How ESG has changed modern finance

by | Sep 28, 2023 | The Urban Media Lab

Edoardo Mollo

 

Introduction

The ESG criteria represent a set of very important indicators that allow the analysis of a company or a State taking into account not only the financial aspects but also the environmental, social and governance factors. The acronym ESG stands for Environmental, Social and Governance:

Environmental: This aspect specifically concerns the attention that the company has towards the environment, taking into account factors such as the emission of greenhouse gases, pollution, the use of clean energy and all those factors that aim to safeguard the ecosystem.

Social: This aspect concerns the influence of a company on the community, its employees and any interested parties. It involves evaluating issues such as social diversity, inclusion, working conditions, responsibility and community involvement.

Governance: Investors evaluate leadership competence, level of transparency, business ethics and effectiveness in managing conflicts of interest.

 

Sustainability and Finance

In the last few years, the adoption of ESG criteria in investing has grown significantly. This is because more and more investors are looking to integrate their financial decisions with sustainability factors. ESG criteria provide a framework for identifying companies committed to sustainability and social responsibility, helping to generate a positive impact on both the environment and society. This impact manifests itself in various ways:

-Risk reduction: Investors are increasingly considering ESG criteria as indicators of risk. Financial instruments associated with companies that employ sound ESG practices tend to be less risky. These criteria can prevent critical issues related to the environment, social or governance issues that could compromise investment returns.

-Increasing demand: Investors themselves are increasingly looking for financial instruments that comply with ESG criteria. This growing demand has pushed financial institutions to offer a wider range of ESG investment options, including mutual funds, green bonds and shares of sustainable companies.

-Improving corporate practices: As companies seek to attract ESG-sensitive investors, many are improving their environmental, social and governance practices. This has contributed to greater corporate responsibility and greater transparency.

-More stringent regulations: Many jurisdictions have introduced laws and regulations requiring companies to disclose ESG-related information. This has made it easier for investors to evaluate a company’s ESG impact.

 

Historical evolution

The financial sector has undergone notable changes before and after the introduction of ESG (Environmental, Social and Governance) criteria. In the past, investments were predominantly oriented towards achieving maximum financial profit, with little concern for environmental and social issues. However, as global concerns around climate change and sustainability have intensified, investors have begun to consider ESG factors as essential indicators for evaluating investment opportunities. The introduction of ESG criteria has resulted in greater transparency and accountability within the financial sector. Investors today seek financial instruments that adhere to ESG standards, rewarding companies that demonstrate a commitment to sustainability and punishing those that do not. This has triggered a rise in sustainable investing and pushed numerous companies to improve their ESG practices. Furthermore, regulatory authorities, as highlighted in the document cited in the bibliography and published on the Bank of Italy’s website, have begun to consider ESG factors in the financial system and to exercise supervision over the way in which financial institutions manage these aspects. The introduction of ESG criteria has led to a profound change in the financial sector, promoting more sustainable and responsible investments, with notable implications for investment decisions and business practices.

 

What are the most sustainable financial investments?

Before discussing which investments are more sustainable than others, we need to understand what an SRI is. According to the ‘Working Group of the Sustainable and Responsible Finance Forum’ the definition of this acronym is: «Sustainable and Responsible Investment aims to create value for the investor and for society as a whole through an investment strategy oriented towards medium-long term which, in the evaluation of companies and institutions, integrates financial analysis with environmental, social and good governance analysis”. To finance SRI investments, companies normally use Green Bonds, Social Bonds and Green Loans. However, profits for investors can be limited if these tools are used and not everyone aims to get rich by doing exclusively ethical finance. However, ESG criteria have also had an important influence on widely used instruments such as shares and ETFs whose sustainability score psychologically influences the average investor’s choice to purchase the security.

 

How ESG scoring works

ESG scoring involves the collection of data and analysis of several indicators, which may vary between rating agencies and the tools used, but typically include financial data, information on company policies, and data relating to environmental and social performance. ESG scores can change from one agency to another, but in general, they are expressed either on a scale of 0 to 100, with higher scores indicating greater sustainability and social responsibility, or on the letter scale ranging from “A” to “F”, where “A” represents the highest score and “F” the lowest score. For example, a company with an ESG score expressed as “A” or “A+” indicates strong adherence to sustainable and socially responsible practices, while a company with an “F” score shows significant deficiencies in these areas.

This letter scoring system makes it easier to understand a company’s ESG performance, allowing investors to quickly assess its commitment to sustainability. It is important to note that variations in scoring criteria may occur between different rating agencies and therefore it is essential to consult reliable sources for an accurate assessment.

 

 

Let’s now take as an example a company that has put a lot of effort into sustainability: ENI. In fact, here on the right we can see the ESG score evaluation graph published on the MarketScreener.com website. It can be seen how all the mentioned factors contributed to the assignment of the final score.

Unfortunately, a very widespread deceptive practice is the so-called ‘Green Washing’*. This phenomenon occurs when an entity, organization or company tries to appear more sustainable than it actually is through claims that exaggerate social efforts, false advertising and other shady scams. The authorities try to combat the phenomenon as much as possible through rigorous regulations in order to have much more reliable information.

 

But the final question is: How much have ESG criteria influenced investors’ purchasing habits?

ADEPP states that more than half of institutional investors (around 52%) have chosen sustainable investment policies. The increase in confidence on the part of institutions towards sustainability reverberates directly on the average investor who has changed his investment selection habits also based on ESG factors. According to an analysis carried out by CONSOB and consultable in the bibliography**, a significant increase in the propensity to choose sustainable investments for both ethical finance and purely profit-making purposes was found. This data was found to be present in all age groups, in every geographical position and independent of financial education and of the investor operating independently or followed by consultants.

 

 

*word that derives from Green and washing which refers to the verb ‘to whitewash’

**number 4 of the bibliography

Article written by Edoardo Mollo: a law student graduating from Luiss Guido Carli with a strong interest in finance, sustainability and digital innovation.

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