Why is everyone talking about ESG?

Aurora’s ESG Experts Joshua Dent and Cerys Stone explore why everyone seems to be talking about ESG, and what it means for you, the Financial Services, and the RegTech community.

A Call to Action

Environment, Social, and Governance (ESG) topics have been discussed and debated within the Financial Services Industry for the last ten years or so, however, it’s only in the last 2-to to 4 years that they’ve become a real priority for firms. This slow uptake is down to corporate culture often having a lack of skills and knowledge on the subject, not to mention short-termism from investors and an absence of regulation up to 2018.

Now, in 2022, post-pandemic, in a climate crisis, amidst an unjustified war in Ukraine, and in a cost-of-living emergency, some progress is (finally) being made with regards to ESG and sustainability. Following on from the Paris agreement in 2015 and line with the European Commission’s Sustainable Finance Action Plan, the EU has taken several measures to ensure that the financial sector plays a significant part in achieving the objectives of the European Green Deal. Moreover, COP26 held in the UK in 2021 led to 450 banks and other FIs creating the Glasgow Financial Alliance for Net-Zero with US$130 trillion for decarbonisation. This is a huge step in the right direction. 

A cultural shift

Suddenly, most of us – with the help of key figures such as Greta Thunberg and David Attenborough - seem to be on the same page and set on seeing progress. There has been a clear cultural shift in the way we are engaging with the subject. The fact that it’s being discussed in most client conversations shows it is now a strategic priority for organisations spanning every segment. Where there was once a short-term view by shareholders that focusing on sustainability would negatively impact returns, there is now a clear recognition that consumer demand means it is critical to long-term success. In fact, Morningstar reported in 2020 that sustainable funds had outperformed non-ESG funds over one, three, five, and 10 years. 

It is now critical for Financial Institutions, Regulatory Technology firms, consultants, and others to play their part in tackling not just the environmental issues but also the social inequalities and poor business practices that are leading to global catastrophes. What we are seeing is a lot of thinking and talking around the subject, which is a great first step, but for change to take hold the next step is to see action. 

The EU leading the charge toward regulations

The European Union has taken the first step towards codifying this cultural shift through the introduction of the Non-Financial Reporting Directive (NFRD) in 2018, which required companies to share non-financial information, including sustainability reports, to stakeholders and investors. The EU has continued the momentum by creating more extensive ESG regulations, allowing for greater transparency of the ESG impact on financial products including the Sustainable Finance Disclosure Regulation (SFDR) in 2021. 

So far, the EU has been alone in implementing measures for ESG considerations, but this is set to change following the 2021 UN Climate Change Conference (COP26). It was at this conference that the International Financial Reporting Standards (IFRS) Foundation formally announced the establishment of the International Sustainability Standards Board (ISSB), to set global industry standards on ESG reporting. There seems to be a long way to go before ESG reporting becomes firmly established within the global regulatory agenda for FIs.

What does this mean for our industry?

The cultural and regulatory shifts have brought ESG considerations to the forefront of Financial Institutions’ agendas. Nevertheless, FIs are now motivated more than just by investors’ appetite and regulatory compliance. The emphasis on ESG reports by FIs can facilitate risk management during the customer onboarding process. As a result, EY noted in 2022 that FIs are finding that there are increasingly strong arguments to implement ESG checks and controls into their customer due diligence (CDD) procedures. Reports on ESG factors during onboarding can create a more accurate reflection of the risk to the customer. This allows FIs and investors the opportunity to have a greater understanding of the impacts and risks associated with their financial decisions. Financial institutions can more easily detect companies that may pose a reputational risk through negative news due to unsustainable business practices, whilst socially responsible investors can clearly identify the environmental impact of their investments. The advantages of incorporating ESG into the CDD process are becoming increasingly apparent in the types of FIs we work with.

Financial institutions are looking toward RegTech providers to generate innovative solutions to facilitate the integration of ESG factors into their onboarding processes. One solution that RegTech providers are looking toward is the expansion of Enhanced Due Diligence measures for higher risk customers to include gathering data on ESG metrics. A further solution to mitigate financial and reputational risk is to incorporate ESG findings in adverse media screening. 

The future of ESG

The financial industry still has a way to go to bring ESG considerations in line with other CDD processes. Whilst there is a clear cultural shift towards more sustainable investment, the development of a global regulatory framework for reporting and measuring ESG factors has only just taken its first step. Without established ESG metrics, data providers are facing challenges in sourcing globally standardised data for all company sizes. 

As further standardisation is introduced through new regulations, there will be increased expectations for RegTechs to tackle existing ESG challenges and a requirement for FIs to enhance their existing CDD processes. We can almost certainly expect ESG to continue its upward trend in the coming years, so watch this space.