Green Finance is the bedrock for sustainable banking & investment decisions going forward
In a conversation with Charulatha, correspondent, Siliconindia Magazine, Roshan shared his views about the concept of ESG in finance and the role does financial institutions play in promoting sustainability.
1. Can you explain the concept of ESG (Environmental, Social, and Governance) criteria in the context of finance? How are these factors considered in investment decisions?
There are key concerns around accountability and responsibility towards Environment, Social and Governance oriented issues and the role of corporates in such context. This is also primarily driven by Investor Demand and Regulation. Sustainability driven and Responsible investment is a key consideration in investment propositions and decision making.
With the 2030 agenda for sustainable development goals and the Paris Agreement for climate change, businesses have an imperative to adopt green and sustainable practices, The amount of investment to enable this transformation is enormous and financial institutions play a pivotal role through their expertise and funding, thereby incentivizing private and institutional investment in sustainability.
ESG is still evolving, with various countries and financial bodies / regulators framing their own standards and taxonomies. However, financial institutions and banks cannot afford to sit back and wait! Most commonly, for banks and FIs that are heavily invested in ‘brown’ portfolios, rethinking their strategy to balance their exposure to ‘green’ or environment friendly portfolios, is a journey that needs to begin right away.
By the same token, though a debated area, ESG scores and ratings are of critical importance in the context of sustainable investment strategies. Banks, wealth & asset managers, sovereign wealth funds, and other large financial institutions face a growing mandate to grow and manage investments under sustainable / green projects. This brings particular focus on green portfolios, investing in green instruments and assets.
Additionally, regulators and clients are calling for increased transparency about the role of large financial institutions over climate change and sustainability related issues. Reduction of financed emissions, the emissions associated with financing and investment activities, along with drawing down operations related carbon emissions are some ways that financial institutions are considering a tangible first step toward building trust around integration of climate change into their core business of providing and allocating capital.
Depending on the scores achieved across the Environment, Social and Governance parameters, investors and wealth managers can meet the ESG and sustainability mandates of their clients. Additionally, navigating clear of ESG controversies, and mitigating the impact of Climate Risk on real and financial assets, are key concerns that drive financial institutions to thoroughly evaluate ESG scores and metrics while making investment decisions.
Integration of ESG data into investment operations is a major imperative in investing strategies
2. What role do financial institutions play in promoting sustainability, and how can they integrate ESG considerations into their decision-making processes?
Integration of ESG data into investment operations is a major imperative in investing strategies. Whether it is the impact on performance returns or the correlation between ESG metrics and financial performance or whether demand is being led by socially and environmentally conscious investors or the funds inflow into Sustainable and ESG oriented investments or monitoring and managing the risk on account of ESG factors, the critical requirement is accurate, standardised data, and the presentation of the same.
Financial institutions have an important role to play in transitioning a country’s real economy to net zero, through supporting their clients in the development of credible transition plans to committed emission reduction. Environmental risks can impact business operations and supply chains. Non-compliance to sustainability can erode a corporate’s reputation which can adversely impact its business and financials, with the possibility of threatening the stability of the financial system.
To this effect, most Central Banks and financial institutions have mandated incorporating climate risk as an additional measure of risk in their investing and/or financing actions and decision making. Alongside traditional credit risk assessment, ESG risk assessment is taking prominence in corporate financing. Physical risks of climate change can lead to increased loan default rates for banks, resulting in increased credit risk. Similarly, banks holding collateral assets of carbon intensive industries could face risk of devaluation due to transition risk.
By understanding their financed emissions, financial institutions can identify green financing opportunities, seize investment options that actively contribute to mitigating climate change and other sustainability-related challenges, and position themselves as leaders in sustainable finance.
The European Banking Authority (EBA) has mandated ESG risk disclosures as part of Basel Pillar 3, requiring financial institutions to disclose climate related risks and mitigations of their clients, along with exposure to green assets, thereby integrating sustainability as part of enterprise risk management. Suggesting a phased approach to the disclosures, the disclosures come into effect starting 2024. The Task Force on Climate related disclosures (TCFD) provides recommendations on information that companies should disclose to support investors, lenders, and insurance underwriters in appropriately assessing and pricing climate related risks.
3. How can investors balance financial returns with environmental and social considerations in their investment portfolios?
The integration of ESG data into investment operations is a vital component towards developing successful ESG investment strategies that can deliver financial gains and still align with core sustainability principles leading to long term value for financial institutions. ESG data management capabilities, data architecture to accommodate sustainability KPIs, along with additional non-financial components is imperative.
Leading research houses, over the last 5-7 years, have repeatedly found that investing in sustainability meets and often exceeds the performance of comparable traditional investments, both on an absolute and a risk-adjusted basis, across asset classes and over time. They also indicated lower median volatility for the funds and separately managed accounts because companies that score well on ESG metrics also tend to be less vulnerable to negative headline risks, large-scale lawsuits, or environmental risks.
Greater orientation towards sustainable investments and ESG considerations are also being driven by regulatory guidelines and frameworks such as the TCFD, SFDR, EU Taxonomy, CSDRD, SEC Climate Act, etc. Financial institutions are under growing pressure to maintain green asset ratios, show stipulated amounts of green funds under investment to stay compliant with sustainability labels and materiality rules. The costs of not having clear ESG, sustainable investments and Net Zero goals in place may directly lead to loss of clients and brand devalue, run the risk of non-compliance to key disclosures, and strong possibility of penalty payouts due to greenwashing charges and ESG controversies, which also have significant business ramifications.
On the balance of profitability concerns, while driving a greater share of green fund / portfolios and increased investment in sustainability linked instruments does lead to an increased initial investment, however, market research strongly suggests that over extended periods sustainable investments and green portfolios yield continued profits that grow with time and are insulated from a large number of market, regulatory and environmental shocks.
4. What are the potential benefits and drawbacks of divestment as a strategy for promoting sustainability in investment portfolios?
The main outcome of divestment as a driver for ESG investment strategies would be to show an immediate decrease of the brown / non-green components in an investment portfolio, while also resulting in an increase in the percentage of green funds. Therefore, the immediate gain is in the ability to show internal and external stakeholders, clients, and regulatory bodies an improved ESG investments portfolio, which improves the overall ESG portfolio scores and market outlook towards the financial institution.
Sustainability risks can lead to a significant deterioration in the financial profile, profitability or reputation of an underlying investment and thus may materially impact its market price or liquidity.
While such divestment strategies do enhance the brand and optics of the financial institution, they may also come with an initial reduction in year-on-year revenues and profitability of the portfolio. Private equity firms are increasingly recognizing long term value in allocating large fund volumes towards sustainable investments and strategies, aligning with key principles of globally accepted sustainability, climate risk and GHG mitigation frameworks.
Upon completion of the divestment related transition, and gradual subsequent reinvestment into sustainability focused instruments, growing the green share of portfolios and directing sustainable fund flows, financial institutions can expect steady returns over extended time frames, ensure lasting compliance to regional and global sustainability directives and enhance client / entity brand perception.
"Sustainability risks can lead to a significant deterioration in the financial profile, profitability or reputation of an underlying investment and thus may materially impact its market price or liquidity"
5. How do you see the future of Sustainable Finance evolving, and what trends do you anticipate in the coming years?
According to Forrester, green finance includes green bonds, green loans, venture capital, and private equity (PE) funding for green tech, green IPO, and green acquisitions. Over the past several years, green bonds have gained momentum as a debt instrument over green loans, for green financing. Forrester analysis estimates green finance to have exceeded US$720 billion. According to the Climate Bonds Initiative, green bonds hit $522.7 billion in 2021; and this accounts for more than half of all green finance. Forrester estimates that green loans exceeded $135 billion. Data from Venture Scanner indicates that VC funding, PE funding, green tech acquisitions and green tech IPOs made up the remaining US$63.2 billion.
In the context of Banking, green and sustainable finance refers to companies raising debt for greening their business, viz, formulating green and sustainable strategies and developing projects that contribute to positive environmental benefits. However, sustainable finance can be applied to a larger context and can be used for funding E, S or G related commitments. In preparation to this, banks will have to ensure that they have formulated their strategic objectives and related policies and procedures to de-carbonize their loan portfolios. Technology solutions for green and sustainability linked financing as well as ongoing loan monitoring and reporting solutions are important to enable banks to be ready for the foreseeable growth in green and sustainable financing.
In context of Sustainable Investment new regulatory frameworks, a want of standardized and consolidated ESG data, impact reporting and full ESG integration will drive the immediate agenda. Clients across various businesses and regions seek ways to drive more sustainable and resilient fund flows that are not only profitable but also compliant with global regulatory frameworks. Financial institutions will aim to ensure that their Net Zero commitments and GHG disclosures are met, to avoid any penalties or controversies. The shift towards a low carbon economy will require collaboration between investors, corporations and governments, providing unprecedented opportunities for new technologies and new business models.
Data and data-oriented technology solutions will continue to be of great importance as investors demand strategic impact and performance data. This is driven by an increasing reliance on sustainable investments data and its management to help investors choose how best to utilize their money in driving positive impact and also meet financial goals. Standardisation of ESG data, greater transparency, and outcome-oriented communication of the impact of green portfolio investments will be critical to hold the interest of millennial and Gen Z retail investors.
Institutional investors, on the other hand, will want to develop consolidated strategies to build long term ESG investments, grow green fund flows, make low carbon investments and stay insulated from climate and regulatory risks. Such concerns will continue to drive the ESG investing outlook through 2024 and beyond.