Sustainable finance is the process of taking environmental, social, and governance (ESG) factors into account when making financial investment decisions. This results in increasing longer-term investments in sustainable economic activities and projects. It has grown into a tough worldwide movement driven by regulators, institutional investors, and asset managers.
Sustainable finance secures and increases economic efficiency, prosperity, and competitiveness both now and in the future while also contributing to the protection and restoration of natural systems and the enhancement of cultural variety and social well-being.
Given the escalation of climate challenges and the perceived detrimental impact that some financial operations have on the environment or human well-being, the idea of sustainability is gaining traction. Previously, investment and credit choices were made to balance risks and projected returns; however, a new dimension is now taking precedence, based on the concept of ‘investing with a purpose.’ This includes investing in and financing activities and enterprises that benefit the environment or society.
Simultaneously, divesting from enterprises that contribute to degradation is being considered. This will have far-reaching implications for banks and other financial institutions, resulting in innovative changes as loan portfolios/assets under management are created, re-evaluated, and/or wound up.
Climate change concerns are severe and critical to the financial sector. They are critical to engaging banks’ decision-making at all levels, from client acquisition and relationship management to Top Management – including, of course, Risk Management and Compliance. Sustainability is now a required component of bank strategic strategy and operations. New regulatory components are being implemented, as well as new governance, information disclosure, and rating organizations.
Sustainable Finance and International Agreements
Countries’ contributions to climate change, as well as their ability to avoid and manage its repercussions, vary greatly. As a result, the Convention and Protocol provide for financial support from Parties with more resources to those with fewer resources and who are more vulnerable. Developed country Parties (Annex II Parties) must contribute financial resources to help developing country Parties implement the Convention. To that end, the UNFCCC created a Financial Mechanism to distribute funding to developing-country Parties.
The operation of the Financial Mechanism is assigned to one or more existing international bodies, according to Article 11 of the Convention. The Financial Mechanism’s functioning is delegated in part to the Global Environment Facility (GEF). Parties determined at COP 17 to designate the Green Climate Fund (GCF) as an operating institution of the Convention’s Financial Mechanism, in line with Article 11 of the Convention. The Financial Mechanism reports to the COP, which determines its climate change policy, program goals, and financial eligibility requirements. Article 11 of the Kyoto Protocol recognizes the necessity for the Financial Mechanism to support efforts by developing country Parties.
Sustainable finance in the Paris Agreement
Article 9 of the Paris Agreement states that rich country Parties must contribute financial resources to help developing country Parties with mitigation and adaptation in addition to their current Convention commitments. Other parties are urged to contribute or continue to provide voluntary help.
Sustainable finance and SDGs
The UN estimates that the world would need to spend between $3 trillion and $5 trillion per year to accomplish the Sustainable Development Goals (SDGs) by 2030, and the current Covid-19 epidemic has upped that estimate by $2 trillion per year. For the last decade, the UN Global Compact has brought together enterprises, investors, and UN agencies to collaborate on sustainable finance. In 2019, the Financial Innovation Action Platform developed into the Chief Financial Officer (CFO) Taskforce to provide the framework for a broad coalition of CFOs working to unleash the full potential of corporate finance to enable a sustainable transition. The CFO Coalition for the SDGs has officially been launched as part of the project.
Nationally Determined Contributions (NDC) partnership and Sustainable finance
For efficient NDC implementation and accomplishment of the Paris Agreement targets, unprecedented amounts of climate funding must be generated. With some nations raising their ambitions and upgrading their NDCs in 2020, gaining access to climate financing remains the most effective strategy to speed NDC implementation and promote transformational change. Access to climate action financing is one of the most frequently requested areas of assistance among NDC Partnership countries.
Incorporating Sustainability into Organizations and the Financial System
Finance is a driving force for sustainability. However, in order to accomplish sustainability through money, the financial system must be rebuilt and adapted to the characteristics of sustainable development. Modern financial systems are one-dimensional, concentrating on delivering transactional economic stability.
Meanwhile, the rising importance of risk connected to non-financial variables implies that the aspects known as ESG (environmental, social, and governance) have emerged as the primary danger to the stability of financial institutions. Adaptation operations aimed at designing so-called three-dimensional financial systems rely on factoring ESG risk into the financial choices of the financial entities that comprise the financial system. This is seen in the risk assessment approach, among other things.
The incorporation of ESG elements into financial institutions’ decision-making processes leads to a more sustainable financial system. The social and governance categories were the most numerous groupings of considerations involved in financial choices. There was no difference in the opinions of specialists from so-called green banks and commercial banks. Experts from financial institutions agreed on the aspects that have the biggest influence on risk assessment and customer rating, with environmental impact control taking the lead.
Sustainable Investment Initiatives
Sustainable investing is an investment discipline that seeks to achieve long-term competitive financial returns while also having a beneficial societal effect by taking into account environmental, social, and corporate governance (ESG) factors.
The United Nations Principles for Responsible Investment (PRI) is an international organization that promotes the inclusion of environmental, social, and corporate governance (ESG) considerations in investment decision-making.
The PRI, which was launched in April 2006 with UN backing, has over 2,700-member financial institutions as of August 2021. These institutions join by signing up to the PRI’s six main principles and then reporting on their progress on a regular basis.
The Equator Principles (EPs) are a risk management methodology that financial institutions use to determine, analyze, and manage environmental and social risk in projects. Its primary goal is to provide a minimum level for investigative work and monitoring in order to promote prudent risk decision-making.
Principle for sustainable insurance (PSI)
PSI are global guidelines for incorporating ESG issues into insurance underwriting. The tool’s goal is to develop a resilient insurance business based on comprehensive and long-term risk management that takes ESG problems into account. As a result, the PSI promotes a risk-aware world in which the insurance business is trusted and fully participates in allowing a healthy, safe, resilient, and sustainable society. Annual progress reports are submitted by signatories.
Principle of responsible banking
The Principles for Responsible Banking are a one-of-a-kind framework for ensuring that signatory banks’ strategies and practices match with the vision for society’s future outlined in the Sustainable Development Goals and the Paris Climate Agreement. Over 270 institutions, representing more than 45 percent of global banking assets, have now joined this transformation movement, paving the path for a future in which the financial community makes the good contributions to people and the earth that society demands.
Introduction to Environmental, Social and Governance (ESG) Risk Management
ESG is an abbreviation for Environmental, Social, and Governance. Non-financial factors are increasingly being employed by investors as part of their analytical process to identify big risks and development opportunities. Despite the fact that ESG metrics are not commonly included in statutory financial reporting, firms are increasingly including them in their annual report or in a standalone sustainability report. Several organizations are collaborating to develop standards and define materiality in order to facilitate the incorporation of these factors into the investment process, including the Sustainability Accounting Standards Board (SASB) and the Task Force on Climate-related Financial Disclosures (TCFD), and the Global Reporting Initiative (GRI).
Investing ethically, or taking environmental, social, and corporate governance (ESG) parameters into account in investment appraisal and assessment, can result in long-term competitive financial returns and a good societal effect.
Asset owners, among other stakeholders, are increasingly concerned about how asset managers, such as private equity firms, assess ESG risks in order to inform buy-out/acquisition decisions and then manage those risks to protect the value and unlock value-generating opportunities during the holding period.
Climate change affects mitigation and adaptation, environmental management practices and duty of care, working and safety conditions, respect for human rights, anti-bribery and corruption procedures, and compliance with relevant laws and regulations are all examples of ESG risks. Responsible investing should also take into account the effects of megatrends (such as climate change) as well as upcoming rules or voluntary standards.
ESG risk management is crucial for identifying, managing, and mitigating all risks. ESG software can help to automate some of the procedures required in measuring a company’s or client’s degree of ESG practice. There is no single way to assess ESG risks. Global authorities have failed to develop a single standard that covers all jurisdictions or unifies all aspects of ESG. Data gathering and analysis should assist a firm in defining ESG and the specific risks to which they may be exposed. Completing a full risk assessment, as you would for any form of risk, is essential for examining business processes and determining how they connect with ESG goals.
Key Challenges for Sustainable Finance
The lack of consensus on and availability of relevant ESG data is perhaps the most significant obstacle confronting the sustainable financing sector.
Due to a lack of standards and a scarcity of disclosure rules throughout the world, corporate ESG disclosure is voluntary and, as a result, unequal and inconsistent. Companies decide what data to report and whether or not to report at all.
The International Financial Reporting Standards Foundation announced the founding of the International Sustainability Standards Board (ISSB) in November of last year. To help investors satisfy their information demands, the board wants to create “a comprehensive worldwide baseline” for sustainable disclosure guidelines. It plans to provide its first rules on climate disclosure in the second half of 2022.
Producing a consensus from an alphabet soup of current standards and frameworks will be difficult but necessary. It is likely to be a more iterative process than proponents of sustainable finance would desire. However, if the ISSB can create the groundwork for consistent and comparable corporate ESG disclosure, it will eliminate one of the most significant barriers to investing in sustainable finance that some investors continue to face.
A second concern confronting the sustainable finance community is its role in financing the transition to a net-zero global economy. The problem here is not financing future green technology. The simple part is identifying and investing in the next generation of zero-carbon technology. Supporting today’s carbon-intensive industries as they transition to a world with a fraction of today’s greenhouse gas emissions is more difficult.
Sustainable finance may provide long-term value by managing risks and rewards while also constructing more robust systems for the future. Investors can choose to invest in firms that have a good social effect and avoid those that do not. Investors might inquire about a company’s ESG policies. Investors can pledge to achieve net-zero carbon emissions by 2050. Finance cuts across all industries and may be utilized in a variety of ways to build a greener, more fair economy.
In addition to benefiting the environment and making society more equitable and inclusive, evidence is emerging that sustainable firms provide greater returns to investors. According to a global poll, consumers are four to six times more inclined to buy from a firm that has a corporate mission that they support. However, if a firm does anything with which they disagree, three-quarters said they stopped buying from that brand and pushed others to do the same.
Carbon-intensive sectors such as coal, oil, and gas are also finding it difficult and costly to acquire finance as major lenders refuse to do business with them.
Faced with inequities highlighted during the epidemic, leaders have been pushed to confront them in the workplace. Climate catastrophes like wildfires and increasing sea levels have harmed more people than ever before. It is time to act – and in order to act, we need money. The financial sector affects all stakeholders, from corporations to consumers, and is the economic backbone.
It is obvious that any firm that does not address ESG risks future operational issues. The business case has been developed, and the interests of the stakeholders are now aligning. Finance is a strong weapon that can (and should) be utilized actively for good, to benefit the communities in which we live and work.