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Financial Institutions and the Transition to a Sustainable Economy

Key takeaways

  • Tarif Fancy, former head of investment at BlackRock, recently posted an important statement in the newspapers: Environmental, Social and Governance (ESG) investments do now contribute to solving the climate problem
  • Amsterdam Data Collective sees in the market that many financial institutions (FI) are engaged in the domain of ESG
  • Supervisors and regulators are developing regulation on the ESG topic for two main reasons: (1) climate-related and environmental risks have to be managed to safeguard the stability of the financial system and (2) FI have a key role to play in making climate agreements a success (e.g., the Paris agreement and the EU Green deal)
  • A fundamental choice for FI is to decide whether ESG is really in the core of the institution’s strategy or whether the topic is another regulatory compliance exercise with major impact on the risk management activities
  • If financial instructions embrace ESG concept in the core of the strategy, then also different performance measurement is needed. How can we measure the impact of a project on biodiversity, CO2 emission, labour circumstances, etc.? And how do all these aspects get reflected in the price of a transaction?
  • We propose some concrete propositions for different types of ESG challenges where we believe immediate results can be obtained

Many interesting articles on sustainability and Environmental, Social and Governance (ESG) have been published recently. Several examples in Het Financieele Dagblad (FD), the leading Dutch financial newspaper, are

  • “De Gouden Glans van Groen Beleggen” (translated: the golden shine of green investing; Ivo Bökkering and Pieter Couwenbergh, April 22, 2021)
  • “Niet de Groene Beleggingen zijn het Probleem, maar de Beheerders” (translated: the green investments are not the problem, but the managers are; Bas-Jan Blom, April 24, 2021).

Both articles are in response to the statement by Tarif Fancy, former head of investments at BlackRock, saying ESG investments do not contribute to solving the climate problem. After all, an increase in so-called funds has not yet led to CO2-reduction and, moreover, ESG investing even seems to have a counterproductive effect because CO2-emissions are increasing. In response to these statements, we can find the following two main messages in the two FD articles:

  1. Financial institutions (FI) do have a role to play in the transition to a sustainable economy and tackling the climate problem
  2. However, there are still many challenges to be faced by FI related to embedding ESG in the institutions’ strategies

In the FD of May 16, 2021 Orai McDonald writes in the article “Klimaatdoelen in gevaar door gebrek aan investeerders” (translated: Climate targets at risk due to lack of investors) that 50% of the EUR 355 billion needed to reach climate targets in the Netherlands is difficult to finance because of uncertainties of sustainable projects and potential high risk/low return. According to DNB a clear policy from the Dutch government is needed. Summarised, it is crucial that governments, the financial sector (FI and supervisors) work together in the transition to a sustainable economy.

Amsterdam Data Collective sees in the market that many FI are actively engaged in the domain of ESG and that they have often created separate departments dedicated to ESG and sustainability. The challenges that come up in conversations between Amsterdam Data Collective and clients are clearly in line with the main messages in the FD articles:

  1. Most FI (bank, insurance companies and asset managers) have not yet clearly integrated ESG into the strategy and business model
  2. FI are sometimes reluctant to invest in sustainable projects because of uncertainty and high risk/low return
  3. Most FIs are working on the integration of climate-related and environmental risks in the risk management framework, however, a lot of work has to be done in the coming years
  4. There is a proliferation of ESG ratings in the market and these ratings are not always in line with each other
  5. The outcome of the ratings can often not be explained because no insight can be gained into the underlying data on which these ratings are based
  6. There are no robust data sources yet to properly assess ESG investments, so ratings are difficult to compare

What are the Guidelines for the Financial Sector to Support the EU Green Deal?

In the meantime, European regulators and supervisors have not been idle to guide FI in what actions should be taken so that the financial sector can play a fundamental part in the European Green deal (December 2019). For banks and investment funds, the outlines of regulations and guidelines at ESG level are already quite clear, as can be seen in the publications of the European Central Bank published at the end of last year – Guide “On climate-related and environmental risks” (November 2020) and the European Banking Authority – Discussion Paper “On management and supervision of ESG risks for credit institutions and investment firms” (October 2020). Insurers and investment funds must already comply with disclosure requirements in the field of ESG according to the EU directive on sustainability-related disclosures in the financial sector (November 2019) and the European Insurance and Occupational Pension Authority (EIOPA) also expressed its ambitions in the field of ESG (January 2021). Moreover, there are also many FI that have signed covenants based on, for example, the OECD Guidelines for Responsible Business Conduct. The conclusion is that the role of FI will be greater and greater in making the green deal a success. While, at the same time, upgrading the risk management frameworks in such a way that climate-related and environmental risks can be measures and management in an adequate manner.

Which key business processes are affected by the EU Green Deal?

If you look at the publications of the ECB and EBA, you can see that these guidelines affect almost all business processes and departments of banks and investment firms:

  1. Strategy – ESG must be clearly embedded in the institution’s strategy
  2. Risk management – ESG and climate-related risks should be integrated into the institution’s risk framework and risk appetite statement (RAS)
  3. Risk measurement –
    1. Climate-related and environmental risks should be embedded in counterparties’ credit assessment (this is the ESG ratings investment),
    1. institutions should measure the impact of climate-related and environmental risks on traditional risks (market, credit and liquidity risk), and
    1. institutions should perform stress tests and scenario analyses related to these risks and integrate this in the Internal Capital Adequacy Assessment Process (ICAAP)
  4. Data management and risk data aggregation – FI are expected to be able to measure and report aggregated risk exposure in the field ofclimate-related and environmental risks

In a recent publication of the European insurance and pension fund supervisory authority EIOPA’s, the main objectives for insurers and pension funds can be read:

  1. Insurers should manage and mitigate ESG risks through their underwriting activity
  2. Insurers and pension funds should reflect policyholder and pension scheme member preferences for sustainable investments, where relevant
  3. Insurers and pension funds should adopt a sustainable approach in their investments based on principles of stewardship

Where Should FI start in the Domain of ESG?

Especially related to product development, some interesting things already happening in the market. Some FI already develop loans product where an interest discount is given when the activities of the lender have a positive ESG impact. The line of thinking here is: Should other factors than financial yield be considered when developing financial products? If a company financed by a loan or investment product deploys activities that support lower greenhouse gas emissions or improve biodiversity, should this also be reflected in the expected yield and hence pricing of the product? This interesting relation between value (financial value but also the value created in the ESG domain) and pricing is key in understanding the impact financial institutions can have in the transformation process of our current economy to a sustainable one. It all starts with the understanding that the impact of financial transactions should not only be measured by the the two traditional forms of capital, financial and manufactured, but also by other forms of capital that are equally important. The Integrated Reporting Framework (<IR> Framework, January 2021) advocates six forms of capital: financial, manufactured, intellectual, human, social and relationship, and natural capital. A major step forward for FI and corporates would be to design business processes such that value creation, preservation and erosion of their activities related to all forms of capital can be measured and managed. More details on long-term value creation, based on the <IR>Framework, can be found in Principles of Sustainable Finance (Schoenmaker and Schramade, Oxford University Press, 2019).

Amsterdam Data Collective can help FI with the challenges discussed in this article. There are different entry points where we can add value depending on the maturity level of ESG initiatives already deployed in the organisation. We believe that immediate results can be obtained with our propositions listed below:

  1. Design Sprint (DS) – A DS on how to embed ESG and sustainability in the strategy and the organisation of the institution. A Design Sprint is an efficient and highly energetic manner based on Design Thinking principles. A DS is carried out with stakeholders from multiple disciplines in two days. The process followed allows institutions to compress months of work into these two days of focus and productivity. The general steps in a DS are Understanding (where in organisation? What are ambitions?) – Mapping (map ambitions to key processes and business model) – Idea Creation (how to implement ambitions?) – Decide (roadmap/implementation and roles and responsibilities).
  2. Gap Analysis – We can help with a gap analysis between the status quo of the organisation, processes, systems, reporting and the ambition of the institution on ESG and climate related risks.
  3. Risk Management Framework (RMF) – We can help institution to perform a risk identification on ESG and climate-related risks, include these risks in the current risk taxonomy, work with the institution to come up with risk mitigation plans, and adapt the risk appetite statement to included targets, warning levels and limits in the area of ESG.
  4. Risk Measurement–
    1. We can help with developing scoring models that can explain the outcome of an ESG rating (using Natural Language Processing techniques). These models can be applied side-by-side with available ratings and will give more comfort in the “why” of the rating outcome.
    1. We can help institutions with setting up a scenario analysis and stress-testing framework that include physical (e.g., flood risk) and transition risk (e.g., risk that business model is not viable in transition to sustainable economy) impact on portfolios and businesses models.

Data Management and Data Aggregation – We can help institutions with a plan on what internal and external data should be unlocked so that the implementation of the ESG strategy and ESG and climate-related risks can be monitored and reported. If this process is still at an early stage, a Design Sprint is again an instrument that can give insight how the data management strategy in this area can take shape for the near future.

Would you like to know more?

Feel free to reach out to us for more information, please contact Frans Boshuizen  fboshuizen@amsterdamdatacollective.com or check our contactpage.

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Frans is Sector Lead Financial Services at Amsterdam Data Collective. Having worked for some of the Netherland’s leading financial institutions in senior management roles, he helps clients navigate through challenging times. He is a pragmatic and empathetic leader who applies his solid background in academia to generate real value from data-science initiatives.

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