ESG and AI
Playing the long game
In an era marked by unprecedented technological advancement and growing concerns about the planet’s sustainability, the intersection of artificial intelligence (AI) and Environmental, Social, and Governance (ESG) principles has emerged as a powerful catalyst for change. AI’s transformative capabilities have the potential to revolutionize how businesses and society address the critical challenges of our time, from mitigating climate change and fostering social equity to enhancing corporate responsibility. As we stand at the crossroads of innovation and ethics, this article delves into the dynamic relationship between AI and ESG, exploring how these two forces are shaping our future and driving a paradigm shift towards a more sustainable and socially responsible world.
When AI first hit the virtual shelves, it seemed like a miracle cure. It could draft your emails, comb through long documents, improve business processes and more. If given the prompt “Can you draft an opening paragraph for an article on AI and ESG?” it could even write the paragraph above this one. But while AI has huge potential, it is still just a tool.
AI in ESG
A new industry of ESG-oriented AI tools has grown to support rising demands from financial institutions. As investors increasingly seek to align their values to their investments, asset managers are looking to technology to help through screening funds, portfolios, companies, or investment opportunities.
To do this, AI combs through a large amount of data including nonfinancial reports to gauge a firm’s ESG risks, values alignment, environmental impact, or exposure to socially or environmentally sensitive issues, thus allowing investment managers to divest from or engage with these companies.
In Islamic finance, this means removing industries that are haram, or not allowed, such as alcohol, pornography, or pork products. In ESG or impact investing, this may mean removing firms in industries like oil and gas or coal. There is a larger debate about whether to engage or divest from these firms, but that is a much larger conversation and two separate discussions pieces (see the GEFI and UKIFC websites for more).
Beyond investment screening, AI can also be trained to analyse any sort of nonfinancial report, ranging from quarterly earnings to environmental reports. This can quickly process the values and attitudes of firms, which can help investors and consumers decide how to best use their spending power.
But, as the saying goes, garbage in, garbage out. AI can only read what is published, meaning that if a firm is misrepresenting itself, AI cannot always detect itIf a company is greenwashing and presenting itself as significantly more environmentally friendly than it actually is, this may go undetected.
Reading ESG / Environmental / Nonfinancial Reports
AI can be an incredibly useful tool in analysing reports published by firms. During my PhD, I used the coding language R (with some clever codes written by someone else) to examine the readability of ESG reports. As AI can ‘learn’, it can essentially train itself to be more effective at executing tasks and analyses such as these. This could include performing Sentiment Analysis on the tone of CEO forewords to quarterly earnings reports. If the CEO uses defeatist language or expresses negative sentiments towards ESG issues, this can be used to guide investment decisions.
While AI can analyze large documents with programs like Sentiment Analysis, it is important to remember that awareness creates opportunity. If firms are aware that AI models will be analysing their reports, those reports will over time be written with this analysis in mind, perhaps blunting its effectiveness.
The Environmental, Social and Governance Impacts of AI
While AI can be used for environmentally beneficial purposes, the impact of running complex AI is hard on the environment. In a recent study by University of Massachusetts Amherst, the training process for a common large AI model produced 283948 kg of CO2, the equivalent of 300 round trip flights from San Francisco to New York. With AI riding a boom, the environmental impact is massive. Furthermore, in order to build these massive processing facilities, firms need minerals and metals. There is continued risk that these are sourced from conflict regions, leading to not only environmental degradation, but human rights abuses and mass exploitation as well.
Beyond the environmental concerns, bias in AI training can lead to unexpected negative real-world implications. For example, the headlining 2018 paper Gender Shades by Dr Joy Buolamwini and Dr Timnit Gebru found that AI misidentified faces at an error rate for women of color just shy of 35% while the error rate for white men was below 1%. The dataset the AI trained on was hugely biased toward lighter skin and male-presenting faces.
Also in 2018, Amazon’s hiring AI came under fire for discriminating against female applicants, as it was trained off the existing datasets of ‘desirable’ qualities in the tech sector, which is predominantly male. This taught the AI to downgrade resumes with any references to women, such as graduating from an all-women’s University or being involved in a ‘women’s’ club. Considering the social element of ESG, this poses a problem if we’re trying to use technology to avoid human bias, but have built human bias into technology.
The general overuse of AI in situations such as these raises important governance concerns. If important decisions are delegated to inscrutable processes, then corporate accountability for the negative consequences of those decisions could be stymied.
So where do we stand?
Even after all this, I, for one, am still an optimist about AI. Any new technology experiences a period of growth and development, often with quite a few speedbumps along the way. With AI being an undisputed part of our collective future, it is best that we recognize these issues early and work through them with openness, awareness, and consideration.
So what is to be done? Three things; first, utilize regulation to ensure transparency and accountability in firm reporting so that ESG AI will have accurate and high-quality data to draw from; second, be conscious of the environmental impact and creative with solutions, such as using renewables; third, conduct rigorous research into the human element of AI and ensure that there is representation in the organizations designing AI. We all see the world through the lenses of our own experience, so bringing in diversity of experiences to built the technology will help ensure that it is designed with more than one lens.
AI can be an incredible tool to further the important work being done in the global economy to transition to net zero, bring human rights abuses to light, and make our world an overall better place.
ESG Standardization
How much is too much?
With the recent publication of the IFRS’s ISSB Standards and their alignment with the TCFD reporting guidelines, an interesting question has arisen: how much standardization is too much standardization? The ESG market has grown exponentially over the last decade to include hundreds of rating agencies, alignment principles, consultancies, and more in an ever-evolving alphabet soup. For many, standardization will be a relief as it saves hours upon hours of digging through methodologies to figure out what exactly something is measuring or asking for. However, there are potential drawbacks.
Having so many options encourages competition and provides choice. As the ESG industry has evolved, there has been a notable focus on environmental issues, which is perfectly logical considering that it is the easiest aspect of ESG to quantify, thus measure, track, and score. If a stakeholder were interested in a different angle, there are options that weight the separate ESG metrics differently, thus offering either a more or less biased ESG score.
As arguments within the ESG landscape evolve, so too will the ESG products. If everything is standardized, there is increased risk of biases being more deeply woven into the fabric of ESG. Too little standardization, and the lack of continuity between ESG scores will render them virtually useless. The answer here, perhaps, is less about standardization and more about regulation and transparency.
If ESG firms were to be required to verify data and firms were required to submit unbiased third party audits, more trust could be built into the system as a whole. If ESG firms committed to more transparency and accessibility, with clear and easy-to-access presentations of their methodology biases, then stakeholders could choose what best meets their own needs. As it currently stands, the lack of overlap between ESG scores leads to confusion, frustration, and obfuscation.
This approach to standardization cannot be taken as a box-ticking exercise. If ESG efforts are to be genuinely impactful, they need to be appropriately communicated and verified. There is a long way to go before we get there, but I, for one, am genuinely optimistic.
Investing: Divestment versus Engagement
In the realm of impact investing, there is an argument between divesting wholly from a business or industry that does not meet the fund’s ESG mandate and buying shares in order to engage with the business in a meaningful way.
There are innumerable ethical or religious reasons why a particular investment is not in line with a fund’s ESG mandates, such as a business operating in a high-polluting industry like coal, concerns over human rights issues such as cocoa farming, or personal moral objections to industries such as armaments or alcohol. The question is, which approach is more appropriate?
The UN PRI has an excellent figure depicting the path of logic in approaching divestment versus engagement.
Divestment
Divestment is a clearcut means of removing a stock from a fund, such as the movement from the 1960s to the 1980s wherein the anti-apartheid movement in South Africa called for divestment from any country cooperating with the government. If a stock does not meet the necessary ESG standards, it is simply sold. In some cases, this is a wider moral issue, such as Islamic finance mandating zero investment in alcohol products or environmentally-focused investors refusing to invest in coal or oil and gas.
Divestment can be used as part of a larger campaign targeting a specific company or industry, such as the coordinated effort of the 350 Campaign to ‘divest, desponsor, and defund’ fossil fuel companies. Signatories of this campaign include Norway’s Sovereign Wealth Fund, the Church of England, and the Rockefeller Brothers Fund, representing over $1.5 trillion in assets.
The argument against flat out divestment is twofold; first, selling your stocks means that someone else is buying them, and second, you lose any ability to influence the company’s direction if you don’t hold a stake in it. This is to say that by divesting from a firm, activist investors lose the ability to influence change in that particular company. The company can operate as normal.
Especially considering the rise of anti-ESG investing firms, who actively invest in ‘sindustries’ or pollutants such as oil and gas, flat out divestment will not necessarily starve the company of much-needed capital. Fortunately for proponents of positive impact investing, the anti-ESG firms seem to be on more of a roller coaster than their ESG-conscious counterparts (see articles from The Economist, Reuters, and Morningstar).
Engagement
The alternative to divestment is engagement, wherein activist investors use their leverage to influence corporate behavior by working with senior management, proxy voting, and working with corporate boards. In exercising proxy votes, investors can also influence who is elected to a company’s board and can stack the board with ESG-conscious members.
Unlike divestment, engagement keeps the investors closely connected to the company it is seeking to influence. As ESG is now being approached from a strategic and risk management perspective, conversations around ESG issues are more common in the board and C-Suite. If an investor is seeking to influence change in a company and they are patient, determined, and it does not conflict with their personal moral code, holding stocks in that company offers the investor access to the company’s leadership.
This may seem like an unlikely way to influence change, particularly in industries reliant on environmentally damaging practices; however, there are examples of positive steps being taken thanks to investor pressure. For instance, Canada’s Oil Sands Pathways to Net Zero is an alliance of leading oil and gas companies representing 90% of oil sands production in the country, which has come together to form a three phase plan to achieve net zero by 2050. The plan works through leveraging the strong investment in research & development in order to create actionable transition plans, incorporating ESG strategies into long-term planning.
There is a time and a place for both divestment and engagement, with a plethora of considerations to work through. While a client’s religious or ethical code may bar them from engaging with a particular industry, it is a deeply personal decision and should not be addressed lightly. There are many pathways to take to achieve ESG goals and net zero, and a good long-term strategy incorporates many different approaches.
Banking Customer Focus on UN SDGs
In the recently released joint report by the UKIFC and GEFI, banking customers discussed their perceptions regarding the UN and UN SDGs, and revealed where their values lie.
The report, Attitudes of banking customers towards the UN SDGs, took a particularly interesting approach as so often the focus is on how the UN SDGs can be integrated into a financial portfolio. Research is often framed from the perspective of the asset manager, government, or special interest nonprofit. Speaking directly to banking customers in different countries reveals the concerns of everyday people, not just industry experts.
Of the top UN SDGs that banking customers focused on, both the Global North and Global South prioritized Quality Education (Goal 4) (30% and 29%, respectively). There is an awareness of how vital it is, not only for children but for adults, to continue learning and growing as the challenges we face as a planet evolve. This goal spans generations and genders, as it highlights the importance of lifelong and gender-inclusive learning.
The top priorities for both Global North and Global South were focused around social equity and quality of life. Quality Education sets the foundation for the other goals of Zero Hunger (Goal 2), Gender Equality (Goal 5), Clean Water & Sanitation (Goal 6), and Affordable & Clean Energy (Goal 7).
Interestingly, the UN SDGs with the least amount of awareness for both the Global North and Global South are Life Below Water (Goal 14) and Life on Land (Goal 15), likely because they are broad, far-reaching goals. Both of these goals significantly impact those living in vulnerable areas such as islands or in areas sensitive to climate shifts, but they can come across as abstract concepts for people who don’t experience direct impacts of climate change in their daily lives.
The other SDGs that received the lowest engagement are Responsible Consumption & Production (Goal 12) and Partnerships for the Goals (Goal 17). Given that this survey targeted banking customers, it is likely that those particular goals seem best addressed at an institutional level. In support of this, it is worth noting that survey participants were strongly in favour of their banking institutions offering sustainability products.
The Global North and Global South agreed that Reducing Poverty and Hunger was the most important UN SDG to consumers. Of the global population, 8.9% are undernourished and roughly 8% are living in extreme poverty, meaning that these issues impact over 650 million people. With increasing environmental risks from climate change, these percentages are likely to increase as a direct result of droughts, shifting weather patterns, and planetary stress.
Recent publications from ESG Today to Reuters have stressed the importance of ‘zooming out’ to see the bigger picture beyond environmental metrics. It is important to remember that while we focus on particular issues, all of the UN SDGs are connected in one way or another. In cleaning up the oceans (Goal 6), we can create quality employment (Goals 7, 8, and 9), healthier communities (Goals 3, 11, and 12), and encourage global collaborations to unite and strengthen our sense of global community (Goals 16 and 17).
Investing in SDG-Aligned Products
In our recently published report, Attitudes of banking customers towards the UN SDGs, an impressive 87% of respondents stated that they would be willing to pay extra for SDG-aligned products. For a product to be SDG aligned, it must be connected to one or more of the existing 169 targets under the 17 SDGs. What exactly does that mean?
An SDG-aligned banking product is similar to a sustainability or green product. It can be a loan, bond, sukuk, or any other sort of financial product. The difference from a traditional product is that these specialty products are designed with a specific goal in mind, usually an environmental or social goal that can be measured. For instance, a green loan that is tied to a particular project may have different repayment amounts for different levels of success, such as cutting emissions from a particular business by 20% or 50%. In this case, the borrower would repay less if they achieved more of an emissions cut.
The findings from Attitudes of Banking Customers Towards the UN SDGs, recently released by GEFI and the UKIFC, found that 80% of Global North respondents and 89% of Global South respondents were willing to pay more for an SDG-aligned financial product. On average, the respondents were willing to pay a premium of up to 4.4%. That’s a significant amount, a clear demonstration that this is becoming more and more important to financial product clients all over the world.
There were variations in feedback that were most evident in age, with the lowest (18-24 year olds) and highest (65+) being willing to pay the lowest premium (3.8% and 2.1%, respectively). This is likely due to differences in awareness. Younger respondents are in the process of learning about financial products and exploring what works best for them, while older respondents may have concerns that impact-oriented investing may not be as effective as traditional investing. In both cases, clear educational tools and resources would be beneficial. Luckily, more and more research is finding that investing from a sustainability-backed approach does well to mitigate risk, tends to be less volatile, and is economically profitable.
When developing these financial products, financial institutions have an opportunity to impact genuine positive change. The OECD’s Framework for SDG Aligned Finance presented this beautifully with two primary objectives:
- Equality: resources should be mobilised to leave no one behind and fill the SDG financing gaps, and
- Sustainability: resources should accelerate progress across the SDGs.
This is pivotal as it emphasises the need to make socially conscious decisions while addressing the SDGs, to ensure that investments in one area are not detrimental to another. For instance, suddenly shutting down all mining operations may be better for the environment, but it could leave the local population struggling if there is no other industry around. SDG financial products must be carefully designed to maximise positive benefit while mitigating the negative.
With a strong interest in SDG-aligned financial products from consumers and research supporting the economic benefits of such an investment, it is no wonder that impact investing has grown 63% from 2019 to 2021, surpassing $1.2 trillion according to the Global Impact Investing Network (GIIN). Demand is rising for positive investments that are good for people and good for the planet.
The findings from Attitudes of banking customers towards the UN SDGs, a joint effort by GEFI and UKIFC, found consistently strong support for financial products that are SDG aligned. These products give banking clients the opportunity to directly support causes they feel strongly about, to invest in their communities, and to see positive returns for socially and environmentally aligned investments. It is empowering for clients, creates opportunities for financial institutions to invest in risk-mitigated, strategic, long-term projects, and fosters a sense of inclusion.
To support this important work, GEFI has designed the SDG Product Platform. Financial products are carefully assessed to ensure that they meet the goals they set for themselves, and GEFI works closely with the asset manager to maintain SDG alignment and economic benefit. Learn more about GEFI’s SDG Product Platform here:
Modern Slavery and Human Trafficking in the Finance Sector: A rising tide
While significant focus in the realm of ESG has been on environmental issues, it is equally important to be aware of the S in ESG. As the third largest criminal economy in the world following drugs and arms trafficking, modern slavery and human trafficking impacts roughly 150 million people all across the globe. This issue transcends geo-political boundaries, industries, and socio-economic status.
Modern slavery, defined as ‘slavery, servitude, and forced and compulsory labour’ (Modern slavery Act, 2015), includes human trafficking. When a person experiences slavery or trafficking, their autonomy and freedom to move are restricted through coercion or abuse. Often, their government-issued identification is taken away, either to control their movements or as a means of forcing them to hand over any money they earn through work. Victims are often exploited through labour, forced marriage, and sexual or domestic servitude. In the UK, the most common forms of slavery are labour and sexual exploitation, and debt bondage.
With an estimated 10,000 to 100,000 people in the UK experiencing modern slavery and over 600 victims rescued in Scotland in 2022 alone, this is clearly a pressing and localized human rights issue. Climate change, covid, and conflicts have fueled a 220% rise over the last 5 years, leading to”high slavery risk” goods imported into the UK reaching $18bn. There are even instances of this happening on UK soil, as with concerns of sweatshop-like practices at the Boohoo factories in Leicester in 2019 wherein the demands of fast-fashion outpaced worker’s rights.
The Role of Finance
As the ILO estimates that roughly 86% of those trapped in modern slavery are in the private sector, and a wave of due diligence and human rights legislation is being implemented globally, firms of all sizes need to think about their positioning in the international economic value chain and how modern slavery may impact their work. Human rights organizations are increasingly citing the displacement and economic hardship caused by climate change as a key contributing factor to a person’s vulnerability to trafficking and slavery.
How does this impact the financial sector? As financial institutions invest in, audit, and offer banking services for businesses internationally, they must be aware of their potential impacts. The sectors most closely associated with MSHT (agriculture, construction, fishing, food, manufacturing, and hospitality) are both common investment sectors and services that financial firms can invest in directly, such as hiring catering or construction firms for direct business needs. Further, slavery may be found throughout complex global value chains and international banking organizations must be especially careful to not offer financial services for the illicit proceeds of human exploitation.
The financial sector is uniquely placed to work through all three action areas set by the Scottish Government’s Trafficking and Exploitation Strategy. Identifying and helping victims (Action Area 1) and identifying and disrupting perpetrators (Action Area 2) can both be addressed through training and empowerment of frontline staff in banks. Addressing the conditions that lead to trafficking and exploitation (Action Area 3) is vital from a risk assessment standpoint, as financial institutions are uniquely positioned to impact financial services from an international down to a local level.
Tackling Modern Slavery and Human Trafficking
The UK’s Modern Slavery Act (MSA), implemented in July of 2015, consolidated and expanded upon preexisting MSHT legislation. Section 54 requires commercial organizations that operate within the UK with a minimum goods or services turnover of £36 million, regardless of where they are incorporated, to publish an anti-MSHT statement within six months of the end of their financial year. Efforts are currently in progress to strengthen the MSA, with critics arguing that firms may take a ‘box-ticking’ approach and fail to thoroughly vet their global value chains.
Of the organizations in the UK working to eradicate MSHT, the UK Independent Anti-Slavery Commissioner and Unseen UK provide detailed research, while Finance Against Slavery and Trafficking (FAST) offers actionable resources for financial institutions. The National Referral Mechanism (NRM) is in place to report any instances of suspected slavery, trafficking, or exploitation.
GEFI is honoured to have Dame Sara Thornton speaking on this topic at our upcoming Ethical Finance Global 2023 Summit in September. This is a difficult but important topic to address, but ethical finance means making the world safer for everyone and having the difficult conversations that need to be had.