Currently, the world struggles with growing challenges from environmental crises such as climate change, biodiversity loss, and social inequality. Our financial system influences how the economy functions and shapes the world. People and businesses have a rising sense of urgency to find sustainable alternatives to environmentally damaging activities. In response to environmental issues, businesses are increasingly looking for ideas and innovations to integrate sustainability into the very core of their business operations.
Moreover, to prosper over time, companies will have to do more than just deliver financial performances. They must make a positive contribution to the society they are operating in, often referred to as ‘corporate citizenship.’ Financial institutions have begun incorporating sustainable financial practices in their main area of strategic importance too.
Sustainable Finance gives market participants the opportunity to act responsibly and drive positive change.
Ambitions often refer to the United Nations Sustainable Development Goals (SDGs) and the Paris Agreement. The latter is a legally binding international treaty on climate change, adopted by 196 countries at COP 21 in Paris in 2015. The most cited goal is to ‘limit global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels. In order to realize this Paris ambition, signatories aim to reach global peaking of greenhouse gas emissions as soon as possible to achieve a net-zero world by mid-century.
What is Sustainable Finance?
The term Sustainable Finance refers to incorporating environmental, social, and governance (ESG) criteria in business and investment decisions for the lasting benefits of all stakeholders, including clients and customers, employees, society at large, and the planet we share.
The E aspect broadly refers to mitigation of the climate crisis and sustainable use of resources. Human and animal rights, consumer protection, and ensuring diversity and inclusion when hiring and promoting fall under the S factor. Lastly, G revolves around business ethics and shareholder rights.
The following non-exhaustive table gives an overview of issues falling under the respective sustainability pillar.
Greenhouse gas emissions, Waste management, Energy efficiency, Pollution, water management. Recycling processes, resource depletion, biodiversity, and Deforestation.
Equality, Gender and diversity, Customer satisfaction, Working conditions, Human rights, and Community relations.
Board composition, Political lobbying, Tax strategy, Bribery and corruption, and executive compensation, risk management, transparency.
How does Sustainable Finance work in practice?
There are typical instruments associated with Sustainable Finance. In the fixed income space, green bonds are increasingly popular. They are a debt instrument explicitly designed to support climate-related or environmental projects using proceeds outlined in the prospectus. Similarly, the field of social bonds is evolving.
Sustainability-linked bonds are another growing field; here, there are no restrictions on the use of proceeds; instead, the issuer commits to improving their performance against agreed ESG targets.
This is directly tied to the coupon paid to investors, meaning failure to meet the established targets results in a higher cost of capital. Additionally, there are green loans and microlending.
Moreover, funds labelled sustainable, including fixed income and equity shares, have become mainstream. Sustainability considerations are increasingly playing a role in investment decisions, and a range of sustainable investment strategies have evolved. This can be simple exclusionary screening criteria, such as coal, nuclear, or classic sin stocks such as tobacco, and incorporating more complex ESG ratings or best-in-class approaches.
Impact investing is another growing field. Investment managers are starting to accept that considering ESG factors does not hamper investment returns, can deliver risk and performance benefits and is compatible with fiduciary duty. In fact, the UN Principles for Responsible Investment go as far as to say that fiduciary duty requires investors to incorporate all value drivers, including ESG factors, in investment decision-making.
Importance of Sustainable Finance: Greenwashing Threat
Global regulators recognize the risks associated with ESG issues and hence reinforce their financial materiality. Central banks around the globe are announcing climate stress tests. The fact that climate-related financial risks can potentially destabilize the financial sector has been acknowledged by major international financial bodies such as the Financial Stability Board (FSB), the Bank for International Settlements (BIS), and the International Monetary Fund (IMF). Institutions like the U.S. Securities and Exchange Commission (SEC) see a growing recognition of the systemic risk that climate change poses.
Consequently, countries are bringing in mandatory sustainability disclosure regulations. Sustainability reporting is the foundation of Sustainable Finance. Increasingly businesses are now choosing to provide sustainability data in their annual filings or publishing stand-alone sustainability reports. These provide insights on factors like business exposure, greenhouse gas emissions, resource use, gender balance, social impacts on communities, and waste management.
Integrating sustainability and increasing visibility by sharing information about performance against ESG goals, the organisation will create a positive reputation with the public and gain the trust of investors and shareholders. Besides the environmental, societal, and reputational benefits of investing in sustainability, organisations also see financial benefits.
This means that not only customers of end products run the risk of falling victim to greenwashing in the form of false sustainability claims. While consumer protection authorities can take action against false advertisements, there is little control over a company’s sustainability claims; sustainability reporting is far less regulated and developed than financial reporting. This creates a real greenwashing threat to investors and impedes measurement of progress towards goals such as the SGDs.