ESG and Fintech: a perfect match made in heaven?

It’s not just Greta. Environmental, Social and Governance (ESG) criteria are increasingly important in the business world. ESG is therefore more and more important in fintech. If you want to be cynical, that’s because it is more and more important for these businesses’ customers. So you need to adapt to continue to sell your stuff. If you feel more positive, it’s because business executives genuinely believe that sustainability is important. Even bank ones. Regardless, it is now evident that people want a clear change when it comes to how companies behave and how money is being invested. It is even more pronounced with the younger generation. They are quite concerned about the world that they are inheriting from their forefathers. Rightly so. ESG and fintech: a perfect match made in heaven?

What do we mean by ESG?

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Firstly, let’s specify what we are talking about here. ESG is a wide category of activities. The environmental aspect is indeed important. But it goes beyond green finance and fighting climate change. As per Investopedia:

Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, auditsinternal controls, and shareholder rights.

ESG Criteria by James Chen for Investopedia

ESG is about deep changes in the way all types of businesses operate. It’s not just oil & gas companies. It is also financial services and fintech. Businesses are now expected to have a positive impact on the wider society. A sustainable business model that drives good outcomes for everybody. Consumers are expecting more from the business world as McKinsey calls out. In some way, capitalism needs to change.

It is important for customers. And it is an increasingly popular way for investors to evaluate companies in which they might want to invest. That’s particularly true in a world of inflated valuations. Thanks to quantitative easing and rock-bottom interest rates. Merci la FED. And it is far from being cast aside by institutional investors amid Covid-19. It actually has been brought into focus by the pandemic. That’s because when you think about it, ESG is about creating shareholder value in the long-term. It helps investors avoid companies that might pose a greater risk down the road due to their environmental or social practices. Or their bad governance. This will increasingly be true for venture capital investments as well. Fintech startups will more and more be expected to have ESG compliant business models.

It’s not only Greta

Millennials and Generation Z care more than their elders about ESG. It’s not only Greta. A lot of young people are genuinely concerned about the world they are inheriting. They want to change how things are done. The younger generation will tend to bet on companies that are good global citizens. It is not just a problem with the environment. Scott Galloway is spot on in “The Algebra of Wealth“: the younger generation is not going to be better off than their parents.

For the first time in U.S. history, young people are no longer economically better off than their parents were at the same age. They are not earning more than their parents. And will not build wealth as much. That’s also true in the rest of the Western World. What it means in practice, is that they are driving for change. That seems very logical. If you cannot win the game, change the game. And if the system needs to evolve, why not changing it for the better?

And with millennials and Generation Z increasingly leading startups, these concerns are increasingly becoming a part of the fintech equation. These fintech founders are mission-driven and want to change the financial services industry from within. ESG and fintech will increasingly become the new normal.

Why it matters for investors and the investment industry

Investors have clearly understood that customers’ preferences are shifting. It means that a growing share of consumers will not buy products or services that are not in line with these criteria. And there is pressure on the Private Equity industry to take ESG seriously. That’s driven by the ones that provide them with cash. For instance, pension funds want private equity firms to invest much more into sustainable companies. Furthermore, asset managers are under increased pressure from their clients and regulators. They need to pursue more sustainable and environmentally responsible investment strategies. Regarding governance, companies are also told to do more. They are at risk of pushback from their shareholders if they do not introduce more diversity in the boardroom.

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However, according to a survey by EY, only 24% of private equity firms are taking ESG matters seriously. Investment managers do not have a mature process in place to evaluate these factors before an acquisition. Still according to EY, Europe is a bit ahead of the USA when it comes to taking ESG into consideration when investing.

That’s not only in private equity

It’s not only happening in private capital. In the debt space, demand for ESG compliant debt is outstripping supply across the credit curve. Investment-grade issuance in Europe, excluding public sector borrowers and financial institutions, stood at €15 billion as of October 2020. Green high-yield issuance lagged a bit behind, with a total of €2.7 billion issued last year according to data from 9fin. Everybody wants a slice of the pie.

Primary ESG issuance still remains relatively small compared to the wider leverage finance market. However, it is important to note the exponential growth in this space. This trend looks set to continue in the next few years, with Cerulli Associates estimating that 35-50% of global assets will be managed under ESG principles by 2025. This will represent an even bigger share by 2050 as more and more governments are aiming for carbon neutrality.

Impact investing is on the rise

At the same time, the impact investing market is exploding. It has grown over 40% last year to $715bn assets under management (AUM). Impact investing got a big push in August 2019 when 181 CEOs of major companies signed the statement from Business Roundtable. In essence, they pledged to run their companies for the benefit of all stakeholders: customers, employees, suppliers, communities, and shareholders. That included financial institutions like JPMorgan Chase. Its CEO, Jamie Dimon, is also the Chairman of the Business Roundtable.

Shareholder primacy seems to be on the way out. We need to move to a model of capitalism more akin to impact investing. There is growing belief that private capital is critical to tackling the world’s most pressing problems. Not everybody is a fan of that approach and that is fine. It will take time. But again, as the younger generation takes more control of the business world, the change is inevitable.

ESG and fintech: what does it mean for the industry?

It can be a great match. For starters, ESG compliant investments is a huge opportunity for fintech. Notably the ones in the investing and investment management space. Facilitating and funnelling this gigantic interest for sustainable and impact investments. The demand will only grow from here. You will miss out if you do not take this shift in consumer preferences into account. By that, we exclude Bitcoin that is just terrible for the environment. It does not mean it will forever be, but right now that’s clearly not the case. Crypto needs to be much cleaner.

At the same time, consumer-focused fintechs are going green. It is just a matter of time before customers expect their bank to provide them with a recycled plastic card. Or that paperless is not even an option but the norm. Banks and fintechs need to have a deep look at how ESG compliant their business is. And make a change where it is needed.

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Being part of the solution

The transition to a greener world is also a massive opportunity. The US rejoined the Paris Agreement. Slowly but surely, the world will become more sustainable. Carbon offsetting for instance is already a big market. And it is only going to get bigger in the years to come. Fintechs can take advantage of this growing opportunity and surf the green wave.

More broadly, governments are pushing for “building back better” at the moment. If we are to spend a lot of money to help with economic recovery, it better be good. Build back better is thought as focusing investments on initiatives that have a positive ESG impact. That’s true all over the world. In the UK, a government review of the EU’s Solvency 2 rulebook noted that it could free up £95 billion of capital. That would drive Britain’s domestic investment and green energy infrastructure. Fintechs can take advantage of that trend by focusing their efforts on ESG initiatives. It also means that you better not be on the other end of the stick. Businesses that are deemed unsustainable will see funding dry up and opportunities vanish…