What is ESG and why does it matter?

November 2, 2022

In a now-famous 1970 Times magazine article, the economist Milton Friedman argued that businesses’ sole purpose is to generate profit for shareholders. The piece remains as polarizing today as it was five decades ago.

While critics have traditionally argued that the basic nature of business does not consider society as a stakeholder, younger generations are embracing social responsibility and driving change.

Today’s world calls for businesses which are not merely entities serving an economic purpose, but conscious beings whose decisions shape the world we live in.

 

The Cyprus Funds Summit -Sustainability is at the top of the agenda

Fund managers and fund administration specialists from all over the world will meet to discuss the ever-changing asset management sector at the 8th International Funds Summit & Expo.

One of this year’s stages , ‘The Impact Investing and Sustainability Stage’, will look into ESG investing and sustainability, explore how investors are shifting into more impactful, ethical, socially and environmentally responsible choices, and describe how the shift is changing the industry. It will measure the impact of sustainable funds and investing towards net-zero, as well as how companies are innovating with sustainable priorities.

The Cyprus Funds Summit will be hosted on 6-8 of November at Hilton Nicosia, and it’s undeniably one of the most important events for the fund industry.

 

Throughout this article, we discuss the role of ESG investing, the challenges posed to the fund industry, and the opportunities for the future.

 

What is ESG?

To begin with, it is important to understand the relevant terminology used when discussing the topic of ESG.

Environmental, Social and Governance (ESG) is the term used to identify matters that are traditionally associated with sustainability or corporate responsibility–focusing on the impact of business activities on the environment and wider society.

In simple terms, it refers to the arrangements that companies make to act as responsible citizens, such as inclusivity, diversity, sustainability, energy, efficiency, waste reduction and compliance with ethical standards..

 

ESG Investing: The Challenges and the Opportunities

As concerns about sustainability challenges and climate change reach a tipping point, environmental, social, and governance (ESG) issues are becoming increasingly important in the business world. Recent studies have consistently highlighted that firms that perform strongly across all three factors of ESG outperform the market and are better in generating long-term value.

More than ever, consumers, investors, and employees are making decisions based on ESG factors such as greenhouse gas emissions, water security, diversity, and inclusion,forcing financial sector organisations to respond respectively.

Nowadays, investors want to back businesses that are committed to preventing climate change and want fund managers who are able to demonstrate that they are investing funds ethically.

As a result, ESG investing has seen increasing popularity over the past decade, with European-domiciled ESG assets expected to reach a value of between €7.4 trillion and €9 trillion by 2025.

For firms looking at their future plans, ESG is going to feature more and more prominently in the way their business and governance models look. This means, they will also have to deal with increasing regulatory demands and assess potential ESG risks to their businesses.

 

What does ESG mean for institutions?

When we talk about ESG, we refer to the way institutions use these three factors (Environmental, Social, Governance)  to address their social and environmental impact.

Environmental

Climate change is causing an unprecedented impact on economies and financial markets.

To counteract this force, environmental criteria must be incorporated into investment decisions, meaning that companies should do more than the bare minimum standard.

With that in mind, the ESG narrative expects decision-makers to address environmental risks through business initiatives — Pollution control, waste burden, greenhouse gas emissions, water security, biodiversity loss, and contribution to the circular economy, just to name a few.

Recently, the Commission also adopted a Complementary Climate Delegated Act that specifies nuclear and gas energy activities in the list of economic activities under the EU taxonomy.

 

Social

When it comes to social ESG criteria, companies are expected to protect the social well-being, equality, and human rights of the people around them.

That said, flexible working conditions, labor standards, data protection and privacy, gender and diversity, and employee engagement are key areas of ESG investing.

Not only does this help businesses score a better ESG score, but it also helps them build a supportive and inclusive workplace that has been shown to boost employee productivity and business performance.

 

Governance

Transparency and fairness are at the core of ESG criteria. Companies are expected to drive positive change by addressing organisational fairness through internal checks and audits.

Moreover, other governance criteria include executive compensation, board composition, bribery and corruption, lobbying, whistleblower schemes, and political contributions.

Gender diversity on corporate boards and in executive ranks is another important governance issue that draws attention to the need for fair compensation and treatment for women and people of color.

 

What are the challenges for fund managers and companies?

Although ESG investing opens up a world of opportunities for the fund industry, it also poses plenty of challenges for fund managers and companies.

First of all, the lack of knowledge seems to be the biggest barrier when it comes to embracing sustainable investing. According to a survey, two-fifths of financial advisors said they do not have a framework in place to discuss ESG investing, signifying a lack of guidance and education.

Yet, a successful transition to ESG investing requires a great understanding of the EU framework and good knowledge of the regulatory requirements.

 

“If we want to incorporate sustainable investing into the business philosophy, it’s crucial that all stakeholders receive the right guidance and education. Having a clear understanding of the framework will allow companies and fund managers to integrate the ESG criteria into their ecosystem”

 

In addition to the above, the transition to sustainable investing is another challenge for companies, fund managers, and investors. As with any change, the transformation won’t happen overnight but rather through a series of well-intentioned steps.

This highlights the need for a materiality assessment that sheds light on the importance of each ESG issue — allowing stakeholders to prioritise initiatives accordingly.

 

What is Greenwashing?

Greenwashing is a marketing tactic that companies use to attract environmentally conscious customers, even when their products and services don’t meet ESG standards.

According to a recent research from Quilter, greenwashed investments was the biggest concern for 44% of investors. Moreover, investors are concerned about ESG investments having higher fees and costs (42%) and if they will perform better compared to traditional portfolios (38%).

Considering that the field of sustainable investing is relatively new, the best way to identify greenwashed investments is to do the legwork yourself.

Impact reports from ESG funds and financial advisors are a great start for educating yourself about socially responsible investing and ensuring good performance.

 

EU taxonomy sets the framework for ESG investing

ESG investing has become one of the top priorities of the EU, with climate and energy targets on the horizon for the years ahead.

To make sustainability part of the business philosophy, the EU has introduced a new EU-wide classification system establishing the criteria for classifying an economic activity as sustainable — known as the EU taxonomy.

According to the EU taxonomy, there are six environmental objectives. Contributions to each objective may be made through different means.

  1. Climate change mitigation
  2. Climate change adaptation
  3. The sustainable use and protection of water and marine resources
  4. The transition to a circular economy
  5. Pollution prevention and control
  6. The protection and restoration of biodiversity and ecosystems

The EU taxonomy could play a pivotal role in how companies, policy makers, and investors make investment choices and, as a result, poses a great opportunity to mitigate market fragmentation and help stakeholders become more climate-friendly.

In line with the EU action plan, the Cyprus Securities and Exchange Commission (CySEC) is continuously fostering compliance with sustainable investing regulations.

 

George Theocharides, Chair of CySEC, said: “Data gathered from asset managers in Cyprus showed that €40.2 million of funds under management have a sustainable investment strategy, which is indeed a very promising step in the right direction. To encourage and assist investors and regulated entities in this regard, and in line with the EU action plan for financing sustainable growth, CySEC has confirmed its commitment to fostering compliance with sustainable finance standards, and in early 2021 we created a dedicated section on our website on sustainable finance, which gives information on the legislative measures being introduced at the EU level.”

 

What does the future hold for ESG investing?

In 2021, $500 billion flowed into ESG-integrated funds, and financial advisors expect the positive momentum to continue through 2022 and beyond.

With sustainable investing at the core of  investor interest and EU initiatives, the sooner companies understand the need to take action, the more they will be able to navigate safely through this period of change.

Without a doubt, the transition to sustainable investing is long-term and will play a pivotal role in the future of the fund industry. Resilience and readiness will define the extent to which a company can withstand the transition to a more sustainable world without being left behind.

As a result, fund managers and companies must deal with an immense task. Careful planning, preparation, and proper guidance are paramount for a seamless transition to ESG investing.

 

How can CX Financia help?

The huge rise in sustainable investing is putting pressure on fund managers and companies to align their business strategy with environmental, social, and governance (ESG) issues.

While any period of change is challenging, sustainable investing opens up a world of opportunities for investors, fund managers, and companies who can nowadays use their business power as a force for good.

At CX Financia, we believe that sustainability is the only way forward. We are dedicated to helping our clients lead this period of turbulence in order to achieve a more sustainable future. As a forward looking firm we remain dedicated in providing advice and guidance on the relevant ESG legal framework and on the implementation of ESG strategies and programmes

Through our extensive experience and regulatory knowledge, we can help investors, fund asset managers, and companies around the world take advantage of the opportunities of ESG investing while managing the risks imposed by ESG regulations and the EU taxonomy.

 

Get in touch with our team to learn more about ESG investing and how we can help.

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