Sustainable Finance
Sustainable investing is experiencing rapid growth, as investors are drawn to sustainability approaches for two key reasons:
1. Risk
The concept of risk-return trade-off in finance dictates that potential returns increase with heightened risk. In simpler terms, lower uncertainty typically correlates with lower potential returns, while higher uncertainty or risk often yields greater potential returns. For quite some time, risk mitigation has been the primary driver behind the use of Environmental, Social, and Governance (ESG) criteria. Policies and shifts in consumer sentiments enable investors to safeguard their investments in an evolving world that is increasingly focused on sustainability.
By utilizing ESG criteria, investors ensure that companies adapt to evolving market conditions and enhance their performance. With numerous governments implementing sustainability policies, and sustainability becoming good business practice in many instances (such as energy efficiency initiatives leading to substantial cost savings), it is imperative for companies to prioritize sustainability to maintain financial viability.
Large funds have divested from coal, despite it being one of the cheapest methods for electricity production and thus profitable. However, investors have witnessed coal being phased out globally due to policy changes. Consequently, they mitigate the risk of investment loss by avoiding the coal sector and instead investing in energy companies with comprehensive strategies, which may involve various energy sources or credible transition plans towards green energy. Another example is fast fashion, where consumers are increasingly concerned about working conditions and environmental impacts. Investing in big coal companies could pose a risk to their survival in the future. In essence, effectively managing these social and environmental risks is becoming increasingly crucial to ensuring expected returns on investments.
2. Opportunity
Investors recognize the Sustainable Development Goals (SDGs) as a roadmap for the future of markets. They are strategically investing in companies aligned with these goals to future-proof their portfolios. Many investors view frameworks such as the SDGs, along with shifting customer sentiments and growing awareness, as indicators that the future of most industries extends beyond risk mitigation. Instead, it involves investing in forward-thinking business models that may not yield immediate profitability but are poised for future success.
Moreover, companies are increasingly demanding that their investments have a positive impact, driving the demand for sustainable financial products. Financial institutions and private investors should respond to this demand by developing the capacity to provide companies with solutions that align with their evolving needs.
What distinguishes ESG from an impact perspective on investment?
In general terms, both ESG and impact considerations encompass environmental and social dimensions. ESG focuses on how a company conducts its operations, while impact evaluates the tangible effects of a company's actions on the world. While an investor might rate a company highly on an ESG scale by considering these factors comprehensively, an impact assessment delves deeper to analyze the actual societal implications of the company's activities.
For many businesses, ESG serves as an initial step, with genuine impact being the ultimate objective. Assessing impact is highly intricate. Consider, for instance, a renewable energy company like a wind power producer. On the surface, investors may view their societal impact as positive due to the generation of carbon-free energy. However, the production of wind turbines requires substantial amounts of steel and occupies significant land or water space. If the company fails to consider ESG factors in its operations—such as the sustainability of steel production, recycling methods for turbines, or mitigation measures for land and water ecosystems impacted by the turbines—it may inadvertently create additional environmental challenges.
Always scrutinize where investors allocate their funds. Even if a fund or product is labeled as sustainable, it may not necessarily align with your specific needs and values. Ensure that investor are well-informed about their investments. Simply having a label does not guarantee that it meets your individual sustainability standards.
Government bonds represent a very low-risk investment, whereas investing in a start-up company carries significant risk. For example, purchasing a government bond with a modest return of 1 or 2% provides a high level of assurance in receiving the promised returns, given the credibility of government backing. Conversely, investing in a start-up company entails the potential for substantial success or failure. While the risk of failure is high, successful ventures offer the prospect of significant rewards.
Sustainable or socially responsible investment
Sustainable or socially responsible investments prioritize not only financial returns but also consider environmental, social, and governance (ESG) factors, as well as the societal impact of investments. It's important to note that sustainable investment is a broad term encompassing various strategies and approaches.
These strategies range from the most asset-intensive/least sustainable intensity under management globally to the least asset-intensive/most sustainable intensity level:
Exclusion Investment: it involves screening based on ethical considerations, where investors build portfolios by excluding companies engaged in non-ethical businesses. For instance, investors may refrain from investing in tobacco companies due to health concerns or coal companies due to pollution issues.
Engagement Investment: it entails acquiring shares in a company with the aim of influencing its behavior, policies, or practices. For example, an investor might purchase shares in an oil and gas company to advocate for increased emissions disclosure or a shift towards a more diversified strategy, including renewable energy.
ESG Compliant Investment: it integrates Environmental, Social, and Governance (ESG) factors into investment decisions. Environmental criteria assess a company's stewardship of nature and resources, social criteria evaluate how a company manages relationships with employees, suppliers, customers, and communities, while governance criteria examine aspects such as leadership structure, executive compensation, audits, internal controls, and stakeholder rights. Investors select companies meeting specific performance thresholds on one or more of these criteria.
Norm-Based Screening Investment: it involves excluding companies that violate globally established norms, such as human rights agreements or the Paris Climate Agreement.
Best-in-Class Investment: it entails selecting companies performing exceptionally well on relevant ESG issues, either overall or within specific industries. Investors might screen companies on sustainability indices and choose top performers based on factors like environmental emissions and social gender equality.
Sustainable Themed Investment: it involve investing in companies pursuing sustainable development objectives, such as funds focusing on themes like plastic and organic waste management or renewable energy technology development.
Impact Investment: it represents the most intense form of sustainable investing, driven by the desire to generate positive social and environmental impacts alongside financial returns. These investments target a range of returns and are made in both emerging and developed markets. A key feature of impact investing is the commitment of companies to measure and report their environmental and social performance, enhancing transparency and accountability in underlying investments.
