COVID-19 has exposed weaknesses across all elements of society – the global economic system, our business ecosystem, our relationship to the environment, and our social norms. It has caused disruption across all of these elements and, as with any fundamental disruption, there will be winners and losers.
Core to this disruption is an intense, global focus on environmental, Social and Corporate Governance (ESG). A growing number of financial services organizations are now seeing clients prioritize ESG over traditional considerations, such as cost-control and profit. There is a shift to embrace brands that align with their own moral, social and political values. Governments, shareholders and regulators are increasingly demanding higher standards in how financial services firms serve and protect their clients, and many firms are rethinking their broader purpose and responsibilities.
This has created a classic “disrupt or be disrupted” choice for firms. Those that transition to ESG-driven purpose models of business stand to become the disruptors, while those that view sustainability as little more than a new compliance challenge could become the disrupted. The determining factors between the two will come down to the “Three Cs”: Climate, COVID, and Credibility. Let’s take a look at each:
For the first time in history, the top five long-term economic risks identified in the World Economic Forum Global Risks Perception Survey are climate-related. These risks include extreme weather, biodiversity loss, climate action failure, natural disasters, and human-made environmental disasters.
As we observe climate week, this survey speaks volumes on how climate has become integral to the sustainability of the global economy. And, as the world seeks to combat these risks by moving to green economy, the financial services sector will be relied upon to fund this transition. The question is, will financial services firms only do what they are forced to do by regulations, or will they view this as a strategic opportunity?
The disruptors will view this as a strategic opportunity. Instead of simply delivering money for investments, they have the opportunity to analyze their business strategy, business models, and products to identify how they can become strongly positioned for the transition to green economy. Part of this involves changing the role of traditional performance metrics, like return on investment (ROI) and return on equity (ROE), and building new metrics centered around ESG, with ROI and ROE being the outcome of strong ESG.
The disrupted, on the other hand, will participate in “greenwashing,” where they position compliance with sustainability regulations as their green bona fides. Firms doing this are viewing green as a compliance cost, not a corporate purpose. If a firm’s sustainability journey is limited to just compliance, investors and stakeholders will likely demand more of them (which may result in moving on to other firms).
Many believe that the COVID-19 pandemic has eclipsed climate change as the greatest threat to the planet, but in reality, COVID-19 and other novel viruses are the result of human activities that cause climate change. Deforestation and human encroachment into various animal habitats exposes humans to wildlife that may act as vectors for novel viruses.
COVID-19 has served as an accelerant for all sorts of business trends – digital transformation, working from home, and even expanded takeout and delivery options from restaurants. It has also created a much broader and more intense focus on environmental and social issues. With so many organizations disrupted by the pandemic, sustainability has moved from a “nice to have” in many business executives’ minds, into a “must have.” This is not only due to the need to create more resilient operations; it is also to satisfy the increasing demands from stakeholders for companies to engage in responsible business.
As a result of all this, ESG is also accelerating as a key indicator of business health. This means financial services organizations have a window of opportunity to position themselves for the emerging green economy. However, that window will likely close with the passing of the pandemic, at which point the early movers will have firmly established mind and market share.
The move to a low-carbon economy has been characterized by fits and starts over the years. However, with the COVID-19 pandemic and the resulting activity it has inspired around sustainability, a growing number of financial services leaders are thinking “if not now, when?” and making a strategic move into adopting corporate purposes focused on sustainable investment.
The firms that establish market and mind share for the green economy will be the ones that truly adopt this moment as a strategic opportunity. For example, European banks have had a very difficult time turning a profit since the 2007-8 financial crisis and the decline of investment banking – previously the most profitable business for those banks. To meet the objectives of the Paris Agreement by 2030, Europe will need $290 billion in green investments. This opens an opportunity for banks to create new profit centers by developing instruments to fund this investment need, such as green bonds.
However, it is not enough to simply offer green investment instruments. Financial services firms will need to be purpose-led by the green transformation, not simply looking to make profits from the trend. For example, if a green investment instrument is not carefully constructed, and includes companies that rely on polluters in the supply chain, customers will dismiss the instrument as being greenwashed and walk away. Likewise, if a bank or asset manager cannot effectively provide a convincing sense of purpose around a commitment to sustainable investments, customers will easily spot that lack of conviction and look elsewhere.
This process of separating the pretenders from the contenders will be interesting, because ratings agencies don’t currently have the historical data used for rating investments. Companies like Deloitte are working on solutions to this problem, using artificial intelligence to establish green scoring. Leading ratings agencies are already working on establishing ESG ratings, but there is still progress to be made before they have ESG and other indices that effectively evaluate the performance quality of sustainable investment instruments.
New Operating Models for the Next Normal
The integration of ESG into business operating models is a significant undertaking for financial services firms, impacting everything from staffing, to analysis, to product offerings. For decades these firms have relied on “tried and true” risk models – but the “Three Cs” are disrupting those models and requiring new ones. These new models must be developed with very little relevant historical data – which will require innovative ways of thinking from financial services firms.
The transition to sustainable investing is likely to happen quickly, as there are many opportunities available. And, the firms that can establish a credible, purpose-led transition to sustainable business models will be in the strongest position to thrive in the Next Normal.
Hans-Juergen is the Global Sustainability Leader for the Financial Services Industry within DTTL’s World Climate initiative. He has more than 25 years of experience in the financial services market and advises his clients in the fields of Business and IT strategy and transformation, risk management and regulatory topics. As a consultant for strategic business and IT transformations at banks, and an expert on regulatory requirements, Hans-Jürgen leverages this essential expertise to support clients in the development and implementation of their ESG agenda. Hans-Juergen previously led the Financial Services Practice in Germany and EMEA at Deloitte for several years.