When climate change was entrenched as a scientific fact three decades ago, most investors did not consider it to be a substantial investment risk. But fast forward to today, owing to the increasing evidence, investors are propelled to include climate considerations in their investment decision making. This practice also holds for social and governance issues. And this phenomenon is only accelerating. Contrary to the earlier belief that considering environmental, social and governance (ESG) factors in the investment due-diligence process implies a trade-off with returns, investors now are constantly scouting for sustainable investment opportunities. They now believe that it will generate long-term returns, with ESG issues having a significant impact on the share prices of a company.
As business attitudes migrate from the short-term gains to the concept of long-term value creation for all the stakeholders, ESG integration becomes a fiduciary duty for those responsible for managing other people’s money. Businesses are becoming wary of the impact they have on the environment and society, pushing investors to assess and evaluate organizations not only based on financial performance but also based on their (ESG) practices.This has resulted in a rise in the number of investors who consider ESG risks as a screening parameter for their portfolio companies. ESG risk covers a broad spectrum of issues ranging from an institution’s response to climate change to ethical labor practices, and issues around board structure and governance.
Breaking down ESG
Environment (E): The environmental factors refer to how an organization operates within the physical, natural environment.[1]Environmental criteria may include a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals. It is used in assessing environmental risks a company faces which include carbon emissions, water scarcity, and rising global temperatures. From an investor’s perspective, managing environmental risks include carbon emission management, waste management, and a move towards a circular model.
Social (S): The social factors refer to how businesses impact their stakeholders — customers, employees, and communities in which they operate. It looks at a company’s business relationships. From an investor’s point of view, managing social risks means understanding relationships a company has with each stakeholder and assessing the impact of poor corporate practices on these stakeholders.
Governance (G): Governance issues revolve around two core components namely, corporate governance and business integrity. Corporate governance is a system of rules, policies, and practices that dictate how a company’s board of directors manages and oversees the operations of a company[2] to achieve transparency and accountability. Business integrity deals with how a company resolves issues like corruption and bribery and remains politically neutral. A high corporate-governance standard facilitates effective, entrepreneurial, and prudent management that can deliver the long-term success of the company. The financial services industry has taken into consideration governance issues, particularly issues like board composition and not engaging in illegal practices, for a very long time, as market trends suggest good governance leads to higher returns.
Source 1: Deloitte – Embracing ESG in the financial system industry
Value of embracing ESG
The environmental, social and governance factors present opportunities for both, businesses and investors. Businesses having sound ESG practices in place benefit from having greater employee satisfaction and morale, and heightened investor interest. Additionally, it ensures stakeholder commitment for the longer term and reduced operational costs and transition costs. For an investor, ESG screening allows the money being lent to act as a positive force towards shaping a better tomorrow. ESG factors further help investors gain a better understanding of a company’s strategy, purpose, and management quality. It allows investors to filter out companies that may not be sustainable and may pose a financial risk due to their practices, reducing investment risks.
In developing countries like Nepal, no sector is better positioned to drive the transition to a sustainable economy and a stable future than the financial sector. Integrating ESG into the financial sector will pave a path for all stakeholders being considered in the decision-making process, which will result in real impact. Over the past years, there has been an increased effort to attract foreign direct investment (FDI) in the country, which is only possible if ESG metrics are given its due importance as it is in developed countries. Sustainable investing is becoming mainstream globally, with a growing fleet of foreign investors using ESG requirements as an internal part of their investment process, and it is time that Nepal hops on to the practice.
Though at a nascent stage, a growing number of financial institutions in the country are adopting ESG practices into their investment decisions. For instance, the NMB Bank, which sources funds from numerous development finance institutes (DFIs) as well, has begun asking borrowers to comply with ESG requirements.DFIs, including FMO, CDC, and IFC, which are active in Nepal require their borrowers to follow prescribed ESG compliance standards.[3] To fuel the usage of ESG and integrate it into the risk management process, Nepal Rastra Bank (NRB) has issued a guideline on environmental and social risk management (ESRM) for banks and financial institutions (BFIs). However, the pace of acceptance has been slow and this needs to be altered so that Nepal does not lag far behind international trends and reporting standards. There is a need to amplify the ESG ecosystem by building strategic alliances between BFIS, corporates, regulators, rating agencies, and the government.
The Next Stage
With the Covid-19 pandemic derailing the economy, there has been a shift from businesses to people, in the eyes of businesses and investors. During the pandemic, ESG funds have outperformed classic indices, and ESG factors emerged as major indicators of resilience in this crisis. [4]
Financial institutions, which are the backbone of the economy as they provide resources to grow, revive and sustain, should realize the role they can play in driving this transition. ESG factors should be integrated with operations and decisions right from strategy to investments, credit offerings to risk mitigation, and finally to external communication and reporting.
Financial institutions should evaluate non-financial information along with necessary financial disclosures. Standardization of ESG definitions[5] and metrics for the valuation of non-financial information that is globally accepted should be developed. In the case of Nepal, more commercial banks and micro-finance institutions should adopt ESG requirements in their investment and lending processes. Being a country prone to climate risk, it should demand climate risk tests and environmental regulations. Private equity and venture capital firms should incorporate ESG requirements, not only as a mere checklist but as a mandatory practice operated into a business’s operations. They can also be the pioneers in ESG reporting where they assess the real impact of their investments. The financial sector with the integration of ESG issues will act as a catalyst and pivotal engine in driving the much-needed capital towards financing the 2030 SDG targets. These are small steps that the country can take to incorporate ESG metrics to build a resilient economy for long term value creation, and there is no better time to do it than now.
References:
[1] James Chen, ” Environmental, Social, and Governance (ESG) Criteria”, Investopedia, Retrieved from: https://www.investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp#:~:text=Environmental%2C%20social%2C%20and%20governance%20(ESG)%20criteria%20are%20a,use%20to%20screen%20potential%20investments.
[2] Corporate Finance Institute, “What is Corporate Governance?”
[3]ShabdaGyawali, “Capital shortages reveal opportunities for ESG-aligned businesses”, August 14, 2019, Retrieved from: https://dolmaconsult.com/services-category-detail/capital-shortages-reveal-opportunities-for-esg-aligned-businesses-134.html
[4] Ernst and Young, ” Risk, returns and resilience: Integrating ESG in the financial sector”
[5] IFC, ” Better ESG Reporting—A Key to Strengthening Capital Markets”, Retrieved from: https://www.ifc.org/wps/wcm/connect/news_ext_content/ifc_external_corporate_site/news+and+events/news/insights/perspectives-i2c6
Thumbnail Picture Source: https://pixabay.com/illustrations/tree-leaves-arrows-sustainability-6205521/
Tanushree Agrawal is a BBA Graduate from Christ University, with a major in Finance. Her areas of interest are Mergers and Acquisitions, private equity, impact investing, and economic policy. She was previously associated with BankerBay, an investment banking firm in India, working with the M&A team. She is a former fellow at beed management.
