Welcome to RegTech Associates inaugural blog on environmental, social and governance (ESG) and socially responsible investing (SRI), from a RegTech perspective.
The Current Crisis and Sustainable Investing
Lockdowns around the world are being eased and as the focus of the global economy and the financial industry moves from rescue to recovery, the layout of the financial landscape is shifting. In this series, we will explore how environmental, social and governance (ESG) factors are moving to the forefront of the industry and political agendas, and the important part that RegTech will play as economies are reshaped.
We expect ESG frameworks and their associated metrics to become key factors for regulators and policy-makers within the finance and technology industries. Therefore regulated institutions and the vendors who serve them must pay closer attention to ESG considerations in order to meet the changing demands of their stakeholders. The outperformance of ESG indices, a move among regulators and businesses toward greater coherence in ESG criteria, and the greater interventionist role of governments in the face of Covid-19 speak to this need.
ESG on the rise
As the world adjusts to a new normal, ESG metrics are being adopted by governments, industry leaders and businesses to revise their understanding of core risk management. Physical and systemic risks will be integrated into overall risk management practices, as their direct impact on business continuity, and ability to impose serious material costs are felt. Risks from systemic crises such as infectious diseases or climate change can no longer be regarded as distinct from the physical safety of workers and cybersecurity of customers and clients. Similarly, the financial impact of a lack of ethical governance is also being reconsidered. New forms of due diligence will be required as regulatory, investor and client demand new forms of transparency and accountability in accordance with ESG frameworks. These considerations must be incorporated into overall risk management practices, and RegTech vendors should develop products that satisfy these needs.
Globally, socially responsible investing as a practice has grown year on year. Increases in the number of ESG indices and the availability of datasets which account for ESG related risks have produced financial products that consistently outperform traditional indices, even in crisis. In the final three months of 2019, investors caused a 76% quarter-on-quarter surge in sustainable funds and poured another $45.6 billion into ESG focused funds in the first quarter of 2020 despite growing concerns over the coronavirus pandemic. The rise in sales has been largely driven by regulatory change, and societal shifts such as the mass reduction of single-use plastic, and these trends continue to grow. Although the long term economic impact of the coronavirus pandemic is unknown, the immediate priorities of businesses and governments will have to change to prepare for the unpredictable nature of climate events, health crises and beyond.
ESG frameworks allow investors to avoid companies with negative environmental impacts and governance practices which make them more susceptible to material drops in share price due to major events or incidents. The fossil-fuel industry during the Covid-19 crisis is a prime example, where disruptions to travel and mobility led to a dramatic decrease in demand and stocks plummeted. Even in less turbulent times, providers of ESG related financial products have been known to downgrade companies that fail to comply with industry standards and score poorly compared to competitors. Equifax, the credit rating agency was downgraded by major ESG data providers, 18 months prior to the data privacy breach that affected over 147 million stakeholders, and cost $650 million in settlements. Where standards are not met, mistakes can result in stock volatility, higher costs of capital, fines and ultimately undermine profitability.
Regulatory changes on the horizon
Regulators and industry leaders had already begun adopting ESG frameworks and their integration will likely be expanded and accelerated in the near future. In May 2019, the European Securities and Markets Authority (ESMA) published advice to the European Commission (EC) on Sustainable Finance initiatives to support the EC’s Sustainability Action Plan in the areas of investment services and funds. ESG considerations will be integrated into a number of important financial directives, namely MiFID II – Markets in Financial Instruments Directive, AIFMD – Alternative Investment Fund Managers Directive, and UCITS – Undertakings for the Collective Investment in Transferable Securities, with final rules and guidance expected to come into full force in early 2021. Earlier this year Blackrock, the asset management firm, committed to making sustainability a key part of their investment process. These regulatory and industry changes are no flash in the pan and illustrate that even before the pandemic, an understanding of ESG as the future was gaining momentum. More institutions will be quick to integrate these frameworks and will want to find cost-effective technological solutions.
The greater influence and awareness of the ESG will change the way business is brokered and investments are made. As clients and investors become well versed in ESG and their preferences in this area, traditional methods of self-reporting and analyst predictions will need to be revised. Regulated institutions will have to collect more data, and use a precision approach to determine how best to comply with the newest regulatory frameworks and industry standards and mitigate risk.
As economies move from survival to reconstruction post-COVID, European governments and the European Commission will be promoting social responsibility within their economic recovery programmes. In the last few months, nations have witnessed dramatic decreases in carbon emissions, cleaner air, and the deployment of the largest stimulus packages since the Great Depression.
The opportunity to fast-track structural changes and combine recovery programs with ESG based policy objectives will help to create a greener and more resilient economic future. Greater government intervention as a result of COVID-19 has also given governments more of a say in influencing the commercial landscape. Increased involvement requires greater accountability, governments will have to impose greater scrutiny, and institutions must ensure conditions are met.
As ESG frameworks are further integrated into policies, indices and regulatory frameworks, regulated institutions will need to find efficient ways to adjust. These changes will require the collection and evaluation of new data sets and changes to the nature of reporting. Identifying the right products, and adopting these practices early will help to better manage risk, satisfy clients, reassure investors and comply with regulators. Technological solutions can make these adjustments far less complicated.
RegTech vendors that want to be at the forefront of ESG adoption and integration will quickly build the tools needed to help institutions on this journey. As client appetites evolve, the products, services and propositions will also adapt, and the best vendors will anticipate additional developments, embedding sophisticated ESG frameworks into offerings, helping to shape more resilient companies and markets.
If this has been helpful and you’d like to hear more about how we can help you make the most of the opportunities emerging in the current landscape, please get in touch.
Precious Oyelade is a marketing and operations professional with extensive project and account management experience. A University of Cambridge graduate, she has worked in education, media and now in tech. Precious currently manages the delivery of programmes to early stage start-ups, helping them to build campaigns and manage stakeholder relationships.