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ESG Investing: The Reshaping of Finance and the Global Economy

Suman D’Souza

Managing Principal, Business Consulting, EPAM

Jeremy Taylor

Head of Capital Markets Business Consulting, EPAM
Blog
  • Financial Services

Though 2020 is now in our collective rear-view mirror, we are unlikely to forget such a challenging year. Filled with political upheaval, climate crises and a deadly pandemic, the year accelerated businesses’ already-packed agendas with a call to demonstrate sustainability, social responsibility and ethics in their operations. And 2021 expedited this trend with evermore socially- and environmentally-aware consumers ready to hold them accountable.

Financial services organizations are responding to the environment, social and governance (ESG) call to action; and best-in-class players are emerging as active leaders. These leaders are not only setting their own standards, but they are also shaping the investment toolkits available with other sectors. Investing in an ESG program is no longer optional—it’s a must have in this age of discerning clients and investors. In this blog, we’ll discuss how we got here, align on key terms and explore the role of the financial services industry in this new frontier. 

Why Now?

While 2020 acted as a catalyst for companies to act in a sustainable way, the wheels have been in motion for a massive overhaul of how we do business for the past decade. Perhaps the most high-profile call to action was the UN’s release of its 17 Sustainable Development Goals (SDGs) in 2015. Ranging from ending poverty to combating the climate crisis, the goals call on the public, private and social sectors to come together to create a more just and equitable society for all.

In response, the Financial Stability Board (FSB), an international group that monitors and makes recommendations about the global financial system, created the Task Force on Climate-related Financial Disclosures (TCFD) to develop voluntary disclosure recommendations for companies to provide to investors, lenders and insurance providers, which it released in 2017.

Additionally, the U.S. and the European Union have each introduced their own Green New Deals, with Europe’s being signed into law, which could require companies to change their ways of working.

The importance of these recommendations and regulations increased in 2020.  The accumulation of all these factors, alongside greater public pressure and the ongoing digital revolution, creates an inexorable and accelerating requirement for firms to transform all aspects of their value chain.

From ABC to ESG: The Alphabet Soup of Sustainable Finance

Before understanding what the role of your organization is in this evolving environment, it’s essential to align on the key terms. A good place to start in terms of understanding the scope of ESG is to look at its definition:

Sustainability is also a key word that is now commonly used to describe a more socially-acceptable way for governments and businesses to conduct themselves. Often used in an environmental context, sustainability refers to the ability to meet the needs of the present without compromising the needs of future generations.

Specifically, sustainable finance refers to the process of taking account of environmental, social and governance considerations when making investment decisions, leading to long-term investments into sustainable economic activities.

The Role of Finance Organizations

Financial institutions can perform a key role in shifting investment towards a more sustainable economy.

When developing their ESG strategies, firms need to take a holistic view of their vision, mission and values. They also need to assess their current business activities and determine a strategy for each sub-business unit that will ensure that they remain viable going forward. This will include divesting from those businesses that are simply unable to be adapted to a sustainable business model.

In simple terms, business units can be categorized according to their sustainability as:

  • Already viable and will remain so
  • Require investment to make them viable going forward
  • Will never be viable

While there is a huge focus on climate change mitigation and all matters environmental, a key component of ESG is also ensuring that any investments and collaborations made have been assessed through a socially-responsible lens. Factors to consider when creating governance and processes are not only in the ongoing management of direct relationships but also managing third- and fourth-party risks with associated exit plans in the event of agreed conditions being breached. Any impact creates negative brand reputation and therefore potential shareholder value impact, which necessitates appropriately granular, accurate and timely data to constantly monitor the entire financial and operational supply chain. Every vendor and partnership relationship must be recorded and fall under proactive, transparent governance processes to eliminate the associated risks. 

Many companies start their ESG journeys closer to home—looking inward. They begin by promoting inclusive hiring practices, improving benefits to employees and assure they are paid adequately and fairly for their work.

Company ESG programs can only improve after they first discover where they are with a full-throated assessment—and they can only continue to advance with ongoing monitoring. An appropriate level of ongoing governance and oversight of ESG adoption status will need to be implemented to monitor progress and continually adapt to what will continue to be a changing landscape. Every decision, at every level of the organization, will need to be thought though an ESG lens. It’s essential that company leadership demonstrates this as it will be crucial to creating the right cultural change and integrating into a business’s DNA.

Conclusion: An Opportunity to be at the Vanguard of Ethical Investment

As the world begins to emerge from the pandemic, organizations stand at a cross-roads, as consumers demand that companies reset their principles to align with the ethical and sustainability values articulated by leading global organizations like the UN.

Evaluation of loan portfolios and asset pricing will now need to include ESG factors alongside the established traditional risk factors. Corporate cash-flows and profitability will now depend on how viable they are for a given climate scenario or how much social benefit they bring. Investment managers, liquidity providers and the capital markets will need to weigh all aspects of a corporation’s operations, product lifecycle and supply chains against key ESG metrics. As such, financial service firms need to understand these risks, analyze and measure the impact on their cash-flows and develop business models and infrastructure to position their businesses accordingly. End clients will demand greater transparency, and as Millennials and Gen Z acquire more wealth and assets, they will therefore care much more about sustainability in the future. This will drive spending habits and personal wealth planning. 

Firms that are effectively stranded with assets tied to carbon emissions and non-sustainable practices will see the value of their businesses gradually depreciate over time and experience an out-flow of investment. Those businesses and asset owners who can pivot their business models towards greater sustainability in all its respects will see a growth in value and will earn an investor a commensurate return benefit.

In our upcoming white paper, we will discuss how EPAM can assist sophisticated technology, high-quality data and analytics and process and procedural updates necessary for firms who are ready to lead the pack into this exciting new arena.

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