Challenges of integrating an ESG approach into lending

Published on July 19, 2022 by Rajesh Dua

ESG stands for environmental, social and governance — the three important factors that determine the sustainability and social impact of an organisation. Investors are now applying these non-financial factors to categorise material risks and growth opportunities before investing. The following illustration describes each of the factors.

The following are benefits of incorporating ESG considerations into company strategy:

  • Strong ESG performance results in higher investor returns. These could be enhanced by allocating capital to more sustainable projects

Regulatory readiness

The UK and the European Union (EU) lead implementation of ESG- and climate risk-related regulations. The US is also expected to take initiatives to include ESG considerations in risk management frameworks.

Importance of ESG

The unforeseen consequences of the pandemic amid the climate change crisis have severely affected the global economy, making policymakers realise the urgency of increasing investment in and accelerating progress on business that prioritises ESG considerations. Society also realises the need for businesses not only to create employment, but also to protect natural resources and consumer interests.

Growth in ESG lending

ESG lending grew to USD322bn in 2021 from USD6bn in 2016, with contract terms and conditions subject to a borrower’s ESG performance. These loans were spread across sectors and were issued mostly by large and publicly listed firms. Studies show that ESG banking activities mainly relate to pre-existing lending relationships.

The EU leads ESG adoption. Countries such as Norway, Singapore, New Zealand, Iceland and Sweden have the highest ESG scores, according to research. The US and a few Asian countries have also adopted ESG approaches in their business and investing styles in recent years. India needs to prioritise adopting an ESG approach in order to meet sector norms.

Six ESG funds launched in India in 2020 collected nearly INR36bn (USD493m) from investors. It is estimated that nearly USD5bn was raised via sustainable bonds in the first six months of 2021. Globally, nearly USD100bn in ESG-related funds came to the markets from 2018 to 2020. It is estimated that ESG investing could be worth USD100tn by 2030.

Challenges in incorporating ESG considerations

Central banks are seeking ways in which to adopt ESG factors in their fixed-income investments. Global central bank reserves have grown to over USD14tn, but only six central banks incorporate ESG considerations in their investments. Equity investors have been incorporating ESG factors in investment decisions for the past 60 years, but only recently have fixed-income investors started doing so.

Central banks need to ensure the approach to ESG is consistent with the current management framework and the traditional role of investment, i.e., to provide safety, liquidity and returns. Incorporating ESG considerations in investment policy is the most effective way to institutionalise this practice, but we list below some of the challenges faced in doing so:

  • Standardising regulatory changes: Regulatory bodies have been working round the clock to formulate a global platform for ESG considerations. Having such a standard could lead to a number of regulations and compliance requirements needing to be met before a business is classified as green and sustainable.

We list below steps to implementing an effective ESG approach:

  • Define your investment belief, as this would define your sustainable investing strategy

How Acuity Knowledge Partners can help

We are a leader in the financial services outsourcing space and provide a wide range of solutions to clients in areas such as analytics and in-depth research on ESG indicators, policies and structured frameworks, ESG scoring/rating and benchmarks. We offer comprehensive thought leadership and specialised ESG research solutions. We also help investment banks and advisory firms establish and grow their sustainable finance practices by providing customised analysis and support.

About the Author

Rajesh has 14 years of experience in banking domain, with 6 years in commercial lending and 8 years in consumer banking space. Prior to Acuity, he worked with Bank of America for 12 years. He has done Masters in Banking and Finance from NMIMS and hold a Bachelor’s degree in Commerce.

Originally published at https://www.acuitykp.com.

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We write about financial industry trends, the impact of regulatory changes and opinions on industry inflection points. https://www.acuitykp.com/