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A leading trend in global finance: ESG and sustanaible investing

Simone Russo


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1. Introduction and concept - 2. Taxonomy - 3. The dimensions of ESG - 4. US and EU: a comparative approach - 5. ESG: what next - NOTE

1. Introduction and concept

Environmental, Social and Corporate Governance, also known with the acronym of ESG, can be described as the set of principles promoting a diversion of private economic resources towards a path of economic sustainability. The mechanics behind this diversion efforts are relatively straightforward and involve two main players: (i) on the one side, large corporations which need to collect and disclose non-financial data, normally responding to predetermined sets of ESG metrics, together with their corporate publications (e.g. financial statements, annual reports) and, on the other hand, (ii) financial players, mostly, Asset and Wealth Managers, Pension Funds and Insurance, which will elaborate those data for carrying out ESG analysis and build a ranking among eligible investment targets so to contribute to their investment allocation process. The underpinning principle of the ESG investing cycle can be summarized as follows: the most virtuous companies identified through the elaboration of the aforesaid ESG metrics should receive more financial resources from institutional investors and con­sequently might have a better access to capital compared to the ones with a worst ESG ranking. The following paragraphs will provide an overview on ESG investing (in its wide construction), moving then to an analysis of both its theoretical and practical implications, providing then a brief comparison on the approaches adopted in the U.S. and E.U. markets vis-à-vis ESG investing and introducing the concept of a shift from a bi to a tri-dimensional investment process. The following chapters will focus instead on different aspects of the ESG ecosystem, starting from the legislative and regulatory framework and concluding then with a more technical analysis over the ESG investing process and consequences. ESG is the most adopted investment approach within the global sustainable investment universe, which also includes impact investing, a more active approach, where, in order to be selected during the investment process, target companies, during the performance of their business, need to provide a positive impact towards environmental or social aspects. Conversely, an investment allocation based on the application of ESG me­trics might be considered more passive in its nature: virtuous and thus eligible companies are chosen effectively following [continua ..]

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2. Taxonomy

Being the biggest trend in finance of the last few decades, sustainable investing has clearly started a labyrinth of definitions surrounding the exponential increase in available products and investment strategies, including the bifurcation between negative/ex­clusionary screening and ESG integration. In this respect, one of the most interesting trend is around new alpha ESG solutions: these are often based on long/short strategies designed to generate extra returns, as opposed to more traditional ESG beta type of allocation. It is possible that alpha ESG strategies might further decrease the semantic difference with impact investing for listed companies, but it seems inevitable that the labyrinth of definitions will keep expanding together with importance of Sustainable Investing and ESG. The Taxonomy Technical Report [1], promoted by the European Commission, clearly moves toward the direction of establishing an EU classification system so to have an harmonized definition, at least within the European Union, on what constitutes “sustainable activities”. The European effort to set clear and harmonised definitions is not just aimed at the implementation of a robust legislative framework around sustainable investments but also to decrease greenwashing risks linked to lack of clear and accurate definitions.

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3. The dimensions of ESG

The extreme importance of the ESG and Sustainable Investments has little to do with their definitions but rather relate to two different layers of analysis: howESGand Sustainable Investments are reshaping finance from a theoretical standpoint by adding a third dimension in the investment decision process; and howESGand Sustainable Investments are reshaping finance from a practical point of view by looking at the amounts involved: their measurable magnitude. In order to understand the theoretical implications, a first analysis needs to start back from the traditional criticism to finance, which became extremely relevant in the aftermath of the 2007-2009 global financial crisis. Financial players have been traditionally criticised for being overly focused on short-term returns and profits, creating a distorted asset allocation into the economic system [2]. A regulatory answer to those critics has been directed to reshape the Corporate Governance framework applicable to the financial players by means of the introduction of stricter remuneration policies, designed to incentive longer terms goals [3] and reduce moral hazard from risk takers. The problem remained though intrinsic to the whole asset allocation chain. The asset allocation from capital markets, has historically been looking at two key parameters: risk and return [4]. Inevitably, a part of the financial allocation has always been lacking a long-term horizon. ESG and its metrics, have been adding the third dimension to finance, the one of the sustainability, which provides a longer-term perspective in the investment decision process and subsequently to the effective asset allocation. An effective image of this phenomenon can be offered through a parallelism going backwards in centuries and namely to what happened to art with the Renaissance, where one of the main achievement, allegedly thanks to Filippo Brunelleschi, has been the introduction of the perspective in figurative paintings representation. By adding the perspective, paintings started to represent reality in a way closer to how our mind is used to see objects: three dimensions. ESG is the Renaissance of Finance [5] thanks to the introduction of a longer-term dimension of sustainability to the investment process, condensed within the ESG rankings and scores, add into the traditional financial analysis, ultimately synthetised by [continua ..]

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4. US and EU: a comparative approach

The two biggest markets, US and Europe, have been following a different approach towards ESG. In Europe, the disclosure of non-financial data by the large corporate is regulated by the EU Non-Financial Reporting Directive [12], which made disclosure requirements mandatory for approximately 6000 large public-interest companies. Conversely, the United States is mostly driven by the spontaneous initiatives of capital markets issuers, institutional investors, rating agencies and other financial institutions. In Europe, we assist at a combination of private and public sector initiatives. The main European government bodies and authorities, including the European Commission, the European Securities and Markets Authority, the European Banking Authority, the European Insurance and Occupational Pensions Authority, the National Competent Authorities, the European Environment Agency and the European Union Agency for the Fundamental Rights, have been working together with a common goal: the allocation of the public and private financial resources, channeled via sustainable investments, to match the target of a net-zero emissions economy in 2050 and beyond [13]. The European Green Deal [14] relies on the private sectors resources as one of the main tools to adhere to the Paris Agreement commitment to limiting the global temperature increase to between 1.5 and 2 degrees Celsius. Notwithstanding the EU Non-Financial Reporting Directive, to facilitate a transition to a net-zero emission economy, Europe started to deploy a new framework of rules, to implement a Sustainable Finance Strategy for the Continent.

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5. ESG: what next

The tree of Sustainable Investing and its ESG trunk have significantly grown over the last few decades and became the biggest hope for the human kind to mitigate the risk of climate changes, to improve targeted social themes linked to the private sector (i.e. equal opportunities, health and safety, customer and product responsibility), and to shed a strong light on the approach adopted by companies in introducing and implementing effective Corporate Governance (i.e. business ethics, compliance culture, board independence, executive compensation, shareholder engagement and tax compliance). The ramification of Sustainable Finance, determining a massive global shift of financial resources toward sustainability, is having profound effects at various levels of the global economy and is boosting several initiatives affecting both financial, legislative and corporate dynamics: - the elaboration and then evaluation ofESG benchmarks and their adoption in asset allocation, together with the introduction of ESG-compliant financial instruments [15]; - some of the anticipated consequences for the traditional energy sector and the problematics still surrounding theESG framework and ESG related metrics [16]; - the development of a sound, effective and more inclusive approach toward Corporate Governance approach, strengthening the Risk Management and Compliance functions within firms as part of the corporate culture[17]; - the introduction of a well-defined andharmonised regulatory framework, especially within the EU and a dedicated focus from national supervisory authorities [18]; - a focus on the corporate governance framework at firm’s level, supported by effective compliance and board independence, also with the aim tominimise the risk (and the impact of) criminal and/or administrative sanctions [19]; - a growing importance of corporate governance in the eyes of the regulatory authority and the multiple coexisting interests within a firm’s corporate governance ecosystem[20]; and - the development of several legislative and regulatory initiatives directly focused on theESG phaenomenon and sustainable finance, but also the rise of self-regulating actions in the industry addressing the aforesaid aspects [21]. The following chapters of this journal are aimed to provide a more detailed commentary on the aforesaid aspects, with the goal to offer an overview on the ESG ecosystem and the implications for its stakeholders.

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