Financial Services

An introduction to sustainability and the ESG principles

By May Vassallo

 

Sustainable finance differs from traditional finance. As environmental, social and governance (ESG) considerations relative to investment decisions within the financial services sector started gaining traction along the past few years, a fundamental question emerged, being ‘why is sustainable finance deemed important?’

While the focal point of traditional finance is comprised of optimal financial returns, sustainable finance emphasizes on an extensively broader variety of returns, highlighting environmental, social and governance factors. A customary definition of the term ‘sustainable development’ emanates from the report of the Brundtland Commission of the United Nations, whereby it stipulates that

[S]ustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”

This is a striking definition as once analysed, it becomes clear that it encompasses a mixture of integrity as well as slight vagueness. It is a righteous statement in advocating the welfare of future generations, however, concurrently, it does not specify or express how society shall administer sustainability. Thus, definitions are not enough; breaking down the ESG acronym is also not satisfactory. Rather, what will increase cognizance within this sphere is guidance, illustration and specific examples portraying how ESG may be amalgamated into an organization’s strategy.

The implementation of sustainable finance within the corporate sphere seeks to fortify and maintain economic growth while concurrently diminishing environmental burden and encompassing social and governance principles.

Sustainable finance plays a crucial part in the circulation of capital required to achieve the policy objectives under the European Green Deal and the European Union’s international engagements relative to climate and sustainability objectives. At present, sustainable finance also has an imperative role in ensuring that investments back up and encourage a resilient economy in order to be able to go beyond and recover from the impact of COVID-19.

 

The ESG Principles

One motivating factor which attracts the integration of sustainability into business strategy is the opportunities which an approach of this sort has the potential to generate. Furthermore, a substantial number of investors and financial institutions view sustainability as a representation of an organization’s approach towards risk management and the circular economy. From an environmental perspective, investors have been taking into account companies’ accountability in the calculation and management of their effect upon the environment, such as waste and water management and greenhouse emissions. In fact, for a number of investors, the embodiment of the ESG principles is not quite optional. The Authorité des Marchés Financiers (AMF), an authority regulating the French financial market, has since 2011 required  investors and asset managers to publish an annual report disclosing how ESG criteria are incorporated in their investment policies. Moreover, as part of its ‘Supervision 2022 strategy’, the AMF carried out ‘SPOT’ inspections in five different asset management companies between September 2018 and January 2019, in order to measure socially responsible investment management systems of said companies.

The European Union (EU) has bolstered its efforts to progress towards a low-carbon, more resource-efficient and sustainable economy. As a matter of fact, the EU has been a driving force of these efforts in terms of the development of a financial system which promotes sustainable growth. In 2019, the European Commission (EC) launched the European Green Deal, a growth strategy the purpose of which is to make the EU the first climate-neutral continent by 2050. The European Green Deal Investment Plan, part of the European Green Deal, shall mobilize a minimum of €1 trillion sustainable investments within the next decade, thereby facilitating public and private investments required for the conversion towards a climate-neutral, greener European economy.

A principal step towards sustainable finance is for financial institutions to opt out of investing in, or rather, lending to, companies which leave behind an unfavourable impact.

The transition towards a more sustainable economy also incorporates the social and governance aspects. Social risks refer to the impact that companies can have on society. They are addressed by company social activities such as promoting health and safety, encouraging labour-management relations, protecting human rights, diversity and inclusion; including gender diversity on corporate boards and gender equity as well as focusing on product integrity. Social positive outcomes include increasing productivity and morale, reducing turnover and absenteeism, coupled with the improvement of brand loyalty. The social aspect relative to how a business organization manages and maintains its rapport with different employees and clientele highlights the extent of its cognizance for human rights, in that, the relationships a company upholds with its employees, for instance, speaks volumes and plays an imperative role in measuring the level of attention which a company gives to the evolution of its employees and its actions towards them. It is important to distinguish between the social pillar in ESG and corporate social responsibility (CSR). Without the latter, there would be no ESG. However, the underlying goal behind CSR is increasing accountability; shedding light upon the integration of social and environmental concerns within the company. While both sound similar in principle, ESG differs as it allows business and organizations to actually measure and record the sustainable and societal effects of their output, as it is quantifiable and criteria-led. In March 2019, the Global Reporting Initiative stipulated that two decades ago, only a few companies published their environmental performance, as opposed to nowadays, where 93% of the world’s largest companies by revenue report information on their ESG. Naturally, the inclusion of ESG, shall not solely fight social injustice, but would also boost shareholder and employee engagement.

Substantial evidence sheds light on the fact that the governance aspect of ESG sequentially yields larger corporate returns. Governance may be gauged through numerous aspects in a business organization, such as, risk management, tax strategy, board structure and independence, transparency, supply chain management, auditing, compliance and codes of business conduct. Investor assurance veers towards good corporate governance; after all, corporate governance matters make headlines on a regular basis. An investor would want to know that a company’s financials are not only accurate, but also transparent and that it encompasses ethical business practices. Investors are drawn towards company policies which promote shareholder (including minority) engagement and are highly likely to be averse to a company which does not seemingly address long-term risk to its business. Another key governance criterion is gender diversity and equality, something which is high on the agenda of institutional shareholders.

 

Sustainability should not be viewed as the exciting side project. To the contrary, it should be an integral part of the core strategy of any company, business organization and financial institution, as it does not solely affect an organization’s risks and opportunities, but also how resources and employees are dealt with. The underlying principle should be driven by an appreciation that all actions should safeguard the interests of future generations. Businesses and organizations with a clear ESG culture, balancing the focus on traditional business efficiency principles with sustainable, socially responsible and environmentally aware business practices are bound to prosper as this does not only draw customers in but also retains them.