08 June 2020
Cornelius Riese identifies three key challenges for the sector
The banking sector has dealt with many transformative challenges over the years. However, sustainability is different to other transformations because the steps we take today will ultimately determine how well equipped we are to deal with challenges far further into the future.
Right now, the Covid-19 pandemic shows us how crucial preparedness is.
There is broad consensus within the banking industry that setting the right incentives and putting us en route to a more sustainable future is important. The success of many green financial products speaks for itself.
However, divergence exists when we get closer to the question of how extensive and how quickly this transformation should unfold. The current regulatory developments around the EU Taxonomy or the renewed EU Sustainable Finance Strategy give a glimpse of just how paramount the task will be.
What are common "traps" banks face when developing their own sustainability agendas? Let's explore three issues in particular.
Sustainability has long been a guiding principle for many banks, especially those based on the cooperative principle and with strong ties to their local communities.
Yet, many banking institutes have started to reevaluate the topic entirely in light of the growing attention from various stakeholders in recent years. For many, the point of departure is first, to understand what we mean when we speak about sustainability.
A sheer abundance of ESG rating approaches – the diversity "trap"
Discussions around sustainability most often take place in the realm of three capital letters: ESG. However, we shouldn't forget that before ESG became a market standard, we had CSR or SRI.
In general, we find a sheer abundance of terms and definitions, regularly used interchangeably. Hence, one of the biggest challenges is to bring light into this thicket of different sustainability definitions, approaches and methods.
There is an urgent need for better comparability of ESG rating scores, as this will also help establish greater consensus – and define industry standards – around sustainable business practices
Looking at ESG ratings, it becomes clear how far we are from a uniform understanding. ESG rating agencies prioritise different ESG components, some highlighting the importance of environmental aspects over social or governance issues, and vice versa.
In addition, they often use different data sources, basing their assessments on company reports or openly accessible data, as well as relying on market data from providers such as MSCI or Bloomberg.
What is confusing too, is the usage of different observation periods.
On the one hand, the breath of different methods – and knowledge – currently in place can trigger important discussions around what are the most responsible and sustainable business practices. Proponents also argue that this abundance takes the complexity of the topic into account.
On the other hand, however, it makes it extremely challenging to compare ESG rating scores.
That is a problem because the diversity of concepts actually leads to a situation where it is difficult to objectively make out which institutions are market leaders.
There is an urgent need for better comparability of ESG rating scores, as this will also help establish greater consensus – and define industry standards – around sustainable business practices.
How to integrate sustainability into business units – the governance "trap"
Another common obstacle for banks is how to best govern sustainability across institutions.
From an organisational perspective, this is best accomplished in a hybrid manner. On the one hand, sustainability has to be managed "close to business". That means in a decentralised way, so that it can be integrated into nearly every business unit – from insurance and asset management, to risk management or business ecology.
On the other hand, and because sustainability has many links to all these different departments, it is crucial to also establish a central sustainability unit.
Such a unit often is newly created with the intention to help actively facilitate dealing with sustainability in other divisions. One "trap" which can easily arise at this point is that this central unit lacks the power to steer the entire organisation of where it needs to be in terms of sustainability.
Traditionally, communications departments have undertaken this central coordination function. However, communications departments often lack the central position within corporations needed to anchor sustainability systematically within the company's entire corporate structure. It can also lead to a situation where sustainability is treated, wrongly, as a communications topic only.
Strategy units are better suited for this task. They have the necessary power and competence to coordinate and support other departments.
One of the first and crucial steps of any central strategy sustainability unit is the import task of stocktaking. In other words, getting an overview of who is responsible for what in terms of sustainability.
At the same time, it is necessary to look deeper at the procedures used for analysing sustainability risks and impacts. Which metrics are employed within different divisions? What is the quality of the data and what are the data sources?
Each institution needs to develop its own inventory. The basic rule applied here should be to consolidate and, where possible, harmonise the different existing approaches.
This is crucial for two reasons. First, this exercise becomes the cornerstone of the development of a classification scheme, which makes it possible to systematically assess every single business or transaction with respect to sustainability.
Second, from there, banks are able to make informed strategic choices and develop their customised sustainability targets.
What role should banks take on? Trapped between advising and preaching
Sustainability is a topic present in nearly every single one of our corporate clients' talks, as industries face deep transformative changes.
Some corporates are natural beneficiaries of the current move towards sustainability. Among them, we find renewable energy companies or sustainable wood producers.
However, even greenhouse gas-intensive industries, such as energy, automotive, cement, aircraft or agriculture, have all – to varying degrees – implemented measures to reduce emissions, and generally want to do more in the direction of aligning their business models with sustainable practices.
ESG has made it possible to validate such sustainable actions quantitatively. For the environmental dimensions, climate change also provides a useful metric, as greenhouse gas emission can be traced and monitored.
The problem is, if we take the Paris Agreement seriously, much more needs to be done. It is clear that replacing combustion engines with electrical or hydro-electrical ones will not alone do the trick.
Using new technologies, intensifying agricultural production, or supporting climate initiatives, are all crucial steps, but much more far-reaching changes would have to be made across all sectors in order to limit global average temperature increase to "well below" 2 °C.
So far, so good. One question, however, remains: who should be in charge of getting there?
As banks, we have the important task to accompany our customers on their transition paths. Honest, informative discussions – even difficult conversations – are a big part of that engagement. However, our role is, first and foremost, to advise – not to lecture or preach.
In our ability to support the path towards a low-carbon economy, we have various instruments in our banking tool kit. We can accompany customers with knowledge coming out of our research departments and, of course, we have a variety of funding and financing programmes available.
We also take great interest in dedicating time and resources to further advance the sustainability debate, assessing the topic from an impact and from risk perspective.
However, should banks start putting together detailed ESG profiles and keep track of them at the individual corporate client level? Who will provide the necessary data? And does good data even exist at this point?
While banks play a crucial role as a key finance provider to the sustainable transformation, the regulatory requirements currently envisioned by the European Commission will inevitably lead to further bureaucratisation and more complex consultation records.
These requirements may be the best option available now. And while big banking institutes have the ability to deliver on such requirements, we need to be wary of the fact that they pose a tremendous challenge for smaller banks and SMEs alike. Often, they simply lack the capacity and the personnel.
These facts become important if we ask what kind of sustainable transformation we strive to achieve.
Building a sustainable economy is a long-term process. It will not happen overnight. Sufficient transition periods and proportionality are needed to bring everybody on board and facilitate real transformative change. Especially now, as banks find themselves at a crossroads in light of the current events: should they put sustainability on hold, or move forward with it?
Mitigating the immediate economic impacts of the crisis becomes the top priority in times of deep economic downturn. However – thankfully – many banks started to develop their own sustainability agendas a while ago, setting up sustainability units and signing voluntary agreements.
These steps have institutionalised the topic, indicative of banks' long-term commitment towards the issue.
While the work on sustainability-related aspects may slow down a little, it will continue. Let's make sure it does not lose its momentum.
Cornelius Riese is Co-CEO of DZ Bank.