Why banks invest in climate-damaging projects and whether ESG investments 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 decisions and actions. Often, however, awareness stops with finances and investments. Not necessarily out of disinterest, but simply due to a lack of information and knowledge as well as complexity.
It happens that most banks invest the money of their customers in lucrative, but often climate-damaging projects, such as fossil fuels. As FinTech pioneers, modern financial service providers like Aspiration or Tomorrow offer an environmentally friendly alternative to traditional banking. The green alternative for investments should also offer ESG investment. However, these have often come in for criticism recently. Find out what this is all about here.
What is behind ESG
When it comes to investing, the market seems oversaturated with offerings that often do not match the values of the sustainable consumer. The magic triangle of investing has so far focused exclusively on the economic investment goals of "security, availability&" Return on Investment" into consideration. The solution: The triangle becomes a square. Environment, social and governance (ESG) investments as a solution to investing in line with personal values.
- Environment: Environmental aspects should fundamentally be about the extent to which companies are addressing their impact on the regional as well as international environment. For example, are there toxic waste products? How does the disposal take place? Does the company act climate neutral?
- Social: Under the social aspects, the extent to which the company addresses and leverages its social impact should be assessed. This is mainly about people from minorities, who are often socially disadvantaged.
- Governance: Under this point the management and leadership level should be analyzed. How does the design of changes within the management level but also within the whole company look like?? 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 standardized rating method
Rating agencies evaluate companies on 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 assessment, these companies analyze 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 as well as Governance, several different documents are available for the investigation as well as evaluation.
The problem: each agency has its own approach and scale for ESG assessment. The MSCI ESG Research rating system, for example, starts from AAA to CCC. Whereas Sustainalytics rates companies in different risk groups. But the process, approach and weighting of the various factors also varies. So far, there is no uniform procedure.
Advantages of ESG Investments
Compared to broader indexes, ESG-based portfolios have actually outperformed in some cases in the past. Thus they are in the front in terms of profitability. What is certain is that investing in companies that are more committed to the environment as well as to combating climate change means that more action can be taken in this direction.
In addition, the shift of funds to green investments may create awareness among other companies to rethink their strategy in the future and also become more committed to sustainable values. However, it is questionable whether this is the case for all companies with good ESG ratings.
ESG companies equal ethical companies?
Companies with good ESG ratings are often automatically equated with ethically responsible companies due to their environmental and social screening. Not infrequently, however, this is a fallacy. While ESG ratings take these aspects into account, they also look at how profitable a company is today and how it will be in the future. Therefore, it is also possible for companies in the tobacco industry or oil production to receive positive ESG ratings.
If you want to invest in ESG portfolios, you should be aware that in the end it's all about money and that's why companies with high profit potential are included. A Socially Responsible Investing (SRI) strategy is suitable for those who want to combine their values and investments independently of a strong profitability of a company. Here you have the possibility to exclude companies from the portfolio that do not correspond to your personal values.
Even though the rationale behind ESG financial investments is a good one, caution applies to the selection process. According to a study by the MIT Management Sloan School, the ESG ratings of the rating agencies agree on average only 61%. The use of different indicators is the main reason for the differences, accounting for around 50%.
In addition, it is possible for corporations in unethical or climate-damaging industries, such as the weapons or oil industries, to 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 operate more in line with UN requirements and goals.
Is it all just hype or is the financial world about to change??
Interest in sustainability has long ceased to be a passing trend. It has evolved into outright eco-wakening. After the boom in fashion, mobility or architecture, the change towards environmentally friendly actions and sustainable business models, it is time for the financial industry to follow suit. After all, what's the point of an environmentally friendly lifestyle if the money in the savings account or investments in the depot goes to companies or sectors that are harmful to the environment?.
When it comes to investing, because portfolios are often opaque or overwhelming, the fear of greenwashing is high. 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, standardization 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 in order to advance sustainable change through green investments.