ESG brings risks and rewards for Financial Services
Digital technology helps financial services overcome ESG data challenges and ESG-related risks.
Traditional financial institutions need to connect with their millennial customers, a demographic that is rapidly acquiring wealth. Offering financial products that are focused on ESG (environmental, social and governance) is one way that can help build that connection. Customers are now environmentally and socially conscious and are considering factors beyond just returns. A recent global survey of nearly 9,200 investors found that 39 percent had invested in companies with a demonstrated ESG performance A similar percentage had considered ESG factors in their investment decisions. With regulators also expecting enterprises to consider stakeholder interests while going about their business – even mandating ESG disclosure and reporting in several countries – sustainable investments are growing exponentially; in 2020, the world’s top five markets recorded ESG investments worth about $35.3 trillion, more than a third of their total assets under management.
For financial institutions, the shift towards ESG has a dual implication. First, they would need to sharpen the ESG focus within their own organizations, and second, incorporate sustainability considerations in their core businesses – lending, investing and fund management activities.
This is a lot more challenging than moving some money into “green” sectors, or lending to small businesses in the local community. This article focuses on one major challenge confronting banks and financial services companies, namely ESG data.
The difficulties of ESG data
Data relating to ESG is abundant and accessible, but it is far from standardised. Unlike financial metrics, ESG measures can be ambiguous and open to interpretation, not least because of a lack of regulatory direction. Also, while ESG-oriented organizations and portfolios focused on such companies are known to outperform the competition, a significant proportion of companies are unclear whether their chosen metrics improve investment returns or deliver socio-environmental benefits. While the major banks are at least reporting ESG metrics – albeit in different ways – smaller institutions lack the knowledge and resources for making disclosures, or don’t see business value in doing so.
The issues with ESG ratings
The data challenge gets amplified when financial institutions use ratings to make investment decisions, especially because there is a big difference in the ESG ratings of different external agencies. So, in October 2021, Infosys surveyed 455 investment and fund managers around the world to understand how they use ESG ratings and data to make decisions.
Investment firms that used both, their own internal ESG ratings as well as those from an external agency, performed the best, earning 6.90 percent higher returns than the S&P 500. However, because ESG ratings are so different and complex, firms end up using data from multiple agencies – our research suggested an average of three. So far, the results were underwhelming, with barely 25 percent of a plethora of external ratings making a statistically significant impact on investment performance. Interestingly, just because a rating was popular, did not mean it was effective; conversely, the research found that one of the less-used ratings delivered the best investment performance.
Also, a sizeable number of respondents were unconvinced about the contribution of (their chosen) ESG factors to investment returns. For instance, 44 percent said that their ability to pick ESG metrics that predicted investment performance was moderate, and an almost identical number said that they had only average confidence that those metrics would benefit the planet and its people in the long run. Again, very few of those who said their ESG metrics delivered one of these benefits (good returns, or good for people and planet) believed it would also deliver the other; the view seems to be that a set of ESG measures cannot maximise financial returns and socio-environmental benefits at the same time.
Clearly, there is a need for investment firms to improve their selection of both ESG ratings and ESG metrics. Fortunately, they already have the data analytics expertise required to understand these issues better.
Managing ESG risks
In an internal operations scenario, the data challenge can hamper a bank’s ability to respond to ESG-related risks and opportunities. The traditional risk models that banks use for underwriting, valuation, asset-liability management, liquidity forecasting etc. are proving less effective in conditions of environmental stress. Banks have to learn to factor ESG information in credit risk models that were built for data, such as demographics, financial health, occupational status etc. Here, they can apply machine learning and analytics to understand ESG data and filter the noise. Banks will also need to revisit the assumptions in their credit risk stress testing frameworks. Once again, a data analytics platform is required for building, testing and iterating new risk models; other digital solutions will be needed for sharing ESG-related risks to shareholders and regulators as part of sustainability reporting.
Tech to the rescue
During Hurricane Irma, Wells Fargo and Bank of America proactively deployed mobile ATMs so customers would be able to draw cash even if the regular ATMs stopped working. This is an example of how technology helps financial institutions deal with the physical impact of climate change.
But banks will have ongoing needs linked to ESG even during normal times. Fortunately, there are a variety of intelligent technologies that can help them deal with these issues. For instance, banks can use an analytics platform to capture, process and visualise data from ESG initiatives to assess performance, and share the insights with various stakeholders. Cloud-based solutions can record and calculate carbon emissions, and capture satellite images to look out for natural disasters. APIs drive open banking and ecosystem collaboration to spur ESG-linked product innovation, creating differentiation and revenue opportunities.
Sustainability is critical to the survival of our planet. Therefore, all businesses, including financial services, have a responsibility to improve their ESG stance, not least because their customers expect it. By becoming more sustainable as an organization, and also in the way they invest, banks can enhance brand value, customer loyalty, financial returns, and compliance. While this is not an easy transition, technology can support them throughout the journey to a sustainable future.