Maddie Saghir reports
During the COVID-19 lockdown, shops, restaurants, bars, and cinemas, were just some of the places to shut. Flights were cancelled, offices closed, and people were encouraged to work from home. While this presented challenges, there was a realisation of how much of an effect us humans have on the planet.
Carbon emissions fell sharply and for the first time in a long time the water ran clear through the canals in Venice. Wild animals were seen to roam the streets in locked down cities and people in urban areas could hear the birds singing again.
In the financial services industry, it seems that the COVID-19 pandemic also caused people to think more about the environment and how environmental, social and governance (ESG) and sustainable investing is of ever-growing importance.
There was a time when ESG was somewhat of a niche in the industry. It can be argued that it was also used as a marketing tool, something for institutions to boast about. But now, the pressure has been ramped up to encourage firms to incorporate sustainability criteria into their governance practices.
While momentum for investment based on ESG principles was already building strongly, Frances Barney, head of global risk solutions at BNY Mellon asset services, suggests that conversations with clients recently suggest that COVID-19 has “sharpened their attention on the non-financial sources of risk”.
Barney explains: “There were strong flows into sustainable investments in Q2 this year and the pandemic is shifting the focus of ESG risks towards concerns such as biodiversity, environmental loss, health and social issues.”
COVID-19 is providing ESG investment opportunities, with governments emphasising sustainability objectives as they inject money into the system. “Issuances of sustainability and social bonds have accelerated as private markets are tapped for help with the response and recovery,” Barney adds.
There is no question that the COVID-19 pandemic and the resulting market crash has cast the spotlight onto ESG and sustainable investing like never before.
Dariush Yazdani, market research centre partner, PwC Luxembourg, comments: “While traditional asset classes recorded significant outflows in Q1 2020, ESG and sustainable funds continued to gain assets; grabbing investors’ attention throughout the downturn.”
“European ESG funds saw net positive inflows of €26.3 billion in Q1 2020 while traditional funds suffered outflows of €160 billion in that same period. This just goes to show the importance that investors are attributing to ESG, even through one of the worst economic downturns in recent memory.”
Challenges
Although ESG is shining in the spotlight at the moment, there are still some challenges that are preventing it from becoming even more mainstream.
The European Securities and Markets Authority (ESMA) sees the following main challenges around mainstreaming sustainability in the financial sector over the coming ten years:
- ESG disclosures by companies: in the applicable legislation, there are significant limitations to the ability of investors and the public at large to rely on ESG disclosure that is comparable, reliable and relevant.
In particular, we concur with the challenges identified in the European Commission’s consultation document on the review of the Non-Financial Reporting Directive (NFRD) and ESMA has made proposals with regards to the improvement of the status quo with respect to, most notably, mandatory standardisation of the disclosures and the proportionate expansion of the personal scope of the NFRD. These and other actions set out in ESMA’s response are needed to address the lack of appropriate disclosures already in the shorter term.
- ESG ratings: lack of a legally binding definition and comparability among providers, no legal requirements to ensure transparency of underlying methodologies.
- Risk assessment: steps needed to enhance management of climate- and environment-related risks. These include increasing the availability and quality of data both from financial market participants and from companies, increasing investor awareness and expertise in the area of climate- and environment-related risks.
Ensuring proper implementation and application of new legislation given the intense legislative activity at EU level in the last few years.
Meanwhile, Demi Derem, general manager, investor communication solutions international, Broadridge, says: “A lot has been done around governance and the problems here revolve around a lack of consistent approach to governance across markets – the second Shareholder Rights Directive (SRD II) implementing law has again highlighted this.”
However, he highlights that harmonisation across geographies today is better than 10 years ago.
In its definition of SRD II’s objectives, the Harvard Law School Forum on Corporate Governance references holding investors accountable for the integration of ESG factors in investment decisions.
Funds need to demonstrate that they are active in the governance of the underlying issuers (across ESG issues), and the issuers themselves need to show that their underlying ESG practices are sound, according to Derem.
He also explains that from an investor’s standpoint the big challenge is the worry around green washing.
“Are they really getting a credible ESG fund or is it just marketing spin? Investors want the transparency and reporting to prove to themselves and their clients that what they have bought fits with their own definition of ESG. Aligned with that they want managers to actually believe in ESG themselves and act responsibly and not simply just have one ESG product in a line up,” Derem adds.
Regulation and education
Another aspect of ESG that is challenging is the lack of education and regulation, with a lot of industry participants agreeing that more could be done in this space.
Natasha Head, manager, business development, Maitland, explains that regulation is coming albeit slowly and should help to focus attention on ESG.
“Certainly, from an education perspective, greater emphasis around the benefits of adopting an ESG approach to investing and its use in determining the long-term value of an asset would help shift the current perspective,” she says.
Yazdani highlights that in order for investors to understand the pivotal importance of ESG and the opportunities it presents, they must be educated on the topic.
“While many institutional investors are ‘clued-up’, many retail investors are unlikely to understand the intricacies.”
“Clearly, there is a growing need to provide these investors with an understanding of the benefits of ESG investments, not only to ESG factors but also to their portfolios’ performance.”
Also discussing the topic of education, ESMA says it considers that increasing financial literacy on sustainability matters is important to both retail investors and finance professionals.
As such, ESMA is strongly in favour of the EU supporting the development of more structured actions in the area of financial literacy and sustainability in order to raise awareness and knowledge of sustainable finance among citizens and finance professionals.
Turning to regulation, ESMA stipulates: “Significant progress has already been made with various initiatives under the European Commission’s action plan on financial sustainable growth, for example, the Taxonomy Regulation and the regulation on sustainability-related disclosures in the financial services sector.”
However, ESMA also highlights that certain further regulatory actions are needed. This includes the current shortage of high-quality data that renders it challenging for both firms and investors to identify, assess and measure sustainability risks and opportunities, therefore, to take measures accordingly.
ESMA explains: “It is therefore crucial to take timely action in this regard. To this end, we strongly believe in the potential of digital tools. Notably, the establishment of a publicly accessible, European single access point covering both financial and ESG information would grant all market participants equal and timely access to publicly reported information.”
Making further headway
To make further headway in the ESG space, the opportunities of ESG could be further highlighted to investors, and a less complex framework could also help to attract investors to ESG. Broadridge’s Derem says firms need to consider ESG holistically.
“When we speak to fund selectors they see a number of brands as leaders. These brands not only have ESG funds but have ESG baked into their DNA. They operate responsibly as companies, they think deeply about ESG, the spend time educating clients, and are highly transparent in how they are implementing ESG.”
“It runs through the whole of the corporate from sales to marketing and product. At the end, investors must trust the manager is delivering quality ESG and believes in ESG in its own right”, he explains.
Something else that investors struggle with is the complexity around the ESG framework. BNY Mellon’s Barney affirms that investors continue to struggle with the inherent complexity of assessing sustainable assets against their ESG objectives.
“There are variations in ESG methodologies, frameworks and disclosures which can be scarce or inconsistent. The lack of standardisation creates difficulties in measuring and comparing non-financial performance, though technology offers solutions that support the scale of data management involved with ESG investment,” Barney says.
Further action that could be taken, according to ESMA, is that the EU could foster the development of a sustainable finance-oriented exchange or trading segments that cater specifically to trading in sustainable finance securities and is better aligned with the needs of issuers.
Additionally, a standardised approach may also help attract investors. While the upcoming EU Disclosure Regulation won’t provide a centralised approach to ESG investing, Head says “once there is a requirement to report, we should start to see developments in a standardised approach whether through guidance or further regulation”.
She also highlights that with the current lack of regulation or standardised approach, many fund managers still view ESG as a burden rather than a beneficial tool.
Indeed, further guidance, regulation, and education are all factors that could help the industry move towards a greener future.
Crystal clear definitions with no room for misunderstanding or misinterpretation is also something that could help financial institutions make greater strides in sustainable finance, according to Deutsche Bank’s Gerald Podobnik.
Podobnik recently commented on the subject saying: “What criteria makes renewable energy green? What energy efficient measures define a new home as green, and which use of proceeds is deemed climate friendly? The EU taxonomy project is working on this and has recently reached a compromise on the framework.”
“But I think we need to go a step further and also define what makes a company green or ESG friendly. Clarity on these issues will be important especially as we define how we plan to grow our loan business and thus our balance sheet.”
He concludes: “We also need clarity on the prudential regulatory rules for banks. If climate stress tests are introduced, for example, then we need to understand what scenarios they would use and what the consequences of the results could be. Capital is a bank’s most important commodity; it is the fuel; so a regulatory-driven system that encourages greater ESG friendly deployment of capital will be beneficial for all.”
