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ESG governance needs new overall oversight

Governments need to create guidelines to complement reforms at micro level.


"An environmentally- and socially-sustainable financial services sector cannot be achieved by tinkering at the margins. A complete re-thinking of processes, policies and organisational structures is inevitable." - Markus Müller.

ENVIRONMENTAL, social and governance (ESG) considerations require a new approach to macro and micro oversight.

The current regulatory approach is centred on the aim to protect customers of financial services firms from what is known as asymmetrical information - the belief that the providers of a financial service in the retail business typically know more than their customers about the financial risks of their proposition.

But to date, there is still no equivalent oversight for ESG criteria. Contrary to financial statements, ESG indicators aim to identify non-financial risks and are forward-looking rather than backward-looking. This is why the implementation of ESG criteria in everyday business, regardless of industry or sector, requires a new type of oversight that complements the existing regulation focusing on short-term financials.

Current developments

There are already some efforts underway in this direction.

For instance, the European Union has this year set the groundwork for the development of the definition of, as a first step, environmental factors (with social and governance factors likely to follow at a later stage) and making sure customers receive sufficient information before choosing a particular financial product.

In Asia, there are efforts underway to educate investors as well, such as the Green Credit Guideline in China. But even so, globally there is a regulatory void when it comes to environmental and social oversight that current supervisory bodies are ill-equipped to fill.

This oversight has to be developed on two levels - micro and macro levels - and this needs to be done at once. There is no time left for a piecemeal approach.

Not only environmental, but also economic and social sustainabilities have become an urgent necessity. Of course it would be simpler to just aim for reform at the micro level, but given the challenges we face, this would come too little too late.

On a macro level, governments need to create clear guidelines and a legal framework in which the aforementioned initiatives on a micro level can flourish.

A new independent supervisory authority would arguably best be able to act as an oversight body for sustainability. It would need to receive a clear mandate from governments with a precise set of targets.

But while carrying out duties for the government, it would remain independent from it. Additionally, this agency would be in charge of supervision of the ESG space.

This institution would need to develop common minimum requirements and verify existing industry standards. These two objectives are necessary steps in order to make sure that the term ESG means the same thing independently from which institution mentions it.

This means that there has to be strong progress in transparency and standardisation, two areas where the corporate sector as a whole is still far from where it needs to be.

A scattered approach where each country works on its own is going to be inefficient and too slow. We need a more comprehensive approach that allows developed and developing nations to work together, we need the kind of wide-ranging international cooperation that can come only from sharing a common goal.

On a micro level, there is a role to play for self-regulation by professional bodies as a way to guarantee certain minimum standards in terms of transparency in this area, which is still often poorly understood.

It is in each industry's own interest to raise public awareness and to make sure that "ESG means ESG" - a key prerequisite to gain the trust of investors and the wider public alike. Furthermore, the operators on the ground are where the combined knowledge of ESG matters resides - they have the experience, the knowledge and the tools to contribute to the debate.

It is fundamental that the input of the firms operating on the front lines of ESG is taken into consideration for the purpose of shaping future regulation. But in order to do so and to contribute to the debate, firms need to engage with the public and the regulator. They need to dedicate resources to this cause by nominating ESG subject matter experts.

Implications for financial services industry

The implications for the financial services industry are profound.

It is important that market participants both on the buy and the sell sides recognise the relevance of common ESG standards for the industry's credibility. Greater transparency is in the interest of all market participants. The requirements on data, compliance and transformational capabilities of business models are set to be significant.

An environmentally- and socially-sustainable financial services sector cannot be achieved by tinkering at the margins. A complete re-thinking of processes, policies and organisational structures is inevitable.

The need for transparency and standardisation in the ESG space has become increasingly urgent because it is only quite recently that ESG investments have gone mainstream, reaching increasing numbers of retail investors.

As long as sustainability was a niche topic reserved for a few specialists, it didn't matter if everyone had a different idea of ESG. But as soon as the wider public gets involved, it quickly becomes imperative to agree on common definitions and proper supervision.

The organic food industry has faced the very same challenges of the past two decades and presents a very interesting case in point of the consequences of lack of coordination. A growing amount of consumers interested in organic produce have been battling for years with a cacophony of different standards of the term "organic".

Most countries have a national definition of their own, some supranational bodies like the EU have developed proprietary standards as well, while at the same time single trade associations and even single supermarket chains each advertise the superiority of their own standards.

As a result, while organic food keeps gaining in popularity, transparency in the sector is still sorely lacking, to the frustration of consumers who often lack the information to know what differentiates these labels from each other.

We believe we have a duty to call for transparency on behalf of our clients and contribute towards the development of common standards, which only a cooperation along the lines proposed above can achieve.

Necessary transformations

The aim of both micro and macro governance systems is to make sure that our economy goes through the necessary transformations that are critical in preserving the world we live in.

This necessity touches every single market participant and every member of our society. We need to adapt in order to avoid destroying what we have. There is no plan B for the environment. It is our responsibility as human beings to preserve the natural environment.

If we destroy the natural resources of our planet, we also destroy the foundation of economic well-being. The preservation of the complex but fragile environment in which we live is necessary for our long-term welfare.

Ultimately, the institutions charged with overseeing ESG matters need to ensure that environmental and social targets as well as regulations are met, but they also need to highlight the risks of inaction.

This is crucial to investors: Only if they are aware of the risks of inaction can they correctly evaluate the financial impact of any economic activity that has a social or environmental impact.

An approach that borrows from the Ordo-liberal school - a doctrine that believes in the primacy of the market economy but argues that the state must provide institutional and legal economic framework for it - may well be what is needed to face the challenges ahead.

  • The writer is global head of Chief Investment Office, Deutsche Bank Wealth Management

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