In her article ’Developing a world in which we can all live sustainably’, Louise Tong looked at why the financial sector is so focused on sustainability. She reasoned that it’s not just a moral and social imperative, but there are financial reasons too. In this follow-up piece, she looks at the role the financial sector can play in helping to address the social and environmental challenges faced by society today.
Banks have broad reach across economies and this is particularly the case in New Zealand, with bank assets totaling around $600 billion. Similarly, where investors choose to invest their money also matters, and the Reserve Bank of New Zealand (RBNZ) reports total funds under management of $217 billion in New Zealand*. Clearly where and how this ‘financial heft’ is applied is impactful.
Many fund managers, including BNZ, have committed to the United Nations Principles of Responsible Investing (UNPRI) as a public declaration of their commitment to including environmental, social, and governance (ESG) factors in their investment decision making and ownership. Worldwide, there are over 3,000 signatories to these principles, representing over US$100 trillion of assets under management.
Similarly, over 190 banks, representing about 40% of the global banking system have signed up to the Principles of Responsible Banking (PRB), representing a commitment to a shared vision to create an inclusive society founded on human dignity, equality, and the sustainable use of natural resources to support businesses to thrive.
The public commitments associated with being a signatory have substance. In July 2020, the PRB signatories agreed to have regular progress reviews, as well as a process for dealing with signatories who fail to deliver on their commitments – and recently, five UNPRI signatories were delisted for failing to meet their commitments.
It’s useful to think of the role that financial institutions can play by framing them across the following three pillars:
1. Shaping the market
Solving society’s greatest challenges rarely comes down to individual action. Collaboration, partnerships, and engagement are the means by which real change is made. Financial institutions, with their knowledge, broad reach, skill sets, and networks, are uniquely placed to play a role in bringing people, organisations, and tools together. They have relationships with key decision makers that can help impact market settings – such as regulators, politicians, policy makers, and non-government organisations. By advocating, engaging, and influencing for the long-term interests of society, financial institutions can help play a key role in affecting positive change.
Transparency through consistent, comparable disclosure is also critical for informed capital allocation decisions. Financial institutions have an important role to play by implementing, and advocating for, a greater degree of high-quality transparency and disclosure.
2. Integrating ESG
As a first step, banks and investors are defining their strategy and approach to sustainability, often in alignment with the Sustainable Development Goals (SDGs), the Paris Agreement, and relevant national frameworks – such as the Zero Carbon Act. They are setting targets; either a dollar value of sustainable financing (such as BNZ’s recent announcement of $10 billion in sustainable finance by 2025), or based on a carbon footprint, and/or in relation to other ESG issues (more recently, there has been a greater focus on biodiversity targets).
This provides the foundations from which these entities then look to embed ESG considerations into frameworks, incentives, processes, decisions, and, ultimately, capital allocation and pricing. One particularly interesting example of this is the French corporate and investment bank, Natixis, who have developed a “green weighting factor” to tilt capital allocation towards “green” lending, and away from lending that has negative environmental impacts.
3. Financing that reflects and incentivises positive ESG impacts – where the ‘rubber hits the road’
For fund managers and asset managers, it’s about integrating and reflecting ESG factors in the products they offer. The market has progressed from simple exclusion (i.e. banning companies with particularly harmful activities), to more sophisticated positive and norms-based screening (i.e. compliance with international standards and norms, such as the UN Global Compact). More commonly, fund managers are integrating ESG analysis into fundamental financial analysis, and actively engaging with the companies they invest in on ESG issues is also a leading practice.
For banks, it’s about working with their customers to encourage sustainable practices (for example, supporting energy companies to build more renewable generation). This can be done through supporting customers with ‘sustainable finance products’; which refers to any form of finance that integrates ESG criteria for the lasting benefit of borrowers, lenders and society at large. There are two main types of sustainable finance – proceeds based and incentive based.
- Proceeds based. This reflects bonds or loans where the proceeds are notionally earmarked for assets with positive ESG characteristics, but the debt is backed by the issuer’s entire balance sheet. Examples include green bonds that reflect the low carbon nature of transport, green buildings or renewable energy assets, or social bonds where proceeds are invested in the provision of affordable, warm, dry homes. These labelled bonds serve to highlight and amplify an issuer’s sustainability profile and the positive characteristics of the underlying assets.
- Incentive based. Another, more widely-applicable form of sustainable finance is an innovative product known as Sustainability Linked Loans (SLLs). These link the cost of debt to the borrower’s performance against agreed targets, which align with the company’s sustainability ambitions and are both specific and measurable. This provides real, tangible incentives for change. While there are plenty of examples of SLLs offshore, there are few examples of SLLs in New Zealand as yet. But watch this space, as they are likely to be adopted at a rapid pace in the near future.
To support credible and consistent approaches, financial market participants have collaboratively established various best practice guidelines to support Sustainable Finance products – such as Green and Social Bond Principles, and Sustainability Linked Loan Principles. Credible frameworks, methodologies, reporting and independent assurance are common themes across the principles, providing investors and lenders confidence in the sustainability credentials of the product.
The time to act is now
In today’s extraordinarily low interest rate environment, the present value of our current actions and future impacts is much greater than it once was. Helpfully, this provides unprecedented clarity: we must address tragedy on the horizon now, rather than later. While action on the ground may have been moving at a frustratingly slow pace, that is certainly changing now. We have the frameworks in place, such as the Zero Carbon Act, and a pathway forward, as outlined in the recently released Climate Commission draft report^.
The financial sector is a material force in today’s society, with broad reach across the economy – and ESG factors are integral to its success. This means financial institutions are uniquely placed to support the necessary shift from a “today trumps tomorrow” mindset to a more sustainable approach that will benefit us all.
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