The Global Risks Report 2023 – highlights well how global risks are interconnected: although environmental factors are the most frequent in the top ten, just this year it is the ‘cost of living crisis‘ that has taken the top spot on the scale of the worst global disasters. In the coming decades, the ecological crisis may even pale compared to the geopolitical, economic and social events that would cause (we hopefully choose to use the conditional) wars, large-scale migrations, collapse of national entities and total disruption of social cohesion. The warning is: we need to act collectively, globally, decisively and with a long-term perspective to set a path toward a more stable and inclusive world. Investing in resilience that is achieved by governing multiple risks, such as financing adaptation measures that result in climate mitigation co-benefits, and investing in areas that strengthen human capital and development.
Environmental, social, and governance (ESG) ratings are powerful tools for authorities and companies to identify and address multiple risks that, such as climate change or geopolitical instability, can negatively impact investors or the resilience of financial markets. In addition, ESG ratings can help align fund flows to achieve the Sustainable Development Goals (SDGs) established by the United Nations with “Agenda 2030 for Sustainable Development” drafted in 2015. Unfortunately, as a Bloomberg survey published in December 2021 points out, major rating companies do not tend to measure a company’s impact on the world around it as much as whether the world can disrupt its profits (Bloomerg,
ESG: FROM ‘NICE TO HAVE’ TO ‘MUST HAVE’
Traditionally, ESG has been considered a “nice to have” factor. Because it was, and still is, complex to estimate the possible benefits on the bottom line, companies did not perceive the value of the investment required to make the change. A global consensus is, by now, desirable for ESG to become a “necessary” activity instead.
The good news is that there are established companies that have been implementing ESG strategies for years, without waiting for government regulations to mandate their choice. Many investors, including Blackrock and other private equity firms, require companies to communicate ESG risks and performance using specific ESG metrics. Industry standards were developed with investors in mind with the founding of the Sustainability Accounting Standards Board (SASB), now the Value Reporting Foundation.
Meanwhile, the European Green Deal has reinforced the role of environmental and social sustainability as a success factor for a “fair and prosperous” economy. Indeed, the new strategy aims to transform the European Union into a climate-neutral society.
S – SOCIAL FACTOR FOCUS GROWS
Yet, as mentioned above, the climate crisis is not the whole story. Some agri-food supply chains or even the fashion supply chain, particularly fast fashion, are clear examples of social risks. More than precarious working conditions, child exploitation, and many other social factors negatively impact the communities affected by these phenomena. Customers and investors are becoming increasingly aware of these phenomena, so much so that some companies in the industry have begun to worry about assessing the ethicality of their suppliers. Many investors believe that the “S” will, in the coming years, become the most important letter in the ESG acronym.
ESG investments can no longer be limited to addressing the urgent threat of climate change, yet must encompass social justice issues, ethical business practices, and sustainable resource management, capturing the link between environmental, social, and governance factors. A paradigm shift is needed in business strategies and of course investments.
The shift from ‘nice to have’ to ‘must have’ is not painless. But if there were direct, immediate, quantifiable benefits in the short term, would the transition be easier to deal with?
THE BENEFICIAL EFFECTS OF ESG
For instance, can a high ESG score have a beneficial effect on banks (key elements of the economic system) during economic downturns?
Through research I conducted, analyzing with an econometric approach a panel of 39 European systemic banks over the period 2011-2020, I found interesting evidence in this direction.
The first evidence is that the entanglement between regulation and sustainable finance is complex and multifaceted, and although it can often be difficult to untangle and understand, it is a crucial element that cannot be ignored.
There is already substantial agreement in the literature that individual banks can benefit from reducing their idiosyncratic risk by adopting sustainable practices. However, can ESG practices also influence banks’ contribution to systemic risk? Might the market experience an easing of credit rationing through ESG?
Do better ESG strategy, in other words, help the bank to be more resilient, influential, and an economic engine in times of collapsing confidence in the banks as a whole?
My conclusion is yes, ESG could give positive help in times of economic distress.
While not reaching sound evidences to set the direction of causality, the survey results suggest that banks with higher ESG scores on average have less influence on systemic risk. These results bear significant implications for financial regulation and highlight the potential benefits of incorporating ESG factors into risk assessments. This study provides a valuable basis for future investigations into the causal relationship between ESG scores and contribution to systemic risk.
Also with respect to the practice of credit rationing, by analyzing the relationship and causality between a bank’s credit behavior and its sustainability practices, the results provide solid evidence of an inverse relationship between a bank’s ESG score and the credit rationing phenomenon it experiences. Moreover, the results suggest a direction of causality, indicating that banks that undertake ESG practices will, on average, experience a slower reduction in their lending. These findings carry far-reaching implications for financial institutions and businesses, as credit rationing has the potential to exacerbate recessions by limiting the amount of credit available to borrowers, particularly small and medium-sized businesses and households, leading to a decline in economic activity and slower growth. Although further research may be needed to extend the analysis globally, the current study provides compelling evidence to support the incorporation of ESG factors into credit risk assessments.
ESG investments have tremendous potential in leading us toward our common goals, which are well represented by the 17 UN Sustainable Development Goals. The potential of finance in guiding investments and allocating resources toward the right causes is probably one of the most promising avenues available to achieve the aforementioned goals. That said, we must recognize that the financial sector is driven by monetary incentives rather than ideals. As a result, it can perpetuate distorted practices, thereby eroding investor confidence in the ESG ecosystem. Lawmakers, institutions and governments must intervene if they want to correct and possibly prevent such distortions.
Fausto Garzillo, consultant at IMC Group