It will not come as a surprise if we say that our world is overcrowded: Nowadays, we are seven billion humans. By the end of the century, predictions say we will reach 10 billion. And we’re consuming natural resources very fast, at a more rapid rate than they’re generated.
These are environmental and social issues, but they’re also economic issues. The Financial Services industry is a vital enabler for the real economy. It supports economic well-being, which then increases the ability of families and Governments to improve social outcomes. The financial industry is playing an increasingly relevant role in the deployment of sustainability.
There are mainly three ways through which financial institutions can tackle sustainability.
The first way consists of sustainable investing. Sustainable investing embraces all those investments contributing to environmental and social issues. They tackle challenges like renewable energy, waste management, greenhouse gas emissions, circular economy or social cohesion and integration.
Sustainable investing is less complicated than what we think, better-performing than we believe, and more important than we can imagine. In fact, research shows that the long-term performance of sustainable funds outperforms non-ESG funds. ESG factors are not just ‘nice to have’ but true determinants of higher success.
Sustainable funds also outclassed traditional funds during the market sell-off sparked by coronavirus in the first quarter of 2020, granting average excess returns of up to 1.83%. This was mainly due to ESG funds’ low exposure to oil and gas, which faced steep losses in value during the initial phase of the pandemic.
If we look at the ESG funds that existed 10 years ago, 77% are still up and running. However, only 46% of traditional funds still exist. ESG funds have withstood the commercial pressures that forced the shutting down of traditional funds. This is probably due to their niche status and dependable, institutional investor base. However, this may change once sustainable investment products reach mainstream status.
Still, institutional investors are the x-factor in sustainability. Why do they hold the key? This answer is a simple one: They have the money.
The second way financial institutions can have an impact on sustainability is by putting in action a full and transparent disclosure on how sustainable their activities are. The European Commission is pushing an agenda that will guide banks and other institutions toward more thorough transparency when it comes to disclosing their sustainability policies.
The Sustainable Finance Disclosure Regulation came into effect in March 2021. Financial market participants and financial advisers are obliged to release details on their sustainability risk policy, as well as adverse sustainability impact of their investment decision and remuneration policies.
Another key issue to keep in mind is how this new regulatory direction is strictly tied to data and analytics. The quantity and quality of ESG data that needs to be consumed should be enough to embed sustainability into decision making. This is not just a compliance check box exercise anymore.
The third and last approach entails banks and especially insurance operators to contribute through value-added services to the awareness of society towards sustainability. Financial players can help their customers to transition to greener attitudes. However, while some progress has been made, a 2020 U.N. report revealed that only two in five businesses that have committed to the U.N. goals have sufficiently adapted their targets to accomplish them.
Banking and insurance customers are more aware and demanding than ever in terms of sustainability. It’s clear that moving forward will need some serious legwork from financial institutions, especially for Gen Z and Y consumers, who are leading the shift toward more environmental and social friendly spending habits.
On the other hand, insurance operators are working to enhance their customers’ practices through impact underwriting. In practice, insurance players are persuading their policyholders to adopt a greener lifestyle in a number of ways, like by incentivising the adoption of eco-friendly appliances, buildings and cars. Besides offering lower premiums for eco-friendly choices, insurers can allow for upgrades to more energy-efficient appliances and machinery as well as encourage people to opt for repairs instead of replacements.
Sustainability: risks and financial implications
Stepping aside from the purely financial context, corporates in many different sectors face risks related to sustainability. We’re talking about all the environmental, social or governance situations that, if occur, may have negative impacts on the assets, financial and earnings of a supervised entity, or even on its reputation.
One of the most obvious examples of an activity heavily impacted by sustainability matters is the supply chain. There are mainly two types of sustainability-related risks that are impacting supply chains.
If we consider, for example, a consumer company, the first type of sustainability risk has to do with the impact of providing goods and services to customers, which will often generate far greater social and environmental costs than its own operations.
The second type of risk is represented by how sustainability impact can interfere with consumer companies’ supply chains. For example, GrainCorp, a large Australian agriculture business, reported that a drought cut its grain deliveries by 23%, leading to a 64% drop in 2014 profits. Unilever estimates that it loses some EUR 300 million per year as worsening water scarcity and declining agricultural productivity lead to higher food costs.
How fintechs and incumbents are fostering sustainability
Everything has been put aside by the global pandemic. The U.N. announced that to reach its 2030 goals would mean “reimagining the way people work, learn, live and consume, and listening to young people.” And we believe startups will play a crucial role in the process, with the advantage of being born as remote-friendly entities.
In the rigid financial sector, fintech startups can bring a breath of fresh air. Fintech can have important potential implications for the implementation of a range of sustainable development applications, as the technologies they rely on will continue to develop over the same timeframe as the implementation of the Paris Agreement and SDGs.
The future development and adoption of innovative technologies like blockchain, IoT, big data will lead to a radically different financial and capital allocation system tailored to reach inclusive and sustainable development.
The Impact of COVID-19
COVID-19 has shown the world what a global challenge looks and feels like. Everything stopped, and this gave us the opportunity to perceive the positive effects that it had on the environment.
However, during the pandemic, the accent has been put on social initiatives rather than environmental ones. For example, companies’ social purpose and their treatment of employees has never been more closely scrutinized. On the other hand, back in March 2020, green bonds issuances were only a third in value compared to the previous year.
Another key aspect emphasised by COVID-19 is the need to manage reliable data in an efficient way. Data, risk management and modeling have played a crucial part in the firms’ reaction to COVID-19 and now corporates should harness the significant efforts made over the past six months. Data capture, building tools and knowledge to improve risk modeling, and stress testing can be valuable allies when building a sustainability policy.
A Conclusion
Mark Twain said, “Plan for the future, because that's where you're going to spend the rest of your life”.
The financial system has worked for long on its own set of principles, focused on attracting clients and maximising short-term profits. These principles are the fruit of a capitalist and closed economy that is no longer valid. In a circular and sharing economy focused on the needs of customers and the environment, social and governance issues are key.
As we have seen, the same financial system that was somehow one of the oppressors of environmental and social development is now at the core of this sustainable transition. By focusing on greater environmental responsibility, climate resilience, low-carbon, human rights, gender equality, social inclusion, sustainable economic growth, and many other objectives financial institutions can thrust for a full-scale transformation that will swiftly spread to other sectors of the economy.
About Alfredo Soria
Alfredo leads Plug and Play flagship Corporate Partnerships for Financial Services in continental Europe. Based out of Frankfurt, Germany, connects leading corporations with startups in order to obtain pilots, contracts, and explore strategic investment opportunities.
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