Banks Are The New ESG Consultants

Recently, New York was host to the annual Climate Week. Other than the current issues such as the environmental threats from the war in Ukraine and the gas crisis, the spotlight was again on new climate goals. The UN’s Race to Zero campaign gave instructions to financial institution to avoid funding businesses related to fossil fuels and energy sources. Instead of following orders, however, the Net Zero Banking Alliance (NZBA), which currently holds 40% of the world’s banking assets, objected singling out some economic sectors at the expense of others.

The topic of ESG and banks is not something recent. Concerns about climate change became the turning point for the decisions of many customers, investors and politicians. Business has become the launch vehicle for green regulations, but banks have to be the fuel – their choice who to fund determines which companies are sustainable and which are not, and this will guide future investors. Consequently, almost 75% of banks plan to increase their spending on environmental, social and governance (ESG) initiatives in the coming year, according to a report by Boston Consulting Group (BCG).

Historically, the banking sector has been highly regulated. Banks are used to following rules, which they believe are the secret to their survival for centuries now. Nowadays, this applies even more because large financial institutions were established, uniting hundreds of branches in different countries and continents, held together by common policies and rules. And over the last two or three years, within the framework of sustainable governance and finance, ESG has become a mandatory part of the integration criteria on the way to the Green Deal. The logic is simple – the European institutions want to transition to sustainable development, and this is done by redirecting capital from unsustainable to sustainable business. This stands behind Taxonomy – it serves as a guide to which companies meet the sustainability criteria and contribute to the protection of the environment and society and which do not.

But why are ESG requirements a huge challenge for the banking sector? Partly because of the enormous amount of work and the need for lots of information. Banks portfolios are huge. Usually, financial institutions cover almost all sectors of the economic spectrum, and in order to fulfill their role, they must understand them. Or to put it another way, banks need to develop to understand the sector-specific impacts of each business they fund. This is also linked to the risk assessment of lenders – in order to fund someone they need to be able to predict ESG risks, for example related to changes in climate or social attitudes, to make sure they will be able to get their money back plus the interest.

How will the banks decide which businesses are sustainable and which are not? Here, Taxonomy divides companies into dark green and light green. The dark greens are the standouts – those that meet all the ESG criteria and fulfill most requirements. Light greens are still in the middle – businesses that have sustainability goals and that have started making changes, but there is still a lot to be done. A recent example is Elon Musk’s Tesla, which was removed from the ESG indices because they did not meet the criteria for human resources management and social responsibility although they have minimal negative impact on the environment.

Currently, three major trends prevail among banking institutions in their policy for choosing partners and borrowers. The first working model is finite. It excludes financing entire sectors that are marked as unreliable. Manufacturers of tobacco and cigarettes, weapons, gambling and even the porn industry are often considered as such. In the policies of some large banks, the „blacklist“ already includes the coal, oil and gas mining sectors. The problem is, however, that often these companies do a lot to cover and improve their ESG metrics, and yet they are overlooked.

The other approach is the so-called disinvestment – withdrawal of investments from businesses defined as unsustainable. This takes time – banks target certain risky sectors and place specific ESG conditions on the companies included. They are given a certain amount of time to achieve a set of goals and, if they fail, they are withdrawn. Here we are talking about the way in which various financial institutions – banks, investment and pension funds – operate. The goal is to quickly decarbonize their portfolio.

The third method is the exact opposite of the previous two. It involves engaging with the customer. It support the methodology that cutting ties will not solve the problems and will not lead to achievement of ESG goals. Banks then take advantage of their position as a shareholder or stakeholder and “hire” themselves to work with their customers to make progress together. Approaches are usually tailored to specific clients and are not part of a financial institution’s overall policy. This, of course, requires more expertise in the field of sustainable development and the direct effect of the investor’s impact on the company’s practices is difficult to track.

Pioneers in both disinvestment and engagement are Western banks and investors. They now have to understand everything related to ESG. In our country, most banks are branches of foreign financial giants. They are awaiting instructions from the parent company. Bulgarians are rather still watching from the sidelines – becoming familiar the situation and checking what their competitors are doing. Most banks already have employees who are responsible for ESG. However, the entire sector is learning on the fly. Which makes the sustainable business financing situation not particularly sustainable. It creates more questions than answers – what data should be collected to make an adequate ESG assessment of a client? What does the bank do after assessing the risks and environmental impacts of a company? How to work with a customer, who does not know how to manage his influences? And how can the bank fulfill its personal business objectives while playing the role of an ESG consultant and keep up with the competition?

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