Christophe Thibierge, Associate Professor in the Finance department at ESCP Business School
Sustainable development can be defined as a development that meets the needs of the present without compromising the ability of future generations to meet their own needs.
The concepts of sustainable development seem to apply easily to certain disciplines; for example, in supply chain management, the issues will focus on transport, energy consumed or even pollution. In marketing, the questions will revolve around consumption and obsolescence perhaps fast fashion or the circular economy.
But what about the role of finance in sustainable development? Is it an oxymoron to say ‘sustainable finance’?
To answer this question, we can look at how today’s finance approaches investment projects, and how concepts of sustainability can be brought to the table.
Understanding the traditional approach to investment
In the field of corporate investment projects, we use decision models derived from economics, such as the calculation of the net present value (NPV) of a project. This model consists of making a cash flow forecast (sales minus expenses) for each year of the project and then applying the time value of money with a discount rate – because one euro in one year is not worth one euro in 10 years’ time. But such a model as the NPV formula – which is widely used in corporate finance divisions when it comes to assessing investment projects – will face several problems when we want to incorporate sustainability issues. And the other classical models (IRR, Payback) are no better since they suffer from the same drawbacks.
First, these models are based on a single objective, which is trying to increase shareholder value. In those conditions, if a project enriches the shareholder, but degrades environmental, social or governance conditions (ESG criteria), it will be considered profitable, even though it is not “sustainable”. Secondly, these models do not consider all the data or consequences. Indeed, project forecasts only consider the revenues and expenses that the project will bring to the company, and they ignore all the consequences outside of the firm (those consequences being called externalities). Pollution, environmental degradation or unemployment are therefore not counted in the forecast because they are negative externalities that have no (or very little) impact on the company’s accounts. Consequently, a project that brings a profitable result to the company will be adopted, even if it is very polluting, socially disastrous or dramatic in terms of the environment. At worst, the company will have written down a provision for a possible lawsuit or a potential fine, but those recorded amounts will be nowhere near the real cost imposed to the external world by the launching of this project.
How concepts of sustainability can be recognised
One of the solutions to make finance more sustainable is to include the cost of externalities in company forecasts. Although not currently done, it is not impossible to do. For example, a company can decide to bill the project’s estimated pollution directly to the investment expenses. Indeed, the expected annual pollution can be estimated in the form of CO² emissions, and then valued as an annual expense of the project, which will therefore reduce the estimated cash flows for each year. To value the CO² emissions, the company can use the current market price per tonne of CO² – even if it is very low – or it can set its own internal value per tonne of CO² and then apply this price to all its projects that generate pollution. If this is done, then a polluting project will be de facto less profitable than a non-polluting project. That will not only be more representative of the economic reality but also more in line with sustainable development goals (SDGs). This reflection can be extended to a variety of external indicators: the average health of populations, the degradation of natural resources or social issues within the company. Of course, this requires an additional investment in collecting those external elements, and an effort to evaluate the financial cost for those items, but:
The simplest estimation model will always be better than not taking these factors into account at all.
The great advantage of this approach is that there is no need to change the model, it is just a matter of changing its underlying parameters. Indeed, investment decision models such as NPV are well established in the financial departments of companies, and they are commonly used because of their great conceptual soundness. So, it is better to adapt a widely used model, rather than trying to impose a new standard.
Accepting the current limits of our financial models
On the other hand, some parameters of the NPV model cannot be changed as easily: whereas we can easily contemplate to include new information in the estimation of projected cash flows, the adaptation of the discount rate presents greater difficulties when it comes to integrating sustainable development issues. Indeed, this rate is supposed to represent the level of risk of the investment project under consideration: in finance, to each level of risk corresponds a level of required profitability.
But when it comes to integrating sustainability issues in the discount rate of investment projects, things become tricky. Yes, we can always add a risk premium for the projects that do not comply in terms of sustainability, but the crucial question is to correctly estimate this risk premium. Should a project that degrades natural resources have a discount rate increased by +1%, +3% or +7%? To answer this question, it is necessary to be able to quantify environmental risk premia, statistically speaking, which is currently difficult to do. Indeed, all classical models in finance are based on the concept of a perfectly diversified portfolio, in which the risks of certain companies are offset by different risks in other sectors. To achieve this overall balance, opposites are needed: virtuous companies versus “vice” companies (tobacco, gambling, weapons), cyclical companies versus stable companies, and environmentally destructive companies versus socially responsible companies.
Today, some investors are indeed ready to consider investment projects on three distinct axes: risk, profitability, and sustainability – but other investors will still continue to apply a simple risk/return ratio instead. They will look for the most profitable company, whatever its environmental score.
It is, therefore, better, for the time being, to leave the discount rate alone and to focus mostly on including sustainability costs in projected cash flows. I truly believe this is a first (easy?) step for sustainability to tiptoe into financial models.
CAN THE CLOUD REVOLUTIONISE FINANCE?
By Walter Heck, CTO, HeleCloud
The scale of the Cloud revolution that businesses have gone through over the last few years can’t be overstated. Across almost every industry, businesses that have migrated to the Cloud have seen increased revenues, higher productivity and were more prepared to face the challenges of the pandemic than those relying on legacy infrastructure.
However, one industry that has been slow to realise the potential of the Cloud has been finance. PwC found that 81% of banking CEOs were ‘concerned’ about adopting digital tools too quickly however, even though 91% of hedge fund executives who adopted Cloud solutions stated that their chosen cloud solutions performed ‘better than expected’. Those sitting on the fence when it comes to the cloud can afford to do so no longer. The speed, security and efficiency offered by the cloud is already changing the face of finance, as it has so many industries before it.
How Cloud can help Finance?
Compliance continues to be an area that financial institutions of all shapes and sizes are spending an increasing amount of time and money on. The majority (71%) of large firms are cutting the size of their compliance departments while GDPR, Brexit and increased global economic sanctions make even simple tasks regulatory headaches. Compliance is also costing the finance sector more every year. Since the financial crash, Deloitte estimates Deloitte that compliance costs have increased by as much as 60% for retail and consumer banks.
Migrating to the Cloud can solve many of these compliance issues for financial service institutions. For instance, by leveraging modern technologies on the Cloud, such as Artificial Intelligence (AI) and Machine Learning (ML), organisations can ensure financial activities remain compliant with local regulations, no matter where the data is stored. AI can also process this data far quicker and more effectively than humans, ensuring compliance matters are solved quickly and with little room for error.
With companies downsizing their expensive compliance departments, while at the same time regulation increase, the role of Cloud-based automation in compliance is set to become even more important to the financial sector.
Financial institutions that utilise Cloud-based automation allow themselves the peace of mind that they are less likely to be faced with sanctions from regulators for unforeseen or unknown infractions when carrying out day to day activities. With the cost of non-compliance running into the billions every year, neutralising this threat has the potential to save significant amounts of money for the financial institutions who make the move to the Cloud.
Data security is vital to the survival of financial institutions. With strict rules in place, and punishments for breaches from regulators and governments increasingly common. As the number of cyber-attacks continues to increase, and costly ransomware continues to put companies out of business, it is imperative that financial institutions take the necessary steps to secure their data.
Traditional on-premises storage and data management solutions of the type utilised by many financial institutions are frequent victims of various types of cyber-attack. Gartner research has shown that up to 60% fewer attacks occur on Cloud structures when compared to on-premises alternatives.
There are many reasons for this but one of the simplest is remote access. An IBM study highlighted that 95% of security failures at companies are due to human error. This can be anything from employees using unapproved third-party applications to being the victim of ‘spill over’ malware for an attack on a different company that bleeds onto another’s on-premises infrastructure. With data being stored and managed remotely, the Cloud offers fewer direct contact points between employees and valuable company data.
However, not all Cloud solutions are created equal and when going alone companies can often find themselves under-utilising the security benefits of the Cloud and leaving themselves vulnerable to threats. Selecting the right Cloud service provider is vital. Storing sensitive data on a Cloud service enabled and managed by an experienced, trustworthy partner, ensures that client and customer data remains safe and accessible without the litany of security issues that come with on-premises infrastructure.
Partnering with a Cloud enabler
The Cloud is already revolutionising finance in the way it has so many other industries. Big players such as JP Morgan and Goldman Sachs have started migrating core applications to the Cloud and setting up Cloud hubs in major American cities. Almost half (43%) of financial services decision makers have stated their intent to increase their reliance on the Cloud over the coming year as more and more finance professionals see the benefits that larger competitors are reaping from Cloud migration.
In periods of great change and uncertainty, it can be tempting to bury your head in the sand and stick to the way things are already being done. However, those who ignore the Cloud revolution leave themselves vulnerable in a rapidly changing and unforgiving business climate. An experienced Cloud services partner can help guide a business on its Cloud journey and ensure they receive all the security and productivity benefits the Cloud offers. With more and more major players moving processes and workflows onto the Cloud, it is up to each finance decision maker to change now, or be overtaken by their forward looking and savvy competitors.
PREPARING YOUR HEDGE FUND FOR THE MODERN CYBERCRIMINAL
By: Simon Eyre, Head of Europe, Drawbridge
The familiar adage that “every organization is a target” when it comes to cyber-attacks, solidifies its place as an undeniable truth for companies in all industries each year. Spring has barely begun and we have already seen what could be one of the biggest cyberattacks of 2021. When thousands of companies were compromised due to the exploitation of flaws in the Microsoft Exchange Server email software, organisations across the globe were once again faced with the reality that the modern cybercriminal will use any opportunity to gain leverage in the cyberspace and get a monetary advantage.
Today’s criminal is capable, skilled, and always following the money. This is what makes the financial industry a tempting target, with alternative investment firms being increasingly being targeted by criminals. Very recently, Sequoia Capital, one of the largest venture capital firms in the world, was successfully phished with sensitive data being exposed to criminal eyes.
So, what can hedge funds do to prepare the organization for an impending cyberattack?
One size fits all?
It is tempting to bolt-on the latest technology on the market, and trust that the product will do ‘what it says on the box’. When constructing a robust cybersecurity program, to avoid investing in cybersecurity plans that are seemingly “one size fits all”, hedge funds should firstly focus on evaluating the cybersecurity landscape and understanding the most common threats and potential attack vectors. The firm’s leadership and cybersecurity team should identify what factors would make your business a target and why would you be at risk, as well as consider the types of cyberattacks your peers have experienced. Ask questions such as: “What kind of breaches and attacks are happening in the industry to firms of our size and strategy?”, “How are other firms mitigating these risks and how can our fund do the same?” and “Where are the cracks in the technical armor?”
During this process, you should consider what data is most important to your business. What are the crown jewels of the hedge fund? Consider where this data is stored, who has access to it, how it is transmitted and whether vendors process it. Never underestimate what might be of value to a cybercriminal. Your most important data can include corporate data, communication records, or personal data of staff and investors.
Prioritize protecting your data and protecting against the most likely attacks that would disrupt the business.
Plenty of phish in the sea
Phishing remains a weapon of choice for the modern cybercriminal. In 2020, we saw as number of attacks occur via social engineering, voice/email phishing and impersonation. One notable example is the unfortunate set of events that set in motion the eventual closure of Levitas, an Australian hedge fund. After sending a fake Zoom invite and it being accepted, hackers planted malware and gained control over an executive’s email, leading to the approval of $8.7M in fraudulent invoices. Shortly after, the firm’s largest investor pulled their planned investment, resulting in the fund being scheduled to wind down.
What can we learn from this? Any employee in the hedge fund could fall victim to a phishing attack, as these emails, calls and invites are carefully crafted and virtually indistinguishable from the real deal. An important mitigation strategy is to invest in high quality staff awareness training that goes beyond ticking boxes on a generic on-demand course and tests. Hedge funds should establish a training program that is relevant to the business, the work environment, and its risks, as well as the systems in use. Standard template training is insufficient in preparing staff for the delicately created and convincing attacks of cybercriminals.
A balanced blend of staff training and technology
Most cybersecurity experts would agree that defense in depth is critical. This means that the hedge fund’s technology and staff should work in harmony to achieve the highest degree of protection for the firm. Many cyberattacks, especially phishing, have time on their side. Once an employee has been convinced to click on a link, criminals will lurk in the background and look for vulnerabilities within the business. To address this issue, in addition to employee training, hedge funds should invest in a vulnerability management solution that helps discover weaknesses within the system. Hedge funds should continually perform vulnerability management with recurring penetration testing of their environment to ensure the safety of their data and uninterrupted service.
The importance of vendor management
Hedge funds today work with a network of independent partners or vendors that support the running of their operations. From law firms, to auditors, brokers, marketers, researchers and administrators, the hedge fund’s network expands into a complex spider’s web, increasing the likelihood of a successful cyberattack with each new silk thread. Why? Criminals will not always go for the bullseye, but rather compromise a target that might have weaker defenses and use their network as a steppingstone to the hedge fund’s valuable data. This is one of the reasons why regulators and hedge fund investors are hyper focused on vendor due diligence. To minimize risk, hedge fund managers should hold vendors to the same cybersecurity standards as the business itself. Remember, your firm’s network is only as secure as the weakest vendor with access to your data. Extensive due diligence of third parties should not be optional – it is required.
Criminals continue to be attracted to valuable data, and hedge funds can expect to be increasingly targeted due to the nature of their business and large transactions being processed every day. To avoid financial and reputational damage due to a cyber-attack, as well as ensure regulatory compliance while navigating a complex regulatory environment, hedge funds must invest in and develop a robust cybersecurity program that is tailored to the alternative investment industry. By focusing on the most important data, most likely attacks and equally investing in people and technology, hedge fund managers can protect their business, while building a reputation as a reliable partner in the alternative investment industry.
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