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December 20, 2021

Environmental, Social and Governance (ESG) in Financial Services: Macroeconomic Trends

Banks are key decision-makers that influence the entire economy with their funding decisions. Implementation of ESG depends on various factors such as customer base, geographies and product set. Financial services providers need to focus on areas that are easiest to deliver in terms of ESG and those that will have the biggest customer impact.

Listed below are the key macroeconomic trends impacting the ESG theme in financial services, as identified by GlobalData.

Covid-19

The experience of a dual health and economic crisis, in which the fate of individuals was dependent on how other people behaved, created a heightened sense of togetherness. The size of the economic disruption reminded retail banks that they were “in this together” with their customers. Resorting to fees or penalties would have pushed even more customers into the red and devastated loan loss provisions further. Enlightened self-interest along with government regulation saw banks focus on helping their customers improve financial resilience, perhaps for the first time.

Unlike in the last economic crisis, banks were not seen as the cause but had an opportunity to help limit contagion and protect customers from the worst economic dislocations. Forward-looking institutions used Covid as a unique opportunity to forge ESG credentials, making short-term decisions to support customers in key moments that will reap benefits long after the crisis dies down.

Growing evidence that ESG makes money

There is growing best practice evidence that environmental impact, diversity, and privacy are key drivers of financial performance at the wealth, corporate, and retail levels. The MSCI World ESG Leaders Index, for example, outperformed the regular index by 1.36% on the quarter. Furthermore, 70% of responsible investment funds outperformed their peers in the first quarter, according to Morningstar. Meanwhile, the interdependency between a bank’s profitability and the environmental record of its clients has become increasingly clear.

Low-interest rates

Long-term ultra-low interest rates are driving board-level pressure to diversify away from net interest margin-based income. Climate tech and ESG reporting sit at the intersection of the potential new business, clear consumer concern, and technology-enabled business.

Generation Hashtag and ESG

Younger customers are not just demanding cheaper, faster, and more convenient ways of managing their finances. They also care about a company’s moral, social, and political values and want brands they affiliate with to align with their own beliefs. Consumer financial services (FS) institutions want to win younger people over, both as consumers and employees, which means taking a stand on issues that will win them more customers.

Several purpose-driven banking organisations, such as building societies or credit unions, often enjoy above-average financial returns and net promoter scores (NPS). A white space, however, exists for traditional financial service institutions in this regard.

Regulatory pressure

Regulators are increasingly emboldened and interventionist, covering everything from fines to new initiatives such as open banking and Europe’s General Data Protection Regulation (GDPR). This approach seeks to force business model change by making minimal, reactive compliance increasingly expensive and unsustainable. Instead of doing the bare minimum, banks are encouraged to hold themselves to a higher standard to get in front of regulation. The multiplying number of regulations at a global, regional, and national level within ESG testifies to how prescriptive the new regime is becoming.

Reputational rebuilding

Banking has a greater need for reputational rehabilitation than almost any industry, except defence. Banks must achieve that rehabilitation while under attack from new entrants unlike defence. Sticking points include the industry’s role in causing the global financial crisis through a bonus culture that rewarded greed and its ability to privatise gains and socialise losses with bailout packages but no meaningful change. ESG initiatives are a way to atone for that by doing demonstrable good for local communities, employees, customers, and the environment, rather than the skin-deep PR of marketing campaigns and greenwashing.

Long-term vs. short-term trade-off

Many unsustainable industries, such as the oil industry, offer supernormal profits in the short term, but these cannot be guaranteed in the long-term. Banks are increasingly aware that, in the future, humans will be much less reliant on fossil fuels due to depletion of natural resources, regulation, or divestment. The upshot is that banks can no longer bet their future on receiving profits from unsustainable industries. This makes the rationale for investing in sustainable assets and divesting from unsuitable ones more palatable and realistic, rather than banks being expected to change due to moral drivers. Sustainability will become a key factor in determining the profitability of investments.

Lack of ESG standards

The lack of standardisation across ESG providers’ data has been a major challenge for investors. MSCI and Sustainalytics, the two most widely used ESG data providers, have a correlation of just 0.53 on their ESG scores. Investors are essentially aligning themselves with that company’s ESG investment philosophy in terms of data acquisition, materiality, aggregation, and weighting, but without a full understanding of how the provider arrived at its conclusions. Moreover, the lack of consistent standards means like-for-like comparisons are not possible.

The lack of standardisation with different terminologies and the same terminologies interpreted in multiple ways has meant everything getting bogged down in pledges and initiatives, hindered by a lack of agreed-upon measurements, standards, and disclosures. So-called greenwashing is much easier if there are fewer agreed-upon terms, which means banks are not as motivated to deliver on what they declare as it is not easily verifiable.

Growing awareness of the political economy of ESG and cultural differences across markets

Leading industrial nations arrived at their current wealth, in part, through the use of resources that were not properly paid for – whether that be environmental resources or slave labour. Global banks refusing to lend to certain industries could deny developing countries the ladder industrial nations walked up and threaten widespread unemployment for non-green sectors.

Sustainability is not a priority in emerging markets in the way it is in other regions, as many economies rely on less climate-friendly industries. Many emerging markets do not have the means to shift their supply chains to make environmentally conscious decisions, nor do they have robust political support for sustainable practices. ESG can appear to a be self-aggrandising, neo-colonial agenda from this perspective.

This is an edited extract from the ESG (Environmental, Social, and Governance) in Financial Services – Thematic Research report produced by GlobalData Thematic Research.

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