FinTech: The Notorious E.S.G

Hogan Lovells

Hogan Lovells

The position as set out in this article is correct as at 9 December 2021.

ESG issues - driven by consumer, investor and stakeholder demand, and rapid regulatory change – have experienced a meteoric rise. They are increasingly reshaping the way business operates, and the financial services industry is no exception.

But what is ESG, and what does FinTech have to do with it?

ESG (Environmental, Social, and Governance) is a criteria, not a definition. It’s constantly evolving, encompassing the key dimensions of wider sustainability (and is often used interchangeably with sustainability). It captures a huge number of topics from climate change to fair supply chains, and risk management to financial inclusion. ESG is most often used as a set of standards to measure the sustainability of a business or an investment; ultimately, the focus on ESG requires businesses – FinTech included - to demonstrate they generate value for society.

While ESG is a relatively recent concept, it’s now frequently the focus of policy, legislation and regulation. FinTech should expect to be subject to some of these legislative changes, and will surely need help navigating them, but more importantly the same changes afford huge opportunities for FinTech development in the ESG space.

The role of regulation

Any FinTech will be shaped by regulation – either in the regulation that applies to them as a business, or in the solutions and products they provide to their customers to help them navigate regulation.

We’re already seeing ESG disclosures play an increasingly important role in driving investment decisions. While there’s currently a lack of uniformity in ESG reporting, mandatory and standardised ESG reporting is sure to grow substantially in the coming years, as exemplified in the proposed Sustainability Disclosure Requirements, and the ESG recommendations from the Kalifa review of UK FinTech (commissioned by the Chancellor). Those recommendations included developing a framework to facilitate sustainability-linked investments, and facilitating uniform sustainable reporting standards and terminology, including a common reporting template for the industry. For more information on the proposed Sustainability Disclosure Requirements, see our Engage article here.

Plans are also afoot for the UK to become the world’s first net zero aligned financial centre. Under the plans, there will be new requirements for UK financial institutions and listed companies to publish net zero transition plans that detail how they will adapt and decarbonise as the UK moves towards a net zero economy by 2050.

It is not just the UK Government that’s taking ESG seriously. The FCA had already stated in a Feedback Statement back in October 2019 that they “want to help…[accelerate] the transition to a net zero emissions economy”, and have very recently published their refreshed ESG strategy. Included within their key workstreams are objectives to maintain close collaboration with other UK regulators and Government departments, as well as influencing and supporting international consistent outcomes in ESG, enhancing climate-related financial disclosures and improving the transparency of performance on diversity and inclusion. They’ve also cautioned that there’s a risk of harm if the financial sector responds to rising consumer demand and awareness of ESG issues without a supportive regulatory foundation and adequate guard-rails. 

It’s clear that ESG matters are extremely high on both the FCA’s and the UK Government’s regulatory and legislative agenda, and this will continue to be true throughout 2022 and beyond. And FinTech can help. The Kalifa Review concluded that FinTech has an important role to play in ESG issues. This is in part due to the need to obtain and process substantial amounts of data from a variety of sources; the review suggested that FinTechs can utilise their digital capabilities to enable relevant ESG data to be collected and processed efficiently using technology solutions.

The most obvious example of FinTech and ESG overlap is undoubtedly in the investments space. We've looked beyond this below to where ESG impacts and opportunities for FinTechs may develop and where we could see FinTech moving next year and beyond.

‘E’ - ‘Green’ FinTech: looking out and in

The most high profile element of ESG in recent years has been the “E” – the environment. Climate change is a core focus of environmental work, and the UK’s GreenTech sector is already booming. It’s clear from the UK’s legislative net zero commitments that the future of finance has to be green – which will generate both challenges and opportunities.

FinTech will have a crucial role in encouraging green innovation and investment, using digital solutions to provide companies with tools to measure and mitigate their climate impact, and working with companies to provide consumers with information they need to make informed decisions.

Looking out: developing initiatives

The move towards a net zero economy will require significant investment in low carbon infrastructure and services. FinTechs have already developed in the green finance space. We have seen FinTechs move to combat climate change by providing products designed to support the economy in this transition, including loans tailored for carbon reduction and renewable energy projects and rural diversification projects. 

Firms are also providing retail customers with products that support the transition,  such as  personal savings accounts that direct interest to plant trees to mitigate carbon footprint as the return on investment, and rewarding  credit card purchases by using the standard fees paid by merchants to buy carbon offsets. This product sector is ripe for growth as consumer expectations become more and more aligned with ESG principles. FinTech is perfectly poised to move quickly and take advantage of this new market.

Transparency and reporting is also crucial to green finance. Institutional investors, such as asset managers, will increasingly rely on corporates to enable them to comply with their own disclosure obligations going forward under the Sustainability Disclosure Requirements. As we’ve also seen, standardisation of data and reporting is equally vital, as investors and consumers demand ESG data they can trust. FinTech is already at work in this space. The FCA and City of London Corporation’s Digital Sandbox’s sustainability cohort addresses common market challenges in ESG data and disclosures under three key themes: understanding ESG data (how can technology help consumers understand the ESG characteristics of their products?); validating ESG data (how can technology be used to automate the assurance of a listed issuer’s ESG data and validation of its ESG-labelled corporate bond issuance?); and transparency in ESG disclosures and reporting (how can technology enable transparency in disclosure and reporting on sustainability, especially on the characteristics of corporate assets and the profile of their supply chains?). We can expect to see more and more FinTechs employing AI and advanced data analysis to develop ESG data solutions. We’re already seeing FinTech use technology to analyse bank statements and generate detailed reports about how much CO2 emissions people's lifestyles produce.

Distributed ledger technology can also be utilised for climate action, as it allows for tracking and reporting of reductions in greenhouse gas emissions along the entire supply chain, including manufacturers, suppliers, distributors and consumers. The use of blockchain will undoubtedly be key in helping companies monitor sustainable development goals.  Blockchain technology is already being used to to integrate renewables into power grids to reduce costs and combat climate change, and to provide visibility over not only a company’s carbon footprint, but also those of their partners, vendors and utilities. This in turn enables companies to reduce their carbon footprint and explore opportunities to create a more sustainable lifecycle for the business. 

Looking in: leading by example

However, new technologies can themselves have a substantial carbon footprint. Researchers from Cambridge University have said that “mining” Bitcoin consumes around 121.36 terrawatt-hours (TWh) a year. To put that into context, if Bitcoin was a country, it would be in the top 30 energy users worldwide, ahead of Argentina. Innovate Finance point out in their white paper on the role of FinTech in Net Zero that this isn’t just an issue for cryptocoins – data centres use 200 TWh per year. While cloud computing may be more efficient than data centres, it still has a  growing energy consumption – and the more powerful the computing, the more energy is used.

Clearly, it isn’t enough to only develop solutions for others to use in achieving their ESG goals – FinTech needs to lead by example, and investors will expect to see them doing so. Luckily, FinTech is already paving the way, with some pledging to be carbon neutral by 2030. Others are setting similar targets, such as a one third reduction in carbon emissions from their own operations and supply chain by 2030.  FinTechs are also among the  founding members of the TechZero charter, a climate action group for UK tech companies working together to accelerate progress to net zero.

This is merely the tip of the iceberg. The possibilities for growth and innovation in the green finance sector are near limitless, and FinTech has a key role to play.

‘S’ -  Financial recovery and inclusion

Whilst a lot of ESG focus, particularly in the FinTech space, has been on the environmental side of matters (which makes sense as it is the only factor that poses a truly existential threat to the future of mankind), the development of 'S – social' focussed projects has increased exponentially since the beginning of the pandemic and is beginning to play just as an important part as the ‘E – environmental’ in ESG. This criterion is equally broad and covers considerations such as labour standards, social inclusion and diversity, data protection, human rights, financial inclusion and much, much more.

Inclusive finance

Nowhere has the explosion of social value projects been more obvious than the development of FinTechs aimed at financial inclusion and the provision of financial services for those who may not otherwise have access to such services. The shift towards digital financial services was already helping societies advance financial inclusion before the pandemic, but the process has dramatically increased in pace recently as groups of people who in normal times would not have been considered excluded struggled to access emergency finance measures and/or to prove their compliance with criteria for receiving government aid. The global demand for FinTech services increased dramatically during the pandemic, perhaps reflecting an ability to react quickly to developments, unhindered by legacy IT platforms.

An example of this is the "COVID Credit" work launched by a number of FinTechs in the early stages of the crisis. In 48 hours a team from the FinTech community built a system based on open banking that would allow a sole trader in the UK to self-certify "furloughed" status to HMRC, by identifying lost income based on access to bank account data. This could in theory have simplified the process of obtaining various forms of government assistance. While the UK government ultimately looked elsewhere for solutions, the idea highlights the dynamic potential of FinTech (and in particular open banking technologies) and shows how disruption can be a force for innovation.

This extends far beyond the UK and European economies. The World Bank estimates a billion people in Asia are 'unbanked' despite markets like India and Indonesia being home to many financial service firms and a hotbed of FinTech activity. Low-income households and groups can benefit greatly from advances in mobile money, FinTech services, and online banking.   FinTech has the power to assist these populations by providing access to accounts, micro-loans and payments systems. FinTechs will be able to do this remotely and can do so in a way that challenges, rather than reinforces, inequalities within those communities.

The road to recovery

Whilst COVID-19 has highlighted the need for digitisation, there is far more work to be done. As global economies move out of the confusion and disruption of the pandemic the financial sphere will need to focus on building an inclusive recovery. Predicted recessions, increased costs of living and sharpening of housing issues will make financial inclusion vital to ensuring all in our society are able to properly recover and rebuild. FinTechs can leverage AI and data analytics to manage this process and challenge traditional models and build a better, more inclusive economic system.

In this regard open finance initiatives could come into their own. Harnessing consumer data to produce a wider range of financial services tailored to those struggling to access traditional finance products or experiencing discrimination within societal structures could be a huge step on the road towards true financial inclusion and empowerment. Economies have been disrupted and this could be a catalyst for development focussed on more than financials.

Whatever comes next, ESG considerations will need to be at the front of these firms' minds when creating products and the social aspect of this will no doubt continue to be an important issue for firms. In the next few years, we can expect continued focus on diversity and inclusion, wellbeing in workplaces and a need for developed economies to look externally and consider their influence and impact on a global level. There is, after all, little practical benefit to being the only net zero economy in the world.

Whilst increased digitalisation can be a force for inclusion it does risk ostracising some members of society and widening what is known as digital divide. Accordingly, aspects like equal access to digital infrastructure, greater global financial and digital literacy through education and projects to ensure we avoid systemic biases when using financial data will all be important drivers of the development of a truly inclusive post-pandemic financial services market. FinTechs are well positioned to be at the heart of these developments.

‘G’ – decision making

Last, but by no means least, we come to the ‘G’. Governance encompasses risk management, values, reporting standards and transparency, senior manager remuneration, and anti-bribery/corruption policies, among others, and is probably the best established of the 3 strands of ESG, given the introduction of the Senior Managers and Certification Regime in 2019. It would be wrong to consider governance in isolation, though: it’s increasingly clear that the Environment and Social aspects of ESG are integral to good governance, and vice versa. Effective governance drives sustainable financial performance and minimises reputational risk, which in turn generates value for shareholders. 

We’re already seeing governance in an ESG context come into greater focus, but it’s likely to take centre stage over the coming year. There’s an additional incentive to ensure good governance for FinTechs in particular – they can expect to be quizzed about their ESG commitments as investors increasingly grow aware of ESG risks and seek businesses that adhere to high governance standards, in line with consumer demand.

Historically, good governance may have been seen as more of a compliance issue, but thanks to the advent of ESG, ESG decision-making will be a top priority, standing item on board agendas across the country – from start-ups to the largest companies.

What’s next?

In this article we have shed light on areas where FinTech and ESG might meet beyond the more obvious examples of sustainable investments. This illustrates the overlap between these concepts and highlights both the opportunity that lies at the feet of FinTechs but also the responsibility that they have when developing new products and entering markets.

Inevitably, therefore, this article has involved an element of crystal ball-gazing and, if the last few years have proved anything, it’s that this is never an easy exercise in the financial services sphere. Whilst we may not see all the concepts and ideas discussed above come to fruition, what is certain is that the future of ESG and FinTech is very much aligned.

Both FinTech and ESG are important growth areas in the UK that regulators are likely to be very focussed on in the next few years. There will no doubt be significant crossover and possibly occasional conflict between the two as regulators push to implement Government plans for net zero whilst striving to ensure that the UK remains an attractive regulatory space for FinTechs to develop post-Brexit.

We can expect a proliferation of new rules, regulations and guidelines on how firms must act to ensure integration of ESG criteria across all facets of their business, but it is important to stress that this is not only a compliance burden for firms but also presents huge opportunity.

Consumers are no longer satisfied by companies that make them or save them money at the expense of all else. FinTechs can lead the way in offering consumers options that combine financial gain/savings with ESG values and less tangible but no less important measures of success. We've already seen this in the success of 'green' investment portfolios and the fact that large scale investors are conducting assessments of ESG compliance when considering which firms to support. Consumer habits and the focus on ESG are already changing markets and this trend is likely to continue.

FinTechs have the opportunity to contribute to fixing some of the world's most pressing issues, developing solutions that seek to reduce or remedy the environmental impact of industry and promote financial inclusion and empowerment globally, without having to abandon hopes of profitability. The development of a sophisticated regulatory environment where obligations are clear and transparent and compliance is capable of being monitored and measured is essential to ensuring consumers and investors alike are able to accurately assess the ESG credentials of FinTechs and make decisions on where to place their money.

The FCA is already considering its role in this ecosystem and we expect other regulators to do the same. The joy (and occasional headache) of working in FinTech is the difficulty of accurately predicting where it will go next but wherever that is ESG won't be far behind.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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