Guides
A guide to ESG in the finance sector
In recent years the financial services sector has been rocked by various scandals and has suffered much reputational damage as a result.
With increasing social unrest worldwide, governance-related topics, such as ESG, have never been higher on the agenda.
ESG has become increasingly important within the financial services sector, and institutions within the industry can use ESG factors to make investment decisions alongside other financial metrics.
Key points
● The finance sector is heavily regulated, and ESG can help mitigate risk in this regard
● ESG can help increase trust in financial institutions
● Investment products are being demanded more and more based on their ability to align with investor values
● The financial services industry has a crucial role to play when it comes to creating a sustainable economy
Demand for ESG in the finance sector
ESG has become progressively more important in the financial services sector because of the connection between ESG factors and financial performance.
Companies with strong ethical and governance practices will likely suffer fewer regulatory fines, and the financial services sector is already highly regulated.
Also, today’s investors demand that more financial products align with their values and beliefs, which has contributed to developing ESG-related metrics.
A growth in regulation can be seen around ESG in the financial services industry, where the European Union has recently introduced laws which require asset managers and investors to disclose how they will integrate ESG factors into their decision-making, for example.
In short, there is a growing recognition that non-financial factors influence financial performance and more and more, investors require that products align with their values.
How is ESG measured within financial services?
Various metrics are used to measure ESG, which vary depending on the specific industry, company, or asset being evaluated. Still, some of the most common methods used in the financial sector are as follows:
● ESG ratings: These ratings measure ESG performance and take into account factors such as carbon emissions, diversity, and executive compensation, among other things
● ESG indexes: can be used as benchmarks for ESG investing and can be used to build new investment products.
● ESG integration: This involves incorporating ESG factors into financial analysis, which may use specialised modelling.
● Impact investing: The purpose of impact investing is to choose to invest in assets and companies with a positive social and environmental impact and good financial returns.
So, there are a variety of methods which can be used to measure ESG within the financial services sector.
Read more: The ESG lawsuit against Shell is a sign of things to come
Why is ESG becoming more important in financial services?
Investor demand: As stated, investors increasingly demand that investment products align with their values, and ESG criteria can be helpful in this regard. So, financial services companies that use ESG criteria are well suited to attract investors.
Risk: Using ESG criteria, firms can limit their exposure to risks such as reputational damage or climate change.
Regulation: With increasing regulation in the sector, firms can use ESG factors to ensure they remain on the right side of the law and limit their exposure to expensive penalties.
Reputation and branding: By demonstrating their commitment to ESG-related factors, financial services firms can also increase the goodwill toward their brand in the market.
ESG opportunities for financial services firms
Increasingly, the economy is moving away from traditional structures and becoming more consumer-led. The challenge is creating a system that helps transition to a new kind of economy, and the financial services sector will have a crucial role in this.
Today’s financial services industry has the opportunity to explore divergent partnerships in addressing social challenges and rebuild trust in institutions by working with different stakeholder groups.
Those in charge of governance in this area can play an essential role in helping individuals and businesses transition to changing work roles.
However, the future is unpredictable, and some shocks may be in store for the financial sector. ESG can help examine the risks and opportunities for different stakeholder groups.
In short, the financial services sector can increase value around ESG by facilitating value exchange, managing risk, allowing for more value-based investment, and providing the security and confidence needed to drive economic growth.
Much of the focus within ESG in the banking sector has been on climate change.
The European Central Bank has recognised that the links between social factors and financial impact can be more challenging to quantify than they are regarding climate change.
Some companies may be required to publish data related to board diversity and the treatment of employees, but this can only apply to large companies.
So, the EU has recognised a need for more data when measuring the impact of social criteria.
The development of such standards has become even more relevant due to the rise in the issuance of social bonds.
Read more: Just be transparent with ESG
What about governance?
Regarding the governance pillar of ESG, this is one of the more established areas since regulation around this has existed for several years.
Measurement criteria include areas such as corruption, board independence, and ethics. This area can also focus on transparency and tax strategies.
The European Commission’s Directive on Corporate Sustainability Due Diligence aims to improve sustainability around governance and value chains. This will encourage firms to mitigate human rights issues across their operations and supply chain.
So, all this represents a challenge for financial services companies when it comes to upskilling workers to cope with new social performance regulations and adopt systems capable of capturing the data needed to measure this.
Firms should focus on the European Sustainability Standards and understand the infrastructure and skill sets which may be required to ensure compliance.
By introducing green initiatives, banks can set themselves apart from the competition and are in an excellent position to facilitate the transition to a more sustainable economy.
ESG provides concrete metrics that help differentiate between businesses that are genuinely committed to sustainable goals and those that are simply greenwashing.
Interestingly, a correlation has been noted between the size of the banking institution and ESG practices, with larger banks also having higher ESG scores. This may be because they have more funds to leverage to create a more sustainable future.
Training in ESG is essential
In terms of the steps those in the banking sector can take to improve ESG, they can first get a qualification in ESG, such as the Diploma in ESG, and develop a more structured approach to this issue, which must come from the top down.
They should set short, medium, and long-term goals and identify where they currently stand in terms of such goals.
Secondly, they should ensure that actions are communicated to all stakeholders involved.
The SEC is increasingly involved in the ESG space in the USA since this has become increasingly important to investors.
Investors are seeking sustainable financial products, but while this brings opportunities, risks are also involved.
One of the areas where institutions should be careful is greenwashing, which involves misleading consumers or investors about the environmental credentials of a business.
Firms will likely face increasing regulation with this, and they must be careful to communicate information in a way that is clear and not misleading.
Financial services firms also need to be able to comply with the rules when it comes to corporate disclosures.
Governance is an area where there may be some risk, and to mitigate this, firms should ensure transparent processes are in place.
After identifying ESG-related risk, it can be raised to senior management and the board accordingly. Additionally, there may be requirements in the future to disclose more information concerning climate-related governance and risk management.
Overall, firms need to bear in mind the reputational risk that might arise due to failures to address ESG-related issues. Breaches may attract sanctions and regulatory attention.
To manage these risks better, firms must be diligent in mapping the ESG landscape and engage with other stakeholders to stay ahead.
They should ensure that adequate training is delivered and appropriate governance and whistleblowing arrangements are in place.
If complaints and concerns are raised, there should be procedures in place to be sure that these are taken seriously and investigated appropriately.