ESG: Incentives & Financial Services Regulation

compliance esg financial services regulation risking it Nov 10, 2021

Financial services are in the process of being reshaped by the winds of change. Many of these changes are driven by changes in international standards. Other changes are all around us, literally! The hotly discussed climate change debate has been put on the centre stage, once again, under the 2021 United Nations’ COP26 Conference.

Winds of Change

Those that point to evidence of material impacts to our lives (and businesses) from the effects of climate change now come from several areas, such as financial services. The types of organisations range from regulatory authorities and standard setters to multinational investment firms and non-profit organisations. The best practices and support for ‘going green’, like the steps that can be taken to reduce our collective carbon footprint, continue to develop. Businesses are encouraged to integrate ESG – Environment, Social and Governance – into their operational framework.

ESG - what is it?

ESG is broad as each of the elements. ‘Environment’ goes beyond carbon emissions. It encompasses issues of water pollution, deforestation, ecological damage and more. Similarly, ‘Social’ addresses the human element. Governance focuses on the oversight and strategic direction of a firm or organisation. Beyond the arguments and positions put forward for firms to embrace ESG, there are growing considerations. One example is that the imperative to do the right thing can also be profitable! Shifts in public sentiment that float through the ether of social media appear to have impacted firms’ uptake of ESG principles.

Weathervanes

ESG principles can easily highlight more complex strategic decisions which may be couched by firms doing the right things. Based on the direction of the winds of change and public sentiment, firms are finding it easier to adjust their operations to embrace ESG. Then, they modestly note their commitments to do the right things.

By “right things” a firm may point to high-level action points like:

reduce pollution created by your firm;
support sustainability efforts; and
eschew suppliers that do not engage in fair trade practices.

Alternatively, more granular principles can be highlighted. Hiring practices are increasingly promoted. The attention drawn to hiring practices to ensure diversity in their Boards and staff is now more common. On the face of it, there is nothing controversial here (or at least to my mind). However, the leadership of some firms may not be entirely convinced that they should embrace ESG.

In any competitive market, cost concerns exist. Financial services firms are no exception. These costs concerns cause firms to look for any strategic advantage. Often, the competitive offering of a good or service may not be the environmentally or socially conscious option. Doing the right thing may be viewed as not practical in the short or long term for a business, and some firms may negate the positive impact that adopting ESG principles can have. One of the challenges is that ESG principles, their impact and goodwill, appear to be hard to quantify.

Convergence Zones: ESG / Risk

Financial services firms do not operate in isolation. There are people, customers, vendors, affiliates and other parties that are directly and indirectly connected to a firm. Social media has changed how firms are perceived as well as how they are publicly discussed. The “Me Too” movement highlighted massive failures (of Governance and human decency). Other movements highlighted aspects of different firms seen as socially bankrupt or environmentally apathetic. The social dynamics that have impacted the attitude and response to a firm that is seen as being ESG ignorant have been caustic.

Activist shareholders and the public, through social media, can present a firm with incredible and tangible operational risks if it is their sentiment does not support the firm’s ESG position (or lack of one). Social media is a very powerful tool. It would appear that social media platforms will, very likely continue to be used to modify the behaviour of governments, groups and firms. For investment firms, the consequences can be dire if the ESG position is unknown or absent. The decision to invest in a commodity, stock or other assets could be presented solely based on the technical analysis behind the expected ROI and volatility.

The tracking error may not lie in the ROI calculations, but the sentiment analysis behind an investment decision. In short, will the investment target create more risk to the overall firm? From that basis, the directors can support the decision between earnings and environment; profit and promotion of social good. The future investment opportunities will no longer be driven by sterile technical analysis. The ESG assessment will also factor into decisions with increasing frequency.

Sustainable Supervision: The Role of Financial Services Regulators in promoting ESG

The impact on the Caribbean region's environment has been viewed as disproportionately severe. Extreme rainfall – the 1,000-year floods seem to occur every 5 to 10 years; the hurricanes are exceeding what wind instruments can measure and, the heat wilts crops and people during the summer months. Beach erosion; over-fishing; marine pollution; and the negative environmental impacts of cruise tourism (which is not sufficiently offset by tourism revenues in my opinion) - all evidence the symptomology of a lack of environmentally conscious behaviour.

What can regulators do? Others may question that even if regulators could do something to incentivise the adoption of ESG, should they? Financial services regulators can help in the adoption of ESG provisions for the firms they regulate. By focusing on outcomes as one of the drivers, regulators can add a positive feedback loop to the ESG discussion. In the risk and return analysis, the sustainability of a firm’s investments and its support of socially and environmentally conscious elements will result in a shift. However, I see that regulators can have a role in accelerating that shift.

The incentives will have to be carefully mapped out to reduce the possibility of greenwashing by less than scrupulous firms. Well framed, the right incentives by a regulator (and by governments) can ensure that ESG measures that are implemented can be sustained. Supervision of some form will likely be developed to assess firms’ ESG compliance in time. The FATF’s recent report on Money Laundering from Environmental Crime[1] appears to telegraph a 'style drift' that could occur in supervision.

Regulators can be a good example to the firms they regulate by also embracing ESG in a more pronounced way. While regulators have traditionally been quiet, the increasing social media presence of regulatory authorities suggest that there is a recognition of a need to engage differently. Embracing SupTech has been often touted as a step towards our collective digital future. But what if it were also driven by support for ESG? Should this not be highlighted? Regulators are already held to high ethical standards, but nothing prevents them from going further.

More Laundering: Greenwashing

Fraud by another name. There are all types of people, including those who would seek to wrongly benefit from any incentives that can be derived from implementing strong ESG principles by falsifying metrics to reporting agencies. Greenwashing – the process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound[2] - is an example of how firms seek to gain an unfair advantage. By not putting in the resources and efforts, the ‘spin’ on their product is crafted to meet the same benefits of those who have.

ESG principles, and particularly for the E and the S, can have more profound impacts in smaller jurisdictions. It is because of the disproportionate impact that there is a need for vigilance for greenwashing. It is also because of the disproportionate impact that the developing metrics for ESG implementation must be made more objective to aid measurement. Greenwashing may only trip legal wires where falsified records required by law are filed with governmental authorities. However, widely accepted standards for the assessment of ESG are coming. In the interim, some firms are developing their own metrics.

Socialised: Feel Good Vibes

In the long run, a solid ESG framework will be positively correlated to business success. And in case it is not clear, to my mind, the G in ESG also supports having a good compliance culture, which translates to less regulatory friction between the firm and its regulator. Shunning larger profit margins may not be immediately popular among shareholders who may not be wholly supportive of the greenification of a business. Diversity in leadership, socially conscious operations and environmentally sensitive investments are all fractals of the ESG branch.

Boards can still act in the best interest of the firm while investing, hiring and buying differently. In the 21st century, ESG will go beyond providing shrubbery for a stretch of highway or shunning toxic assets for investments. While the debate continues, some may be of the view that the ESG and climate change discussion is a game. The oceans, air, forests, people... everything is all interconnected; much like a game of marbles, one can knock all out of place. Regardless of the position you may hold, the risk/reward ratio continues to be weighed on the one blue marble we exist on.