There has been a growing recognition of the significance of Environmental, Social, and Governance (ESG) factors in investment and business decision-making, leading to a significant evolution in how ESG risks and opportunities are assessed. In this dynamic landscape, equity investors, fixed-income investors, and lenders are using ESG factors to make investment decisions, as responsible companies have consistently provided better financial returns and offer better protection from downside risks.
Effective ESG risk management needs good data, the ability to estimate if data is not readily available, an understanding of material issues for each sector, data for benchmarking against peers in the industry, and models to score the company on its risk management capabilities.
This allows investors to identify businesses with significant risks and those that are proactive and manage ESG risks well. ESG leaders are characterised by their robust ESG risk management, active stakeholder engagement, measurable impact, ethical leadership and accountability, and commitment to innovation. These distinguishing factors collectively position ESG leaders at the forefront of sustainable investment, enabling them to drive meaningful change globally. These ESG leaders will often attract attractive lending terms and interest rates and get greater multiples on their stock price.
The business case for integrating ESG into lending
For banks and other lending institutions, ESG risks could manifest from multiple areas, and they will need effective strategies to manage their portfolio to avoid negative financial implications or reputational damage.
Lending institutions need to outline the various types of risks that could affect their portfolio operations and, in turn, reduce their creditworthiness. Environmental risks are now widely discussed and understood, and RBI’s guidelines on the climate disclosure framework are now making this mandatory.
Banks also have a significant influence as lending institutions and can encourage businesses to work towards the interests of local communities, safeguard human rights, and offer decent pay to ensure adequate living standards. Social factors can translate into severe risks for businesses and loss of reputation for financial institutions lending to them. Finally, governance issues are well understood, and companies not adhering to local regulations, independence of the board, business ethics issues, or board compensation and remuneration could have a detrimental impact on the bank’s lending portfolio and reputation.
While some of the banks, due to evolving regulations and the looming climate-related risk, have started incorporating physical and transition-based climate risks into their portfolio assessments, however, very few of them go beyond to understand the wider ESG impact from their borrowers.
Opportunities in Sustainable Finance
Sustainable finance has seen spectacular growth since 2015; as per Precedence Research, the worldwide outstanding amount of green, social, and sustainability loans, bonds, and similar instruments exploded from less than $100 billion in 2015 to $4.5 trillion in 2022. There has been reduced overall activity in 2023; however, the value of this market is expected to grow 20 per cent annually for the next decade and touch almost $30 trillion by 2032. The bulk of this growth will come in from Asia Pacific.
Like many places around the world, India has witnessed the hottest summers in over 100 years, and extreme weather events are becoming more frequent. India’s 2030 climate targets submitted under the Paris Agreement involve a reduction in carbon emission intensity by 45 per cent compared to 2005 and an increasing share of non-fossil-based energy sources. India needs approximately $170 billion per year in investments and so far is raising an average of $44 billion per year, which is ambitious.
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Sustainable finance is pivotal for India’s sustainable development, including financing projects like renewable energy, eco-friendly infrastructure, new technology supporting climate risk mitigation, and green initiatives. Beyond the traditional green financing products, like sustainability-linked loans or bonds, opportunities include ESG integration in investment and impact investing tied to positive outcomes like microfinance initiatives, banks can invest in research and innovation and partner with fintech companies to explore innovative solutions for sustainable finance.
Risk management strategies
Traditionally, banks focussed on financial risks such as market, credit, and liquidity risks. Non-financial risks are now recognised with the introduction of ESG. With improved data on how its clients are performing beyond the traditional financial numbers, banks can now get a longer-term horizon and resilience of the business. For instance, how will the business weather climate change, social unrest, policy or regulatory changes, internal needs around equal pay, employee development, etc? Banks will need to invest in domain experts who understand ESG, and tools that can help gather high-quality data and assessment platforms. Having this allows them to manage their risk and identify opportunities.
Challenges and Barriers
The primary challenge often stands out as a lack of transparency and standardised data. For the data to be acceptable, it must have provenance, follow global reporting frameworks and methodologies, and be reviewed for accuracy by independent assurance providers. Additionally, most businesses should not have the requisite ESG knowledge to provide accurate data on time. Banks must invest in solutions that can help plug this gap and offer end-to-end solutions.
Sustainable finance introduces new risk dimensions, including environmental and social risks, which are complex to assess and manage. Most banks may not have the expertise and tools necessary to understand and analyse this risk. Building this capability in-house is challenging due to cost and resource constraints, as investments will be needed in technology, data analytics, hiring experts for capacity building, and employee training.
Divestment or transitioning from existing portfolios to align with sustainable finance objectives is also logistically and financially challenging.
Conclusion
In conclusion, while the adoption of sustainable finance or ESG by banks and other financial institutions holds immense potential for driving positive environmental and social impact, various challenges and barriers must be addressed. Standardisation of definitions and reporting frameworks, improved data availability and quality, enhanced risk management capabilities, and increased stakeholder engagement are crucial steps towards overcoming these obstacles. By collaboratively addressing these challenges and fostering a supportive regulatory environment, banks can effectively integrate sustainability considerations into their operations, contributing to the transition towards a more sustainable and resilient financial system.
Views expressed by – Ramnath Iyer, Co-Founder and CEO, ESGDS
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