What precisely is the definition of sustainable finance? What about ESG? Sustainable investment? What is the difference – if any – between them all?
In an environment where solving global climate change and growing inequality has become ever more urgent, investing to make the planet a far better place is becoming increasingly popular. However, to do so requires us to grapple with a blizzard of terminology and acronyms that always seems to obscure more than they illuminate.
An alphabet soup including sustainable finance, ESG, impact investing, corporate social responsibility and green financing represents a frightening learning curve for investors and event asset managers. A number of these terms are often – wrongly – seen as interchangeable; others overlap in ways that are not always well defined.
Yet, the necessity to know this new landscape has become pressing. The Covid-19 pandemic has relieved the need for a different approach to investing – and a fresh appreciation of the risks that arise in an increasingly uncertain and unpredictable world.
The pandemic and other environmental risks should be viewed as similar in terms of impact, representing a crucial warning call for decision-makers. Moreover, the consequences of the Covid-19 crisis on the economy are vital and therefore, the economic system highlights the bounds of most forecasting models.
Defining sustainable finance and ESG
Many of the topics during this new lexicon are subsets of one another. More confusing still, the related taxonomy is wide-ranging, and there are definitions of the relevant terminology. The largest of those is ‘sustainable finance’ or ‘sustainable investing’, which, unhelpfully, are different labels for the same thing – that is, the consideration of environmental, social and governance (ESG) factors when assessing the suitability of a business, activity or fund for investment. These factors essentially trigger three questions:
- Do they really care about the environment?
- Do they really care about people?
- Are those running the enterprise ‘doing the right thing’?
The areas covered will include the following:
Environment: Energy consumption, pollution and generation of waste, use of natural resources.
Social: Human rights, community engagement, health and safety of employees et al.
Governance: Ethical conduct, transparency and disclosure, executive pay, avoiding conflicts of interest.
Various metrics are used to score a company’s performance or an ESG fund in each of those areas. While these include ethical considerations, the focus of the analysis remains financial performance.
For some institutional investors, particularly pension funds, delivering solid returns to supply beneficiaries with an adequate retirement income may be a priority that overrides ESG factors. However, their critics argue that companies ignoring such factors are susceptible to underperform over time due to their increased exposure to environmental, reputational and legal risks.
They have numbers to support their case. An analysis done by KCIC Consulting, The report on the Landscape of Climate Finance in Kenya, found that sustainable funds outperformed their traditional peers over multiple time horizons. Taking these factors under consideration – a process referred to as ESG integration – offers asset managers a broader view of a corporation or fund. But it goes no further than that and is never prescriptive. Which begs the question: What if ESG integration doesn’t go far enough?
The next step: socially responsible and impact investing.
For investors wishing to travel further, the subsequent step is Socially Responsible Investing, where a screening process selects certain companies or industries – and actively eliminates others – for a fund or investment portfolio. Elimination could also be of entire sectors, like weapons, gambling or fossil fuels, or concerning the reputation of individual companies, which could be suffering from mistreatment of employees, use of child labour or environmental damage.
Investors can also take a seemingly counterintuitive approach: investing in companies with problematic businesses to drive positive change as shareholders. Referred to as ‘active ownership’, it can bring interesting AGMs. If this doesn’t go far enough, there’s Impact Investing, sometimes called social impact investing.
Victor Ndiege, CEO of Kenya Climate Ventures, says: “Impact investing goes even further by choosing companies that are actively seeking to make tangible improvements, as an example within the quality of water for communities. Investors usually expect to take advantage of such a corporation, but its impact is going to be as important or maybe more so for the impact investor.”
And the debt market?
Like equities, debt instruments even have their place during this new landscape, primarily within the sort of green bonds. These are used to finance or refinance a selected environment-friendly project like renewable energy generation, energy efficiency within the home, or pollution-free transport.
A newer, relatively-smaller market exists for sustainability-linked bonds or loans. These aren’t tied to a selected project but are given to improve a company’s social and environmental sustainability metrics – like its greenhouse emissions, wastewater discharge or energy consumption.
The spectre of greenwashing
Inevitably, not everything runs smoothly in ESG investing. For example, Greenwashing, where companies provide a misleading impression of their ESG credentials, represents a real risk for asset managers and investors.
Some companies may conceal information or lie outright to investors about their corporate sustainability. But grey areas are a more extensive problem.
ESG investing is bringing rapid change to the asset management industry. Despite the complexity and, at times, confusion of the varied strands of sustainability, firms haven’t any choice but to stay up.