Imagine you are on a plane and the pilot says that there is a malfunction (hopefully this never happens). The plane is about to crash and the only option you are left with is jumping off the plane with or without a parachute. What would be riskier: parachute or not parachute?
Probably you will take the parachute (I would do too), but is this option less risky? According to the ISO 31000 on Risk Management, a risk can be understood as the effect of uncertainty on objectives. The risk would be the part of uncertainty that we can somehow measure (frequently in terms of likelihood and impact).
So, let’s analyse the parachute situation for a minute. If you do take the parachute, let’s say you will face three potential outcomes: a) 80% chance you may do alright, b) 19% chance you will land and have an injury, and c) 1% chance that you will die. Now, if you do not take the parachute, you will most certainly die (100% chance). The most uncertain situation is therefore jumping with the parachute. Therefore, we could say that it is the riskier option, can we?
This analysis is incomplete. We are missing a key element in how we assess risks: what our objective is. We assess risks according to what we would like to achieve, not on the basis of empty data. This means that we take a goal-oriented approach to risk following a basic principle: we need to accept uncertainties to achieve our objectives. As we want to survive our jump off the plane, the option that gives us less uncertainty (and therefore less risky) is doing it with a parachute.
The same principle applies to the sustainability-related risks. However, sometimes the objective may be misplaced of even too narrow for a useful risk assessment to be implemented. Let me give you an example to clarify this point. Managers are increasingly concerned about the climate-related financial risks (and they should be). By focusing on reducing financial losses, companies may assume that climate change is happening to them while dismissing their own responsibility in the problem itself. A similar confusion may occur when assessing social risks such as those related with human rights. As a result, decisions aiming at managing the risks will be ineffective. While trying to shield the company, they will forget those facing the greater impacts.
Social and environmental risks will certainly have consequences on financial outcomes as well other objectives. But the focus of the assessment should not be placed on the company alone, but on those being impacted by the risks (people and the environment including its biodiversity). We can refer to that as a sustainability-centred approach to risks. If our objective is truly achieving greater sustainability, then our risk assessments and decisions should reflect that. The starting point? We need to understand what sustainability means for us and how we contribute positively and/or negatively to it. This is typically the scope of a materiality assessment, something we will discuss on another blog.
In our last blog I discussed the evolution of corporate sustainability initiatives from CSR to ESG and how the ecosystem of initiatives is organised. In this blog we will discuss what sustainable finance is, its purpose and implications for business.
What is sustainable finance? Sustainable finance is one of a number of terms used to label activities related to the interaction between the economy, environment, society and finance. Related terms include ‘responsible banking’ and ‘responsible investment’, ‘environmental, social and governance’ (or ‘ESG’), and ‘climate finance’. These terms are often treated synonymously, but there are differences in their scope, particularly in terms of whether they include social and governance issues. Approaches which embrace the full range of these issues are more likely to be termed ‘sustainable finance’, whereas those that focus mainly on environmental issues are more likely to be referred as ‘green finance’.
Why sustainable finance? You may remember 2008 because of the global financial crisis. You may also remember that after each financial crises we lose trust on financial institutions. This is what happened after 2008. Strong consensus emerged from policymakers, regulators, civil society and from financial services that many financial institutions had engaged in too many harmful financial activities without any positive social impact. The financial sector needed to fundamentally reconsider its strategies and activities, and align these with more socially responsible, longer-term objectives. So, the answer was that finance should become more sustainable, including but not limited to considering broader economic, environmental, and social factors in lending, insurance and investment decisions.
In recent years, emphasis has been also placed on how finance can support sustainable economies and societies more generally. Financing sustainable economic, environmental, and social objectives, often those set out in the UN Sustainable Development Goals. More recently, and particularly from 2015 with the signing of the Paris Agreement on Climate Change, policymakers, regulators, and financial services have focused on environmental sustainability. This has included significantly increasing the financing of new technologies and activities designed to reduce greenhouse gas emissions (climate change mitigation) and/or support climate-resilient development (climate change adaptation) and disclosing climate-related financial risks.
Sustainable finance is moving into the mainstream of finance as public policy, regulation and market forces collaborate to align the financial sector to humanity’s biggest challenges. This agenda is having a direct impact on businesses looking for financing opportunities. They are now increasingly required to disclose their sustainability performance regarding ESG dimensions. Investors are being also called to take a more responsible approach regarding the companies they fund.
While business attention on sustainability issues is not new, there has been an explosion of interest since the late 1990s and early 2000s, as a consequence of pressures from social movements, corporate scandals and a growing awareness regarding environmental degradation and climate change. Hundreds of new corporate sustainability guidance, standards, and tools have appeared as business seek a ‘golden rule’ to implement socially responsible initiatives, with the influx at times leading to confusion among managers, CEOs, and investors.
So, how is the corporate sustainability ecosystem organised?
From a business perspective, corporate sustainability has been reflected in (typically) voluntary commitments made explicit through corporate social responsibility (CSR) initiatives. CSR would be then anything that a business does to respond to society’s expectations beyond the minimum legal requirements. This sounds right, but it has one key limitation. Top managers and the Board of Directors have frequently prioritised shareholders’ expectations in the short term (let’s say a year). As most shareholders would like to see a return on their investment, profit maximisation became the main metric of company success. This implies that sustainability has not been central to the way companies are managed and valued.
The solution? A greater focus on the role of finance in promoting sustainability will definitely help. This is what is happening today, and it has been happening for a while now. The integration of CSR to finance and investment decisions has shifted the debate to the concept of sustainable finance and its broad operationalisation as environmental, social, and governance (ESG) issues. Both concepts, CSR and ESG, are then virtually the same as they attempt to promote greater responsible business conduct. Of course differences exist. While CSR focus on what socially responsible things we do, ESG is the way me measure our sustainability performance (and publicly disclose it).
So, now that this is clear, let’s try to organise the CSR/ESG ecosystem. All the CSR/ESG instruments can be classified in three categories: 1) frameworks, 2) standards and 3) rankings/ratings. Frameworks refer to principles or guidelines on how sustainability issues should be managed and disclosed (e.g., OECD Guidelines for Multinational Enterprises, Integrated Reporting). This is basically a set of principles to guide business conduct towards greater sustainability. Standards, on the other hand, exist in the form of formal documentation that set requirements and specifications on what to do and disclose (e.g., GRI, SASB). They can be specific actions that a company should implement or specific indicators that a company should measure and ultimately disclose. On the other hand, rankings and ratings are a third-party evaluation of a company’s ESG performance. They basically provide a benchmark on how well a company is doing in terms of sustainability. The challenge here is to link company ESG performance with ESG impact, but this is something we will discuss another time.
The ESG ecosystem is progressively becoming part of mainstream finance and investment. In our next blog we will discuss some of this by focusing on the concept of green and sustainable finance and how is impacting business.