Sustainable finance refers to a school of thought that takes into consideration Environmental, Social, and Governance factors while making financial investments. Sustainable finance is a fairly new metric that is being utilised by investors when it comes to making financial decisions and has emerged in response to a global economy growing more and more aware of the kind of world they want to live in. In 2021, $859 billion in sustainable investments was taken in by global companies and this number is predicted to grow to greater than $53 trillion by 2025.
(Source : https://www.weforum.org/agenda/2022/01/what-is-sustainable-finance/)
● Environmental considerations: This consists of factors such as preservation of the environment, prevention of pollution, climate change etc. For instance, an investor may choose not to invest in a company due to the fact that the company has been linked with significant carbon emissions.
● Social Considerations: Social considerations consist of human rights issues, inequality, racism, etc. These considerations include choosing not to invest in a company because the company's founder or vision is racist or the company gets it’s products manufactured by workers in sweat lodges.
● Governance Considerations: This factor consists of matters such as management structures, compensation practices for the employees etc. For instance, choosing not to invest in a corporation since it underpays it’s employees.
In the past, investment decisions were primarily made on the basis of profit considerations, sustainable finance is vastly different from that. In sustainable finance, one recognizes the kind of impact investing in a company can have and attempts to utilise it to push the world in a more conscionable direction.
Importance of Sustainable Finance
The financial sector holds an immense amount of power and influence. Sustainable finance, as stated earlier, recognizes this and attempts to use it for the overall betterment of society. This is done in two ways:
1. It gives an incentive to companies to be more socially, environmentally and governance conscious. If companies and corporations notice that more and more investors are choosing to primarily invest in companies that take into consideration environmental, social and governmental factors, it pushes them to value such factors and consider them while making business decisions.
2. It is painfully apparent the kind of impact that investments in companies and major corporations have in today’s world. They influence major aspects of the society as well as everyday aspects of our lives. Similarly, the companies that we, as individuals invest in today, that we help grow today, are bound to impact our future majorly. Hence, investing in companies that consciously make ESG decisions, is akin to giving power in the hands of players who are likely to help change the future world into a better place.
The European Union strongly supports sustainable finance, and the Green Deal by the EU was created on the same principles. The Green Deal intends to direct private investments into carbon-neutral projects. As per the EU, the financial sector plays a key role in contributing to the creation of a low-carbon, climate resilient and circular economy. (Source -https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/overview-sustainable-finance_en)
Advantages of Sustainable Finance for Investors
Apart from making the world a better place, studies show that sustainable corporations tend to provide higher returns to investors. A study conducted by BlackRock found that 81% of a globally-representative selection of sustainable indexes outperform their parent benchmarks and companies with better ESG profiles are performing better than their peers, enjoying a “sustainability premium”.(Source - https://www.blackrock.com/us/financial-professionals/insights/sustainability-letter). According to PWC, 49% of all consumers and 66% of millennials use the internet to learn more about a company’s ESG practices before buying a product or service. The younger the generation, the more worried buyers are about ESG standards and thus businesses should keep this in mind in order to protect their market share and brand positioning. (Source - https://research.aimultiple.com/benefits-of-esg-reporting/)
There are two primary reasons why ESG companies are outperforming their counterparts.
● The first reason is companies that put more effort into ESG standards are more appealing to young professionals and have 14% higher employee satisfaction rates. Attracting and retaining outstanding employees is a significant competitive advantage for a firm because it is rare, difficult to imitate and extremely valuable. A strong ESG proposition can help companies engage with quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. Employee satisfaction is positively correlated with shareholder returns.
● The second reason is that ESG companies tend to have a positive public image associated with them. This, paired with the strong customer base, makes ESG companies a preferable choice when it comes to giving contracts. In other words, due to the above mentioned reasons, ESG companies have an easier time landing contracts in relation to their counterparts. A study by McKinsey also showed that ESG companies tend to have less regulation, save costs by utilising fewer resources and avoid losing money on old processes that were carbon-intensive, and tend to also retain the best employees due to their existing value system.
Current issues with Sustainable Finance:
Sustainable finance is becoming more and more popular, but it's still at a nascent stage. There are still a few kinks that need to be worked out before sustainable finance can truly take off, some of which are listed below:
● Since sustainable finance is fairly new, the talent pool within ESG companies is still quite limited. Hence, even if investors want to employ sustainable finance, their pick is limited.
● There are no well-defined benchmarks for ESG investing and sustainable finance. Different values matter to different people, hence without a set metric, it's difficult to fairly evaluate if an investment is indeed a part of sustainable financing, for investors as well as companies.
● Identifying ESG companies in the current scenario is easier said than done. There is no specific universal body presently that evaluates whether a company is ESG conscious or not. To identify an ESG company, investors need to personally research them and use their metrics. Sustainability principles vary from place to place.There are many different initiatives currently underway to consolidate existing sustainability principles, however, due to a large number of such initiatives, the area is ripe with confusion. The main issue this causes is checking the validity of the company’s claims when they declare to be sustainable. Currently, the International Sustainability Standards Board has been set up by the International Financial Reporting Standards Foundation to tackle this exact issue. The board is going to come up with new and effective rules that can be used to evaluate and validate sustainability claims by companies and corporations.
Authored By: Jitesh Agarwal, Co-Founder, Treelife Consulting