Financial services’ societal role in climate change: the power of nudge

(These are my own personal views.)

Everyone is suddenly talking about environment, social and governance (ESG). My friends in the ESG investing world are smiling — they’ve been beavering away on factoring ESG into investment decisions for more than 15 years. For those of us in governance, this work has gone much longer — I co-authored the first corporate governance policy for the UK’s National Association of Pension Funds in 1996. For me, a lifetime away.

Certainly, things have changed — the “E” particularly. We are at a pivotal time for climate change. We either make a material change in how we behave globally to arrest — or better, reverse — global warming, or we will all live with the consequences, as will our children and grandchildren (and beyond).

The “S” has also popped. Traditionally, this focused on labor rights. Today, human capital and diversity and inclusiveness have also been embedded, as well as the role of companies in their communities. No one denies the importance of this broader view of social factors.

ESG: a bad rap?

The importance of ESG — in investment decisions, credit rating agency thinking, and in public views of capitalism and specific companies — has shot up the agenda. Recent letters from prominent investors to companies have set in motion a lot of activity, much of which will be positive, over time.

Yet, the ESG label has garnered negative connotations in some quarters, especially in corporate boardrooms.

To some degree, this is because we are drowning in a lexicon of terms and standards: ESG, corporate social responsibility, sustainability, and the Sustainability Accounting Standards Board and its Task Force on Climate-related Financial Disclosures. On top of that, misperceptions of what these are or are not abound.

But, some of it stems from how ESG has been used to date. In 2018, $31 trillion of investments were being influenced by ESG considerations (up 34% from two years earlier), with total assets under management of $92 trillion.[1] One assumes the 2020 data will show a continued increase.

On the face of it, this suggests ESG is very real and positive.

However, of the total, almost $20 trillion was in so-called negatively screened funds — that is, in funds where ESG was used as a factor to screen out, or materially underweight investments in, companies with ESG concerns. Less than $2 trillion was invested in leading-class ESG — that is, purposefully invested in companies with positive ESG characteristics.

It’s not unreasonable, then, for business leaders to conclude ESG is simply about stopping activity — avoiding certain “dirty” industries (think oil and gas) or companies linked to socially difficult issues (think private prisons and immigration). Nor can you really fault those companies that issue ESG-related reports without full commitment — the aim, in some ways, is to stay off the naughty list.

Hopefully, climate change will be different

My hope is the manner in which financial services addresses issues stemming from climate change will be very different.

For one, I trust it doesn’t get clouded by perceptions on the utility of ESG. Climate change is real and, in my view, financial services has the potential to play the most significant role in helping deal with the direct physical effects brought on by changing weather patterns and, more importantly, in helping us get to a low- or zero-carbon economy.

The business case for taking on a leadership role is compelling.

First, identify and manage the risks

Risks associated with climate change need managing.[2]

One could argue many of the most important asset classes (especially real estate) will be directly affected, perhaps faster than we think. A colleague recently mentioned some insurance firms are substantially reducing their exposure to commercial real estate (CRE). Their rationale: the assets are overpriced, because the effects of climate change have not been properly priced in.

If that’s true for CRE, surely, it’s true for residential property.

Think about that — two of the most important asset classes in the economy may be overpriced.

If true, inevitably, this means specific geographic microregions will be affected. It’s not hard to predict a vicious cycle. Microregions — those getting wetter or dryer — start getting less real-estate investment. This affects the local economy. Tax revenues fall. Municipal bonds start being affected. A hollowing out of microregions starts to unfold. Suddenly, contagion across asset classes occurs. Finding such fault lines in a firm’s assets and investments is critical.

Too much hyperbole? The head of supervision for the Federal Reserve Bank of New York (New York Fed) recently said:

“[F]inancial markets and institutions face the potential for a ‘Minsky moment’ related to climate change — an abrupt repricing of assets in response to a catastrophic event or change in investor perceptions. Financial firms and supervisors need to consider the potential and impact of this type of sudden event.”[3]

Second, size and seize the opportunities

Beyond managing risks, there are real commercial opportunities. Sustainable finance — albeit vaguely defined — is blossoming.

On the investing side, the range of options is already diverse and continues to expand. Fund categories include exclusion, inclusion, impact and philanthropic, and varieties in between. As noted above, the aggregate size of these funds is already significant and growing.

However, product innovations extend well beyond investing. Examples include:

• Sustainability-linked corporate loans: To encourage clients to meet their sustainability goals, banks are offering incentive-based loans, whereby the lendee either receives differing levels of rates depending on what sustainability hurdles they achieve, or the lendee pays a “step up” rate if it doesn’t achieve its own stated sustainability goals.
• Transition bonds: These are bonds that provide funds to finance transition technologies, such as less-carbon-intensive alternatives, or to enable a shift to a more sustainable business model.
• Social bonds: The brethren of environmental bonds — these provide funds for areas such as education, health care, housing and employment.
• Resilience bonds: These are akin to catastrophe bonds that link insurance premiums to resilience projects, so the issuer garners a financial benefit in premiums linked to the loss they avoid by completing the project. In effect, the reduction or “rebate” relates to measurable risk reduction.
• Insurance-linked securities (ILS): Typically, these are 12-month duration securities designed between the entity that needs specific insurance and an investor (as distinct from a 3–5-year catastrophic bond, whereby the issuer discloses its model assumptions and a set of investors invest). These highly tailored ILS may evolve into more standardized short-term securities, but already are a large part of this insurance segment.
• Energy-efficient mortgages: In effect, these typically provide additional funds in a consolidated mortgage to pay for home-efficiency improvements.

Other such innovative products exist, and we should expect — and push for — much more ahead. This will require firms to put their best talent on driving sustainable finance.

That said, we have a long way to go before the elements of sustainable finance have the impact they surely should. Albeit hard to properly size the market, the aggregate size of these products globally is probably well below $1.0 trillion (this compares with a global corporate debt market that is around $30 trillion).[4]

Third, drive societal change: make it mission-centric and use the power of nudge

In the end, I’m hoping financial institutions recognize their true power in this area: to have societal impact by helping their clients, customers and communities manage through more extreme weather events and transition successfully to a low- and zero-carbon economy.

A starting point is viewing their role in climate change as mission-centric and mission-critical. In general, financial services enables the real economy; that’s why I work in the industry. Its ripple effect is enormous. The same should be true for climate change. This sector is central to the transition.

Developing new products and services is step one. In the NextWave of financial services, this may mean bundling new kinds of mortgages and insurance products to keep people in affected communities, or other such combinations.

But the power of nudge should be not underestimated.

The obvious nudge is as investors. As passive investment continues to dominate the investment world, the option to screen out — or take the Wall Street walk — is eroded. Instead, there has to be real engagement, with investors encouraging (or demanding) that firms accelerate their transition.

But perhaps the most significant nudge opportunities relate to leverage points in the broader ecosystem that financial services firms can use.

For example, think about the housing appraisal process — getting appraisers to incorporate the real economic benefits of more efficient housing (the R-value) in their appraisals (i.e., lower heating bills) would show the value of investing in home efficiency improvements and allow banks to offer higher mortgages for builders or homeowners. Insurers could consider how underwriting standards and incentives could encourage builders to build in elements that address soil erosion or changing flood plains and thus reduce claims. The list goes on.

I think the power of nudge could be exponential (as do others).[5]

A partner to a better (not hotter) future

One hopes that, over time, the mixed perception of ESG changes. At its heart, it should be about critical elements of building long-term value and showing that capitalism works.

What I’m more hopeful for is financial services firms diving headfirst into putting climate change at the center of their strategy, products and operations. The headlines I want to read 5 or 10 years from now are:

• Climate change has been arrested (yeah!) and we’re heading back in the right direction (double yeah!)
• Financial services and the real economy partnered in a unique way to make that happen

Game on.

Endnotes

[1] 2018 Global Sustainable Investment Review, Global Sustainable Investment Alliance, http://www.gsi-alliance.org/wp-content/uploads/2019/06/GSIR_Review2018F.pdf

[2] Being business-minded about climate change: Ten ways to address climate-related risks and opportunities in 2020 and beyond, EY publication, February 2020, https://www.ey.com/Publication/vwLUAssets/ey-climate-change-whitepaper-brochure/$File/ey-climate-change-whitepaper-brochure.pdf

[3] Climate Change and Risk Management in Bank Supervision, Kevin Stiroh, New York Fed website, March 2020, https://www.newyorkfed.org/newsevents/speeches/2020/sti200304

[4] The global sustainable debt market was about $250 billion in 2018, see Green Finance Is Now $31 Trillion and Growing, Bloomberg, June 2019, https://www.bloomberg.com/graphics/2019-green-finance/; the ILS market was approximately $93 billion in 2018, see Insurance Linked Securities Market Grows to $93B in 2018: Willis Re, Insurance Journal, February 2019, https://www.insurancejournal.com/news/international/2019/02/01/516526.htm

[5] Nudges To Improve Earth’s Climate Gain Traction, Hersh Shefrin, Forbes, April 2019, https://www.forbes.com/sites/hershshefrin/2019/04/14/nudges-to-improve-earths-climate-gain-traction/amp/