The influence of ESG on financial institutions. We have been hearing about Environmental Social Governance (ESG) for quite some time in the economic market, financial institutions, corporate governance reports, and social media as well. Now how did it come and why are businesses talking about it?
ESG is expanding right now and why are financial institutions and other businesses implementing it?
The role of financial institutions (FIs) is no longer an intermediary for borrowing and lending, but they have evolved to being the driver of capital in the transition toward a sustainable and green future. Sustainable finance is expected to witness a growth in demand.
It can be said that Malaysia is launching ESG by the end of this year. There are also organizations out there from different industries and not only the finance industry that are adopting ESG practices in their business operations. What is so great about ESG and what can it do? ESG has been a hot topic in today’s world.
So, let’s get into it right now and discover what ESG is all about.
ESG is defined as the adoption of various practices including procedures, policies, and metrics that organizations implement to enhance the positive impact on the environment, society, and governance bodies and vice versa. In today’s world, investors are more aware of ESG and its importance in making investment decisions.
Hence, various industries and businesses have started integrating ESG into their operations and business strategies. The United States of World Commission has defined ESG “as a subset of sustainability and meeting the needs of present generations without compromising the ability of future generations to meet their own needs”.
The public sector is showing interest in ESG investing, including central banks that have shown support in transitioning financial systems towards a “greener”, low-carbon economy.
Various central banks in the emerging market are now committed to integrating ESG assessment and investing practices as one of their responsibilities. As there is a growing demand for ESG, the finance industry is now producing more products and services related to ESG ratings.
The ESG ecosystem is booming in providing information related to environmental, social, and governance issues. Financial Intermediaries, governments, and international organizations are now getting influenced by ESG practices.
How ESG started
The story of ESG began in January 2004. A significant milestone in the emergence of ESG investing took place. At that time, Kofi Annan, the former Secretary-General of the United Nations, reached more than 50 CEOs of major financial institutions. He invited them to participate in a collaborative effort facilitated by the UN Global Compact with the support of the International Finance Corporation (IFC) and the Swiss Government.
His objective was to find ways to integrate ESG into capital markets. In 2005, this initiative produced a report entitled “Who Cares Wins,” with Ivo Knoepfel as the author. The report presented the arguments that ESG factors in capital markets produce good business sense and lead to better sustainable markets and better outcomes for societies.
In the 2006 United Nations’ Principles for Responsible Investment (PRI) report, which included the Freshfield Report and “Who Cares Wins,” the concept of ESG issues was introduced. It marked a significant milestone as it mandated the inclusion of ESG criteria in the financial assessments of companies, aiming to promote sustainable investments.
Initially, 63 investment companies, including asset owners, asset managers, and service providers, with a total of $6.5 trillion in assets under management (AUM), signed on to incorporate ESG considerations.
Fast forward to June 2019, the number of signatories had grown substantially to 2450, representing a combined AUM of over $80 trillion.
How FIs and other businesses are using ESG’s risks in today’s world
As investors’ focus is increasing on ESG factors, it can potentially impact the issuer’s long-term performance, presenting both risks and opportunities. Consequently, these factors should be duly taken into account when making investment decisions.
Some basic factors include the corporation’s response to climate change, its proficiency in water management, the effectiveness of its health and safety policies in preventing accidents, its supply chain management practices, the treatment of employees, and the presence of a corporate culture that cultivates trust and promotes innovation.
While definitions differ regarding the form of consideration of ESG risks, ESG investing is an approach that seeks to incorporate ESG factors into asset allocation and risk decisions to generate sustainable, long-term financial returns. In recent years, there has been a significant focus on ESG criteria and investing, driven by several key factors.
First, recent research conducted by both academia and industry indicates that, under specific circumstances, ESG investing can enhance risk management and potentially generate returns comparable to those of conventional financial investments. Although recent studies have shed light on the potential benefits of ESG investing, there is a growing recognition of the complexity of measuring ESG performance.
Second, giving attention to the risks from climate change, setting the benefits of globally accepted standards of responsible business conduct, and the need for diversity in the workplace, suggests that societal values will increasingly influence investor and consumer choices and may increasingly impact corporate performance.
Third, corporations and FIs have escalated from moving from short-term perspectives of risks and return, aiming to more longer-term sustainability of investment performance. Due to this, certain investors aim to enhance the sustainability of long-term returns, and some investors wish to incorporate a formalized alignment with societal values.
Regardless of the approach, to maximize returns and profits in the long term, the sustainability of finance should incorporate broader external factors and reduce the tendencies for controversies that deteriorate stakeholders’ trust.
ESG Risks vary from one investor to another
ESG risk factors can be complex, as investors choose either to achieve long-term returns or incorporate societal values, and companies evaluate their ESG based on how they want to align with their values and analyze their company’s worth for their purposes. Either way, it helps to guide both investors and businesses on various risks. The quality of a company’s ESG risk management is important for investors in weighing risk and return.
ESG is on its way to Malaysia
The Malaysian government has announced the launch of ESG standards by the end of 2023 to help companies transition into renewable energy. This rapid progress of ESG does present a challenge to FIs and regulators to ensure that Malaysia is able to be well-positioned at the forefront of sustainability. This refers to banks incorporating ESG in financing transactions such as overall credit risk assessment and financing decision-making process.
As a result of this initiative, there has been an increased demand for ESG compliance in corporate transactions and highlights the importance of evaluating a company’s business practices and their potential impact on future financial performance.
There is also a perspective from the legal, whereby, due diligence is performed on each element of “environment”, “social”, and “governance” to check if a business will comply with the local and sustainability frameworks and regulations.
So, what do you think about ESG? It is neither an easy process for FIs, other organizations, and even investors to perform and review ESG risks. The work is heavy to stay ahead at the forefront of ESG developments.
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