Environmental, Social, and Governance (ESG) is a term and concept first proposed in June 2004 by the UN Global Compact’s “Who Cares Wins” initiative to focus on interplay between environmental, social, and governance issues

Importance of ESG Issues for Financial Institutions

ESG issues cover:

  • Environmental: Greenhouse gas (GHG) emissions, biodiversity loss, pollution and contamination, carbon regulation exposure, renewable energy;
  • Social: Labour practices, community displacement, human rights, health and safety, financial inclusion;
  • Governance: Corruption and bribery, reputation, management effectiveness

After a period of high multiple growth and low costs of debt, which characterised the period 2003-2007, financial stability and investment returns of the companies are now more closely linked to operational improvements. However, this cannot be delivered by focusing on financial factors alone. The companies that proactively manage ESG issues are better placed than their competitors to generate long-term tangible and intangible results and accordingly investors, analysts, and bankers have to consider ESG performance in their analysis of companies.

To ensure global long-term financial stability and economic development, the financial sector needs to focus on more responsible and sustainable business practices and factor in environmental and social issues into investment decisions, alongside traditional financial metrics.

Financial institutions need to urgently acknowledge and take action on significant ESG challenges such as climate change, population growth, and resource scarcity, which have larger implications for businesses, the economy, and society at large. These ESG challenges have particular relevance to financial institutions in relation to their role as financial intermediaries and as capital raising agents. Financial institutions are significant catalysts in promoting economic development. This role needs to include the promotion of sustainable business practices, failing which, financial institutions will end up facilitating practices, which have significant negative environmental and social impact and will miss opportunities to create new products and services that capitalise on ESG issues.

All financial institutions need to understand that incidents relating to negative ESG outcomes caused by their lending, client relationships, and advisory decisions, can affect them. These incidents may cause reputational and brand damage. In addition, they may potentially have direct financial impacts, such as:

  • Increased non-performing loans due to credit/default issues and client inability to comply with loan agreements;
  • Increased risk of litigation due to lack of appropriate disclosure on ESG risks for equity and debt issuance activities;
  • Higher cost of capital for the bank itself, related to:
  • Equity and debt holders requiring higher returns due to perceived poor risk management ability and quality of loan book;
  • Loss of a low cost patient source of capital for banks with retail operations if depositors shift their funds away due to concerns about the bank’s ESG impacts

Case in Point:
An Indian Congolomerate’s waterfront and power plant project: The company had damaged creeks and mangroves around its project site and clearances were secured on a piece-meal basis, circumventing mandatory regulations. As a result of this environmental degradation and non-compliance with ‘green’ regulations, a fine of INR 2 billion was imposed in 2013 and Environmental Clearance given to one part of the project was cancelled. The project developers were asked to build a harbour for the fisher folks to help revive their lost source of livelihood.

ENHANCED RISK MITIGATION

Financial institutions need to consider a full range of direct and indirect risks, including those driven by environmental and social issues, via their operations and client relationships.

They should consider the ESG risks that arise as a consequence of financing the operations of their clients, and understand how well the clients mitigate and capitalise on their potential exposure to ESG issues. This would also help financial institutions develop deeper insights into their business strategy and planning procedures.

By incorporating ESG criteria, the financial institutions can develop a more comprehensive approach to risk management. Addressing and potentially lowering or mitigating ESG risks increases the ability to understand the scope and significance of ESG issues and identify areas underserved by current products.

Case in Point:

An international bank had a potentially significant relationship with a mining and resources customer till 2009-10. The bank engaged with NGO stakeholders that raised concerns about a prospective project’s impact on the environment and on indigenous peoples. The issues were discussed with the client and bank attended a site visit in early 2010. Bank’s Reputational Risk governance process provided the framework for the bank to examine these issues and the client’s actions at the highest levels of the bank. As a result of this deliberation, the bank decided to exit the relationship with the customer in 2010.

VALUE CREATION

As ESG challenges such as climate change, water scarcity, deforestation, displacement of indigenous communities, and labour rights trickle down through value chains, new trends and pressures will continue to emerge. Financial institutions acting as a catalyst for sustainable development could take advantage of these new opportunities, stronger client relationships, and potential revenue streams.

Value may be created and sustained by:

  • Differentiating through innovation on existing products;
  • Identifying and creating new products and services in line with the new and emergent requirements of markets and society;
  • Adopting ESG governance systems to reduce the cost of doing business;
  • Helping clients improve their ESG performance through proactive management and advice, which can deepen the client relationships and also improve the quality of client portfolio;
  • Aligning with employee expectations in terms of social values, ensuring a better rate of attraction and retention for core human resources;
  • Having an enhanced reputation as a leader in managing ESG issues, driving competitive positioning and potentially increased market share.

ESG SIGNIFICANCE IN THE GLOBAL CONTEXT

Globally, financial institutions have developed their business cases in publications from organizations including the United Nations Environment Programme Finance Initiative (UNEP FI), the International Finance Corporation (IFC), Principles for Responsible Investment (PRI), CDC (a UK development finance institution), Carbon Disclosure Project (CDP), and the CFA Institute. These organisations provide the basic framework for ESG and organisations can adapt those principles as per their requirement.

ESG-related regulation and compliance is a constantly evolving process. Environmental and social regulation can be aimed at the broad company level, and more specifically at the banking and finance sector. Some of the recent regulatory developments are as follows:

The China Banking Regulatory Commission has launched the Green Credit Guidelines, specifying how banks should integrate sustainability into their lending practices, both in domestic and overseas financing  in 2012 and published the Green Credit Guidelines Statistical System in 2013, requiring
Chinese banking institutions to report loan balances in 12 green sectors, including sustainable forestry, sustainable agriculture, and overseas lending based on international sustainability standards.

FEBRABAN, the Brazilian Federation of Banks, signed the Green Protocol in 2009 with the Brazilian Ministry of Environment. Banks, the government and NGOs jointly developed a set of indicators to monitor compliance with the Protocol and banks are now reporting on this.
In May 2014, the Central Bank of Brazil published Resolution, which requires all financial institutions authorised to operate by the Central Bank to draft and execute a Socio-Environmental Liability Policy (SELP) by 2015. The main aim of the SELP is to prevent losses stemming from environmental damage caused by the activities of the financial institutions as well as their clients.

Influenced by global dialogues and stimulated by Indian policy makers, the Indian business diaspora has been, for the past few years, increasingly engaging in conversation and action on management and measurement of ESG parameters. This shift in focus towards non-financial metrics comes amidst an increasing demand from global customers and investors for ESG disclosure, along with the launch of the National Voluntary Guidelines for Social, Environmental and Economic Responsibilities of Businesses (NVG-SEE), which is applicable for all Indian businesses. In 2012, the Securities and Exchange Board of India (SEBI) mandated the filing of an annual Business Responsibility Report (BRR), which focuses on ESG performance, for the 100 largest publicly traded firms. Some of the adopters of the ESG framework in the Indian context are as follows:

Signatories to CDP: HDFC Bank Ltd, IDBI Bank Ltd, IndusInd Bank, IDFC, Reliance Capital Ltd, State Bank of India, Tata Capital Limited, Yes Bank.

Signatories to UNEP FI : IL&FS, Yes Bank.

IN CONCLUSION

In the end it all comes down to basics. And the basics are such. If you cannot or do not make the ground you stand or work on a priority, at some point in time, this ground will crumble. Businesses will suffer. And no one wants to bank on a suffering business. Worldwide, financial companies are going green or blue, because it helps their viability and visibility with customers and the community they do bussiness in. With dynamic markets and much-needed wider customer reach, a viable business equals a bankable business. It thus comes as no surprise that financial institutions adopting ESG have proved time and again that it is equally important to be relevant than just successful. 

As shared with IFIN Panorama Editorial Team


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