Sustainable Finance is one of the biggest trends to hit investors in years, as the most conscientious ones, seek opportunities to do good while doing well. In this episode, Futurist Chris Crespo unpacks the good, the bad and the confusing of Sustainable Finance and the reasons for why, investing experts and illiterates alike, should care.
The following is a transcript of the video above
Today we are going to demystify the mother of all buzzwords, Sustainable Finance, what are they and how will they affect your life, regardless of whether you are investor or not.
Unless you’ve been hiding in a bunker at the bottom of the ocean for the past several years, chances are you would have heard about Sustainable Investments. This is a huge trend in financial services, but unless you are an avid investor, the details of it may have probably just gone over your head. However, in the not so distant future, this trend could impact what you eat, what you wear and what you drive, so don’t go away yet.
I went through a ton of research and newspaper and magazine articles to find out more about Sustainable Finance and it is a bit of a mess.
As it is often the case with financial information, the literature is filled with jargon and buzzwords, that create a lot of confusion and ambiguity. In today’s episode I will try to break this down for you as I would have liked it to be broken down for me in a simple and easy way to understand.
Let’s start at the most basic level. Let’s say that after covering your main necessities of food, housing and entertainment you are left with a little bit of extra money.
You may choose to get that money to work for you as a way of growing your wealth. For this, there’s a number of things you may choose to do. You may choose to head down to your local betting shop and gamble it, you may choose put it in a saving’s account and receive a minuscule interest on it, or you may choose to invest it in the various capital markets which is where you would go to buy stocks, swaps and equity. All of which represent different ways of investing in companies.
Investors with experience follow different strategies to diversify their portfolios. But essentially these strategies try to distribute risk and maximise returns.
But, occasionally, investors also have a conscience and many have historically chosen to place their money on companies that align with their values. A good example may be investors who decide that they will not put their money on companies that manufacture weapons, tobacco or alcohol regardless of how profitable they may be.
Now over the past ten years the collective consciousness of investors has expanded beyond vices and war towards a broader picture of how their investments may impact society at large.
And this is basically what Sustainable Finance is all about. It’s a type of investment in which an investor considers other factors beyond profit, typically grouped as Environmental, Social and Corporate Governance, or ESG.
Sustainable investing has has become very popular, especially amongst millennials and impact investors who prefer to put their money into companies that not only don’t conflict with their values, but that actually drive positive change.
The market has been quick to respond to the rise in demand for sustainable investments, and professional analysts or investment fund managers swiftly started giving ESG scores to investment products like stocks, exchange-traded funds (ETFs), and mutual funds. An ESG score is essentially a number that gives a quick snapshot of how sustainable an investment is.
Think of it as the label you find in all packaged foods. It is there to provide you with information regarding the nutritional composition of your food, and to help you make more informed choices on what you buy.
So let’s have a quick look at what the ESG categories typically look at.
1. The Environmental dimension typically looks at criteria related to the impact a company has on the environment. This could be its carbon footprint, the way it manages waste or its use of clean energy and technology.
2. The social dimension refers to the impact a company or a fund has on social criteria. This includes things like a company’s labor relations, but also the well-being of its employees, and members of its community at large.
3. The Governance dimension deals with how a company’s management drives positive change. It takes into consideration the quality of a company’s management, as well as the overall transparency and disclosure of its interests and even corporate political contributions.
The trend has now hit mainstream investment. According to Bloomberg, the size of global investment in sustainability could reach $54 trillion US by 2025, which would be equivalent to one third of all assets under management, witch is the total market value of the investments handled by a third party on behalf of investors.
So what is important to know about this?
Well, Sustainability as a framework for guiding decisions and encouraging responsible business practices sounds great right? And it is, for the most part, but as with all things, the devil is in the detail.
To understand the main challenges or contention points regarding sustainable investments we will look at the two most regular concerns expressed by Investors, Investment Fund Managers and Executives; namely, the issue of Greenwashing and the Tradeoff between Profit and Sustainability.
According to a survey done by Responsible Investor the words that investors would like to see disappear from the lexicon of sustainable finance were ESG and the phrase “Doing well by doing good”, which is often mentioned in the ongoing debate around tradeoffs between ESG investments and profits.
An article published by Critical Resource says that looseness and subjectivity around what “doing good” means, is starting to put investors off. And this is because it’s not clear who should define what doing good is or how to compare different types of good that may conflict with each other.
In the absence of agreed standards, some funds use highly sophisticated methods to determine what good means, while others rely more on virtue signalling to paint companies to be more sustainable than they really are.
In addition to this, the ESG data is at best highly imperfect, and at worse downright misleading. And this is because the data is often put together, with little due diligence, from from public information like news articles and a company’s own sustainability reports. And we all know how reliable the media and self reported assessments are, right?
Unfortunately, this causes a lot of confusion for investors as it is very difficult to say with certainty if an investment actually has a sustainable impact. It also makes it easy for some companies to hide unsustainable practices from the public through a type of corporate misbehaviour known as greenwashing.
One paper published by a group of Swiss, German and French researchers in the Journal of Business Research, calls greenwashing it as it is: lies, misconduct and misleading communication.
The paper identified 4 actual types of greenwashing that go from falsifying information, all they way to deceiving and manipulating investors.
According to the Wall Street Journal, in many cases, existing funds are just cynically rebranded as “green” to attract more investement — without evidence of any changes in the fund composition or its investment strategy whatesoever.
Another article by Bloomberg shows that in other cases, ESG labeled products contain large polluters like “fast fashion” manufacturing to boost the fund’s performance.
Companies like H&M, Zara ad Uniqulo are some of the companies in Fast Fashion that have been caught greenwashing.
Brands in this category have a habit of over-advertising its green initiatives, even though they are often limited to only a particular line of clothes which represents a tiny fraction of their production.
Other examples of companies who have been caught greenwashing include Volkswagen who admitted to cheating it’s ESG reports in 2015, British Petroleum now called Beyond Petroleum, and even Ikea, which has always been considered a beacon of sustainability was linked to illegal logging activities in Ukraine in 2020.
Regulators are trying to address the problem of greenwashing through regulation.
In Europe, attempts to define sustainable finance standards have lead to the creation of not, one, not two, but three different and sometimes overlapping pieces of regulation
- The first of this is the Sustainable Finance Disclosure Regulation (SFDR). which mandates that financial market participants disclose ESG obligations. The first part of this regulation went into effect on March 10, 2021. However a more detail set of disclosure requirements is set to go into effect on the 1st of January 20222.
- The second piece of regulation is defined in the Non-Financial Reporting Directive or (NFRD), which applies to large European listed companies. This regulation requires companies to publish reports on the policies they implement in relation to Environmental Protection, Social Responsibility, and a other European imposed quotas on diversity
- The last piece of regulation, at least for now, is the EU Taxonomy for Sustainable Activities which requires companies and asset managers to report the percentage of their turnover, aligned with categories within the EU Taxonomy
While the efforts to standardise are welcomed by some, there is also broad concern that all this regulation is adding an additional layer of bureaucracy which far from bringing clarity and transparency to investors, is creating more ambiguity and complexity.
But all this brings us to our second challenge which is, Does a higher ESG score translate into doing more good?
According to Forbes More and more industry participants now recognise that some ESG factors are in fact economic factors which in the long term can impact the financial performance of a company. Things like access to raw materials, the prospect of future higher taxation on energy consumption, access to the labor market and even the company’s reputation, could have a very real impact on a company’s bottom-line.
I think the change in behaviour we have seen in the market over the past 10 years show’s clearly that many investors want to do good with their investments. In fact a survey done by Morgan Stanley showed that 85% of individual investors and 95% of millennials are interested in sustainable investing. However, at the same time 64% agreed that investors must chose between making money and being sustainable, implying that sustainability and profit require a tradeoff.
And here is where things get really confusing, because anyone wishing to find out whether there is indeed a tradeoff between sustainable investments and profits will be inundated with an endless list of articles referencing recent studies that show a strong correlation between between the two. And just as many others suggesting that the correlation may be more casual and does not alway hold true.
The problem that investors now face is that with all the ambiguity and subjectivity in defining sustainable investments and measuring their real impact, how can studies show with any degree of certainty that there is in fact a strong correlation between sustainability and profit.
To avoid overselling both the impact and the gains of sustainable investment and disappointing enthusiastic investors in the process, I think it is sensible to adopt a more cautious and balanced stance.
A credible claim could be made on the fact that fund managers do agree that good ESG performance can reinforce trust between a company, governments, customers, and employees.
At best, good corporate ESG performance is a useful proxy for good business and responsible management of a firm’s fiduciary responsibilities. But we need to realise that as reported recently by Critical Resource, “even with decent ESG data, it would require a rare degree of technical insight and predictive brilliance to pinpoint consistently where value may be created and destroyed due to ESG issues.”
If we think of investors as consumers of investment products in the capital market, it’s great to provide them with more options and more information that can help them inform their decisions with more clarity.
How investors are to judge between tradeoffs of ESG categories where companies may favour social over environmental or governance over social is still unclear. Should an investor prioritise investing in a company that creates a lot of good jobs in a poor region, but at the expense of environmental damage. Or should they chose over one that preserves the environment by removing jobs through automation is probably a topic for another episode.