Compliance to ESG standards and principles will permanently transform the way we conduct business, says international banking veteran Philippe Dirckx.
Today, no one is surprised to see financial literature or press filled with a cohort of acronyms such as DLT, AI, API or anything that starts or ends with bit, coin or chain.
There are good reasons for that: Distributed Ledger and Blockchain Technology will address some of the challenges of complex ecosystems, while crypto assets and currencies will open doors to new forms of investment and delink money from its traditional issuers. Open Banking regulations are accelerating the adoption of APIs as the dominant connectivity channel, while Artificial Intelligence (AI) will help us make sense of the zillions of data bytes the world generates and consumes everyday.
ESG – or Environment, Social and Governance – is at top of the agenda of every corporate and financial institution. It is fast becoming a critical metric for investors around the world. With the renewed warnings on climate change, the louder calls for diversity and inclusion, the aftermath of the global financial crisis, and the never-ending fight against corruption and money laundering, companies have become very much aware that any deviation from these best practices could cause reputation backlash with serious financial consequences.
Institutional and private investors have become more assertive in their asset allocation strategies and are expecting the highest standards from the companies they invest in.
ESG has over the years become an integral part of the governance disclosures in corporate annual reports. To the same extent, investment managers have provided their clients with their investment guidelines and allocation methodologies.
Positive financial impact
Beyond the fact that these are obvious best practices that all well-managed companies should follow, there are also financial incentives.
Indeed, according to Bloomberg, the growth of investments in ESG funds and in responsible finance funds has outpaced MSCI returns.
More specifically for China, the University of Cambridge recently published a study tracking ESG metrics for diversity against 122 Chinese technology SMEs. The report discovered a 19.5 percent increase in profitability at firms with highly-gender-balanced management teams in times of adverse conditions, and a 24.8 percent increase in return on assets during such conditions.
In 2015, a study led by Robeco and the Hong Kong University of Science and Technology’s Business School on “The Role of Governance relative to Environmental and Social Factors in Equity Returns” concluded that “Asian equity investors can capture better returns and lower portfolio risk by considering Environmental, Social and Governance (ESG) factors, specifically the governance factor“ .
Regulators are shaping the landscape
Although these are not new topics, the integration of the ESG principles and guidelines in corporate governance and investors strategies are nevertheless green field for many.
In 2006, under the stewardship of the then secretary general Kofi Annan, the UN launched the Principles for Responsible Investment (PRI) which led – in 2013 – to an assessment questionnaire for investment managers to fill in and submit.
In December 2015, the high profile G20 Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) was created, and by February 2017 published its recommendations.
Securities markets regulators have started providing frameworks for supervised entities.
On 11 April, following its Strategic Framework for Green Finance published in September 2018, the Hong Kong Securities and Futures Commission (SFC) issued a circular “to provide guidance to management companies of SFC-authorised unit trusts and mutual funds on enhanced disclosures for SFC-authorised green or environmental, social and governance (ESG) funds”.
With the inclusion of Chinese Equities in the MSCI, scrutiny on ESG reports and compliance to international practices will only increase. It is not surprising then that in September 2018, the China Securities Regulatory Commission (CSRC) established an ESG information disclosure framework for listed companies.
By 2020, all public companies in China will be subject to a “disclose or explain” requirement for environmentally related information .
Harmonisation and standardisation are needed
According to the recent BNP Paribas ESG global survey 2019 across 347 asset owners and asset managers, the adoption of ESG guidelines, disclosure and their incorporation in investment strategies have accelerated over the past years. If a vast majority of the respondents to the survey are planning to dedicate more resources to ESG due to regulations, effective integration will require a mindset change to embed ESG expertise across the organisation.
There are also more practical challenges to be addressed. Today most investors make allocation decisions (best in class, thematic or exclusionary) based on research and ratings computed and published by the likes of MSCI, Bloomberg or Vigeo-Eiris.
But there is a growing demand for in-house assessment, which requires access to raw structured data. Today, data come from multiple sources, in different formats and standards. As highlighted in the BNP Paribas survey, better data collection and analysis tools (using AI or Machine Learning) are therefore needed to foster adoption and streamline integration.
Responding to such demand, IHS Markit recently launched a global ESG data reporting platform, offering a single warehouse for ESG related reports. SWIFT has taken a similar approach when launching its KYC Registry, which significantly reduces operational costs for its clients.
The harmonisation of guidelines and frameworks is recommended, by defining ISO-type global standards – and/or by leveraging international institutions like the International Organization of Securities Commissions (IOSCO). In its Strategic Framework for Green Finance, the Hong Kong SFC recognised that “apart from the issue of quality, environmental and climate-related disclosure currently lacks comparability. There are differences between local requirements and international reporting frameworks, and also among the numerous international frameworks themselves […]. Without a convergence of reporting standards, reporting will remain fragmented.”
The challenge will be to enable that comparability by moving from unstructured to structured and standardised data, without locking the process into constrained or simplistic frameworks, which can lead to meaningless reports, and would be detrimental to the production and proper integration of ESG metrics in both investors’ asset allocation strategies and corporate governance.
Here to stay
Regardless, the ESG acronym is here to stay and for good reasons. To the same extent that DLT, AI and API will fundamentally transform the way we build, deploy and access tomorrow’s business solutions, compliance to ESG standards and principles will permanently transform the way we conduct business.
Philippe Dirckx is an international banking professional based in Hong Kong with broad experience in financial markets, including in the areas of trading, post-trade, technology, market infrastructure and strategic business development.