Top Voice: Wajahat Azmi, PhD



Understanding how ESG activity affects bank value is essential because events like the 2008 Financial Crisis and the LIBOR scandal have eroded confidence in financial institutions and illustrate the complacency of both banks and regulators. If a bank is ineffectually run, it could require a government bailout, which explains the scrutiny of the government, media, and academia (Wu and Shen, 2013). ESG activities provide a potential substitute for these governance structures and could be of value to shareholders, bondholders, depositors, and taxpayers.

Using a sample of emerging market banks, we find a non-linear relationship between ESG and corporate performance. Increases in ESG activity improve bank performance. However, ESG activity is beneficial only up to a point, after which there are diminishing marginal returns to ESG activity.

Of all the ESG parameters, environmentally friendly activities have the greatest effect on bank value. The significance of this component is not surprising because awareness of environmental issues has become necessary in the past decade, and people understand that banks play a strategic role in funding projects that can affect environmental change. As investors increasingly recognize the impact of climate change, the signaling benefits of environmental ESG activity is likely to increase. Especially in emerging markets, where air quality and pollution are essential concerns to a bank's stakeholders, activities that positively impact a bank's environment could be viewed as a commitment to the community.

Finally, we examine the channels through which ESG activity impacts bank value and find a positive relationship between ESG activity and both cash flows and efficiency. We find ESG activity negatively affects the cost of equity but has no effect on the cost of debt. One possible explanation for these results is that bondholders care primarily about the bank's tail risk, while shareholders place greater importance on the upside potential of ESG activity.

We note a positive relationship between ESG and both cash flow and the net interest margin of emerging market banks. We posit the positive relationship between ESG and cash flow is due to reduced information asymmetry and greater access to funds. This finding is consistent with Cheng et al. (2014). We argue that depositors are more tolerant of lower interest rates at banks with greater ESG activity. Consistent with this net interest margin channel, banks that invest more in ESG activities are more profitable.

For this edition of the Top Voices in Sustainability series, IB will be speaking extensively with Dr. Wajahat Azmi, a senior consultant, and academic researcher, who recently published an exciting and ambitious research paper on the impact of ESG activities on bank valuations. Here's the transcript to the full interview:

The Interview

Q: Since around March of last year, the world has been in a state of perennial lockdown. How have you been keeping during the lockdown period, what have you been up to over the last 12 months or so? Tell us about any interesting projects you have worked on during the interim period or any personal activities you have engaged in that have been successful. 

WajahatIts been a challenging year and looking at the trends, I think it will take another year or so for things to get normalized. Nevertheless, the period has also brought opportunities to learn new things. For the past several months, I have been actively engaged with two startup projects. One is in the energy space and the other is in digital banking. My role is to formulate strategies to penetrate different regions. Additionally, I am also helping these companies raise funds. In particular, the digital banking project is very exciting and we have already minted coins. We are in the process of getting these coins listed and also approaching The Bank of England for the appropriate license. Besides all the above, I am also working on a Waqf project focusing on OIC (Organization of Islamic Cooperation) countries.

Q: Would you care to share with our audience a little bit about yourself, your background, and your trajectory towards a high-impact career. What brought you to this specific sector. Where do you draw your inspiration as a professional from?

WajahatI belong to one of the northern states of India and obtained my first degree in Business Administration from one of the public universities. I graduated in 2009 and I bet everyone remembers those Global Financial Crisis (GFC) days. While reading some news about the impact of the GFC, I incidentally came across an article on Islamic finance. Though I come from a practicing Muslim family and myself a practicing Muslim, I had no clue of Islamic finance. I won't go into the details of that article but the thing that remains with me was that Islamic finance proved to be resilient and somehow managed to save itself from the storm. I then moved to Malaysia and pursued my degree in specializing in Islamic finance and was also introduced to the concept of Sustainability/ESG during various seminars and lectures. As I saw a lot of similarities between the two, I chose to write my thesis on the behavioral aspects of Islamic finance and sustainable investing. Since then, I have always advocated the adoption of Sustainability principles into operational activities, investing, so on so forth. Post PhD, we did a lot of research and consulting work related to Islamic finance and its comparative relationship to sustainable finance. I always maintained that integrating both the principles is more rewarding for investors especially in terms of risk as it brings price stability. Moreover, combining these two strategies also brings more people to the greater objective of tackling climate change. I believe with more awareness about Islamic finance, we will see more use of ESG/Sustainability linked Sukuks as well as the green Sukuk.

Q: As I am sure you may be aware, as far back as 2015, a number of prominent French financial institutions (BNP Paribas, Credit Agricole and Societe Generale) openly refused to participate in a project called the Adani project in Australia. However, as recently as a few months ago, a $600m "green" loan provided to State Bank of India by Amundi (The prominent French investment manager) invested in a project called Carmichael, which is a thermal coal mine under construction in the Galilee Basin in Central Queensland. This has created a somewhat ethical dilemma. Can you explain a bit about the concept of environmental, social and governance investing in practice? Particularly, the concept of negative/exclusionary screening and positive/best-in-class screening. What are the major similarities and differences between the two approaches?

Wajahat: Sustainability investing has grown rapidly over the years and the pandemic has just made that growth more exponential. The increasing interest from not only institutional investors but retail investors has forced fund managers and now the banks to integrate ESG principles into investment-decision making processes. While the term ESG has gained popularity, the terminologies associated with this kind of approach in investing vary considerably. The most commonly used terms are Sustainable investing, ESG investing, and Socially Responsible (SRI) investing etc. One of the reasons for these terminologies can be attributed to the evolving nature of ESG investing. For instance, it mainly started as religious-based investing, mainly applying negative/exclusionary screening to positive/best-in-class screening. Negative/exclusionary screening mainly focused on screening out industries that are considered unethical such as the weapons industry, arms and ammunitions industry, pornography, etc. On the other hand, positive/best-in-class screening goes a step further and screens firms that show leadership, for instance, in the energy space, human rights, etc.

The approach to negative screening is straightforward whereas positive screening requires more in-depth analysis as the firms need to be assessed based on their emissions, safety measures in the workplace, etc.

Religious investing from the Islamic perspective also gained traction over the past decade and the Islamic finance industry now is estimated to be close to $3 trillion. In 1996, Dow Jones, under the expert supervision of Islamic scholars, came up with the screening criteria guided by Islamic principles. There are a lot of similarities between the negative screening of the sustainability approach and the Islamic screening criteria. The criteria of screening businesses are more or less the same as both avoid the most unethical industries. However, the Islamic criteria goes one-step further and screens the firm based on leverage, interest income and liquidity. One of the other major differences between the two is that Islamic criteria avoid financial institutions that deal based on interest. For instance, Islamic criteria excludes conventional banks, insurance firms, conventional asset management firms, etc.

However, recently, Dow Jones have also come up with an index that combines sustainability and Islamic criteria making it one of the most sought-after investment ideas as it satisfies the expectations of Islam as well as sustainability investors. It also helps in price stability as it has a larger investor base as compared to Islamic investing and sustainability investing, respectively.

Q: In the US, the Acting Chair of the Securities & Exchange Commission, Allison Lee, recently noted in a letter published in March that the SEC are integrating climate and ESG considerations into the agency's broader regulatory framework. Meanwhile, in the UK, the Chancellor of the Exchequer, Rishi Sunak MP, announced that the UK will be the first country in the world to make disclosures that are aligned with the Task Force on Climate-related Financial Disclosures (TCFD) fully mandatory be 2025, going beyond the "comply or explain" approach adopted under the SFDR. As an ESG professional, could you explain what kind of regulatory environment firms which operate in the ESG space operate under?

Wajahat: The approach to addressing ESG issues differs considerably between US and the UK. For instance, in US, there are hardly any disclosures that are mandatory. In fact, with the exception of a few, the US regime is largely comply or explain. For instance, if a company does not have a financial expert in the audit committee for a justified reason, it can explain to the regulators.

The regulations in the US require that public firms disclose all information to investors including ESG related risks. Last year, SEC stated that companies should focus on the key and relevant variables that are crucial for understanding the valuation of US businesses. Without any specific reference to ESG, the SEC has included several key ESG parameters, such as employee benefits, energy consumption etc., to be included in its disclosure rules. Some of the companies adhering to these rules also go that extra mile and use the guidance provided by GRI, SASB, TCFD etc. to make their disclosures communicate more effectively to stakeholders. However, in the last 2 years, five disclosure bills related to ESG, climate, human rights, tax payment and shareholder protection were presented before Congress. Although they are yet to get the green signal, they demonstrate the growing interests in building up a regulatory framework around ESG metrics.

On the other hand, UK regime is also not very different from US in the sense that there are not any direct mandatory ESG disclosure requirements. However, the UK government has stated that they want to bring about a green industrial revolution. This could be done by implementing recommendations of TCFD and making climate-related disclosures mandatory. The plan is to put the substantial portion of these climate-related disclosures in place by 2023 and cover the full economy by 2025.

Under the current regime (since 2018), only certain public companies are required to disclose material non-financial information, however with the new initiatives, the TCFD guidelines would cover a significant number of companies. The UK has also showed interest in developing their own green taxonomy.

To summarise, both the US and the UK up until now have made only a few regulations mandatory and for certain companies only. However, both countries have showed intentions to bring substantial regulations in order for the firm to disclose non-financial information focusing on climate and ESG/Sustainability related risks.

About the Top Voices in Sustainability Series

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How does the interview series operate? Essentially, each and every quarter, we will publish an interview with one of the world's most influential professionals and place the interview on our website and weekly newsletter. The theme of the interview series is "sustainability in the energy sector".

"Religious investing from the Islamic perspective also gained traction over the past decade and the Islamic finance industry is now estimated to be close to $3 trillion. " - Wajahat Azmi

Q: In terms of hydrogen, there have been a number of firms who have sought capital to fund their respective projects, one of which is Storegga - an, independently operated, low-carbon project delivery business at the forefront of the global Net Zero strategy. Through its wholly owned subsidiary, Pale Blue Dot, Storegga is the lead developer of the Acorn Carbon Capture and Storage ("CCS") and Hydrogen project, providing essential infrastructure to help the UK meet its net zero targets. As an impact-focused investment professional in the industry, what would you say are the key factors influencing the success of private equity in the clean tech sector?

Wajahat: In recent years, we have witnessed a growing enthusiasm in clean energy, especially due to private equity. This is due to the increased awareness about global warming. However, the success of it largely depends on several factors.

I believe, individual drive to become ESG compliant is very essential to the overall strategy of sustainability. It not only allows the firm to look beyond profit but also put that extra effort into contributing to community development through various initiatives. It also saves us from greenwashing and other deceptive green initiatives at the firm level. In essence, individual's seriousness and honest commitment is a critical success factor.

Historically, the clean tech sector has had some stellar innovations and made it big with the help of VCs and PE. However, the majority of clean techs failed as a result, the new ones find it difficult to raise funds. In fact, B. Gaddy, V. Sivaram, and F. O. Sullivan (2016) in MIT Energy Initiative Working Paper argued that despite being more risky, clean techs provided lower returns as compared to the firms with the same risk profile.

The profit margin and early success of these investments are the key factors that drive the success for PE investors. Early success is very critical as it provides a sort of validation by the target consumer/market players. In essence, providing a sense of security to the PE investors that the technology is accepted by key market players.

It's a case of "Doing Well While Doing Good".

Other critical success factors are the incentive structures provided by the regulatory authorities. The incentives in place should be both for consumers and corporates. These incentives could be in form of subsidies, entry barriers, tax rebates etc.

Another important factor is IP protection. IP protection is critical as it gives exclusivity to new and existing patents (pending patents as well), copyrights, trademarks and other relevant rights.

To conclude, better profit-margins, capital efficiency, sufficient IP protection and the ease of doing business are the key factors influencing the success of PE investors.

Q: In relation of the future of sustainable finance, there happens to be quite a lot of pragmaticism in place regarding the ambition of blockchain technology. Speaking on the virtues of blockchain technology as a mechanism for conducting and managing financial transactions, how much of an evolution is the idea of digital finance from Infra-PPP frameworks (i.e. hybrid capital)?

Wajahat: One of the main issues in the infra-PPP setting is the lack of transparency and trust. This obviously leads to disputes and hence delay in project delivery.

PPP projects are complex as there is continuous information flow from one party to the other throughout the life of the project. For instance, everyone prepares and maintains their own ledger and that leads to multiple reporting and at times discrepancies in their reports. The other issue with regard to PPP projects is the dispute with regard to the scope of work. Everyone in the system maintains their independent ledger and reporting which can, unfortunately, lead to the origination of multiple and sometimes contradictory reports. Additionally, the information is subject to manipulation at various stages of the project.

To summarise, what we need is a structured data system that is resilient to any unauthorized manipulation not only from the perspective of shared data but also from the clarity of the deliverables. In other words, we require a system that is robust to data manipulation and brings clarity in deliverables - hence avoiding any disputes. This is where blockchain technology can play a crucial role. The technology itself has many aspects and use cases, but constructing "Smart Contracts" is most the relevant in overcoming the issues mentioned.

In my view, blockchain is much more than just bitcoin and has various uses. I think, the use of blockchain to write "Smart Contracts" is one of the greatest innovations, especially from the PPP and social finance perspective.

Q: Earlier, you mentioned the regulatory environment which firms in the US and UK operate under respectively. What are some of your thoughts on the emergence of green/sustainability standards and taxonomies which have been developed to support the growth of renewables in developed markets such as the European Union? How do these frameworks encourage firms to comply with a move away from alleged greenwashing?

Wajahat: The EU in the past couple of years has passed two important ESG-related regulations - SFDR in 2019 and the Taxonomy in 2020. I believe the introduction of sustainability standards and taxonomies are a great way to further regulate ESG-related disclosures. Besides SFDR and the taxonomy, other standards such as GRI, TCFD etc., firms have started to integrate in their operational activities. The common focus of these standards, beside others, is to encourage firms to disclose climate risks and opportunities. As a result of this, many large corporate entities have pledged net-zero commitments (Microsoft by 2030, Amazon by 2040 and the Apple by 2030). This obviously opens a lot of growth opportunities for the renewables sector. With the emergence of innovative battery technologies, renewables have gained more popularity as the excess energy can also be traded.

Moving from just recommendations to regulating and establishing standards makes greenwashers warier of the consequences of getting caught. As in case of presence of regulations, greenwashing can result in penalties and in worst-case scenarios, close of business.

Q: Of the 17 UN Sustainable Development Goals, would you agree that Goal 7 - the provision of clean and affordable energy is at the forefront of society's challenge admidst COVID-19? If so, what will the next few years hold in store for the progress of SDG7 as we bounce back from the economic shock of a global pandemic?

Absolutely, SDG 7 along with SDG 13 are the most important among the 17 SDGs. There are countries incentivizing the adoption of clean energy through production-based incentives, investment-based incentives, and robust regulatory frameworks. For instance, many countries provide a minimum feed-in tariff where the producers are guaranteed a minimum price per kWh for a pre-agreed period. Similarly, many agencies provide interest-free loans for the purchase of equipment. There are tax (direct and indirect) rebates as well in most countries.

The next stage is promoting and incentivizing the production of battery technologies. This can be a game-changer as batteries are essential to realising the full potential of clean energy. With more research and development efforts, we can also tackle the issue of the carbon footprint of ships. The battery manufacturing market is already a billion-dollar market but I think more policy initiatives are required to scale efforts, especially in emerging markets.

Thank you to everyone who made this interview possible. For more interviews in this series, follow us on Twitter @ibrgroupintl or connect with us on LinkedIn.