This is an excerpt from 'The Future of ESGTech 2024' report.
What is sustainable finance?
Sustainable finance refers to the process of taking environmental, social and governance (ESG) considerations into account when making investment decisions in the financial sector, leading to more long-term investments in sustainable economic activities
and projects.
Environmental considerations might include climate change mitigation and adaptation, as well as the environment more broadly, for instance the preservation of biodiversity, pollution prevention and the circular economy. Social considerations could refer
to issues of inequality, inclusiveness, labour relations, investment in people and their skills and communities, as well as human rights issues. The governance of public and private institutions – including management structures, employee relations and executive
renumeration – plays a fundamental role in ensuring the inclusion of social and environmental considerations in the decision-making process.
In the EU’s policy context, sustainable finance is understood as finance to support economic growth while reducing pressures on the environment to help reach the climate- and environmental objectives of the European Green Deal, taking into account social
and governance aspects. Sustainable finance also encompasses transparency when it comes to risks related to ESG factors that may have an impact on the financial system, and the mitigation of such risks through the appropriate governance of financial and corporate
actors.
As the European Commission defines it, sustainable finance is the catalyst for supporting a resilient economy, delivering on policy objectives, and driving private investment into funding a net zero and a nature positive future.
Alongside this, sustainable finance is about supporting both sides of the spectrum – what is environmentally friendly today, and what will transition to environmentally-friendly levels over time. The latter concerns increased investments into green production
methods, reducing the environmental footprint, or funding a sustainable city.
As the European Commission defines it, sustainable finance is the catalyst for supporting a resilient economy, delivering on policy objectives, and driving private investment into funding a net zero and a nature positive future. Alongside this, sustainable
finance is about supporting both sides of the spectrum – what is environmentally friendly today, and what will transition to environmentally-friendly levels over time. The latter concerns increased investments into green production methods, reducing the environmental
footprint, or funding a sustainable city.
Financing the net zero transition and a nature positive future – where are we now?
According to Daniel Stephens, senior partner, at McKinsey & Company, the focus has been on the supply side of the transition, or as he explained “with fossil fuel providers and with providers of alternatives to fossil fuels.”
However, in Stephens’ view, “the biggest gap we see in the market today is investment on the demand side: supporting financial institution clients to reduce their fossil fuel demand or shift their demand to clean fuels by transforming their operations and
assets. This is a harder problem – but it is also one that is fully aligned with the growth and revenue ambitions of commercial finance providers, and so we see a massive opportunity.”
In June 2023, the European Commission released recommendations for how non-financial and financial organisations can use technology and tools to provide transition finance. These include leveraging the EU Taxonomy, EU climate benchmarks, the European Green
Bond standard, and science-based targets. With these tools, companies must move from climate change mitigation and climate change adaptation to a circular economy, prioritise water and marine resources, pollution prevention and control, and biodiversity and
ecosystems.
What do financial institutions need before channelling investment?
Regulators and policymakers have created frameworks to support these organisations with their journey to net zero. These frameworks consider current regulation, risk management, and stress-testing, among other numerous other considerations, which has proven
to be problematic. Due to the multitude of standards and initiatives out there, banks, insurers, asset managers and fintech firms are struggling to understand what they must comply with.
As Jose Manuel Campa, chairperson of the European Banking Authority explained at the WSBI World Congress in 2022: “At the start, like any other issue, is all about management. If banks are confronted with a new risk they need to start by making sure that
they incorporate into their management structures the right mechanisms to proactively measure, manage, monitor and report on the impact of these risks in their activities.”
Using Europe as an example for the time being, like the European Commission, the EBA has also published numerous reports on how banks should manage, supervise, and evaluate ESG risk when it comes to business strategies. Most importantly, the EBA – and similar
organisations around the world – have also provided methodologies for capital allocation.
Michael Sheren, president of MVGX, elucidated to Finextra that it must be reiterated that “financial institutions provide the liquidity (funding) for the operation and expansion (growth) of the real economy (provider of goods and services). Real economy
actors (car manufacturers to dry cleaners), on the other hand, are the clients of banks and finance companies and form the primary source of their revenues.”
To paraphrase Sheren’s comments, it could be argued that although bank operations generate a substantial carbon footprint, what he referred to as ‘real economy actors’ in fact generate he greatest percentage of emissions. Looking wider to the entire world,
while governments have committed to the Paris Agreement, reducing these emissions and achieving net zero by 2050 will require “all real economy participants [to] change or alter their business models to meet the carbon reduction requirements.”
Why are financial institutions of paramount importance for sustainability?
What is the role of the financial institution? Advising how data should be analysed to understand the risks associated with pushing capital to sustainable activity, Campa added: “I realise that currently data availability and data quality is a significant
challenge. But here is an area where I believe financial institutions can act as catalysts for the necessary transformation of our productive capacity.
“Financial institutions provide finance to all sectors of the economy. They have access to every entrepreneur, corporate and household in our society. Credit institutions help them pursue their goals and materialise their dreams by supporting them and providing
them financing for their projects, their mortgages and life needs. That is the fundamental role of banks in our society.”
However, as Sheren stated: “All of these decisions are fraught with risk for the financial institutions. Deciding what clients to support by providing funding for CAPEX and R&D for the Green transition is a key area of focus for financial institutions. Banks
cannot immediately drop all of their high emission clients, however, if the clients do not change their business model, they will default on their loans as the cost of running brown companies increases through rising carbon taxes.”
Already, there are numerous considerations that financial institutions must make. Discussing this influx of ESG frameworks and aligning of sustainability initiatives, Richard Conway, CEO of ElastaCloud, stated that “ESG frameworks provide some high-level
content to allow corporate entities to be compared across their industry spectrum. New regulation will penalise institutions that do not have clear and adequate investments mitigating their carbon footprint. The issue whether the true cost of carbon offset
is bundled into this methodology which is currently isn’t.
“This means that whilst accuracy in numbers in frameworks like TCFD may show a true representation of emissions for a company, choice in offsets may render this reporting a waste of time as the true offset cost of carbon is being misrepresented. Corporate
citizens are still expected to be good environmental citizens which is not a given. Whilst frameworks like CSRD help through reporting and auditing pressure there are still many gaps.”
Conway also highlighted that AI and data analytics will play a significant role in providing guidelines for reporting. Further to this, Conway clarified that all business involves risk, but with proper planning, banks can reach peak sustainability. It is
the financial institution’s responsibility to mark out a path towards a net zero and a nature positive future, but how can they do that for sustainable cities?
As Noreika expressed, in collaboration, these organisations can drive the climate transition, balance sustainability with profitability, and accurately price climate risk. Kirsteen Harrison, environmental adviser at Zumo agreed with this point on collaboration
and stated that “we all have a role to play in the transition to net zero – in this race, we all win, or we all lose, and we believe collaboration is the way forward.”
Providing a concluding comment, Sheren added that “banks, insurers, asset managers and fintechs must decide which clients they think will be able to transition to a net zero business model and which clients will not. Further, they need to understand new
technologies and take a view on what new products will substitute old high carbon products. Finally, they will need to determine if they would like to finance ‘brown’ sectors, such as gas or oil for a limited time while they are still needed.”