea that this type of data, traditionally not considered financial in nature, would not only contribute to incremental returns but also respond to investors’ desires to base their choices on ESG metrics or personal preferences.
Speaking out
While Mr Young stresses that Arabesque simply follows societal and market trends without judgement, other companies have used their assets under management to wield influence. In 2018, BlackRock chief executive Larry Fink grabbed headlines with his annual letter to CEOs, in which he noted that society expects companies to serve a social purpose, and that it is the firm’s fiduciary duty to encourage this by engaging with them over those goals and the companies’ longer term prospects.
The world’s largest asset manager has set up its own ESG research and sustainable investing products, and believes that over the next 10 years assets in exchange-traded funds that incorporate ESG factors will balloon from $25bn to an overall total of more than $400bn.
Intesa Sanpaolo is aiming to be a “world leader” in this space too, according to CEO Carlo Messina. The Italian bank’s focus on sustainability issues was inspired by the Ellen MacArthur Foundation, which promotes a move towards a circular economy that redesigns business models to remove waste, with the aim of reducing environmental impact and the use of raw materials. The bank started including social goals in its strategic plan in 2018 too. “You always have to remunerate shareholders appropriately but you also need to reward companies that are particularly active in this area [that have sustainable business models],” says Mr Messina.
But even when taken seriously, dealing with ESG can be confusing. Issues around data, metrics, disclosure standards and corporate processes are substantial challenges.
There are at least three fronts on which banks and other financial firms are having to fight to keep up with changing times: agreeing a common definition of sustainability; managing related risks; and rewarding behaviour and business models that have a positive impact.
Defining ‘green’
Sustainability is still a blurry concept. “What you should look at is the environment of the company [you’re working with]. If the environment changes, would the company adapt to that changing environment? That’s the question that you should ask,” says Denis Childs, head of positive impact finance at Société Générale and co-chair of the UN Environment Programme – Finance Initiative (UNEP FI) positive impact initiative.
To understand a company’s chances of long-term survival, let alone success, there is a widespread consensus that a common language is important. Loose definitions allow for ‘greenwashing’, a superficial dedication to sustainability goals that serves more as a marketing gimmick. A common language can also help harmonise methodologies to create a clearer picture.
“If you look at renewable energy and how much CO2 is avoided, you have many methodologies that lead to different results,” says Mr Childs. “It’s not that one methodology is better than another, but it’s difficult for governments and asset owners to understand exactly what is going on.”
The UNEP FI is working on that common language, mindful of the challenges in achieving the 17 UN Sustainable Development Goals (SDGs) set up in 2015 for 2030 and of the estimated $2500bn in financing needed annually to reach them.
In 2018 it launched consultations on a responsible banking initiative that will culminate in guidelines to be announced at the end of September 2019. Principles for Responsible Investment, an investor network the UN supports, has already created principles for the investment community and works with governments around the world to create regulation, codes of conduct and clarifications on what should be considered an ESG factor. The Global Reporting Initiative, another organisation in the UN’s orbit, has set up sustainability reporting standards that any company can adhere to.
Integration efforts
Possibly the most ambitious efforts in terms of a common taxonomy come from European legislators. The EU is looking to define and legislate what makes an economic activity sustainable as part of a wider sustainable finance action plan. This includes the creation of low-carbon and positive-carbon-impact benchmarks, and rules that will force institutional investors and asset managers to disclose how they integrate ESG factors in their risk processes.
The latter would really help to get the investment community serious about sustainability, according to Åse Bergstedt, chief sustainability officer at International, the private equity arm of Sweden’s Ikea group, and former head of sustainability at Nordea.
Mandated transparency is also widely seen as forcing a more professional approach to sustainability. Many may already be heading in the right direction but simply do not address issues as a matter of sustainability, according to Ms Bergstedt. Others believe they do but in fact have not reorganised jobs and processes to include ESG considerations.
“When the business strategy changes, so does my work,” says Ms Bergstedt. “I need to be senior enough that I report to the CEO of the company. In every business area you need to have an [ESG counterparty], like for compliance, otherwise [sustainability] can never be integrated.”
Others agree that forcing transparency can only be positive. The more relevant information the better, says Mr Young. “We had this debate [in the past] – should we have Generally Accepted Accounting Principles rules? Today it would be a ludicrous conversation. You should disclose what you have on your balance sheet and your income statement,” he says. Many believe the same should be true for ESG across industries, including financial services.
Banding together
As a company prepares to embrace ESG, it will inevitably come up against issues of data availability as well as quality, and the overall challenge of interpreting that data. Taxonomy efforts have so far focused on environmental factors rather than social ones and, according to Sustainalytics chief operating officer Bob Mann, the process of gathering and analysing information is somewhat expensive.
But there has been progress. To begin with, the simple fact that climate risks are accepted as financial risks is promising and can only indicate that research and analysis functions are moving in the right direction.
Indeed, climate change is now accepted as a source of financial risk to the point that some of the world’s largest central banks have joined forces to persuade the participants of the financial systems they oversee to take action. They too are offering guidance on getting it done.
The Network for Greening the Financial System (NGFS) is a group of 36 central banks that includes those of France, England and China. In its first report, published in April 2019, the group called for the creation of a taxonomy, as well as for action on climate risk.
“Climate risk is a source of financial risk, but only three or four years ago it was unheard of that central banks, particularly in this large group, would come to such a conclusion,” says Frank Elderson, chair of the NGFS and an executive director of the Dutch central bank’s supervisory board. He adds that such a statement is now as obvious as it is urgent. “Why do we think it is necessary to point that out? It is because we now understand the channels by which climate change and climate-related risk translate into financial risk,” he says.
These channels are physical, legal and transitional, and they all circle back to the financial system: from the rising number of insurance claims caused by extreme weather events, to class actions in the vein of litigation against tobacco firms, to rules introduced by governments to comply with the Paris Accord. In the Netherlands, Mr Elderson points out, a new law states that low-energy-efficiency buildings, rated D or below, will not be rentable from January 1, 2023, therefore if a bank has taken that building as collateral, inaction could lead to serious issues.
The Taskforce on Climate-related Financial Disclosures (TCFD) has also called for action on climate risk. Set up by the Financial Stability Board (FSB) in 2015, it has made great efforts to win consensus and signatories to its voluntary codes, which more than 580 companies have signed up to, including some 60 banks. As FSB chair, Bank of England governor Mark Carney has given stern warning against climate risks. TCFD chair Michael Bloomberg has also lent his public influence to the project.
Finding the upside
Assessing a bank’s sustainability is a particularly complex task.
“Data availability is poor and there’s no globally agreed methodology to calculate risk in financial institutions,” Arnaud Cohen Stuart, head of business ethics at ING, said in a previous interview with The Banker. “It is a challenge as we have lots of loans not only to stock-listed companies that may disclose their carbon footprint, but also to unlisted companies that do not disclose it.”
Sustainalytics’s Mr Mann recognises the challenge. “Depending on the business model, what you want is the exposure of their long-term portfolio to ESG [risks]: are they lending to [unsafe] dams? Are they lending to oil and gas?” he says. “The biggest difficulty we face is the complexity of the issue. It is not easy to roll [that information] up in simple metrics. It is not black and white, it is not a price-to-equity ratio.”
Banks, as opposed to asset managers, have broader considerations to deal with, agrees Mr Childs. But they have also been slower at looking at the positive side of ESG. While investment firms began looking at impact investing, lenders were beginning to look more selectively at which project to finance. The Equator Principles, launched in 2003, were meant to provide minimum due diligence standards and monitoring. Given the importance of risk management, Mr Childs believes that banks should put greater effort into supporting fresh ideas and new companies with positive impact.
“You want to focus on results and impact to create a common language, but you also want to look at untapped markets. This means not just understanding what is green or not green, it is also a matter of finding new business models,” he says. “In some ways asset managers were ahead of banks on the positive side [looking at climate change-related opportunities]; banks started with project finance and the Equator Principles and really focused on the negative side [on which projects to avoid].” Société Générale works with clients on new business models, he adds, and takes inspiration from pioneers in this area.
There are many interesting examples of this. Signify, formerly known as Philips Lighting, provides LED lighting for the streets of the US city of Huntington Beach in partnership with American Tower, a wireless infrastructure provider, which bought exclusive access to 200 existing lamp posts. These were transformed to be integrated with antennas to support mobile services, and can be used for applications such as 5G and the Internet of Things.
Mr Childs says that replacing street lighting with more efficient LED lighting can be very expensive for cash-strapped local administrations. But selling access to those spots solves the mayor’s budget issues while providing a better service to citizens and offering a business opportunity to lighting, wireless infrastructure and telecom operators alike. In the future, the lamp posts could also be used to monitor air pollution.
Scouting for and financially supporting companies that create this type of innovative solution and have a positive impact is important, for individual businesses so that their business models can have both impact and make a return, and for the wider community, as private sector money would fill the overwhelming global sustainable finance gap estimated by the UN. “If you say that companies should be in business for reasons other than profit, you may be right, but this may not raise those trillions of dollars you need [to meet the SDGs],” says Mr Childs.
Green bonds grow
There are other examples of how banks can support positive environmental impact. Through capital markets, banks can help channel funds to the most deserving companies. Green bonds issuances have grown to about $230bn in value, according to the Climate Bonds Initiative, and there are efforts to refine definitions too: the China Green Finance Committee and the European Investment Bank have joined forces to find a common taxonomy.
Capital markets are an imperfect tool and have hosted a good deal of bad or even illegitimate behaviour but, according to Mr Young, they can provide a way to amplify society’s positions on important issues, from the environment to human rights. “Public companies’ conduct on the way they pollute or treat labour... in the short term it’s probably the biggest impact on society and our world,” he says. By channelling funds to or away from them, investors, from wealthy individuals to savers through their pension funds, can influence corporate behaviour, he adds. “As we sit here today, if we had equal pay for women in companies, that would be transformative,” says Mr Young.
As structurers and underwriters of green and social impact products, banks have an important role to play too, and one that may improve their sustainability.
In an average rating score, Sustainalytics usually looks at nearly 100 indicators to compile its sustainability reports. It identifies about 10 specific challenges an industry faces and fleshes out metrics under each of those headings: the extent to which climate change risks affect the industry; the effectiveness of the firm’s sustainable finance initiatives; how good it is at human capital issues; how effective is its health and safety; data privacy.
“It’s a mix of looking at their products, the carbon impact of their products, and the management systems related to this. If they have programmes and policy in place, we look at how robust and significant they are,” says Mr Mann. Integrating ESG into a bank’s growth strategy is likely to be as challenging as analysing those very efforts. But the direction of travel is set, and with societal and legislative pressures mounting, adapting business models is becoming increasingly urgent. For any bank leader uncertain as to how their organisation would score in a sustainability test, now would be a good time to give it some serious thought.
