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ESG ratings of financial products: Don’t dismiss a good idea for its challenges

Friday, 23 June 2023

Monde Economique by Nabil Hatimy, Head of Clients Delivery & Partnerships at Indigita SA

It is one of today’s most widely used acronyms in the financial world: ESG, which stands for Environmental, Social, and Governance. The three letters represent a framework used to describe the sustainability and ethical impact of a company or investment. The ESG concept originates from a variety of sources, including, among others, the Paris Agreement, and several initiatives by the United Nations, such as the Global Compact initiative.

Over the past years, the ESG framework and the associated values have steadily gained importance within the financial industry due to heightened public awareness, especially among younger generations, regarding climate change, limitations to natural resources, and the importance of sustainable and ethical practices.

Despite all the ambiguity around its measurement and definition, ESG still addresses a fundamental and increasingly relevant need of investors and companies to link financial performance with a positive impact on our planet and society.

ESG in practical terms

To be applicable in the realm of finance, ESG criteria need to be translated into tangible scores and benchmarks. This task is carried out by specialized data analysis providers, who run ESG assessments. The subject of these assessments are companies and their individual financial products, such as bonds and shares. Each company and its financial instruments is assigned an ESG score based on an extensive range of parameters, which capture its environmental, social, and governance impact and performance.

The main purpose of issuing ESG scores is to help investors identify and assess the sustainability and ethical implications of different investment options based on a standardized measurement approach. Banks and financial institutions are increasingly acknowledging the significance of ESG scoring for their risk management, the identification of investment opportunities, and the formulation of investment strategies centered around ESG considerations.

Industry challenges

While ESG scoring offers many benefits in theory, its implementation can pose a challenge. That’s because the criteria used to form an ESG rating have not yet been officially defined by a recognized authority. This creates a situation for the end investor where the true ESG quality of a suggested financial product may still remain somewhat unclear, despite the availability of an ESG score. The lack of formally defined criteria to build an ESG score has led to competition among data providers as they strive to offer solutions for financial institutions that align with their existing product offerings. The goal is to prevent the need for a complete product overhaul while still providing reliable and credible ESG indicators. This has, in some cases, led to a phenomenon known as greenwashing, where rating criteria are tweaked in a way that makes certain products, services, or companies appear more environmentally or socially conscious than they really are.

The role of the regulators

Regulatory bodies across the globe have acknowledged the importance of fostering transparency around the topic of sustainability in financial markets. Several initiatives have been launched that aim to establish regulatory frameworks for clearer ESG integration and reporting. But due to the rapid pace of development in the ESG space, the financial world regularly finds itself outpacing regulatory efforts, which involve time-consuming coordination between national and supranational regulators. This is why, to this day, financial institutions and investors continue to face a high level of uncertainty and lack of clarity regarding ESG investments. Formal guidance and official positions currently come from various sides, such as the Swiss Financial Market Authority (FINMA) and self-regulatory bodies like the Association of Swiss Banks, but are issued in absence of a fully defined legal framework and lacking international coordination. For institutions and investors operating in a cross-border context, this mesh of local interpretations, positions and guidance further adds to the complexity.

Where does this leave financial institutions and investors?

The idea of making ESG criteria an important aspect for investment decisions is a commendable approach to foster financial investments that contribute to a better future. However, the implementation of this idea comes with substantial challenges around the effective implementation of ESG criteria in terms of standardized rating systems, transparency, and the raising of awareness among end investors. To successfully implement ESG-based products, services, and investment strategies in such a complex environment, financial institutions and investors need to rely on experienced partners and technology providers with a track record of successfully navigating the ESG space. Partnering up with the right experts will ensure accurate data management, seamless reporting, and efficient execution of ESG-related activities. Despite all the ambiguity around its measurement and definition, ESG still addresses a fundamental and increasingly relevant need of investors and companies to link financial performance with a positive impact on our planet and society.

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