Companies – from multinational corporations to small to medium enterprises (SMEs) – are facing a new layer of scrutiny from banks and investors. And everyone is talking about ESG. Why is this? And what do firms need to consider?
In 2015, several international agreements spurred publicly owned banks to act on sustainability:
- the United Nations General Assembly established the Sustainable Development Goals – 17 global goals to steer the world to "a better and more sustainable future for all"
- the Paris Agreement – a legally binding international treaty on climate change – was adopted at COP 21 in Paris, on 12 December, and
- the G20 and UN agreed Financing for Development to get the central and public sector banks to mobilise private banks and financial institutions.
That’s when private sector firms started to align business strategies and corporate culture with development goals.
What is sustainable finance?
From a bank’s perspective, sustainable finance is an additional framework used to decide how to assess a client’s business.
Previously, a bank would base these decisions on financial reports, business plans and credit worthiness.
Now, they look at a firm's sustainability and performance targets. Some banks might discontinue working with a client if the business isn’t doing enough on sustainability.
The SDGs weren't designed as a financial framework, but without an alternative, banks are sometimes using them to align their lending.
What’s ESG and how does it fit into corporate investment?
ESG stands for ‘environmental, social and governance’.
An ESG score measures the environmental and social good that a company does through its operations. The problem is that there are different ESG scoring methodologies. Some will look at the way a firm is run, rather than its products or services.
Some ESG branded companies may manufacture products you wouldn't necessarily consider green and have a surprisingly good ESG score, for example, British American Tobacco. An oil company might score well for ESG if it has good governance and high environmental standards of drilling.
A breach of social standards – which comes under the ‘S’ in ESG – could have an impact not just on a company but on those who invest in it. For example, a company that uses exploited labour in its supply chain, risks reputational damage.
But recently, that reputational damage has also extended beyond the company to investors in that company, including pension funds and fund managers.
This is especially true if that stock forms part of an investment product that’s branded as ‘ethical’ or ‘sustainable’.
How can a company improve its ESG score?
One effective method is to design operational performance metrics that target particular elements of an ESG score that a company wants to improve.
A company might also seek to explain how its strategy aligns with specific SDGs and the underlying targets within that goal.
The key to success is to have a clear operating plan setting out what you’re going to do and how.
What’s the future of sustainable finance?
There are moves among regulators – particularly in the EU – to standardise ESG measurements. Sustainability standards are also likely to get stricter.
Recent court cases around the world are also shaping corporate behaviour as well as government policy on sustainability and climate change.
Earlier this year, a Paris court found the French government guilty of failing to address the climate crisis.
In May, a court in the Netherlands ruled that Royal Dutch Shell has a duty to comply with global climate policy. Other firms will be looking at how this legal precedent could affect their operations.
And just this month in Australia, teenager Anj Sharma won a case against the Minister for the Environment. The court ruled the minister must consider harm caused by climate change to the rights of future generations when approving the expansion of a new coal mine.
See our Centre for Sustainable Finance