2020 will be the decade ESG, climate and sustainable finance turn financial services on its head
ESG or ‘environmental, social and corporate governance’ criteria refers to the set of most widely accepted factors that are considered when assessing the social impact of a business. With evidence mounting daily showing the catastrophic costs of inaction, there is an ever greater imperative for the financial sector to act.
It is hard to open a paper or watch the news without seeing a new eye-catching report on climate change or the social impact of certain businesses on society. Although the hyped ‘ESG’ acronym might make this seem like a novel phenomenon, the financial services industry have weighed social factors into decision making in the past (eg the Sullivan Principles in response to the Apartheid).
What is different today is that definitive action is being demanded by a greater number of voices, at a larger scale than ever before — spurred by the overwhelming evidence that climate change will have a significant and detrimental effect on our way of life. The money flooding into ‘ESG’ funds has also highlighted the business opportunity for institutions who can respond.
This dual pressure has exposed the lack of reliable tools, frameworks and data sources available to corporates, fund managers, bank lenders and the whole financial services industry. We believe this represents an enormous opportunity for young companies.
There is a direct link between financial services, the environment and social impact… the challenge is measuring it
What do financial services actually do? At the very basic level, the financial industry exists so that resources (something of value, usually money) can flow into projects and ideas (usually businesses) that create value (usually more money).
Of course, it is a lot more complicated and nuanced than that, but at the basic level before making a decision there is some kind of ‘cost and benefit’ analysis done. Sometimes this process includes certain ‘externalities’ which might not seem as obvious at first glance. This rationale is not exclusive to financial markets. Governments weigh these considerations before making policy announcements based on what they think the reaction will be; individuals make these choices in their daily life when juggling a budget; even in the animal kingdom a lioness with cubs to feed must decide what prey to target based on their likelihood of success.
The factors you weigh will often tip the balance of that decision. Herein lies one of largest challenges — things that are easiest to measure tend to be what is factored into the decision. David Pilling wrote about this concept eloquently in The Growth Delusion where he explores the pitfalls of this at a national and international level where we use fixed equations like GDP as a barometer of economic activity. This equation includes things like hard government dollars spending on infrastructure but excludes tougher to measure metrics.
To use one example — if you have a local park where residents can meet, relax, socialise, exercise etc what is the quantifiable benefit of this? Technically not much. At the national GDP level, you can’t tax any ‘revenue’ from friends going for a walk to catch up and keep fit. If that park didn’t exist however, and those friends had to pay for a gym membership and a drink afterwards — well that would be positive for GDP…
So how do we work out how to measure things like this so we can factor it into our decision making?
Most politicians know they would soon be out of a job if their government suddenly sold all public parkland for development to boost GDP. One of the reasons for this is that we intuitively know that there is more ‘value’ or positive externalities in green public spaces than we can easily quantify.
The same goes for a host of other environmental assets and social rights like having clean air to breath, drinking water, equal opportunities, a biodiverse ecosystem, the freedom to choose our religion etc without fear of discrimination. At the core, the movement and feeling behind the ESG push is that these vital assets and rights have, to date, not been properly quantified and factored into decision making.
Back to financial services…
For a long time, the primary focus of investors has been to maximise risk adjusted returns. Modern Portfolio Theory, a mathematical framework pioneered by Nobel laureate Harry Markowitz, and the Sharpe ratio, developed by fellow Nobel winner William F. Sharpe, are two the bedrocks of this area of finance. Achieving positive ‘alpha’, i.e. the return made over a benchmark, is the other holy grail. The question then becomes how you find investment opportunities that will generate predictable and strong returns.
Weighing ‘ESG’ has not historically been a critical input into this equation but this is changing. Financial services, like all industries, has a social licence to operate. The industry can finance projects and maximise profits… so long as these returns are not made unfairly. A business profiting from historically mispriced national resources, and the financiers of that business, are now in the spotlight as society is beginning to see the direct negative implications from this through climate change and other social factors.
An investor who used to only factor and weigh price volatility against potential financial returns now has a host of other things they must in mind when making investment decisions. Some market purists will argue that all of this will come out in the wash — as forecasting future financial returns includes an analysis of the sustainability of this income stream. Even if this is true, there is still a need for analysts and market participants to have better tools to be able to make these decisions.
Regulators and government will have a key part to play
There are now over 1,800 climate laws worldwide including 140 strategic framework laws according to the Grantham Research Institute. An increasing number of these relate directly to the investment community.
Mark Carney, governor of the Bank of England, has been a vocal advocate of the need to start assessing climate risk explicitly when looking at the stability of financial markets.
“That financial institutions have come out so strongly in support of enhanced disclosure reflects their recognition that there is a correlation between managing climate risk and long-term value creation as well as their belief in the power of markets. They know that for markets to do what they do best — allocate capital effectively and dynamically — they need the right information… until recently, reliable information on how companies were anticipating, responding or failing to respond to climate-related risks and opportunities has been hard to find, inconsistent and fragmented.” Full speech link, 2018.
In fact the BoE will begin stress testing banks against climate risks in 2020 to see how well prepared they are for these shifts.
What is our working thesis?
We believe that we are only just beginning to scratch the surface of the impact this will have on financial markets. It’s hard to think of an area which won’t be impacted by this over the next decade. Risk, compliance, reporting, data, investment monitoring, predictive analytics, pricing… all these areas will need to begin quantifying and weighing the cost and impact of climate and other ESG factors. At present we are looking at the market landscape with two lenses.
The first relates to wider ESG reporting and investment frameworks:
- What are the tools that investors and companies can use to demonstrate their actions on environmental, social and government factors? [Anecdotally we hear that of some existing ESG scores, 80% is weighted to corporate governance!]
- What data powers this and how can you deal with inconsistencies?
- How does this flow into the investment and wealth/asset management market and become a structured part of the decision making process?
- How will this change how funds and mandates are constructed/marketed? There are sure to be growing pains as it is incorporated into fund manager workflows.
The second is more risk and compliance focused, looking at both the transition and physical risks of moving to a low carbon economy and what this means for the value of assets:
- What earning streams are reliant on dirty industries?
- What is the real cost of providing your service when you factor in the environmental impact?
- Would your business still be viable if you had to pay for these environmental costs? Up to what level?
- What physical assets and public infrastructure are you dependent on? Is this at risk of extreme weather events?
- Are insurance premiums factoring in this cost? What would they become if they did?
- What happens if you can no longer access or afford insurance for your business?
- What if you could no longer borrow against dirty assets?
- Looking across a portfolio of assets (debt, equity etc), what does this mean?
This is an enormous topic and we are only just starting to scratch the surface. If you are a like minded investor, industry practitioner, or a young technology company building tools that can support this transition then we would love to speak to you and share thoughts!
