Why banks invest in climate-damaging projects and whether ESG systems can be the solution
Author: Lara-Sophie Buckow
With the increasing impact of climate change, there is a growing awareness of the consequences of our personal choices and actions. Often, however, awareness stops when it comes to finances and investments. Not necessarily out of disinterest, but simply due to a lack of information and knowledge, as well as complexity.
As a result, most banks invest their clients' money in lucrative but often climate-damaging projects, such as fossil fuels. As FinTech pioneers, modern financial service providers such as Aspiration or Tomorrow offer an environmentally friendly alternative to traditional banking. In addition, ESG investments are supposed to offer green alternatives for investments. However, these have often come under criticism recently. Find out what this is all about here.
That's behind ESG
In terms of investment, the market seems oversaturated with offers that often do not correspond to the values of the sustainable consumer. The magic triangle of investment has so far exclusively considered the economic investment goals of "security, availability & return". The solution: turn the triangle into a square. Environment, social and governance (ESG) investments as a solution for investing aligned with personal values.
- Environment: The environmental aspects are fundamentally concerned with the extent to which the company deals with its impact on the regional and international environment. For example, are there toxic waste products? How does waste disposal take place? Is the company climate neutral?
- Social: Under the social aspects, it is to be assessed to what extent the company deals with and uses its social influence. This is mainly about people from minoritieswho are often socially disadvantaged.
- Governance: Under this point, the management and leadership level will be analysed in particular. What does the organisation of changes look like within the management level but also within the entire company? Is diversity also taken into account within management positions and how are employees treated?
ESG companies are therefore primarily about the inclusion and appreciation of all parties involved.
No standardised rating method
Rating agencies are responsible for assessing companies on the basis of their ESG attributes. These are agencies such as MSCI ESG Research, Sustainalytics by Morningstar, Institutional Shareholder Services (ISS) or Bloomberg and S&P, among others. For the rating, these companies analyse publicly available documents such as annual and sustainability reports, structure and composition of the board of directors, but also remuneration and corporate policies. For each category, i.e. environment, social and governance, several different documents are available for the analysis and evaluation.
The problem: Each agency has its own approach and scale for the ESG rating. MSCI ESG Research's rating system, for example, starts from final grades AAA to CCC. Whereas Sustainalytics evaluates companies in different risk groups. But the process, the approach and the weighting of the various factors also differ. So far, there is no uniform procedure.
Benefits of ESG investments
Compared to broader-based indices, ESG-based portfolios have even outperformed them in some cases in the past. This puts them in the lead in terms of profitability. One thing is certain: investing in companies that are increasingly committed to the environment and combating climate change means that more measures can be taken in this direction.
In addition, the shift from financial resources to green investments may make other companies aware of the need to rethink their strategy in the future and also to be more committed to sustainable values. However, it is questionable whether this is the case for all companies with a good ESG rating.
ESG companies equal ethical companies?
Companies with good ESG ratings are often automatically equated with ethical companies because of their environmental and social screening. However, this is often a misconception. Although these aspects are taken into account in an ESG rating, it is also a question of how economically viable a company already is today and will be in the future. This is why it is also possible for companies in the tobacco industry or oil production to receive positive ESG ratings.
Therefore, those who want to invest in ESG portfolios should be aware that in the end it is also about money and therefore also include companies with high profit opportunities. For those who want to combine their values and investments independently of a company's strong profitability, a Socially Responsible Investing (SRI) strategy is suitable. In this case, one has the possibility to exclude companies from the portfolio that do not correspond to one's personal values.
Although the underlying principle behind ESG financial investments is positive, caution must be exercised when selecting them. According to a study by the MIT Management Sloan School, the ESG ratings of the rating agencies agree on average only 61%. The main reason for the differences is the use of different indicators, which account for around 50%.
Comparison of different ESG ratings, source & copyright by MIT Management Sloan School
In addition, it is possible that corporations in unethical or climate-damaging industries, such as the arms or oil industry, receive very good ratings because they perform very well in terms of governance at the management level. Conversely, it is possible that companies whose social division or corporate governance has potential for improvement receive lower ratings, even though they act more in line with UN requirements and goals.
Is it all just hype or is there a change in the financial world?
TThe interest in sustainability has long since ceased to be a passing trend. It has developed into a veritable Eeo-wakening.After the shift towards environmentally friendly action and sustainable business models is booming in fashion, mobility or architecture, it is time for the financial industry to follow suit. After all, what is the point of an environmentally friendly lifestyle if the money in the savings account or investments in the custody account flows into environmentally harmful companies or sectors.
When it comes to investments, the fear of greenwashing is high due to the often opaque or overwhelming portfolios. But the offers are there. There are more and more funds or ETFs that are sustainable. What is clear is that the ESG system needs improvement, standardisation and transparency. ESG ratings cannot be trusted blindly and often cause more confusion. Now is the time to create clarity as well as certainty for investment strategies to drive sustainable change through green investments.