The Basics of Sustainable Finance

Written By Kali Taylor

Overview

Finance is the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting (Investopedia). To simplify things, I am going to focus on investment, which is the process of putting money into or purchasing an asset in hopes of it generating income or appreciation in value (Investopedia).   

Investment is ultimately about understanding and managing risk vs. return.  There is a principle in finance referred to as the risk-return trade off that states “potential return rises with an increase in risk” (Investopedia). In other words, where there are low levels of uncertainty there will likely be low potential returns, and higher levels of uncertainty or risk will be associated with with high potential returns.  The key word here is potential as there are no guarantees on any investment.  

Sustainable Investment or Socially Responsible Investment (SRI) are investments that not only seek to make financial return but also take into account environmental, social and governance factors or the impact an investment will have on society.

Categories of Sustainable Investment

A crucial thing to remember is that sustainable investment is a blanket term that includes a wide range of investment strategies and approaches, with differing degrees of rigour. This is why the term can get a little confusing. Many things are labelled sustainable investing even though the exact approaches taken can vary widely. Eurosif (European Sustainable and Responsible Investment association) breaks sustainable investment into 7 main categories. These are listed below in order of importance based on Assets Under Management (amount of money invested according to that strategy).

  • EXCLUSION - screening based on ethical considerations

    • Example: screening out any companies that engage in selling arms, tobacco, or oil and gas

  • ENGAGEMENT -  acquisition of shares with the intention of changing its behaviour, policies or practices

    • Example: shareholder action on oil and gas companies pushing for more disclosure of emissions, or pursuit of more diversified strategies in renewable energy, etc.

  • ESG COMPLIANT INVESTMENT - integration of ESG factors into investment decisions

    • Environmental criteria consider how a company performs as a steward of nature.

    • Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates.

    • Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights

    • Example: only investing in companies that meet certain thresholds of performance on these factors.

  • NORMS-BASED SCREENING - exclusion of companies that aren’t practicing globally established norms

    • Example: eliminating companies that do not align to the UN Declaration of Human Rights, conventions of the International Labour Organization on workers rights, the Paris Climate Accord, or the UN Global Compact. 

  • BEST IN CLASS - selecting companies that are performing particularly well on relevant ESG issues either in general or within an industry

    • Example: an investor screening a large number of companies (say the Dow Jones Sustainability Index) and choosing the top performers on certain environmental and social factors, for example gender or emissions intensity.

  • SUSTAINABILITY-THEMED INVESTMENT - investment in companies that pursue some sort of sustainable development objective

    • Example: funds on specific sustainability themes such as women empowerment, renewable energy, education, etc.

  • IMPACT INVESTMENT

The Global Impact Investment Network (The GIIN) defines impact investment as:

Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Impact investments can be made in both emerging and developed markets, and target a range of returns from below market to market rate, depending on investors' strategic goals.

The growing impact investment market provides capital to address the world’s most pressing challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services including housing, healthcare, and education.

A hallmark of impact investing is the commitment of the investor to measure and report the social and environmental performance and progress of underlying investments, ensuring transparency and accountability while informing the practice of impact investing and building the field.

Risk vs. Opportunity

Why do investors take sustainability approaches? Two answers… risk and opportunity. Risk mitigation has been the primary motivation of using ESG criteria for quite some time. Investors can use ESG as a way to ensure that companies are adapting to changing market conditions and improving their performance. With more and more governments implementing sustainability policy and some sustainability strategies also being good business (like energy efficiency which is a cost saver), it is increasingly important that companies are considering sustainability in order to remain viable. For example, many large funds have divested from coal. Coal is still one of the cheapest ways to produce electricity meaning it is profitable but investors have seen how coal has been phased out in many countries due to policy and therefore mitigate the risk of losing their investments by just avoiding the sector all together, or by investing in energy companies that have a more holistic strategy that includes a portfolio of different types of energy or a credible transition plan.

The opportunity side is slightly different. Many investors see frameworks like SDGs and changing consumer sentiments as the future. For them, it goes beyond just mitigating risk and into investing in the businesses of the future, in areas that may not be as lucrative at the moment but will be in the future. In addition, clients are increasingly demanding that their money has a positive contribution and therefore want sustainable financial products. Investors need to respond to this demand and build the capacity to ensure their clients that they have solutions that will meet their needs.

ESG vs. Impact

You might be asking yourself, what is the difference between ESG (environment, social and governance) and impact? This is a crucial distinction to make. The way I think about it is this - ESG is about HOW a company operates whereas impact is about WHAT a company is or does.

I will use tobacco as an example, if you go to a tobacco company’s website you will undoubtedly see information about their sustainability plan and performance. These strategies usually include things like ensuring there are no human rights abuses in the supply chain, doing rural development in the communities where tobacco is produced (social issues), minimizing environmental footprint such as water inputs, emissions created, packaging, etc. (environmental issues), and finally having a clear corporate structure, gender parity in the workforce, transparency in reporting, etc. (governance issues). An investor could look at these dimensions and score them high on an ESG rating. However, impact goes one step further and looks at what the company actually does and the impacts of that business on society at large. A tobacco company’s product is highly addictive and has a range of negative health impacts, so even if they manage all their ESG issues, there are still legitimate and serious questions about the company’s impact on society.

I do want to make it clear that ESG is important. As a society, we are better off if all companies are considering these factors in their business. But for me and for many others, ESG is just the first step… true impact is the goal. Now it is also important to note that determining impact is extremely complex. Think about a renewable energy company such as a wind power producer. Generally, we would think that their impact on society is positive because they are creating carbon-free energy. However, producing a wind turbine requires large amounts of steel and space in the form of land or water. If the company is not considering ESG factors in its operations like how the steel is produced or recycled when a turbine reaches the end of its useful life or how to mitigate the impacts of the turbines on land and water ecosystems, this will create other issues. So you can very much see how both ESG and Impact are important considerations.

My Advice

This has provided just a very brief and simplified overview but I want to leave you with one piece of advice. Look VERY closely at where you are putting your money. Even those something is called a sustainability fund or product, does not mean that it necessarily has the rigour that may correspond to your needs and values as a person. For example, in many large sustainability funds that are available to retail investors like you and me, the major holdings will be in tech companies. This is because tech companies have a relatively low footprint compared to (for example) resource companies. However, we know that isn’t all there is to the story. A company like Amazon often features in sustainability funds and we know there are serious concerns about employee treatment, or the overall impact of a company like Amazon on consumerism overall. It’s not simple by any means but make sure you are informed about what you are investing in - just because it has a label doesn’t necessarily mean it will meet your individual standard of sustainability.

Keep Learning

Here are a few great resources for further reading and learning:

How to Support?

With every video, I provide links to related organizations that you may or may not choose to support with your pocketbook.

  • Share Action - works to make the financial system more sustainable - Donate

  • Prime Coalition - catalytic capital for climate solutions - Donate

  • The best thing you can do to support sustainable finance is to educate yourself on where your money is invested - for example, understand where your pension fund (public or private) invests and push them to align to sustainability.

Kali Taylor
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