Laying bare the risks

Jannah Patchay examines the digital solutions that can be applied to the ESG data challenges.

Over the past couple of years, financial markets have seen a marked shift in the way in which sustainability and environmental, social and governance (ESG) are perceived, from ethical and moral imperatives, to being key drivers of risk and resilience in the financial sector.

Whilst the focus to date has been primarily on the “E” in ESG, social and governance factors are becoming the focus of greater attention from both investors and regulators. This has been particularly driven by the combination of a global pandemic along with recent geopolitical events, not least of which is Russia’s invasion of Ukraine.

From an environmental perspective, climate change is a source of risk, on a systemic level, to individual financial institutions, and to long-term investments. There are of course the obvious physical risks and the financing of projects susceptible to it.

Transition risks – arising from the continued financing of “brown” projects such as oil and gas extraction – will also begin to crystallise as these fuels are gradually regulated out of use, and the value of those investments will decrease accordingly. If not managed appropriately and via an orderly transition and divestment from these activities, this will ultimately lead to what Mark Carney has described as a climate-driven “Minsky moment.”

In other words, the true exposure to and risks of climate change are realised, and asset prices suddenly and catastrophically collapse, precipitating a global financial crisis on a truly unprecedented scale.

Regulators are driving change by introducing ESG and sustainability risk management, taxonomy, disclosure and reporting and – coming soon – prudential requirements for financial institutions under their supervision. These regulatory measures implement the policy interventions determined at national and international level, as the agreements made at forums such as COP26 trickle down to practical change.

Investors also create demand for the greening of finance and for more environmentally and socially sustainable outcomes overall, driven both by ethical motivations and the desire for long term growth and sustainable returns. Asset managers and pension funds are not only fuelled by the growing demands of their end-investors, including the general public, but also by a real concern over the medium to long term viability of their investments in companies that may not have sustainable or climate-adaptive business models.

Sustainable finance refers to the integration of ESG and sustainability measures into the financial system, so that value and risk are measured not only through profit, but also through their environmental and social outcomes. Green finance goes beyond this, looking at the active financing of the transition to a green and sustainable economy, through loans and investments that are linked to green projects and outcomes.

The obvious challenges lie in demonstrably proving outcomes and ESG measures to investors and using these as inputs to pricing and risk management. It requires data – a great deal of data, about the investment or loan instrument itself, the performance of the issuer and of any specifically-linked projects, and the measurement of these against benchmarks and performance criteria, for reporting back to investors and incorporation into pricing.

There are a number of barriers to the mobilisation of finance for sustainable outcomes. A lack of standardised ESG disclosure mechanisms – in a form that can readily feed into investment decision making – leads to information asymmetries in the market, creates opportunities for “greenwashing” and poses difficulties for investors in terms of the ability to fully risk assess and price potential investments. Combined this contributes to illiquid markets that lack transparency in both pricing and investment outcomes.

Data is essential for ESG investing – but the costs for individual financial institutions of accessing and processing the huge volumes of ESG-related data required can be prohibitive. Furthermore, by the time it is collected and published, much of the data on individual instrument such as green bond or green loan performance may be out of date, by at best a quarter and at worst more than a year. So, there are many obstacles – but what’s the solution?

Digitalisation and ESG

Digital finance integrates frontier technologies including distributed ledger technology (DLT), artificial intelligence / machine learning (AI / ML), and the internet of things (IoT) with big data to deliver digital-native assets, and sophisticated marketplaces on which they can be transparently priced and traded.

These digital assets can be designed to be programmable, capable of carrying their own data and sourcing inputs and updates from underlying data sources and networks of sensors, able to execute pre-programmed logic and automatically reporting to investors, regulators and other stakeholders. If these sound like some kind of magical, wishful thinking, have a look at my previous article on digital assets, their potential and some of the work being done in this space.

Digital assets and digital finance have the potential to deliver better ESG outcomes for lenders, issuers, investors, regulators and the economy, in a way that is cheaper and more accessible by all participants. Take the example of a green bond, ostensibly issued to finance a green infrastructure project. As a traditional bond, the ability to reconcile actual use of funds and ESG performance to the original prospectus and its objectives would be dependent on periodic issuer disclosures, and would require active tracking, interpretation and monitoring on the part of investors.

A digital green bond, on the other hand, could be linked directly to an array of sensors and project management tools that automatically update it with metrics on a real-time basis. This real-time data can then be assessed by the smart contract governing the digital green bond, against predetermined performance criteria, and divergences whether positive or negative automatically reported to investors holding the asset.

With these capabilities, issuers can also structure financing instruments that incentivise better performance against ESG objectives, for example by automatically paying out to investors when certain targets are met or enabling investors to better manage ESG risk exposures by compensating them when performance thresholds are not met.

Far from being a flight of fancy, real-world projects are underway to explore the potential of sustainable digital finance. With Project Genesis, the Bank for International Settlements (BIS) and the Hong Kong Monetary Authority (HKMA) collaborated to successfully develop two prototype digital green bond platforms. Using an app, an investor can monitor accrued interest on a government-issued green bond, track in real-time how much green energy is being generated by the underlying project, and also view the corresponding savings in CO2 emissions. The investor can also participate in a transparent secondary market for the digital green bond. The future is here, it’s sustainable, and it’s digital.

©Markets Media Europe 2022

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