ESG x Fintech: Investing sustainably

Sustainability is perhaps the hottest of all topics currently, and its relevance to financial services has come into sharp focus in recent years. Regulators have strived to make their expectations for regulated entities on sustainability clear; businesses have tried to demonstrate their sustainable credentials in an effort to attract investors and customers, who themselves are increasingly incorporating sustainable factors into their decision-making. 

In the past, sustainability was often not thought of as the responsibility of investors, who typically had limited considerations outside of the potential for financial returns in mind. Financial returns are of course still key to investors, but sustainable impact goals are also fast becoming a core part of the investment strategy of many and it is increasingly recognised (eg as noted in our recent report A Legal Framework for Impact: Sustainability Impact in Investor Decision-making) that investors can have a positive sustainability impact themselves.     

Changing views or increased access?

Much has already been written on how millennials are driving change in investment behaviour, with various studies and polls indicating that having a positive influence from an ESG perspective is a big factor in the investment decisions of this generation. 

What has driven this change in approach? Awareness of ESG issues has of course risen, but there has also been an exponential increase in access to ESG information and data, to funds which have ESG goals embedded into their strategies and to companies who have started to incorporate ESG credentials into their processes and corporate actions. Sustainable fintech solutions, also known as “green fintech”, are also enabling investors to make conscious investment decisions, to monitor their portfolios and to make an active contribution to ESG initiatives. Technological developments mean that it has never been easier for investors, and especially retail investors, to have a say in which initiatives and companies their money goes to.

The emphasis is often placed on the environmental component of ESG; for example, investment products such as indices which exclude companies with particularly large carbon footprints are often considered in this context. However, a larger focus is now also placed on the social element of ESG. For example, there are an increasing number of products which allow investors to promote gender equality through their investment decisions, such as ETFs which provide exposure to companies which comply with certain gender diversity criteria or portfolios which only include female-led organisations. The Covid-19 pandemic has accelerated the move towards sustainable investing in general, but it has also sharpened the focus on this social element of ESG, as investors take an interest in how companies have treated their employees and other stakeholders. Those who have prioritised factors such as short-term profits over the longer-term impact of their actions have typically been viewed less favourably.  

The growth in sustainable investing cannot be solely attributed to investors simply wanting to “do good”. ESG investments have in many cases been found to have a positive, or at least a neutral, impact on financial returns and it is possible to use ESG factors in investor decision making as a risk mitigation strategy. ESG-focused investments are in some cases perceived to be less exposed to negative financial performance as a result of the company being better prepared to deal with an ESG crisis or being less exposed to ESG-related scandals. Such investments therefore have the potential to have a stabilising impact on portfolios.

Outside of direct investment, some banks have also been using ESG credentials as a distinguishing factor in an attempt to attract customers in what is a competitive and challenging environment. Our recent blog post The outlook for UK challenger banks highlighted the difficulties faced by these entities in the current market, particularly in attracting new customers, and strong ESG policies may be one way for them to gain a competitive advantage. Banking service providers will need to adapt to meet the demands of customers and the expectations of their stakeholders, who are increasingly influenced by ESG factors and who are turning to entities who can prove their credentials, often by demonstrating that the projects and companies that they invest in and finance themselves are ESG-compliant.

Challenges with sustainable investing

However, the area of sustainable investment is not without controversy.  ESG and sustainability are inherently subjective topics which are difficult to measure in practice.  Many ESG goals are based on the potential for longer-term impact, and so it is difficult to find or to measure success in the short term. There have also been accusations of greenwashing, where investors or other stakeholders are given false impressions or false information to suggest that a company’s products are more sustainable than they are in practice.  Examples include cases of funds which claim to be ESG compliant but are later found to be heavily invested in fossil fuel reliant markets.

 The FCA recently published its guiding principles on design, delivery and disclosure of ESG and sustainable investment funds and noted that many of the applications that it receives “do not bear scrutiny”. It gives examples such as applications for funds with ESG-related names which do not track an ESG-focused index, funds which claim to have a strategy of investing in companies contributing to positive environmental change but which do not contribute to the net-zero transition, and funds which claim to be sustainable but which included high-carbon emissions energy companies in their holdings.

Changing regulations

The FCA’s guiding principles build upon its recent proposals to implement climate-related disclosure rules for asset managers, life insurers and FCA regulated pension schemes. The proposals are aimed at helping to “make sure that the right information on climate related risks and opportunities is available along the investment chain – from companies in the real economy, to financial services firms, to clients and consumers”. The ambition is to encourage investment in more sustainable projects and activities, in line with the Government’s economic strategy of supporting the transition to a net zero economy.

In Europe, measures have been adopted which are aimed at improving the flow of money towards sustainable activities across the EU. Six delegated acts aim to amend MiFID II, AIFMD, the UCITS Directive, Solvency II and the IDD in order to require firms to consider sustainability risks and incorporate them into their risk management and conflicts policies and procedures as well as into due diligence processes and product governance and oversight arrangements. Investment firms providing financial advice and portfolio management will need to carry out mandatory assessments of the sustainability preferences of clients, and to take those into account in the selection of financial products, and client reports will need to explain how the recommendations meet those preferences.

The fact that regulators as well as investors are taking ESG and sustainability seriously is good news for the sector (as well as for the planet!). Increasing demand and a growing trend in sustainable investment will incentivise companies to do more to contribute positively to ESG and regulatory measures will enable regulators, investors and other stakeholders to hold them to account.  It remains to be seen what the investing landscape will look like in years to come, but sustainable investment is likely to continue to be a significant part of the picture.