The Role of Sustainable Finance in the Race to Net Zero

At A Glance – An Essential Role to Play

Sustainability matters to investors due to the surmounting risk associated with the climate emergency. As it stands, 125 countries are currently committed to net zero by 2050 – so what role do global financial institutions have to play in instigating this transition?

The symbiotic relationship between responsible investment and protecting planetary boundaries will prove to be a powerful tool, argue leaders of COP26.

The following article provides an update on the trajectory of ESG (Environmental, social, governance) performance in the wake of COVID-19. Through industry insights, it analyses the continued value of sustainable investing through strong returns thus far in 2020. It distinguishes the variance between materiality and immateriality indicators of both commercial and diversified banks to illustrate which indexes guide investors decision making.

Commentary from Marc Carney, Financial Advisor of COP26, draws attention to key areas of focus for global financial markets and policy makers in this new age of adaptation. This includes how lessons from the 2008 recession can be used to guide structural changes as nations manoeuvre their recovery efforts into one that is green.

Stewardship of future generations and the flattening of the climate curve requires inclusive multilateralism with all state and non-state actors but without the backing of the financial community. Our ability to curb 1.5-degree pathway is limited.

In Focus – 2020 Updates

If you are familiar with Sustainable & Social, you will have followed my various features on ESG analysis within the financial industry. For a brief recap, you can click here.  

Currently, 93% of the world’s largest 250 companies report on their ESG performance. The Global Initiative for Sustainable Ratings has identified that over 600 ESG products exist across the world from over 150 organisations. This in turn provides over 10,000 unique ESG metrics related to environmental, social and governance criteria that are used to inform asset and portfolio managers strategies. (Source: KKS & Global Alliance for Banking on Values)

The uptake of ESG has accelerated in recent years, for example in 2012 the value of global assets allocated via ESG related strategies was $13.2 trillion, by 2018 this had hit $30 trillion. Given the emphasis on green fiscal stimulus packages to remedy the economic downturn provoked by COVID-19, as a sense check, one could assume the only way is up!

There is compounding evidence pointing to the positive impact of ESG for investors.  A recent study conducted by Saïd Business School found that companies with a good sustainability rating received 15% more investment from wealthy investors every month over the years 2016-19, compared to those with a lower rating!

Supplementing this, KKS Advisors and the Global Alliance for Banking on Values conducted a comprehensive research case that revealed the power of ESG in providing returns. From their sample of 100 banks between 2010-2017, they found that top materiality portfolios outperform others by 2.65% in average risk-adjusted returns.  This further strengthens the notion that the pursuit of sustainability targets and strong financial performance are not mutually exclusive. Through ESG strategies, banks and firms are able to deliver value to all stakeholders.

An important note on the methodology of this study, they split the performance of these banks into materiality and immateriality related issues.

Materiality related factors for commercial banks include:

  • Access and affordability
  • Labour practices
  • Data security and customer privacy 
  • Lifecycle impacts of products/services 
  • Business ethics 
  • Systematic risk management 

This varies from diversified banks which have materiality related factors such as:

  • Fair marketing and advertising 
  • Compensation benefits 
  • Diversity and inclusion 
  • Integration of ESG risk factors
  • Management of legal/reg environment
  • Systematic risk management 

Immateriality issues are those that would NOT be immediately affected by the financial condition or operating performance of a bank such as:

  • Staff activities, use of office, greenhouse gas emissions, energy/waste management, health and safety  
  • Greenhouse gas emissions and climate change 
  • Energy management
  • Water resource management 
  • Human rights and community relations
  • Employee health and safety  
  • Business model resilience 

The Impact of COVID-19 on the Direction of Sustainable Finance

The spread of COVID-19 has accelerated economic recovery packages throughout the world that look at green fiscal stimulus measures which are resilient to future climate related shocks. It is therefore no surprise that the effects of coronavirus have enhanced the investment appeal of ESG as asset managers hedge their bets on funds committed to a sustainable future.

Earlier this month, the FT in partnership with Savanta, the market research company, published a study that revealed:

  • Almost 9 in 10 managers believed the pandemic would result in increased investor interest in ESG investing
  • 35% interviewed expected significant increases in ESG (Wealth managers such as Rathbone Brothers, Canaccord Genuity Wealth Management and James Hambro & Partners) whereas 52% expected a slight increase.
  • Interestingly, only 3 % of those polled said they believed interest in ESG would slightly decrease and 10% expected no change.

Data provider Morningstar has identified similar trends. They note that investors added a net of £2.9 billion into ESG investment funds in the first quarter of 2020 which makes it the second-best recorded quarter for such funds.

Activity published under BlackRock confirm the pattern. In a statement they announced sustainable strategies have performed far more superiorly in this period of extreme volatility. The firm noted that 94% of a globally representative selection of widely-analysed sustainable indices outperformed their parent benchmarks in the first quarter!

Commentary from Marc Carney

This month COP26 launched their Race to Net Zero campaign to mobilise leadership and support from governments, businesses and investors on climate action and for a healthy and resilient economic recovery. Financial Advisor to COP26 and previous Governor of the Bank of England, Marc Carney shared the vision on the direction of the finance industry in an insightful panel discussion with Maria Neira, Director of Public Health for WHO and Nigel Topping, High Level Climate Champion for the UK.  

The role of sustainable finance must use financial frameworks such as climate stress tests and lessons learnt from 2008 to create jobs and to unlock sustainable growth.

Carney warned leaders must take a cue from the current health crisis, noting “You can’t wish away systemic risks and it is cheaper to deal with them now and mitigate them because we cannot socially isolate ourselves from climate change”.

With 125 countries currently committed to net zero, he underpinned the essentiality of reporting and reviews of targets and climate ambitions in order to continually distinguish the leaders and the laggards and drive optimum performance.

Reporting is a vital instrument for asset managers to measure where they are currently positioned in this transition to a low carbon economy.  For this reason, the whole industry must collaborate to create a precise and unified reporting infrastructure that enables them to do so.

Banks will have a fundamental role to play in reaching carbon neutrality. Carney emphasised the importance of their incorporation of net zero into their lending structures and risk management techniques such as climate stress tests and adjusting their supervisory approach.

The power of the Network for Greening Financial System which oversees countries responsible for two thirds of world emissions will be integral in dictating how supervisors should oversee banks and risk management. The UN Principles for Responsible Banking which launched in 2019 will also look to encourage activity in this arena through their model of cycle value creation.

Financial institutions are well aware of these measures, but need to scale their commitments at a rapid pace. The momentum has also been shifted by citizen engagement and curiosity as to where their money is being invested. If this allocation of funds is not in line with their nation’s commitment to the Sustainable Development Goals and the Paris Agreement, these banks stand to experience much scrutiny by their customers.

Moderator Topping queried the lessons that financial players can learn from the 2008 recession to inform next steps.

Carney explained whereas before there was not sufficient structural policy, there is a higher level of sustainable infrastructure in place to guide institutions. He noted that the finance sector must now question where the economy is headed and look beyond simplistic measurements of direct greenhouse gas emissions, but to broaden their analysis to incorporate for Scope 2-3 greenhouse gas emissions as well.

He placed value in the private investment sector and how they can steer the correct direction for an economy that society truly wants. This includes investing in sustainable organisations that are more inclusive and divesting from fossil fuels.

“Whereas finance was the problem in 2008, finance can be part of the solution for the economic recovery of COVID-19, but more importantly a long-term catalyst to mitigate climate change.”

The recent launch of Race to Net Zero online conference with Nigel Topping, Marc Carney & Maria Neira

Perhaps the most important takeaway from this is the nexus of how climate, finance and public health will need to be streamlined to reach our climate goals.

The panellist Maria Neira, supplemented Carney’s dialogue with some striking figures relating to the investment needed to curb the 7 million deaths that are attributed to the effects of pollution and particulate matter annually. She noted financial reform from the pandemic must include stopping taxpayer’s money funding pollution and fossil fuel subsidies. 

A recent study by the WHO revealed that:

  • Globally, about US$400 billion a year of taxpayers’ money is spent directly subsidizing the fossil fuels that are driving climate change and causing air pollution.
  • Neira sited that the TRUE value of this subsidy (including damage to health and the environment) stands at roughly US$5 trillion per year. This is more than all governments around the world spend on healthcare and about 2,000 times the budget of WHO.
  • Placing a price on polluting fuels in line with the damage they cause to human health would approximately halve outdoor air pollution deaths, cut greenhouse gas emissions by over a quarter, and raise about 4% of global GDP in revenue.

If this does not translate into motivation for a green economic recovery encouraged by the finance industry, I don’t know does.

Final Thoughts – The Protagonists in the Economic Recovery

Financial institutions will be the protagonists leading an economic recovery that tilts us in the direction of future green industries. Social and green bonds have had record issuance numbers in the first half of 2020 and new entities such as ‘Eden bonds’ which would be government bonds sold to investors on a long-term basis to finance the purchase and rewilding of farmland in the UK are also being discussed.

At a research level, it is evident that as the popularity of ESG increases amongst asset managers, organisations will be more willing to disclose more in-depth information on their environmental, social and governance performance.

This current trajectory opens up the conversation on how we, as a global society, view traditional forms of economic growth and if metrics such as GDP are becoming increasingly outdated.

If we are to reach carbon neutrality by the necessary date of 2050, we need to reframe the dialogue surrounding economic growth and policy. Policy makers and leading figures must be more agnostic in their interpretation of growth as Kate Roughton, author of the seminal Doughnut Economics, laments.

Achieving targets laid out in the Paris Agreement is not the sole responsibility of financial institutions, but all stakeholders must collaborate in an unprecedented manner to complete this unfinished business. Every moment counts and we cannot get to 2050 without unprecedented progress in 2020.

If you enjoyed this article be sure to read the analysis on the effects of climate change on human health and the post-pandemic green economic recovery.

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