Interest in environmental, social, and governance (ESG) investing has been growing rapidly in recent years. This accelerated interest is a direct response to a rise in global business risk, coupled with a greater demand among investors for environmentally sound, socially conscious, and sustainable business investment opportunities.
The trend towards ESG investing may be a welcomed bright spot for the financial services industry that tends to prioritize earnings over values. However, there are a number of fundamental challenges banks and investment firms face when serving ESG investing opportunities to their clients. These challenges deserve significant consideration and planning in order to fulfill investment goals and remain compliant with ESG regulations.
Understanding ESG Investing
Before we can get into the challenges of ESG investing, we need to attain a little perspective.
ESG stands for three core sets of criteria:
- Environmental – How committed a company is to preserving and conserving natural resources
- Social – How committed a company is towards building positive relationships with employees, suppliers, customers, and the communities where it operates
- Governance – How a company approaches leadership, executive compensation, internal controls, audits and shareholder rights
These ESG criteria have two main functions:
On the one hand, banks and investment professionals are using ESG standards as a business risk assessment. In this case, ESG is employed to test the fitness of a business in an increasingly uncertain world. A wide range of global challenges are putting business resources, operations, and reputations at risk. These challenges include: climate change, environmental degradation, increasing regulatory requirements, economic uncertainty, and demographic shifts as well as threats to data privacy and security. All of these challenges can derail an unprepared business and its operations, and this translates into greater risk for investors.
On the other hand, socially conscious investors also use ESG criteria to screen potential investments in search of companies that share the same values or mission that they do. Many younger investors want to invest specifically in companies that are committed to environmental, social, and operational responsibility.
Three Challenges to ESG Investing
Given the above, there are three fundamental challenges to integrating ESG with investment decision making:
Keeping up with ESG Regulatory Changes
Regulatory bodies have been working to achieve a global standard definition of “environmental,” “social,” and “governance.” With that standardization comes a fresh wave of regulations and compliance requirements. For instance, you cannot just label any business as “sustainable” or ‘green’ because your institution or firm unilaterally decided so. In an attempt to avoid ‘greenwashing’ practices (i.e. the process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound.), a company needs to meet strict requirements as set out by the European Commission.
Additionally, the European Commission’s recently announced amendments to MiFID II that are of great relevance and importance. Under these amendments, financial institutions and investment firms will be obligated to make a sustainability assessment for each client to help ensure that the business accurately meets the desired level of sustainability.
Setting Internal ESG Investing Standards and Goals
ESG investing means different things to different institutions and financial professionals. Specific client segments will also have specific needs and preferences. The definition of environmental, social and governance will thus vary to some extent between one financial institution or firm and another. It may additionally vary within the institution itself depending on the targeted investors.
Banks and investment firms will therefore need to conduct a thorough audit and risk assessment to determine ESG investment goals. These institutions must also establish the criteria that will be used in order to ensure portfolios and the investments included therein meet the stated goals. For instance, how will the institution balance improving ESG credentials with the management of factors, such as credit risk, cost reduction and consolidation.
Getting Reliable Data
ESG analysis has been growing in importance as part of the ESG investment process. Each company and industry has its own specific ESG risks and opportunities. During due diligence processes, the use of ESG criteria is a way to evaluate potential operational, reputational, or regulatory risks. This can only happen, however, when there is access to accurate, reliable and relevant ESG data.
One of the biggest challenges for investors is that this information takes on many forms and requires an assortment of sources that must be continually updated. Examples include: a business’ financial data, operational and organizational data, environmental impact metrics, and market data. These metrics just scratch the surface.
In short, ESG investing represents a good opportunity for financial institutions and investment firms to reduce investment risk, while simultaneously catering to values-driven investors and promoting higher ethical standards. While there are certainly challenges to ESG investment integration that need to be addressed, the long-term benefits of ESG will touch both the companies and the wider society and they certainly outweigh the costs to be incurred .
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