What are the ESG (environmental, social and governance) criteria and why are they important for investors?

ESG stands for environmental, social and governance, but what does each of these letters mean?

• The E for environmental encompasses the effect that companies’ activities have on the environment - directly or indirectly.
• The S for social includes the impact that a certain company has on its social environment in the community.
• The G for governance alludes to the company’s corporate governance - for example, the composition and diversity of its Board of Directors, transparency policies for its public information, or its codes of conduct.

Companies are increasingly incorporating these three letters into their language, as the weight these criteria have for investors when choosing one investment or another, is key. Let’s talk about socially responsible investing. What does it mean?

Sustainable and responsible investing is an investment philosophy that integrates environmental, social and good governance criteria in the process of studying, analyzing and selecting securities for an investment portfolio, according to the latest SpainSiF report (promoted by BBVA) on sustainable and responsible investments in Spain.

Investors, increasingly interested in ESG criteria

Initially, it was the rating agencies specialized in sustainability that paid attention to these concepts, with more or less focus on some of them depending on the sector of the analyzed company. Sustainability or CSR teams were in charge of providing information to these agencies, which in turn shared their assessments with their customers.

Institutional investors have historically considered aspects related to corporate governance relevant for investing in banks. In recent years, their interest in the climate and social issues has progressively increased.

Some of the biggest asset management companies - especially those with passive management funds (like Vanguard, State Street, BlackRock) and also some active management funds, have created specialized teams, developing internal methodologies to assign their own sustainable ratings.

Therefore, “In 2020, there was a notable increase in analysis and request for information on environmental and social issues from investors, which was also associated with progress in BBVA’s sustainability strategy, and with the publication of our first report from the Task Force on Climate-related Financial Disclosures (TCFD) in November, which was very well received,” notes the Investor Relations (IR) team. Thus, the Group made an extraordinary effort to interact with a focus on these topics at the end of 2020, and into 2021.

In these interactions, “investors focused on the way BBVA is implementing its sustainability strategy, with a special interest in climate change,” the IR team explains. For example, they ask which sectors are the most sensitive to climate change in the loan portfolio and how the bank is helping clients in their transition toward a low carbon economy. Other topics that have generated greater interest have been diversity and the salary gap, cybersecurity, customer data protection, business ethics and financial inclusion initiatives in developing countries. In essence, topics that ESG rating agencies take into account.

Investors have stressed the importance of having uniform data on sustainability across banks in order to be able to compare and evaluate the companies in which they are investing.

Global awareness

Marked by the COVID-19 pandemic and the global social and economic crisis, the year 2020 has led to “greater scrutiny of ESG issues from institutional investors and ‘proxy advisors,’” according to the latest report from the Observatorio de la Inversión ESG (ESG Investment Observatory), published in March 2021.

This report indicates that last year, the world’s largest asset investors moved toward “near complete integration of ESG factors in their investment policies.” In this regard, they point to two turning points: in March 2020, the asset manager BlackRock published a letter asking companies to provide information according to the guidelines of the Sustainability Accounting Standards Board (SASB) and the TCFD. And on January 26, 2021, “in their annual letter to CEOs, BlackRock reinforced this message, reminding companies that the climate transition represents a historic investment opportunity.”

One of the international forums that has become most aware of the impact of climate risk on the economy and society is the World Economic Forum. In 2020, it released the sustainability and inclusive economy manifiesto “The purpose of companies is to collaborate with its stakeholders in creating shared and sustained value.” The World Economic Forum is also responsible for the commitment to publish ESG metrics, ‘Measuring Stakeholder Capitalism Initiative’, which has been adopted by 61 companies that are members of this forum and by the group of executives that are part of its International Business Council (IBC). BBVA joined this commitment in 2021.

In the banking sector, the frame of reference for sustainability includes the Principles for Responsible Banking, which,in recent years under the auspices of the United Nations, has been signed by BBVA and other founding banks. The purpose is to align banks’ strategy to sustainable development, one of the goals in the United Nations Sustainable Development Goals (SDG) and also in the Paris Agreement on climate change.

Are regulators aware of this change?

On the one hand, 2020 was also a year for progress in legislative matters. In the European Union, one of the biggest milestones was the creation of a taxonomy that classifies environmental economic activities based on six objectives: climate change mitigation and adaptation; the protection of water and marine resources; the transition to a circular economy; the prevention and control of pollution; the protection and restoration of biodiversity and ecosystems. The European Green Deal was also presented in 2020, marking a milestone because all policies and legislative bills must consider sustainability in a cross-cutting manner. This year, the publication of the Renewed Sustainable Finance Strategy (the updated and expanded version of its Sustainable Finance Action Plan) is expected.

In the banking sector, the European Banking Authority (EBA) launched its Sustainable Finance Action Plan in December 2019 with a mandate from the Commission to sequentially integrate them in prudential regulation. Among other things it included: the voluntary exercise of sensitivity to transition risks in 2020; the dissemination of ESG risks according to Pillar 3 of Basel (2022); and a report on the classification and prudential treatment of assets with a sustainability perspective (2025).

Last but not least, the ECB will publish the first results from its stress tests to examine the financial sector’s resilience to climate change in the middle of this year. Furthermore, it will also conduct another stress test with a supervisory perspective in 2022, notes Arturo Fraile, a financial regulation expert at BBVA.