The world will change more in the next ten years than it has in the last century. Digitalization, new technologies, the climate crisis, biodiversity loss, geopolitical shifts and changed values will shape our future. The speed and extent of this transition will be driven by regulation, technology, consumption, and the availability of capital.
This environment has a wide range of implications for the financial system and poses new challenges for its actors. New concepts and perspectives are required to ensure that the financial system allocates capital to the right opportunities and can manage risks effectively. What they need first, however, is transparency. Transparency is essential as investors and companies need a common language so they can better understand one another.
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There is a growing consensus among the world's largest institutional investors that issues like climate change, loss of biodiversity, and human rights violations represent investment risks. They must understand and manage to make the right investment decisions and protect the value of their assets under management on behalf of their beneficiaries ("outside-in perspective").
In addition, institutional investors also want to look beyond the simple risk and return figures to understand the impact of their investee companies, namely the positive and negative impacts of those companies' on environmental, social and governance (ESG) factors ("inside-out perspective").
The latter can be motivated by a desire to contribute to solving global issues (as part of the Net Zero Asset Owner Alliance (NZAOA), for example), manage their reputational risk or better understand the viability of firms' business models within the context of the above-mentioned megatrends (such as what a firm that relies on biological resources is doing to prepare for the decline in biodiversity).
The lack of corporate reporting on these issues means that financial institutions' access to this kind of information remains one of the core challenges of sustainable finance.
Asset owners are looking for financial institutions like banks or asset managers to offer them investment solutions that meet their requirements. Indeed, a survey recently conducted by SWIPRA among asset owners and managers shows that 93% of asset managers are missing information on the strategic relevance of the non-financial factors and 67% believe that relevant information on social factors is missing whereas 63% of pension funds are missing additional relevant environmental information.
Linda Freiner, Group Head of Sustainability at Zurich Insurance Group in a discussion with KPMG representatives, Patrick Schmucki, Director, Corporate Responsibility Officer and Marc Gössi, Partner and Global Lead Partner Zurich Insurance Group.
Over the past five years, Zurich Insurance's sustainability strategy has changed dramatically, moving away from an introspective, siloed initiative to a top management-driven, forward-looking business strategy. How did this change happen, and what measures did the company take to position itself as a pioneer?
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Given financial institutions' role as fiduciaries working on behalf of their clients (the asset owners), three things are absolutely essential: they must understand their clients' preferences and objectives, integrate those into their investment decisions and transparently report back to their clients on how they delivered on those preferences and objectives. It comes as no surprise that the past four years have seen a sharp increase in the number of sustainable investment options in Switzerland.
Depending on requirements of the clients, financial institutions will follow different approaches. For clients who are looking to mitigate financial risks from climate change or loss of biodiversity, financial institutions will need to develop new models and stress tests to identify, quantify and manage such risks. Conversely, for clients who are looking to create a real-world impact with their money, financial institutions will need to deploy processes to engage with investee companies or establish robust and stringent processes for the measurement of the achieved impacts.
In the specific case of banks, comparable risk models are applied to the credit business to assess default risk more accurately. Equally, banks can support borrowers with new products that incentivize firms' sustainable transition like green bonds, sustainability linked loans or derivatives.
To incorporate context-specific information on risks and impacts into their investment or funding assessments and models, financial institutions require granular data from their investee companies or borrowers.
The purpose of businesses shall be to solve the problems of people and the planet in a profitable way. This means that their ability to anticipate and adapt to the changing expectations of their clients and key stakeholders becomes their most important success factor. This ability must be deeply ingrained in the culture, governance, and processes of a firm. And most of all, the transformation will need to be financed, be it with debt or equity instruments.
To meet the expectations of investors and lenders, the traditional backwards-oriented financial reporting is no longer fit for purpose.
Firms must transparently report how it identifies and manages emerging risks to its business as well as how it plans to exploit future opportunities.
In addition, firms must disclose credible targets, KPIs and long-term plans to increase their positive (or mitigate negative impacts) on ESG-factors. Clear targets, commitments and reporting on actions will be part of getting and retaining access to finance.
Incorporating relevant non-financial KPIs in financial contracts can not only strengthen the relationship with investors but also provide attractive investment opportunities with a different risk-profile, as the rising volumes of Green, Social and Sustainability Bonds demonstrates.
With growing regulatory guidance and clearly defined expectations, such as the EU Taxonomy, this interaction will become more robust and trust will grow, as reporting becomes more reliable and comparable.
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Sustainable finance can do the same thing for financial markets as the x-ray did for medicine: revealing risks that have gone undetected by traditional financial analysis and providing insight into value creation beyond financial profit.
Given the fact that poor long-term sustainability can change a company's risk and return profile, sustainable finance adds a new and more comprehensive perspective to financial analysis.
This also means that traditional methods of value assessment will evolve and – by extension – the robustness with which firms measure, steer and report on their non-financial performance will soon be no different to what investors today expect of today's reporting.