“We do not inherit the Earth from our ancestors; we borrow it from our children.” – Native American Proverb
The advent of Sustainable Finance is indeed a ground-breaking enabler in the social and development sector. The new source of innovative finance provides incremental capital for development projects and social entrepreneurs but quantifies social change through measurable impact evaluation. To understand sustainable finance, it’s imperative to understand the evolving sustainable development sector and the role of the chief universal actor within the social ecosystem, the United Nations. UN is the principal driver of sustainable development through specialized agencies, key international organizations, and multilateral development banks. United Nations promotes human rights, peace & security, sustainable development & humanitarian assistance through its specialized agencies. In 2015, the UN formed a framework of a very ambitious, bold, and targeted plan in the form of seventeen sustainable development goals to address pressing problems by 2030. These goals became a guiding beacon and benchmark for international development. Along with SDGs, Addis Ababa Action Agenda and the Paris Agreement on Climate Action became the 2030 Development Agenda. Sustainable Investing is now a global mainstream phenomenon. The Global Sustainable Investment Alliance estimated the market at $30.7 trillion in 2018, an increase of 34 percent over the previous year in five major markets. Today, ESG forms the core of sustainable investing, complemented by impact investing, corporate social responsibility, and a significant social change and impact enabler. Europe accounts for the lion’s share of sustainable investing with assets at $14 trillion, followed by the US at $12 trillion and Japan at $2.2 trillion. The most substantial increase between 2016 and 2018 was Japan, which grew by 300 percent.
Graph source: Global Sustainable Investment Alliance | The middle Road
The IMF defines Sustainable Finance as incorporating environmental, social, and governance (ESG) principles into business decisions, economic development, and investment strategies.
Sustainable Investing has come a long way from following a negative screening of companies and sectors, such as gambling and tobacco, to incorporating a 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. Today, organizations play a far more active role in incorporating sustainable investing within their framework. Morgan Stanley, a leading investment bank globally, follows a bottom’s up to best in the class approach to identify investment decisions that bring positive social and environmental externalities. The investment bank spends considerable time researching businesses with sustainable competitive advantages around a set of key performance indicators minimizing costs to increase profits like consumer product safety, human and supply chain management, governance standards, carbon intensity, etc. Addis Ababa Action Agenda on Financing for Development led and organized innovation in finance for the development sector. The role of some of the most significant multilateral banks, esp. the World Bank (IFC), IMF, and European Investment Bank, kick-started private sector financial products for achieving sustainable development goals. The launch of the first green bond fund in 2007 foretold the beginning of the present avatar of Sustainable Bonds.
Impact Investing and blended finance help structure deals for projects attracting private capital based on risk-adjusted money.
Although Sustainable Bonds, Impact Investing and Blended Finance still account for less than $2trillion of capital, accounting for less than 2 percent of the global debt capital markets. Paris COP21 agreement brought in buy-in for climate change and finance from many countries leading the way with a quantifiable target of limiting global warming. Social Impact Bond, a collaborative pay-for-success model, evolved in public-private partnerships primarily through development impact bonds in the private sector. This complemented in a limited manner the evolving sustainable finance setting up a public-private partnership as a key enabler within the SDG framework. Adoption of sustainable finance with alacrity by selected developing countries turned out to be a shot in the arm nudging other countries to follow suit.
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 the environment ecosystem, focusing 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 the 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 percent. 1
Image: The middle Road
McKinsey defines S as the community relations between various actors within the business and social ecosystem, including labor 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 models in mapping and calculating measures based on ESG impedes measuring accountability and impact. Still, companies are nevertheless setting their benchmarks. G relates with the company’s governance and best business practices, 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. Addis Ababa Action Agenda on Financing for Development led and organized innovation in Finance for the development sector. The role of some of the most significant multilateral banks, esp. the World Bank (IFC), IMF, and European Investment Bank, kick-started private sector financial products for achieving sustainable development goals. The launch of the first green bond fund in 2007 foretold the beginning of the present avatar of Sustainable Bonds. Impact Investing and blended finance help structure projects attracting private capital based on risk-adjusted money.
Although Sustainable Bonds, Impact Investing and Blended Finance still account for less than $2 trillion of capital, accounting for less than 2 percent of the global debt capital markets. Paris COP21 agreement brought in buy-in for climate change and Finance from many countries leading the way with a quantifiable target of limiting global warming. Social Impact Bond, a collaborative pay-for-success model, evolved in public-private partnerships primarily through development impact bonds in the private sector. This complemented in a limited manner the evolving sustainable Finance setting up a public-private partnership as a key enabler within the SDG framework. Adoption of sustainable Finance with alacrity by selected developing countries turned out to be a shot in the arm nudging other countries to follow suit. Sustainable Finance fosters an ancillary industry in impact evaluation. Armed with evidence-based impact, the pie of Sustainable Finance increased as more serious investors who spurned investing into the development sector due to lack of accountability, transparency, corruption, especially in developing economies, started looking at the development sector. Slowly but steadily, new regulatory, accounting standards, forums, and committees emerged, including Equator principles, UN PRI, Global steering committee, GIIN, IRIS, GSIA, G20 Sustainable Finance Group, Sustainable Global Network, TEG, standards governing sustainable bonds, to name a few. Notwithstanding different ideologies which constantly create hurdles for a consensus forward outlook, the world is on the cusp of the most significant and most sustained innovation in social Finance. The next decade will prove to be the most critical era in humanity for tackling poverty, empowerment, equality, healthcare, live hood, among other vital issues facing society.
The Way Ahead: Increasing Pie
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 an effective form of funding is a long way from being a significant source of financing with a market of less than $40 billion in 2017.
Impact investing a direct measure of serving undeserved markets for social and economic good still ranks $500 billion. 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. CSR will provide invaluable wealth through collaborative public-private partnerships as a key actor. Using norm-based investing using UN benchmarks will aid in fostering segments that 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 are vital. Benchmarking key initiatives by organizations in the 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. 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 late John F Kennedy, but the result of one of the most colossal collective purposeful scientific work within the society in modern times. However, the ESG market is a distortion in implying social good. It includes many companies which are not directly impacting sustainable markets but washing sustainable themes in the name of substantial corporate practices. It’s a long road ahead yet a promising one.
- IMF Sustainable Finance
Global Sustainable Investment Alliance
SSIR Marginalized returns
Morgan Stanley ESG and Sustainable Investing Report
McKinsey Five ways ESG creates values
- Who Cares Wins