Making the Case for Sustainable Finance
Broadly defined, sustainable finance is the application of the concept of sustainable development onto the sphere of financial activity - the goal of sustainable finance is to create long-term economic value, while also providing social utility and/or promoting environmental stewardship. The idea is to address and reinforce the interconnectedness of capital markets, environmental restraints and social trends, since the critical role they play in driving market changes are often overlooked. Thus, investors are able to generate positive environmental and social benefits while achieving economic returns.
How does the concept of sustainable finance play out in the real world?
Investors looking to create a positive impact on society and the environment invest in sustainability funds made up of sustainability bonds or company equities which have passed stringent evaluation of the company or government against environmental, social and governance criteria. This kind of investment strategy is referred to as impact investing, since its goal is to generate positive impacts for society on top of making financial gains, and has become increasingly common among private and institutional investors.
The bonds and equities that investors are interested in are those that are attributed ratings and attestations by independent third parties like the Carbon Disclosure Project, Dow Jones, S&P, MSCI, Vigeo Eiris, and Sustainalytics based on the transparency of the sustainability information made available by the companies as well as their sustainability performance, placing particular emphasis on the governance of sustainability in the company and its strategic approach to sustainability. Typically, impact investors will consider the performance of an equity or bond in these sustainability ratings before deciding to invest in them.
While mainstream investors are still apprehensive of impact investing, studies have shown that the motivations that deter investors are largely unfounded. In a study published by McKinsey, which took into consideration roughly 50 impact investment cases, showed that misconceptions, such as the notion that sustainable funds provide investors lower returns, do not speak to the actual results achieved by the funds, and the social benefit of the investments were often more wide ranging than expected.
The rise of sustainable finance in the 21st Century
The European Investment Bank laid down the foundations for the Green Bonds market 10 years ago, issuing the world’s first Climate Awareness Bond (CAB). However, these sustainable finance instruments have become more prevalent following the Paris Climate Accords of 2015, in which developed economies committed to raise $100 billion USD each year by 2020 to finance climate mitigation and adaptation measures.
Since then, more than 685 green, social and sustainability bonds have been issued across the world. In 2018, green bonds alone mobilized more than $167 billion for environmental projects, a trend that financial institutions like the International Capital Market Association (ICMA) predict is likely to continue in the future, despite contractions in the global economy due to the COVID-19 pandemic.
What role do Nations play in the promotion of sustainable finance?
Many wealthy economies have developed action plans aimed at incentivising financial markets to develop these principles of sustainable finance into financial instruments, issuing sustainability bonds, green bonds, and social bonds to allocate fixed-income towards projects with positive social or environmental impacts, with the goal of facilitating the redirection of capital flow toward projects bent on developing a more sustainable economy, and promoting greater transparency and long-term vision and risk management in the private sector.
To develop a common language and framework of interpretation in emitting these financial instruments, as well as a shared means of classifying the kinds of projects that sustainability bonds may be used to finance, economic and financial institutions like the European Commission and the ICMA have published a series of guidelines for bond emitters and investors, defining what economic activities constitute a sustainable investment in the Taxonomy Technical Report, as well as establishing a common methodology for evaluating investment opportunities, relating the amount of emissions to stock and bond value.
The EU Green Bond Standard provides a series of criteria for financial institutions to follow when issuing a Green Bond, to ensure transparency and comparability of the bond stipulations. The EU Green Bond Standard (EU GBS) is a voluntary standard offered to issuers of green bonds, so that they are aligned with the leading green bond best practices in the market. The EU GBS proposes a series of components to observe when issuing a green bond, including the kinds of projects that qualify as a “Green project”, how it relates to the issuer’s investment operations and allocation and impact reports detailing how the funds will be allocated, the environmental impacts derived from the investment and the metrics used to measure them.
But how do sustainable funds perform in the market compared to traditional funds?
Despite the growing success of sustainable funds among investors, concerns about real performance still remain. Although research suggesting a positive correlation between sustainable investing and investment performance is amassing, some researchers claim that a clear connection between sustainability criteria and financial performance has not yet been established. To come to a consensus on the real financial performance of these funds in relation to traditional investment funds, Morningstar conducted an analysis of the performance of 4,900 funds over the short, medium and long terms across different investment categories, comparing average returns, success rates, and survivorship rates over 10 years for sustainable funds versus traditional funds. The study found that for each area of research, sustainable funds outperformed their traditional counterparts. In fact, sustainability indexes across most geographies outperformed conventional indexes, throughout the COVID-19 crisis, as did indexes focusing on a range of sustainable themes - testament to their resiliency to market volatility.
Thus, for investors, taking environmental and social concerns into consideration when evaluating an investment opportunity is a means of monitoring the non-financial risks that the opportunities may pose. Even for investors who are primarily focused on financial returns rather than driving sustainable change, sustainable investment opportunities tendentially provide more stability in returns than conventional counterparts resulting in better financial performance.
Through the help of public and third sectors, sustainable finance has achieved a shared interpretation by many in financial markets. Implementation of standardized interpretation of sustainability funds and the popularization of sustainability ratings allow for greater transparency and understanding on the part of investors as to what projects and stock options may actually be considered a sustainable investment. This standardization of sustainability funds and use of sustainability indices across markets help validate these investment options and build faith in investors, while through the comparison of sustainable funds to their traditional counterparts it becomes clear that they are also the more reliable investment option,thus further helping to build the case for sustainable finance.
Yet while the tools exist to drive financing toward projects with positive environmental, social and economic impacts are steadily gaining popularity among private and institutional investors, in order for these instruments to effectively help economies to reach the goals they have set for themselves during the 2015 Paris Accords, sustainable funds will need to become a more commonplace investment in the market.