What is sustainable finance?

Updated in 2023: Sustainable finance 101

Transcript

Once upon a time, investing was all about making as much money as possible. Fund managers would pick investments that gave them the greatest return. Fossil fuels, weapons, tobacco – these were all fair game.

But the rules of the game are changing. Take climate change, for example. A recent report from the United Nations warns that the planet is on track to heat up by over 3 degrees Celsius by the year 2100. This poses major risks to many investments. Some assets could suffer damage from extreme weather and rising sea levels, while others could lose value as the world transitions to a low-carbon economy.

That’s where sustainable finance comes in. Investors, fund managers and financial authorities are increasingly aware of these risks and looking at ways to start accounting for them.

So, in this episode of Landscape TV, we’ll explore what sustainable finance is, how it works, and why it matters more than ever before.

So, what is sustainable finance? Also referred to as green finance or ESG finance, sustainable finance means making investment decisions that consider social and environmental impacts rather than just financial returns.

According to the European Union, sustainable finance not only promotes economic growth but also considers what’s known as ESG, which stands for environmental, social and governance factors.

Environmental factors include things like greenhouse gas emissions, biodiversity loss, pollution and water consumption. Social factors include human rights, inequality, labor relations and health and safety.

And lastly, it’s also important to consider corporate governance factors like executive pay, transparency, board independence and shareholder rights. These ESG factors differentiate sustainable finance from regular finance.

Sustainable finance is a pretty recent phenomenon. The world’s first green bond was only issued in 2007. But the sector has grown swiftly ever since: In 2020, a record $554 billion in sustainable bonds were issued across the globe, over double the amount issued in 2019. And as the COVID-19 pandemic shakes up the global economy, many financial experts believe sustainable investing is becoming the new normal.

But now, let’s take a step back: why do we need sustainable finance in the first place?

Well, for one thing, the planet is now hotter than it’s been for at least 12,000 years. Almost half a million people have died in climate-related natural disasters in the last 20 years, and last year’s worst climate disasters caused at least $150 billion worth of damage. But climate change isn’t the only environmental crisis we’re facing.

The Earth is also going through a mass extinction that could wipe out more than a million species in the coming decades, and this biodiversity loss is already proving costly for humans.

That’s because healthy ecosystems provide the basic necessities for human survival: things like food, clean water, energy and carbon sequestration. These ecosystem services contribute most of the world’s GDP, yet 39 countries are at risk of losing them through ecological collapse.

The good news is that we can easily combat both climate change and biodiversity loss by restoring our planet’s ecosystems. The bad news? We’re not spending nearly enough on tackling these issues. Humanity will need to spend an extra $600-800 billion per year to reverse biodiversity loss by 2030.

On top of that, it would cost another USD 2.5 to 3 trillion per year to achieve all of the Sustainable Development Goals. So, how exactly can sustainable finance help plug these massive gaps in funding?

First, let’s take a closer look at who provides these funds. There are six main groups of sustainable financiers: banks, corporations, institutional investors, central banks, international financial institutions, and green funds.

Of course, we can’t talk about finance without mentioning banks. The banking system holds a huge amount of financial resources that can be mobilized for green investments.

Corporations are some of the largest investors in climate and other green projects, mainly through corporate social responsibility initiatives and green bonds.

Institutional investors include pension funds, sovereign wealth funds and insurance companies.

Central banks can provide public funding for green investments. They can do this through quantitative easing, which means injecting money into the economy, which can then be channeled towards sustainable projects. Central banks are also responsible for setting financial regulations. For instance, they can deter investors away from fossil fuels by setting high capital requirements.

International financial institutions, or IFIs, are multinational entities that provide financing at the regional or global level. Some examples of global IFIs are the World Bank and the International Monetary Fund, while regional IFIs include the European Investment Bank, the Asian Development Bank and the African Development Bank. IFIs can help scale up green investments by issuing green bonds, testing new financing methods, and influencing policymakers to give more support for green projects.

Lastly, green funds are multilateral funds that provide financing to address climate change, biodiversity loss and other environmental issues.

A special mention goes to the Luxembourg Green Exchange, which is the world’s first and leading platform for green bonds and other sustainable investments, and part of the Luxembourg Stock Exchange.

But how exactly do investors determine which potential investments are in line with their values? One of the main ways is by integrating ESG criteria into investment decisions. For instance, a less polluting company may be given preference over a more polluting one.

Another way is to exclude certain investments from a portfolio, which is known as ESG screening. There are three types of screening: negative screening, positive screening, and norms-based screening. Negative screening means not investing in sectors or companies that perform poorly on ESG, which usually includes things that are socially or environmentally harmful, like fossil fuels, tobacco and gambling.

On the other hand, positive screening means only investing in sectors and companies that perform well on ESG. Between these two extremes, there’s also norms-based screening. Rather than only investing in the best ESG performers or excluding the very worst performers, norms-based screening involves screening investments against international standards. These include alignment with corporate recommendations like the United Nations Global Compact, or social and environmental frameworks like the Paris Agreement and the Universal Declaration on Human Rights.

Lastly, at the very top of the pyramid, we have impact investing, which not only accounts for ESG but specifically aims to solve social or environmental problems. Examples of impact investing include combating poverty by funding projects in underserved communities, or investing in sectors that have a positive environmental impact, like clean energy and sustainable agriculture.

So now, how does the money get to these sustainable investments?

Just like traditional investing, green financing can take two forms: debt and equity.

In debt financing, investors lend money to borrowers in the form of loans or bonds, and that money is later repaid with interest. In equity financing, investors are given stocks and shares in the project and can receive dividends in return for the capital they invested.

Equity investments can offer higher potential returns than debt investments, but they also tend to be riskier. Stock prices can fluctuate, and if the project goes bankrupt, investors can end up losing their entire stake.

That’s where IFIs and green funds come in. It’s important to note that not all stock and debt is treated equally. In the event that the project goes bankrupt or gets liquidated, there’s a strict hierarchy in terms of which shareholders and debtors get repaid first. Most private investors want to be close to the top to make sure they get their money back.

So, what green funds and impact investors can do is put themselves at the bottom of the hierarchy by buying up the lowest-ranked stock and debt. That means they get repaid last if things go wrong. By absorbing that risk, they can make the project more attractive to other investors.

Another common way to manage risk is taking out a guaranteed loan. So if the project can’t pay off its debts, a third-party guarantor, like a central bank or the World Bank, steps in to repay the investors. So that also drastically reduces the risk of investing in the project.

Thanks to all of these mechanisms, the field of sustainable finance is growing rapidly. Sustainable investments were once seen as very risky since prioritizing ESG can potentially mean lower returns. But that perception is now changing. A recent study by Morningstar found that sustainable funds have actually outperformed traditional funds over the last 10 years, including during the COVID-19 pandemic.

Investors are starting to recognize these benefits, too. For instance, in 2020, Norwegian asset manager Storebrand divested from several oil and mining companies for lobbying against climate action.

But on the other hand, banks are still lending trillions of dollars to industries that contribute to climate change and biodiversity loss, like fossil fuels, mining and agribusiness. And there are still major questions over what we mean by a sustainable investment. There’s still no universally accepted measure of ESG and no independent auditors to make sure that companies aren’t simply greenwashing their investments.

Overall, sustainable finance needs to move beyond just negative screening, and a lot more money needs to be going toward truly green investments like sustainable land use, biodiversity, and renewable energy.

So, there’s still a long way to go for sustainable finance, but the foundations are there for it to reach its full potential.

What do you think the future holds for sustainable finance? Let us know in the comments below. And if you enjoyed this video, please remember to hit that like button and subscribe to our channel for more content from the Global Landscapes Forum.

Thank you for watching, and we’ll see you next time.