“We do not inherit the Earth from our ancestors; we borrow it from our children.”
– Native American Proverb
Sustainable Investing is now a global mainstream phenomenon with the Global Sustainable Investment Alliance estimating the market at $30.7T in 2018 an increase of 34 per cent over the previous year in five major markets. IMF defines Sustainable Finance as the incorporation of environmental, social and governance (ESG) principles into business decisions, economic development and investment strategies. Today, ESG forms the core of sustainable investing complemented by impact investing and corporate social responsibility and a big social change and impact enabler. Europe accounts the lion’s share of sustainable investing with assets at $14T followed by the US at $12T and Japan $2.2T. The most substantial increase between 2016 and 2018 is in Japan, which grew by 300 per cent.
Sustainable Investing has come a long way from following a negative screening of companies and sectors example gambling, tobacco to incorporating more action-driven bottoms-up approach including best in class screening, ESG integration, sustainable themed sectors, norms-based investing, impact/community investing, corporate engagement and shareholder action.
Graph source: Global Sustainable Investment Alliance
Today, organization’s are playing a far more active role in incorporating sustainable investing within their framework. Morgan Stanley, a leading investment bank in the world, follows a bottom’s up to best in the class approach to identify investment decisions which bring positive social and environmental externalities. The investment bank spends considerable time in research in identifying businesses with sustainable competitive advantages around a set of key performance indicators minimising costs to increase profits like consumer product safety, human and supply chain management, governance standards, carbon intensity etc.
A formal definition of ESG doesn’t exist, but 2020 sustainable development goals play a pivotal role in outlining their objectives.
E stands for managing environment ecosystem with a focus on reducing carbon footprint through climate mitigation and climate adoption. Climate mitigation directly targets carbon emissions through businesses, policies, interventions while climate adaption signifies focus on renewable, water and energy efficiency, clean technology etc. Focus on green, and low carbon buildings are key focus areas of US government agencies Fannie Mae and Freddie Mac, leading global agencies in green securitization. Fannie Mae targets low carbon buildings and financing for energy and water efficiency improvements of at least 20%. 1
Graph Source: Global Financial Stability Report: Lower For Longer; Evolution of ESG
McKinsey defines S as the community relations between a various set of actors within the business and social ecosystem including labour relations, diversity and inclusion.1 Both E and S signify corporate social responsibility for businesses and their role in playing a defining role in promoting social and environmental causes. A lack of transparent quantitative and qualitative model in mapping and calculating measures based on ESG are impediments in measuring accountability and impact. Still, companies are nevertheless setting their benchmarks.
G relates with governance and best business practices of the company including accounting and disclosure practices, transparency and regulatory management etc. Better governance factors enable shareholder and societal value over the long term visible through the sustainable performance of companies like P&G compared to Enron.
The MSCI KLD 400 Social Index, the first ESG index in the world, is a capitalization weighted index of 400 US securities that provides exposure to companies with outstanding Environmental, Social and Governance (ESG) ratings and excludes companies whose products have negative social or environmental impacts.
Companies compliant with ESG framework are more likely to add value as compared to companies which lack the foresight in developing sustainable practices. In five ways that ESG creates value, McKinsey outlines top-line growth, cost reductions, reduced regulatory and legal interventions, employee productivity uplift and investment and asset optimization as critical enablers in generating a long-term advantage. The upcoming EU e-directive and EU carbon neutral policy by 2050 compel organizations to be regulatory compliant for sustaining businesses.
Usage of renewable technology is the least costly even when adjusted for subsidies.
The Way Ahead: Increasing the pie
Graph Source: Climate Bond Initiative
Sustainable investing which kick-started with equities now includes fixed income among other asset classes. Securitization (CDOs), especially in the green asset-backed securities (abs), is rising in the US and China. Innovative new ways to back securitization through loans/leases on electric vehicles and hybrids, solar and wind assets, loans for energy-efficient improvements are few examples of financial ingenuity in the bond market. Fannie Mae is the largest green bond issuer in the world, dominating more than 80 per cent of the market in 2017. Apart from the US, China is using ABS segment to roll out bonds in the renewable sector. Securitization, which began in the US during the 1960s to bring out the cost of mortgages is an effective way of addressing different investor risk appetite depending on the risk-adjusted return of the investors. CDOs collateral debt obligations, are structured products that takes cash flows originating from a security or portfolio of securities and distributes them as tranches to investors depending on their risk adjusted return and term horizon.
The loans are sourced from the originator and offloaded from the holding companies usually banks and agencies through special purpose vehicles into tranches: senior, mezzanine and subordinate/equity although mezzanine tranche is not a necessity. Senior tranches have the first lien on cash flows, followed by mezzanine terminating in equity (residual flows), i.e. cascading waterfall of cashflows leftover after paying senior and mezzanine. This method of cash flows to different tranches is Waterfall of
The growth in the Euro is stalled in this space due to stringent regulations and the presence of covered bonds.
Covered Bonds mostly used in Germany and Scandinavian countries are secured bonds with superior credit ratings backed by collateral of assets, making them safer than unsecured bonds.
Securitization has its pitfalls as epitomized in the 2008 credit crisis, especially in ABS backed by subprime loans and the inherent inclusion of credit default swaps in synthetic CDOs. Still, securitization as a significant form of funding is a long way from being a significant source of the financing with market less than $40B in 2017.
Impact investing a direct measure of serving undeserved markets for social and economic good still ranks $500B. Sustainable bonds, including green bonds, are slowly but steadily rising. The social stock exchange is right enabler for promoting sustainable investments, but their longevity in becoming a mainstream exchange remains a suspect. One of the essential features of any stock exchange is to be a market maker in that segment, i.e. to buy and sell securities at a spread remains yet elusive for social exchanges.
Further, social enterprises are patient capital, generating positive cash flows over a long period. There is an ongoing debate as to their potential to give above average return as highlighted in this report published by Stanford Social Innovation Review. Blended Finance is a focused method of developing selected projects in low income and developing countries and limited to a few actors, especially multilateral banks, governments and impact investors. Recent social innovations, especially social impact bonds are expensive to implement with limited scope to scale up.
ESG Resurrection and Reforms
A surge in ESG through corporate social responsibility and governance is a sustained measure in attracting capital in the development sector. As a key actor, CSR will provide invaluable capital through collaborative public-private partnerships. Using norm-based investing using UN benchmarks will aid in fostering segments which might not be attractive in the short term but sustainable over the long term through professional guidance, mentorship and capital infusion.
Invigorating sustainable investing through key government reforms is vital. Indian government thrust to the social venture sector through alternative investment funds to attract private capital is a step in the right direction. Bench marking key initiatives by organizations in ESG sector through a quantitative and qualitative dashboard will infuse more sustained capital in this sector. Standardizing, through a global regulatory body will increase transparency and accountability.
Incorporating sustainable development goals as a core thesis in governance will have the most lasting effect within the social ecosystem. India’s social innovation through bench marking achievement in SDGs across various states in India is a critical reform which needs to be replicated globally. A sustained change is neither lopsided nor achieved individually. A collective thrust backed by the government imbibes a sense of pride within civic societies, enabling a sense of purpose and motivation among all the actors within the global ecosystem and a rolling stone gathers no moss. Americans didn’t achieve the impossible by landing a human on the moon to please President Kennedy, but the result of one of the most colossal collective purposeful scientific work within the society in modern times.
However, ESG market is a distortion in implying social good. Its includes many companies which are not directly impacting sustainable market but washing sustainable themes in name of corporate substantial practices. Its a long road ahead yet a promising one.
Rome was never built in a day. Its takes time and sustained patience.
References otherwise embedded
- Green Securitization Climate Bonds
IMF Sustainable Finance
Global Sustainable Investment Alliance
SSIR Marginalized returns
Morgan Stanley ESG and Sustainable Investing Report
McKinsey Five ways ESG creates values