How the finance industry influences ESG impact
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By allocating capital towards projects that benefit the environment or society, investors and lenders aim to drive change in the real economy.
As providers of capital, investors are in a strong position to influence how companies and governments respond to environmental, social and governance (ESG) considerations.
The integration of ESG in financial decisions allows asset owners, lenders and asset managers to allocate more capital to activities that have a positive ESG impact, creating an incentive for businesses or borrowers to improve their ESG performance. It can also be used to withhold resources from activities that have a negative effect on the environment or society.
There are three key ways in which financial institutions drive ESG impact in the real world:
- ESG investing, which either prioritizes investments in companies that have strong ESG attributes or excludes those that do not.
- ESG-linked financing, which offers preferential funding terms to companies that demonstrate strong ESG performance.
- Engagement with companies to encourage them to improve their ESG performance.
ESG investing has soared in popularity over the past two decades. Global ESG assets surpassed USD30 trillion in 2022 and are on track to exceed USD40 trillion by 2030, accounting for over a quarter of projected USD140 trillion assets under management (AUM) by the turn of the decade, according to the latest ESG report from Bloomberg Intelligence.
Moreover, ESG investing is no longer the preserve of public markets. As of November 2023, there are about 2,800 private-capital ESG-related funds with a total of USD1.1 trillion in assets.
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ESG investing growth is moderating
Growth in public ESG assets had averaged around 12% per annum between 2016 and 2020, but is forecast to drop to 3.5% between 2022 and 2030 (see Figure 1). To some extent, this is only natural after a period of robust growth. But it also reflects a recent backlash against ESG investing, as reflected by a slowdown in ESG fund launches.
This does not, however, mean that the finance industry is channeling less investment to sustainable initiatives. Global investment in the energy transition, for example, hit a record USD1.8 trillion in 2023. But in order to achieve net zero by 2050, global energy transition investment needs to average USD4.8 trillion per year between 2024 and 2040 – almost triple the outlay in 2023. The finance industry has a crucial role to play in closing that gap.
Another driver of the backlash against ESG investing is greenwashing, which in the asset management industry consists of unsubstantiated or misleading claims about the ESG characteristics and benefits of an investment product (see Figure 2).
To address this issue, EU regulators have proposed sweeping changes to rules on labelling ESG investments to give investors simpler and clearer information. Other global regulators are likely to follow.
Asset managers are also looking for ways to gauge more effectively whether the companies they invest in are living up to their ESG pledges. One potential solution is to use artificial intelligence (AI) to sift through vast troves of data to fill gaps in ESG datasets, and to assess companies’ ESG claims against an intelligent estimate of actual performance.
To explore these issues further, please read:
How banks and green finance are helping address climate change
A growing focus on engagement
In addition to reallocating capital with a view to making an ESG impact, the investment industry also seeks to drive change through engagement and stewardship, which includes holding direct discussions with investee companies to encourage specific courses of action and potentially voting on shareholder resolutions.
A 2024 survey of 69 organizations managing USD16 trillion in assets showed that respondents allocated approximately 7% of their total investment management spending to stewardship, including the costs of internal staff, third party providers of stewardship services, data subscriptions, memberships and reporting.
The survey was carried out on behalf of the UN Principles for Responsible Investment (PRI) as part of the PRI’s Active Ownership 2.0 program, which argues that more engagement is needed to deliver against beneficiaries’ interests and improve the sustainability and resilience of the financial system.
According to PRI, greater engagement also needs to happen between asset managers and asset owners to ensure that the former align their stewardship activities and public messaging with the latter’s long-term interests.
A similar dynamic is at play on a smaller scale in the wealth management industry, where clients are increasingly looking to tailor their portfolios to not only their individual risk tolerance and objectives, but also to account for their sustainability preferences (see Figure 3). In this way, they can seek to ensure their savings and investments have a positive ESG impact.
For more detail on these issues, please see:
How investors achieve impact through stewardship
How wealth management makes a positive impact to legacy and lifestyles
Driving direct ESG impact
Finally, the financial industry itself creates a direct ESG impact. Several studies demonstrate that improving access to financial services creates a string of social benefits, including:
- Helping to reduce systemic poverty and improve financial security by giving people the financial tools to save for emergencies, build and protect their wealth (for retirement or to pass on to future generations), and insure themselves against health and other issues that can become catastrophic financial events.
- Providing access to loans and other types of finance to bolster entrepreneurship and drive consumption. This can increase employment, reduce inequality and spur overall economic growth and development. It also lessens reliance on exploitative informal financial service providers.
- Enabling more efficient international transactions, connecting businesses and individuals to broader opportunities.
- Supporting the provision of essential services in developing countries by creating payment channels for providers. For instance, it can pave the way for water and sanitation providers to invest in more communities.
Financial technology (fintech) offered by start-ups and incumbent banks is leading the charge in improving financial inclusion across the developing world. This trend was accelerated by the COVID-19 pandemic, which hastened adoption of digital financial services on the back of a ramp up in e-commerce because of social-distancing measures.
McKinsey estimates that fintechs will grow at roughly three times the rate of the overall banking industry between 2022 and 2028, largely fueled by – and further fueling – the growth and development of emerging markets, especially in Africa, Asia, Latin America and the Middle East. In the process, they could help promote inclusive growth, unlock green finance and empower marginalized groups across the world.
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