The Concept of Sustainable Finance for Financial Institutions

The concept of sustainable finance and ESG have been on everyone’s lips for quite some time now, but there are still numerous unresolved questions regarding its execution in the financial sector. This is why we put this topic on the agenda of the last SCHUMANN Digital Credit Risk Management Conference, which was a. o. addressing decision-makers and leaders from corporates, financial institutions and the insurance industry.

Thomas Maletz, Vice President Regulatory Compliance at BFS finance, gave us his point of view on the questions arising from the concept of sustainable finance of a financial service provider’s perspective.

‘Sustainable finance’ is known as the practice of taking into account environmental, social and governance (ESG) criteria when making investment decisions. The aim is to achieve investments in sustainable economic activities and to accomplish a shift towards a more resource-efficient and sustainable economy.

The finance sector will play and already plays a key role: It has an enormous impact on creating a more sustainable future as its actors decide about allowing research in the relevant fields or supporting companies that respect and follow ESG criteria when doing business. Therefore, sustainable finance refers to the process of taking due account of environmental and social considerations in investment decision-making.

In September 2015, the heads of state and government and high representatives, meeting at the United Nations headquarters in New York, agreed on the so-called “Agenda 2030” with its 17 Sustainable Development Goals. The UN members stated that they “are committed to achieving sustainable development in its three dimensions – economic, social and environmental – in a balanced and integrated manner.”

The Agenda 2030 was followed by the ‘Paris Agreement on Climate Change’ in December 2015 (COP21). It is called a landmark in the multilateral climate change process as, for the first time in history, it is a legally binding international treaty in the fight against climate change. The members agreed that every five years, they would meet with an updated plan reflecting their increasingly ambitious efforts. The UN climate change conference in Glasgow in 2021 (COP26) was the first time the members met after COP21 in order to revise their strategies.

In 2019, the EU committed to being a global leader in climate change. The “European Green Deal” was being born, aiming the EU to become the first climate-neutral continent by 2050. One of the results was the “regulation on sustainability-related disclosure in the financial services sector” in March 2021 and the “Fit for 55 Package” in July 2021, a set of inter-connected proposals, which all drive towards the same goal.

The developments described above explain the growing pressure coming from politics and the regulatory side. And indeed, things are happening in the private financial sector. In his presentation, Thomas Maletz mentioned a few examples of investors, insurance businesses and companies changing their attitude and their policies, aiming at sustainable strategies.

Blackrock, for example, is conducting a “tectonic shift to sustainable investing”. As Blackrock is stakeholder and shareholder of thousands of large companies all over the world, they are moving und pushing companies, investors, and asset managers to do more sustainable business. The reason: They expect to earn more from sustainable investments than from non-sustainable investments.

Other examples that illustrate the paradigm shift in the last two years are big insurers like AXA and Allianz. They have announced strengthening their restrictions on coal, oil, and sands business. It will be very interesting to see what effects this will have on the behaviour of credit insurers and setting credit limits.

A landmark case was certainly the judgement of the Netherlands court in July 2021 that oil giant Shell must reduce its emissions in order to align its policies with the Paris Agreement. The decision applies in the Netherlands only but will for sure have wider effects elsewhere.

According to Thomas Maletz, this development is expected to be continued.

The daily business of investment and credit decisioning will be marked by the obligation of considering social and environmental aspects.

Maletz sees three interacting risk categories that ask for identification and valuation:

• Physical risks, like hazards.
• Transition risks on the client level, like what is the value of the carbon bubble in the balance sheet? What happens through the sharp rise of carbon costs? Will clients change their strategies, their markets, their target audience?
• Legal and regulatory risks, like change in legislation (e. g. in supply chains), regulatory requirements by investors and reputational risks.

Those risks represent a new category of risks to financial institutions: Traditionally, aspects like creditworthiness and fraud were considered. This spectrum has to be widened now.

Thomas Maletz sees four main transition drivers of sustainable finance:

• Corporate culture: Companies must answer the question if sustainability should be a corporate value. And if the answer is yes – is it already part of it?
  According to Maletz, it should, because a company couldn’t move forward without. He sees huge chances in including sustainability into the corporate culture. Young professionals, for example, expect sustainability to be a main part of the corporate culture of a company they are working for. Following ESG criteria is a major aspect to choose an employer. And today, well-educated professionals have a broad choice.
  Same applies to future customers: the young generation will make their decisions in favour of companies aligning their activities to sustainability.
• EU and national regulation: The regulation follows known footsteps: It asks for building a strategy and establishing a risk management, including risk analysis, classification, mitigating, supervising, and reporting – same business as known.
  The new aspect is the classification with the help of a Client ESG Rating. Getting a reliable ESG Rating is one of the main challenges for risk managers, especially for smaller and medium sizes businesses as there is no public information available for it.
• Investors: Investors will be on the lookout for profitable and sustainable financial investments. Referring to sustainable risk classification of clients, a Client ESG Rating will be and may already be a key factor for successful investors.
• Customers: Regulatory requirements and the related interest of large investors in sustainable investments have not only reached large corporations, but are also increasingly coming into the focus of small and medium-sized companies. Triggered by supply chain legislation and increased requests from financing banks for company-related ESG information, business and financial managers are increasingly seeing the need to align their companies and strategies with ESG criteria. As a consequence, the demand of these companies for ESG compliant financing is increasing.

People can discuss whether there is a climate change or not. But whatever the outcome of such a discussion: It is a matter of fact that changes are already happening and that regulation forces financial institutions to act. Investors and companies are pushed to more sustainable investments, assets, and clients.

With the given instruments and techniques, the challenges can be handled.

Watch “The concept of sustainable finance” with Thomas Maletz from BFS Finance at SCHUMANN Digital Credit Risk Management Conference 2021 on YouTube: