Sustainability Chapter 7: Sustainable Finance PDF

Profitably Protecting the Planet: Sustainable Finance ESG is all the rage as of late in the finance world. When BlackRock CEO Larry Fink quoted the UNGC call to action of “Who Cares, Wins,” during a speech to shareholders, other financial institutions took...

Profitably Protecting the Planet: Sustainable Finance ESG is all the rage as of late in the finance world. When BlackRock CEO Larry Fink quoted the UNGC call to action of “Who Cares, Wins,” during a speech to shareholders, other financial institutions took note, and their euros and dollars followed suit. Investment firms with huge reserves of capital are now leaning towards “Investor Activism.” They are divesting from old-fashioned, high-carbon industries, pouring funds into low-carbon ones, creating a sea- change across all industries. Private-sector investment is the primary source of capital for low-carbon alternatives and mitigation efforts. In This Chapter, We’ll Cover: ESG Factors on Investment Financial Institutions While the “How and What” of sustainability are equally Data Providers interesting and important, the “Who will pay for it?” at Types of Investors the end of the day is the determining factor if Challenges of Criticisms of Sustainable Finance Sustainability is either a pipe dream or becomes a part of how we do business in the future.  What is Sustainable Finance? Below Growth Value Driven Model, summing According to the New Markets & Geographies up the key areas where applying European Commission, New Customers & Market sustainability can increase Share returns on capital. Sustainable Finance is defined Product & Services as: Long-term Strategy Return on “…the systematic integration of Productivity Capital environmental, social, and Operational Efficiency Employed governance factors in financial Human Capital Management (or equity, shareholder decision-making processes. Reputation Pricing Power value, economic value added) In practice, this means embedding these factors into both risk Risk Management Operational & Regulatory Risk management, investment and Reputational Risk lending decisions, with the aim of Supply Chain Risk financing activities and projects that Leadership & Adaptability are economically, socially and environmentally sustainable.” Why is Sustainable Finance important to investors? Just as sustainable business practices require a paradigm shift for how business leaders manage their companies, Sustainable Finance is a new perspective for investors. Beyond being a clear indication of changing expectations and behaviors in investors, both private and institutional, it also is important for business leaders to be familiar with for many reasons, including the following… In it for the Long-term Mitigate Risks Stranded Assets Sustainably minded Savvy investors are investors understand that divesting from “high- while “green” companies Wish to be ready for both physical and carbon” companies that may not offer quick rely on assets now that returns, they have more transitional risks. may be phased out or staying power and overall obsolete over time. performance.  Three Levels of Sustainable Finance The challenges and investment opportunities business leaders face hinge on a hierarchy of needs: Financial Risk and Economy Return First, we need breathable air, and a Impact on livable environment, on top of Society Society that we need a fair, just, and inclusive society on top of which Impact on we may have a productive and Environment prosperous economy. Environment Each level has its investment opportunities that sustainably- minded investors may wish to take advantage of. The Four Aspects of Sustainable Finance Financial Outcomes ESG-focused companies tend to outperform their “high-carbon” counterparts in the long term. Some investors are recognizing the potential of these companies, and sticking with them. Governance Processes Accountability, transparency, and diversity in a governing body all play into investors’ willingness to take a chance on a forward-thinking upstart or an established firm retooling their decision making processes. Social Performance How a company treats its employees as well as communities in its areas of operation affect a firm’s investability. Environmental Performance Actively minimizing its footprint, and having the metrics and case studies to back it up play into the optics of how investors perceive the investment potential of a company.  Stranded Assets As the world changes and technology advances, certain assets become liabilities instead. These are known as Stranded Assets, or “assets that have suffered from unanticipated or premature write-down or conversion to liabilities.” For example, factories for horse-drawn carriages in the early 1900s declined as automobiles replaced them. The same will hold true for carbon-intensive businesses and industries towards low-carbon industries. Investors are aware of this, and have adjusted their strategies accordingly. There are three ways that assets become stranded: Public Policy Consumer Trends The Reduction in Cost of low-carbon alternatives  The Role of the Financial System in SF The traditional 20th century financial system is modeled much like our current global manufacturing network, but replace Take, Make & Waste with Growth, Expansion, and Profit. Year after year of relentless expansion in any industry is unsustainable, finance included. Despite this, not everything is an uphill battle. Certain functions of the financial system as they are now Forecast complement investment investment trends strategies and incentives for or positive sustainable finance initiatives,returns such as: Define a lending strategy, directing the fund to invest in or divest from high-carbon industries. Monitoring investments and influencing governance Boards must balance the interests of competing interests of different shareholders, ESG minded or not. Risk management and diversification of assets Deal with uncertainties, both physical and transitional.  Sustainable Finance Action Plan Sustainable Finance Action Plan (SFAP) was designed by the EU to improve the flow of investments to sustainable activities., and to ensure investors that their euros are going towards organizations or securities that align with their own standards. The EU’s 3 main goals under the SFAP are: Reorienting capital flows towards sustainable economy Mainstreaming sustainable into risk management Fostering transparency and long-termism into financial and economical activities  EU Taxonomy What counts as ‘green,’ exactly? One of the measures under the SFAP, the EU Taxonomy helps classify which economic activities count as ‘green.’ The taxonomy helps investors, companies and leaders to identify environmentally sustainable economic activities. This helps ensure capital is directed towards sustainable projects. To be aligned with the EU Taxonomy, an economic activity needs to contribute to one of six ESG guidelines, while doing no harm to any of the others: The Six Objectives: Climate Protection and Change restoration of Transition to a Mitigation biodiversity and circular economy ecosystems Climate Sustainable use Pollution Change and protection of prevention and Adaptation water and marine control resources  What types of Green Finance Products are available? Nearly any sort of financial instrument these days has a “green” counterpart attached to it in some way: Credit cards, mortgages, car loans, savings- deposits, bonds, and low-carbon ETFs, all purported to not only afford some sort of financial benefit, but do so along with the betterment of the planet and people. In the next few slides we’ll explore some of the more prominent examples of Green Financial Products offered to both individual investors and institutions. EU Green Bonds Also falling under the category of “Sustainable Bonds”… the proceeds from Green Bonds are used to finance any projects or initiatives with an emphasis on sustainability or any particular aspect of ESG. For example, green bonds could be used to finance a renewable energy project, helping a company refit their facilities with eco-friendly or low-carbon technologies, or even infrastructure projects for communities in need. Uniquely available to EU-based investors are EU Green Bonds, which adhere to a set of reporting obligations and transparency requirements to ensure investors’ funds are actually funding a green project, and aren’t just greenwashing.  Low Carbon ETFs Exchange Traded Funds or ETFs are a way for investors to maintain a diverse portfolio with a single investment. Low Carbon ETFs apply a “filter” to this principle by offering investors easy access to a selection of “low carbon” stocks. Organizations looking to have their stock traded on these indexes must meet a series of criteria, covered in the Data is Everything, slide of this chapter. Microfinance Also known as Green Inclusive Finance (GIF), Microfinance instruments give investors an opportunity to make a big impact on people’s lives with relatively little capital. Microfinance can be something direct and concrete, e.g., supplying a town with a well, or medicine, but it’s more concerned with lending credit to communities otherwise excluded from a stable banking institution. Something like a $20 loan could help smooth out the peaks and valleys in a 3rd world merchant’s cash-flow. How much positive impact Microfinance actually has on communities is up for debate, yet for investors it offers both financial returns along with the “feel good” factor and a diverse investment portfolio.  Opportunities in Sustainable Finance In order to achieve the Sustainable Development Goals laid about by the UN by the year 2030, there will need to be a collective investment of $6.9 trillion USD per year. Take a look at any investment firm’s portfolio and you will see the following areas as ripe for opportunity in the sustainable investment sphere: Transitioning between sources of energy production [We could include modals for these to Land, urban and rural infrastructure detail real-world examples of where investors are putting Transportation and industrial systems their money to fund these projects]  Impact Investing A term floating around in financial circles you’ll hear often is Impact Investing, or “socially conscious investing.” It’s a way for investors to make “any meaningful change in the [world], due to specific actions and behavioral changes by individuals, communities, or society as a whole.” The term was coined by the Rockefeller foundation in 2007, who define impact investing as “investing made with the intention to generate positive, measurable social ad environmental impact alongside a financial return..” Don’t confuse Impact investments with grants or charities! Any financial institution has a fiduciary duty in not throwing money at a problem for the sake of a soothed conscience, but affecting a financial benefit for the investor. The two aspects of impact investing are: Measurement Intention Securities and/or firms must offer to Achieve financial returns along investors some form of measurable with positive ESG impact. impact, both financial and ESG related. Types of Impact Investors Impact First Typically charitable foundations, prioritize environmental impact over financial returns… “concessionary capital” Impact and Return Place equal priority on impact versus return Return-First Focused primarily on financial returns but seek impact as a “nice to have” for their portfolios.  Sustainable Finance Organizations and Frameworks The “leading proponent of responsible investment” working to “understand the investment implications of ESG factors” and “support its international network of investor signatories in incorporating these factors into their investment and ownership decisions.” Serves as a “common baseline” and management framework as well as “a financial industry benchmark for determining, assessing and managing environmental and social risk in projects” Sustainable Finance Organizations and Frameworks The B stands for “Benefit for all.” Aims to “make business a force for good.” B Lab is a non profit that offers a certification for companies that meet a strict series of transparency and sustainability criteria. A bank or other financial institution certified by B Corporation benefits from increased loyalty and trust from customers and investors, as well as an alliance with a global network of like-minded businesses. Also mentioned in the Data and Reporting chapter, the SASB helps “companies disclose relevant sustainability information to their investors…” and the “disclosure of topics and metrics that are most likely to be useful to investors.” Sustainable Finance Organizations and Frameworks Serves as a “global framework for the insurance industry to address environmental, social and governance risks and opportunities. ” “aligns the banking sector with the objectives of the UN Sustainable Development Goals” and “enables a bank to embed sustainability across all its business areas and to identify potential opportunities to make the most impact in a contributing to a sustainable world.” Long-Term Investors are ESG Investors The increasing number of signatories to the UN Principles for Responsible Investing shows that asset owners and investment managers are increasingly adopting sustainable investing. Demand from asset owners is rising Globally, asset owners, including pension funds and insurance companies, are leading the way by adopting ESG integration strategies for their entire portfolios. Altogether, these asset owners hold $65 trillion or about 35% of the world’s financial assets. are seen as increasingly ESG indicators material. When a growing percentage of a company’s market value can be attributed to intangible assets, mainstream investors are increasingly looking at ESG performance. Focus on Material Issues over Donations In order to attract investors, drive performance, and remain competitive, modern-day companies should focus on material issues relevant to their industry or business, not only to avoid accusations of greenwashing, but also to please ESG-conscious shareholders while at the same time returning a profit. It’s Worth Noting E.g., Coca-Cola highlighting its own material issues of water-usage and plastic waste, taking responsibility The term double materiality and offering solutions to them is much more effective encompasses concerns of than putting money into an adjacent initiative. both financial and non- financial nature. Contemporary investors, both individual and firm-level, recognize companies’ efforts towards material action over donation. Wise business-leaders are keen to this, and see the “forest for the trees,” and are making the tough decisions to invest more money in their own industries’ problem areas.  ESG Data Providers (1 / 3) Investors and business leaders alike will want to be familiar with and have a (costly) subscription to at least one of these ESG Data Providers. These providers are the gatekeepers when it comes to a company being perceived as fresh and green, or old and rusty by potential investors. Each data provider has its own metrics and methodology for how a company is scored. A common criticism against these providers (and sustainable finance in general) is there’s no set “standard” for how a company is scored. E.g., Morningstar uses a 1 – 5 “globe” system, whereas MSCI rates a company from AAA to CCC. As a result, a single company might score “high” with one provider, but only “average” with another.  ESG Data Providers (2 / 3) The well-known global business and financial information provider has added an ESG tab to their Bloomberg terminals. Bloomberg sources their own proprietary ESG data, as well as from other data providers, on over 11,500 companies in more than 80 countries. Bloomberg terminals are already widely used by professional and personal investors the world over, so having ESG data integrated directly into the user interface makes them a first choice for assessing ESG scores for various companies. Another key player in ESG data sourcing, Morningstar’s interface is user-friendly to laypeople but still comprehensive enough for professional use. Morningstar integrates ESG data along with their in- depth financial analysis tools, giving a good picture of a company’s financial and non-financial performance.  ESG Data Providers (3 / 3) Sourced by Bloomberg, MSCI offers their own scoring and data collection methodologies that are geared more towards professional investors, such as institutional investors, asset managers, and companies looking to benchmark their ESG performance against industry peers. A software package that offers robust features at a more affordable cost than a Bloomberg terminal. FactSet excels at equity and portfolio analysis, including ESG metrics. Sustainalytics “helps investors identify and understand financially material ESG risks at the security and portfolio level.” It emphasizes SME insights that go beyond traditional quantitative metrics.  The Importance of ESG Rankings Investors are no longer asking “if” ESG scores are part of their investment strategy, but “how” and “where.” Your company’s ESG Ranking in its region’s index is of crucial importance for its investment potential. The S&P 500 ESG Index is a key benchmark for ESG- ranked companies, with the Eurostoxx as its European counterpart. Both indexes function like their traditional counterparts, except with the removal of any “high- carbon” companies, or those with potentially stranded assets, and then ranks them according to the main ESG data providers. These scores are derived from over 450 data points, such as energy use, emissions, waste types, employee relations, and governance practices. Challenges to Sustainable Investing Sustainable Investing is not without its critics. Tariq Fancy, the former Chief Investment Officer for Sustainability with BlackRock Inc., in his series of essays, The Secret Diary of a Sustainable Investor questions if it’s actually a good idea to rely on private interests, driven by profit, to reign in their operations in the name of sustainability. Tariq likens corporations to a basketball team. A basketball team is meant to score as many points as possible, while still playing within the rules. If members of the team happen to cause harm to spectators, or damage the court, then regulators and organizers need to step in to restrict the chance of that happening. It’s folly to expect the team to play ‘worse,’ yet still within the rules. The overall point being: we need government and regulation to balance against private interests. We cannot expect private interests to regulate themselves.  Challenges to SF: Danone CEO Ousted Case in point for why it’s necessary for your shareholders to be aligned with your values and mission statement: in 2021 the shareholders of the French multinational food company Danone ousted CEO Emmanuel Faber, known champion for sustainable business practices. From the shareholders point of view, Faber’s push for ESG initiatives and realignment of company standards ate into sales and revenue. While you won’t find many CEOs ousted in this fashion, it still stands to highlight one of the core problems brought up by Tariq Fancy: private interests are first and foremost in it for growth and profit, and when sustainability gets in the way of that, corners, or people, will be cut.  Key Takeaways Stranded Assets are goods or services that are obsolete, uneconomical, or non- productive. Cigarettes are a good example of this, having become far less popular among younger people, forcing tobacco companies to adapt or die. For many shareholders, when the rubber meets the road, short term profit unfortunately supplants sustainable practices. The different sources of ESG data providers all have their own sorting algorithms and scoring criteria. This leads to a range of different ESG scores for a single company. This doesn’t stop these scores from being very important for a company’s investment potential. The Sustainable Finance Action Plan is the EU’s methodology for driving investment into more “green” companies, and the EU Taxonomy helps define what “green” actually means. There are a range of “green” financial products that are becoming more popular for investors in the past few years that range from green mortgages to low carbon ETFs. Challenges abound for Sustainable Finance: we are more concerned with the consequences of climate change but not the solutions. The status quo is hard to change, despite existential crises.  References Ditlev-Simonsen, “Corporate Responsibility”, palgrave-mcmillan, 2022 Schoenmaker, “Principles of Sustainable Finance”, Oxford, 2019 Gutterman, “Sustainable Finance and Impact Investing” , Business Expert Press, 2021 Link: https://www.google.co.th/books/edition/Principles_of_Sustainable_Finance/zoN8D wAAQBAJ?hl=en&gbpv=1&dq=sustainable+finance&printsec=frontcover Principles of Responsible Investment, https://www.unpri.org/ “Green Financial Products and Services” - unepfi.org Fancy, The Secret Diary of a ‘Sustainable Investor’, Medium, 2021