What is ESG in Banking, Private Equity, and Venture Capital?
We answer the question, “what is ESG in banking?” and analyze the steps financial institutions can take towards more ethical, sustainable business operations.
In an age of credit and debit cards, where 41% of Americans say they no longer use cash, financial institutions hold a staggering amount of power in society. The decisions made by banks, venture capitalists (VCs), and stock markets can have a dramatic impact on the world around them. This is not something to be taken lightly.
Whilst there will always be an element of risk when it comes to money, it is necessary to weigh the pros and cons of every decision to ensure that the right decisions are being made. Environmental, Social, and Governance (ESG) impacts should be at the forefront of these decisions.
As more concerns are raised daily about the current state of the planet and society, it has become more important than ever before for financial services to turn their attention towards ESG investing and do their part to mitigate potential risks.
Today, we’ll take a look at what ESG is, what it means for banks and VC operations, and the necessary risk management steps that can be taken to ensure sustainable finance practices and operating models remain consistent.
What are the three pillars of ESG?
At its core, ESG concerns the impact that companies have on the world around them. They can be considered as their individual components or as a whole group depending on the steps your enterprise has already taken towards achieving each result.
- Environmentally, what are the emissions produced? How big is a corporation’s carbon footprint? What are they doing to help fund the protection of the planet and limit their own negative effects?
- Socially, how do employers treat their staff? What are they doing to help their local communities? Do they strive for inclusion and diversity?
- Governmentally, how ethical are companies? Are they transparent in their business practices? Do they engage in any immoral or illegal practices, such as bribing to get their way?
When VC investors and banking industries take the time to build their business models and practices around ESG frameworks, it becomes easier to limit any ESG risks that may arise in the future. A broader perspective and a wider overview of the impacts your decisions can have will help you maintain a sense of responsibility. In turn, this will influence your business strategy and make it easier to put your ESG performance first.
This will bring in an additional set of benefits, such as better customer relations, without too much of an impact on your bottom line. For example, according to an article from Forbes, 76% of consumers reported that they would not continue a relationship with financial organizations that did not adhere to, or did not take enough efforts towards, ESG responsibility.
A company that has never thought much about ESG strategies may find it difficult to suddenly adopt new policies to make themselves more sustainable. As social attitudes move towards favoring greener, more considerate business practices, those who do not take initiative could find themselves being left behind.
Before we look at what more you can do to achieve greater ESG sustainability, let’s take a closer look at what elements they incorporate.
Environmental responsibilities
Financial institutions have just as much corporate environmental responsibility as any other industry. After all, without the appropriate funding, projects cannot go ahead. When it comes to both the internal workings of your company, as well as where you plan to invest, it is important to be considerate of:
- Carbon emissions
- The amount of waste produced
- Whether you/the people you invest in use fossil fuels or renewable energy sources
- Water consumption
The negative environmental impacts posed by climate change can have huge financial repercussions. The Financial Stability Board created a program called the Task Force on Climate-related Financial Disclosures (TCFD), which helps companies be more transparent about their climate-related financial reporting practices.
These climate-related disclosures allow banks and investors to analyze the risks associated with each company before making any financial decisions. Not only does this encourage businesses to be more environmentally responsible from the beginning, but it helps investors to see which organizations have the most potential for risk, so they can be more considerate in their allocation of capital.
Social responsibilities
When it comes to social responsibilities, these refer to the perceived duties that institutions have to the community they operate in and with, the stakeholders within a company, which providers they use, and how this affects consumers at the end. This is also where businesses can reflect on how ethically they manage their finances and use their profits in a way that benefits others.
When it comes to corporate social responsibility, other considerations include:
- The treatment of employees
- DEIB (diversity, equality, inclusion, and belonging) practices
- Charitable donations towards local projects and initiatives aimed at helping the community
- The treatment of customers
- How ethical and sustainable their supply chain is i.e. using the correct providers, not exploiting third parties outside of the company
This is particularly important to venture capitalists who are constantly taking financial risks in startups and entrepreneurs. If you are seeking VC investments, then you need to be mindful of your ESG practices, and be transparent in how you will use the funding you receive.
Consider these questions:
- Do your beliefs and values align with those held by VCs?
- Do you engage in ethical business practices?
- Will you be a source of sustainable investment with realistic prospects?
- Will you be of benefit to the community you are operating in?
A study by the European Investment Fund (EIF) found that more mature VC enterprises were more involved in ESG reporting. 80% of later/growth-stage investment companies were actively considering ESG factors, compared to only 66% of seed-stage investments.
One reason why this may be the case is that there is a greater amount of ESG data available from more developed VC investment organizations about the work they do. This is because they have both the time and availability of finances to consider beyond their own sphere of operations and can take the time to properly invest in sustainable, ethical practices.
This is a luxury that isn’t often afforded to smaller VC initiatives, which are more focused on their own survival rather than the wider impact they may be having on the world around them. This is supported by additional data from the EIF, which found that only 54% of smaller VC firms (fewer than 10 assets under management - AUM) considered ESG practices, compared to 85% of larger firms (more than 500 AUMs).
Governance responsibilities
Corporate governance is a huge concern in any company, but the scope for possible corruption in the world of finance is a particular problem. An article from the UK news outlet The Guardian found that 1 in 30 banks from around the world failed to comply with international anti-corruption laws, including money laundering, tax evasion, and fraud.
Governance responsibilities aim to help shed light on the inner workings of the financial sector, ensuring everything is above board and legal. This also includes an evaluation of risk management that banks and lenders should conduct before offering their financial services to people or organizations.
Not only does non-compliance to these regulations pose a legal risk to a company, but it also poses a financial risk to investors and consumers who put their trust in such investment funds. Without a thorough amount of knowledge, the financial markets can be a very confusing place. Most people rely on portfolio and asset managers to help make lucrative, sensible decisions, so a strong amount of integrity is needed.
Compliance with governance responsibilities also helps prevent internal issues such as a conflict of interest from customers and employers alike, especially if there are ever political motivations involved in an investment.
How can ESG be beneficial for financial institutions?
Now that we’ve looked at what ESG is, we can understand how it can be highly beneficial within the financial sector.
- Better brand reputation. Social media can be a wonderful tool or a company’s worst nightmare. Ethical, responsible brands can find that positive attention gained on the internet can boost their business. Negative attention directed at unethical, unsustainable companies can spread like wildfire, and in an age where nearly 80% of investors are paying close attention to ESG initiatives, it really isn’t something you can afford to skip on.
- Better risk management. Before leaping into decisions, it’s vital that VCs and investors analyze the pros and cons of their choice outside the basic boundaries of how it will affect the company. Keeping ESGs in the forefront of your mind will help you make more selfless decisions that have a more positive impact on your environment.
- Social responsibility attracts top talent. If you want to present yourself as a considerate, responsible employer, a focus on the ‘S’ of ESG can help do just that. Highlighting the importance of your employees, putting their health and well-being first, and offering competitive compensation can all help attract talented individuals who will want to work for you.
- Reduced costs. A report by McKinsey & Co. found that better ESG practices lowered overall costs for banks and VCs by up to 60%.
How to increase ESG practices in the financial industry
There are many ways you can go about increasing your application of ESG responsibilities in your financial organization. Here are just a few ways to be aware of.
The Equator Principles
This list of 10 principles acts as a framework for risk management when financial institutions decide to fund various projects. By acknowledging this list, any negative impacts that may arise from such projects are either completely eradicated or greatly reduced.
These have been signed by many large banks around the world across 34 different countries. The principles are:
- Review & Categorisation
- E&S Assessment
- Applicable E&S Standards
- E&S Management System & EP Action Plan
- Stakeholder Engagement
- Grievance Mechanism
- Independent Review
- Covenants
- Independent Monitoring & Reporting
- Reporting & Transparency
Establish metrics to eliminate climate risk
By setting up KPIs to monitor your carbon emissions, waste disposal, and energy usage, you can better understand what you need to do to improve. Without an honest baseline, it can be very difficult to know what changes you should make.
For example, in 2020, it was found that the 18 largest banks in America were responsible for “financing the equivalent of 1.968 billion tons of carbon dioxide”. This research was carried out externally by climate scientists in the South Pole. But if measures had been in place within the banks, it would have been much easier to spot the issue ahead of time and take the necessary steps to lessen their impact.
Total carbon dioxide emissions of the largest banks worldwide in 2020, by bank
Conduct positive and negative screening
Positive and negative screening essentially means going through a vetting process whereby you analyze the ESG risks involved with taking on a client.
When neative screening, you look for anything in the client’s history that could have a negative impact on your ESG. This includes:
- Dubious foreign relations
- Manufacturing of illicit or problematic goods such as tobacco or weapons
- Overdependence on unsustainable resources such as fossil fuels
- Exploitation of workers
Meanwhile, positive screening does the inverse and helps you connect with brands and opportunities which will boost your ESG score.
In conclusion, with how much of an impact the financial industry can have on the world, it would be extremely unadvisable for banks and lenders to not pay attention to ESG initiatives. Not only are these factors beneficial for the environment financial services operate in, but they are also highly advantageous inside of a company as well.
By taking the time to be a little more considerate of how you conduct your operations, you can make enormous changes. When a greater emphasis is being placed on how to act ethically and sustainably, there’s no excuse not to get involved and start weaving ESG practices into your core values and structure.