When it comes to ESG, all roads really, do lead right back to the Finance Sector. This is because the sector is the engine for powering the whole economy. The power of finance therefore comes with great responsibility to lead when it comes to creating a more sustainable global and local economy. While financial institutions must clean up their own ESG performance, it’s even more important that they become both the catalyst for other sectors to invest in sustainability and fuel ESG excellence.
In 2024 the sustainable transformation of finance continues to be driven by four themes: increased investor demand, more sophisticated risk management practices, regulatory changes, and reputational branding. These drivers have been further accelerated since the global Covid- 19, pandemic starkly highlighted the interconnectedness of ESG risks between markets and across sectors.
Despite these new insights, there is still much to be improved in the finance sector according to new global research by ISS. Their ESG performance chartbook finds that in the financial sector, only 20% of issuers have an ESG Performance Score above ‘Prime’ (ESG scores above 50 out of 100), and most issuers score poorly across all key issues except business ethics. Scores for governance were highest, with 79% scoring above Prime, while Social scores came in at 30% above Prime. Sadly for the Environment Scores, only 9% came above Prime. Of the key issues used to assess ESG performance, sustainable investing scored the worst ‘due to poor disclosure’, while business ethics scored the highest.
The financial sector has been an ESG leader for over a decade, evidenced most prominently by the hugely influential Task Force on Climate-related Financial Disclosures (TCFD), launched in 2015. Then in 2021, this was complemented by the Task Force on Nature-related Financial Disclosures (TNFD), which helps integrate natural capital into investment strategies. These initiatives have been instrumental in sparking action on climate change among Financial Institutions (FIs), and spurring sustainability progress more broadly.
Despite the popularity of TCFD recommendations, and other related guidance; these initiatives were not intended to be a standard to meet, but rather a catalyst to build a snowball of further action on enabling a Just Climate Transition, as defined by the Climate Justice Alliance.
| Framework | What’s it for? |
|---|---|
| TCFD: Task Force on Climate-related Disclosures / TNFD: Task Force on Nature-related Financial Disclosures | To develop voluntary, consistent climate and nature-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders. |
| PRI: Principles for Responsible Investment | To understand the investment implications of ESG Factors. To support its international network of investor signatories in incorporating these factors into their investment and ownership decisions. |
| EU Green Bond Standard | A tool used to ensure that economic investments create a ‘real-world environmental impact’. |
| Green Loan Principles, from The Loan Market Association | Consists of voluntary recommended guidelines, to help identify “the instances in which a loan may be categorised as ‘green’.” |
| United Nations Sustainable Development Goals (SDGs) | A set of 17 Goals that all sectors can work towards. For the finance pertinent issues include increasing financial inclusion for individuals (SDGs 1, 2, 3, 4, 10), small and medium-sized enterprises (SDGs 5, 8), and Governments (SDG 13). See KPMG Sector Matrix |
| United Nations Environment Programme (Finance Initiative) | Catalysing action across the financial system to support the transition to more sustainable and inclusive economies worldwide. It works with 500+ members, representing $170+ trillion, and provides guidance, to advance market practice. |
| Global Impact Investor Network (GIIN) | This Network provides a platform for like-minded investors to meet and take part in activities that build the impact investing industry from a practitioner’s perspective |
For the finance sector, ESG reporting against appropriate metrics is crucial for ESG success. To achieve best practice disclosures, FIs can utilise the International Financial Reporting Standards (IFRS), along with IFRS 2, which deals specifically with climate-related reporting. In addition, FIs such as banks can utilise supplementary guidance IFRS 15 (banking), or IFRS 2 Volume 18—Investment Banking & Brokerage, which includes tables with ESG metrics to report against metrics relating to revenue, market sector, and ESG integration.
| Other useful IFRS guidance for the finance sector | |
|---|---|
| Financial Instruments | IFRS 9/IAS 39, IAS 32 |
| Presentation of financial statements | IAS 1, IAS 7, IFRS 7 |
| Consolidation and special purpose entities | IFRS 10, IFRS 12 |
One of the most prominent ESG weak spots in finance, and perhaps the most important reporting metrics to have come into focus recently is that of “financed emissions”. PWC recently highlighted the importance of understanding and addressing financed emissions in the finance sector, given that they form a large part of an FIs Scope 3 emissions. With Scope 3 emissions representing around 70% of the total for an FI’s carbon footprint, financed emissions can offer a more accurate assessment of the climate action or inaction of sector participants. As PWC states, the role of the financial sector in ESG success is often tied to how it allocates capital. How this capital is deployed determines the value chain impact (Scope 3 emissions, among other metrics) of the FI, derived from the capital generated.
From a risk perspective, financed emissions are also key to understanding the exposure of financial institutions to climate transition risk (the dominos of capital risk can fall both ways of course, as seen in the 2008 financial crisis). It could be said therefore that this new emphasis on ‘Capital’ when it comes to ESG, creates the sector’s biggest risk, while also offering the world its biggest opportunity to accelerate ESG progress and climate action. This is borne out by the ISS study mentioned earlier that highlights sustainable investing and environmental performance as being the worst-scoring ‘key issues’ within the sector. Against this backdrop, the role of capital in creating sustainable versus non-sustainable outcomes is clear to see.
Despite the importance of financed emissions to ESG performance, there is an ongoing challenge in obtaining reliable and accurate data. The data typically used to calculate financed emissions comes from internal, external, and public data sources, which can lead to a lack of granularity, verifiability, and even data inaccessibility. To make the process easier and more transparent, FIs should define emissions boundaries early on at a project-by-project level. FIs can also utilise IFRS S2 in conjunction with PCAF (The Partnership for Carbon Accounting Financials) for better financial emissions reporting. PCAF provides methodologies to calculate financed emissions, which are included in the requirements of IFRS S2. These requirements came into effect on Jan 1st 2024, requiring companies to:
With climate-related financial uncertainty, traditional risk management approaches are no longer sufficient when determining the financial implications of climate and ESG-related risks. When assessing the materiality of ESG factors and the risks and opportunities associated with them, FIs can take a “Double Materiality” approach to risk management. Double materiality reflects the impact of ESG factors on an entity’s financial performance and risk profile, while also assessing the impact of the entity’s business activities on the environment and key stakeholders.
To allocate sustainability-linked capital in a risk-adjusted way, The European Central Bank (ECB) Guide helps FIs understand climate and environmental risks. The ECB also sets expectations on how banks should incorporate climate and environmental risks into their risk culture, risk appetite, risk monitoring framework, and loan portfolio management. This includes expectations around Scope 1, 2, and 3 GHG emissions reporting. This guide is mandatory for financial institutions under direct ECB oversight, and optional for other institutions. The Guide is a great best practice model for other jurisdictions to emulate, given its depth and breadth of scope.
To direct capital to sustainable activities, FIs must be able to define what activities are sustainable. To help investors and FIs, the EU Taxonomy has formed a good benchmark for other regions such as the UK, and the UAE, to emulate when it comes to allocating investment to more sustainable activities. The EU Taxonomy highlights clear objectives that can help guide FI activity. These are:
While not specific to the MENA region, these European developments chime well with recent ESG commitments by Middle-East Nations on ESG-related investing, reporting, and risk management.
We have covered ESG ratings in a recent article. Ratings are very important tools for helping FIs allocate capital sustainably, and to better integrate ESG factors into FI instruments. In the table below are the four broad ways FIs are harnessing ESG, according to the Corporate Governance Institute (CGI):
| ESG ratings | Ratings to specifically measure ESG performance against factors, such as carbon emissions, diversity, executive compensation, risk management etc. |
| ESG indexes | These offer benchmarks for ESG investing and can be used to help build or inform new investment products. |
| ESG integration | This involves incorporating ESG factors into financial analysis, which may use specialised modelling. |
| Impact investing | Helps FIs choose to invest in assets and companies with a positive social and environmental impact and good financial returns, using impact as a way to measure success. |
Once ESG factors have been integrated into an FIs business and investment model, mobilising the capital needs a vehicle (or instrument) to deliver on that model. At a recent conference called the “Post-pandemic landscape for central bank statistics”, four key instruments for ESG integration were highlighted (See table below).
| Types of ESG Financial Instruments | |
|---|---|
| Green Financial Instruments | Financial instruments where the proceeds are used to fund environmentally beneficial projects. |
| Social Financial Instruments | Financial instruments where the proceeds are used to fund socially beneficial projects. |
| Sustainability Financial Instruments | Financial instruments to fund both environmentally and socially beneficial projects. |
| Sustainability-Linked Financial Instruments | Financial instruments linked to the issuer achieving predefined sustainability targets. |
With climate risk and sustainable finance moving up the sectors’ agenda in recent years, a unified plan of attack for net zero was created at COP26 called the Glasgow Financial Alliance for Net Zero (GFANZ). The alliance consists of over 550 firms in the global financial sector that have independently committed to the goal of net zero by 2050. This also includes the setting of interim targets for 2030 or earlier and reporting transparently on progress along the way. This has not been without its issues however. For instance, financial institutions were happy to join GFANZ and be heaped with praise for committing to its “Race to Zero”. Yet as the enormity of the task has become clearer (particularly seen at COP29), many banks are keen to revise or abandon these commitments. This may seem disingenuous, yet its simply evidence of the complexity of ESG success in finance, and the need for rational debate on how to best support FIs in enacting change.
Despite ongoing political headwinds (such as the election of Donald Trump as US President), and the rising issues of factionalism more broadly, COP29 was still able to produce some good progress, with the tripling of finance to developing countries (from USD 100 billion to 300 billion annually by 2035). This is one way the sector is helping tackle inequality and the unequal social and environmental effects of climate change on developing nations by providing the finance needed to begin supporting National Adaptation Plans (NAPs). The UNFCCC secretariat (UN Climate Change) also praised COP29 in Baku as catalysing “big strides” in transparent climate reporting, which will build a stronger evidence base to strengthen climate policies over time. It’s also worth noting that The Net-Zero Banking Alliance (NZBA), whose 143 members oversee $74 trillion in capital, offers a huge pool of assets for creating more sustainable outcomes via sustainable finance.
MENA has been leading the way in ESG in recent years, as seen by the many ESG initiatives and commitments that came out of the 2023 COP27 conference in Dubai. In fact, by 2023, nearly three-quarters of top MENA banks had introduced ESG strategies. In the 2023 EY ESG MENA Bank Tracker, 45% of banks surveyed had established sustainable finance frameworks linked to ESG factors. Of these frameworks, most were backed by international standards such as the International Capital Market Association’s (ICMA) Green Bond Principles (GBP), Social Bond Principles (SBP), and Sustainability-Linked Bond Principles (SLBP).
However, despite these great moves, more than 80% of the banks surveyed had not issued a climate commitment statement, while only 60% said that they carry out materiality assessments. Furthermore, only 20% of the banks had developed climate risk policies, with only a fifth having created robust ESG frameworks backed up by key performance indicators.
Thankfully the 2024 tracker shows greater momentum based on market indicators, with consistent investor interest in ESG-related plans and projects. This has been helped by supportive government-led budgets across the region, and the region is increasingly seen as a stable investment destination, in a world of rampant inflation and energy price instability. This gives MENA financial institutions a clear opportunity to offer more ESG-related products while helping businesses understand how to improve their own ESG performance.
In a recent sample study that included UAE banks over the period 2014-2019, ESG performance is increasing over time. In addition, the empirical results reveal that ESG performance has a positive and significant impact on banking financial performance. As of the time of writing The Abu Dhabi Global Market (ADGM) which focuses on Sustainable Finance (SusFin) has issued $8 billion in sustainable bonds. Furthermore, the UAE ranks fifth in Quality Infrastructure (QI) for Sustainable Development Index 2024. This index serves as a comprehensive framework converging multiple indicators that evaluate the readiness of national QI systems to contribute to sustainable development goals. According to Dr. Sultan Al Jaber, Minister of Industry and Advanced Technology in the UAE, by financing QI, and integrating ESG factors into investments, the finance sector can help “drive efficiency, competitiveness, and productivity in the industrial sector”, as one example.
An excellent article in “International Banker” recently discussed ESG integration opportunities in Arab banks. The article offers some excellent pointers as to how all FIs can harness ESG as a “strategic imperative”. By accelerating ESG integration, banks and other FIs can offer financial instruments that can help fund the achievement of environmental goals, as well as mitigate social risks. This is all enabled by strong governance practices, providing stakeholders with the assurance that FIs and their clients are utilizing financial, environmental, and social capital sustainably. A focus on ESG integration can therefore enhance FI’s reputation, attract ethical investors, and contribute to socioeconomic developments in the Middle East Region
We have summarised the advice highlights in the table below:
| Environmental factors: Key themes: Transition to a circular economy that promotes and enables environmentally sustainable green projects, the adoption of renewable energy, and the implementation of eco-friendly practices | Measuring, monitoring, and implementing strategies that enhance energy efficiency, waste management, and business activities’ impacts on natural resources. |
| Social factors: Key themes: Promoting inclusion and diversity, and ensuring fair labour practices | Encompasses measuring, monitoring and implementing strategies that improve labour practices, community engagement, and customer satisfaction. |
| Governance factors: Key themes: Transparency, and value chain approach to ESG risk and opportunities | Assessing, monitoring, and adopting a corporate-governance framework that upholds transparency and ethical behaviour. |
