ESG: changing more than just the climate

10 February 2020 | UK & Europe | Articles

ESG is not going away. It may not be influencing our business or investment choices now, but it will certainly be a factor in future. And either way, considering environmental, social and governance factors will soon be a requirement for all regulated firms. Getting ahead of the curve could give you the advantage.

Not long ago, most of us put environmental and social concerns in a separate compartment from profitability; there was a widespread feeling that ‘green’ funds, or investing with a ‘responsible’ angle, would never make money.

Now, though, regulators are pressing for an increasing focus on the environmental, social and governance – or ESG – aspects of risk management and investment decision making. Capitalism is being forced to help facilitate everyone’s journey towards a greener planet. ESG will affect all financial services companies, and getting to grips with it soon could bring competitive advantage. In five years’ time, it may be unthinkable that climate risk wasn’t always considered by corporate boards, trustees and investors alongside the usual operational, finance, interest rate and regulatory risks.

Clear definition

The scope of ESG is very broad. Although E tends to hog the limelight, S and G are just as important. An investment in offshore wind farms might move us towards a low-carbon economy, but if the turbine components are made using child labour it’s not an ESG-friendly investment. Arguably, the G is the first one to consider. Without good governance environmental and social aspects will never be handled adequately.

To date, stakeholder engagement has been hindered by “greenwashing”: claiming that your product or service is more sustainable than it is, often with the help of confusing jargon and ill-defined metrics.

So one of the first targets is to introduce some objectivity into defining, measuring and disclosing how green you are. This will be facilitated by the introduction of a standard universal taxonomy which will provide both a common language and a classification tool to help investors and companies make informed investment decisions based on ESG criteria. Work is already underway at an EU level to do this. The resultant clarity should drive capital in the right direction.

Present and future

The impetus for financial services markets to help combat climate change has come from a series of global, European and UK initiatives. The UN kicked it off and the Paris Agreement added crucial definitions, with requirements for regulators, wealth managers, credit rating agencies and benchmark providers to ensure proper conduct. The EU has produced a sustainable finance action plan requiring companies to consider sustainability risks and to disclose how ESG is integrated into the investment process. The plan will also introduce new benchmarks and a European-wide taxonomy.

That’s broadly where ESG comes from. Where has it got to so far? The EU’s taxonomy already exists in draft. Although it’s not mandatory yet, its existence means that financial institutions can start evaluating their portfolios from an ESG perspective, and individual companies can see how they measure up. Doing so will include listing activities together with performance criteria that gauge their contribution to the six environmental objectives listed in the taxonomy.

Sit up and take notice

This is where it gets close to home. In the very near future, the European Commission plans to clarify how the industry should integrate sustainability risks and factors into its governance and investment processes. This will be done either by amending delegated acts under, for instance, the UCITS, AIFMD, MiFID II, Solvency II and IDD directives, or by introducing new delegated acts under these directives.

Although most of this will not happen for a couple of years, you’ll be affected regardless of Brexit. The UK government has stated that it will comply with or exceed the new requirements. ESG is being treated as part of the government’s Clean Growth Strategy and relevant initiatives are underway from the FCA and PRA. For financial advisers, COBS 9 suitability rules will be amended with the requirement to consider a client’s ESG preferences in due course.

Getting started

Clearly this issue can’t be ignored, and there are signs that parts of the industry are already taking note. According to Morningstar, in Q3 2019 there were 2,230 sustainable funds available in Europe alone. Of course, we need to get further with ESG before we can assess how robust the sustainability claims are.

Meanwhile, every financial services firm needs to start thinking about its ESG roadmap. In doing so, it’s important to remember that embracing ESG may not be reflected immediately in increased profitability: much of today’s clientele may need some convincing that ESG-conscious investing is the way forward. Once a new more eco-conscious generation of investors becomes active, the pressure is likely to be coming from them, although some investors will always have other priorities.

Whether your investors are looking for it yet or not, regulators are soon going to impose this way of thinking on your business. And there could be a first mover advantage to getting on board before it’s compulsory.