A common challenge that financial institutions grapple with is the kind of approach they should take towards ESG (Environmental, Social, and Governance) and sustainable finance in order to maintain their position as a market leader.
Our advice for financial institutions is to begin by focusing on developing a sustainable finance strategy. This is a first in a series that will explore how NextWave can provide technological solutions to automate these steps or enhance their efficiency. This includes collaborating with industry experts from NextWave to formulate strategies for achieving successful sustainable finance.
What is the relationship between ESG strategy and a sustainable finance strategy? As per the diagram above, ESG data is at the core of building an ESG strategy. With competitive data, solid strategy can be built. This data is fed to financial institutions to provide sound decisions in funding sustainable finance. When both corporate and financial institutions put this kind of effort into ESG, national commitments are met. (However, it’s important to remember that a variety of factors, including individual efforts, also contribute to a sustainable and responsible economy.)
With more countries implementing ESG regulations and increasing demand from investors for sustainable products, organisations with business operations will eventually need to manage ESG data in a manner similar to financial statements. This is why the IFRS (International Financial Reporting Standards) is diligently working on globally recognised and standardised IFRS Sustainability Disclosure Standards. These standards will establish a common framework for identifying good and useful ESG data. The process of managing ESG data necessitates the implementation of an ESG Strategy.
Sustainable finance strategy sets industry players apart. For example, corporations have the responsibility to reduce carbon emissions, whilst financial industry players make the decision whether to fund either carbon-intensive or more sustainable projects to promote a responsible and sustainable economy. Financial institutions and organisations help achieve this through financing, lending, investment, or bond issuing activities. They adopt a sustainable finance strategy coupled with an effective ESG Strategy to effectively fulfil the role of gatekeeper.
As the diagram above illustrates, reliable ‘ESG data’ forms the foundation of the entire ecosystem for building a ‘sustainable and responsible economy’. Within this ecosystem, multiple participants collaborate to achieve the common goal of a sustainable environment. At a high level, we will examine the roles of stakeholders in three major categories:
- Obligor: Some corporations may have significant impact on the environment and society, either directly or through their downstream businesses. However, the extent of their impact varies based on their industry and practices. For instance, the impact assessment differs between a manufacturing company with factories and an IT solution consulting company. Obligors are expected to embrace responsible practices in their operations and adhere to ethical business conduct. With new regulatory requirements and pressure from clients, obligors provide financial institutions with information demonstrating their commitment to sustainability and responsibility. This may include sustainability reports, impact assessments, or compliance with relevant standards or certifications. However, obtaining this information often requires delving into the data of their supply chains.
- Financial institution: Financial institutions manage their own ESG data, but their primary environment impact is generally lower than that of corporations. This is due to the fact that financial institutions, such as banks, would have significantly high indirect (Scope 3) emissions compared to their own, direct CO2 emissions because they finance carbon intensive industries. For example, Apple actively pursues environmentally friendly designs on their products by using approximately 20% of material made from recycled content. However, a significant portion of the environmental data that financial institutions rely on are on the obligors (other corporations). Hence, financial institutions play a crucial role in this ecosystem by channelling capital towards projects and initiatives aligned with ESG principles. They could integrate ESG criteria such as carbon footprint, social inclusion, or ethical business practices into their lending and investment decisions, enabling them to offer specialised sustainable finance products like green bonds, impact investments, and sustainable loans to support obligors engaged in sustainable and responsible activities. As such, conducting due diligence is a key responsibility. Financial institutions assess the sustainability and risk profile of the obligors and investment portfolio, ensuring they meet responsible criteria and have minimal negative impacts on the environment and society. They act as gatekeepers but also go beyond this role by reporting their findings, including stress test results, to regulators. This places additional pressure on the industry as it navigates ever-evolving ESG reporting requirements in this complex field.
- Regulator: The current sustainable economy is primarily driven from the top-down by regulators and politicians, with the urgency of addressing rising global temperatures by accelerating action. In response to this, regulators are implementing standards and guidelines related to responsible finance and sustainability to mitigate further climate change. As of 2021, 34 regulators and standards bodies in 12 markets were conducting official consultations on ESG. Many are gradually mandating disclosure requirements and monitoring financial institutions to ensure compliance with ESG and sustainability regulations, such as SFDR (Sustainable Finance Disclosures Regulation) and CSRD (Corporate Sustainability Reporting Directive). Among their roles, regulators work to prevent ‘greenwashing’, which refers to the misleading presentation of a company’s environmental efforts. They help ensure that claims of sustainability and responsibility made by obligors and financial institutions are accurate and substantiated.
Embarking on a sustainable finance journey
Sustainable finance represents an initiative to reshape the fundamental DNA of a business model. What does this mean? As regulatory demands on financial institutions increases, more stringent restrictions will be imposed on investments and fundings towards carbon-intensive sectors (‘brown money’). However, instead of simply choosing divestment from such companies, investors can wield their influence by securing board seats and steering corporate strategies toward greener, more environmentally responsible pathways.
Embarking on the journey of sustainable finance involves:
- Leadership Commitment: Demonstrating a commitment to sustainability at the highest levels of the organisation.
- Establishing Metrics and Targets: Setting clear sustainability metrics and targets to measure progress.
- Developing a Policy Framework: Creating a comprehensive policy framework that guides sustainable finance initiatives.
- Integrating ESG Risk Assessment: Incorporating ESG (Environmental, Social, and Governance) risk assessment into credit and investment processes, utilising collated ESG data from obligors.
- Developing Sustainable Finance Products: Creating sustainable finance products through stress testing and portfolio management.
- Engaging with Stakeholders: Actively engaging with stakeholders and, if necessary, participating in the governance of obligors.
- Providing Training: Offering training to enhance the knowledge and skills of personnel.
- Regularly Reviewing and Updating the Strategy: Continuously reviewing and updating the sustainable finance strategy.
- Ensuring Compliance: Ensuring that all activities align with relevant sustainability regulations and reporting requirements. As sustainable regulations evolve, the consequences for non-compliance differ according to each regulation. (e.g. CSRD penalty is up to 10 million Euros or 5% of the annual revenue whilst no direct penalties have been defined under SFRD).
The biggest challenge for FS firms is knowing how to effectively leverage technology and data at pace to stay relevant and to get ahead.
We would love to hear from you for an informal chat about your goals and to share some approaches to delivering enterprise business solutions and transformation faster, cheaper and more effectively.
January 22, 2024