Sustainability has been evolving as an increasingly important issue in the banking industry for a long time now. As stakeholders called for increased importance on Environmental, Social and Governance issues, banks had begun incorporating ESG considerations into their risk management processes, purpose statements and investment decisions.
The importance of ESG considerations has been emphasized even more in wake of the Covid-19 pandemic. Banks are now realizing the importance and urgency to incorporate ESG concerns in all decisions and also the many opportunities and values a holistic and sound ESG framework would bring to the bank – but the question for many banks now, is how to determine what that means in the context of their internal operations, as well as with the companies they work with and invest in.
For banks themselves, sustainability involves an institution’s commitments to environmental, social, and governance (ESG) criteria – how a bank’s internal practices, investments, and external collaborations impact the environment, how they affect society, and how they are managed (governance).
Environmental ratings include a bank's commitments to reducing its environmental impacts through investments, as well as in its internal practices.
Social issues count, too; investors and consumers today are also seeking out banks that will engage in projects that have a positive impact on society - reducing poverty, increasing diversity (both racial and gender), enhancing human rights, and increasing consumer protection.
Likewise, governance is also a key issue; investors and consumers want to ensure that banks engage and invest in projects or companies that are diverse, that pay their employees a living wage, have reasonable levels of compensation for executives, etc.
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Broader ESG commitments now standard for banks
The push for sustainability in the banking industry is coming from three directions – regulators, customers and investors. With concerns rising over climate change and the need to reduce carbon levels, regulators have begun setting timetables for the reduction or elimination of greenhouse gasses.
With increasing demands from regulators, banks are responsible not just for their own operations but also for the actions and performance of their vendors, pushing banks to ensure that their supply chain is sustainable, in order to minimize indirect negative impacts.
Banks are also seeking to ensure that their supply chain is sustainable, in order to minimize indirect negative impacts. To comply with new data privacy laws, banks must seek to ensure that their vendors have rigorous and comprehensive data privacy measures in place too.
While banks have in recent years increasingly been involved in financing environmentally sustainable projects, more is demanded of them today – and in response, banks have begun to broaden the scope of their ESG commitments to their internal practices and external collaborations too, facilitating their shift to eco-conscious organizations.
There are many benefits to banks for doing business in this manner. Sustainability-conscious companies are better equipped for managing their future risks, thereby making such companies good investment opportunities for banks and their corporate customers.
And customers are driving the trend, as well. According to Forrester, “71 percent of US Progressive Pioneers - the most progressive customers who lead the demand for business innovation - are ‘green’ or ‘super green’”. Banks are now seeing greater demand for sustainable practices, which they must fulfill in order to retain customers.
Bankers are trained experts to tackle complex financial products and transactions. One of the key challenges for banks to establish and implement a comprehensive and holistic ESG Strategy is how to build the know-how and awareness across the organization and different business lines, to embed ESG strategy in every function of the bank. More and more banks adopt the approach to partner with external ESG solution providers, to bring the best practices and innovation internally.
Measuring sustainability – Today’s reality and the challenges ahead
A number of organizations now offer ESG ratings, which rank companies, banks, investment funds, and other targets on the basis of their commitment to these areas. Fitch, for example, rates all these for their ESG commitments, along with how specific ESG issues directly affect a target's overall rating. Ratings providers identify relevant core metrics for companies, and then compare institutions based on how well they perform against each metric (typically based on UN Sustainable Development Goals).
But those metrics are not necessarily objective; when it comes to investments, for example, what's sustainable in one industry or geographical location may not be in another. “Sustainability” means different things to different institutions, and organizations that want to reduce their ESG impact need clear criteria to determine if an investment meets their goal of responsible investing.
Determining what constitutes “sustainability” involves a deep dive into the data, with a calculation process that’s very complex and often demands ongoing monitoring and backtesting of the algorithms. Additionally, separate ratings organizations are likely to come up with different ratings for the same company. And the evaluation process is likely to be biased towards larger, public companies that have the resources to report verifiable data on their sustainability activities.
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How technology can solve these challenges and bring new perspectives to banks
The process of rating a company’s sustainability performance is becoming increasingly data-intensive. Ratings agencies have to scour through mountains of data to derive insights from publicly available and verified information. Data startups using advanced AI and machine learning technologies could mine this data, assessing the relationship between all the factors involved and supporting intelligent decisions on sustainability.
Using sophisticated computer algorithms which can analyze and process both structured and unstructured data to digest all of the information available about a company - which can be an extremely time-consuming task for human employees – ratings organizations could supply banks with clear information on the sustainability of companies. In addition, Sentiment Analysis, which assesses the tone of text from data sources such as articles, social media posts, research reports can be used to understand a company’s sustainability performance.
Using new AI tools, ratings agencies can develop objective criteria that will take into account the circumstances of an industry, properly weighting sustainability criteria as appropriate. In addition, access to data will ensure that an accurate picture is drawn – without being filtered by the company, and thus possibly skewing ratings results.
Furthermore, advanced machine learning and artificial intelligence will be able to quickly parse data and make ratings adjustments as new data comes in – and even make specific recommendations on how companies can improve their sustainability scores.
Armed with objective, verifiable data on sustainability, banks will be able to better determine with whom to do business based on ESG ratings that fit the profile of clients an institution seeks, and whether they comply with regulations. AI can give banks an opportunity to develop a holistic approach to sustainable investing, based on intelligent use of data.
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Rebecca Shao, Head of Data & Data Strategy
Kriti Gupta, Data Engineer, The Floor (opens in new tab)