Sustainable finance has been described as the interrelationships that exist between environmental, social and governance (“ESG”) issues on the one hand, and financing, lending and investment decisions, on the other. Sustainable finance has also been explained to be a long-term approach to finance and investing, emphasizing long-term thinking, long-term decision-making and long-term value creation. Companies now operate in an environment in which more and more capital providers are taking sustainability issues into consideration when deciding whether to fund a particular company or project and this means that the finance committee, as well as the entire board of directors, need to understand how the company’s ESG-related strategies, principles and practices can impact its access to capital and the stability of its relationship with investors and bankers. An additional consideration is measurement and reporting of ESG-related performance, a topic that the finance committee must consider in collaboration with other board-level committees such as the audit and corporate social responsibility committees. Measurement and reporting techniques are evolving and differ across jurisdictions; however, there are emerging standards that need to be understood as more investors and lenders rely on sustainability reporting for collecting information necessary for them to make decisions about allocating their capital.
When reviewing and approving the company’s financial strategies and specific capital projects the finance committee needs to be mindful of the various factors that motivate investors and decision makers to incorporate sustainability aspects into their investment and lending decisions:
- Many investors and lenders take sustainability issues into consideration in order to make better risk management decisions, avoid future financial issues and make better long-term investment and lending decisions. Investors and lenders are increasingly skittish about funding companies and projects that carry high legal and reputational risks due to concerns about compliance with applicable laws and regulations and ESG norms and standards.
- A growing number of investors and lenders are focusing on sustainability as a means for uncovering promising new business opportunities and undervalued assets. Companies that can offer investors and lenders a path to participate in financing innovative solutions to environmental and/or social problems can tap into new pools of capital.
- Investor are taking a more values-driven approach to funding decisions and avoiding investment in companies or projects considered to be “unethical” and/or which are likely to cause environmental or social harm. At that same time, these investors are proactively seeking out projects that have a demonstrable positive environmental or social impact.
- Certain investors, as well as shareholder activists, are interested in applying pressure on companies to change their behavior with respect to operational activities that have adverse environmental and social impacts (e.g., threatening to withhold or withdraw capital unless companies cease to engage in activities considered to be unsustainable).
- Some investors, like consumers, enjoy being associated with “good causes” and are therefore driven to invest in companies that have a good reputation with respect to ESG matters as a means for embellishing their own social identity.
Sustainable investment can be broken down into several categories, information that is helpful to companies when they attempt to identify the types of sustainable investors that might be interested in providing capital for their operations and new projects:
- Negative/exclusionary screening: Negative or exclusionary screening consists of avoiding specific assets due to considerations of moral values (e.g., tobacco or gambling), standards and norms (e.g., human rights), ethical convictions (e.g., animal testing), or legal requirements (e.g., controversial armaments such as cluster bombs or land mines, excluded in order to comply with international conventions). Companies engaged in “negative” activities must be prepared to make significant modifications to their business models in order access capital from investors and lenders applying these types of screens.
- Best-in-class/positive screening: “Best-in-class” (positive) screening contrasts significantly with negative screening and calls for investment and lending decisions to be made based on a company’s demonstrated high ESG performance. Investors can rely on a growing number of reference indexes to select projects that can improve both the risk and return aspects of their portfolio and companies need to be mindful of the criteria applied by the reference indexes and track their performance, although it should be understood that such indexes are not infallible and that it remains difficult to reliably measure ESG performance..
- ESG integration: ESG integration involves new and emerging methodologies intended to systematically and explicitly include ESG risks and opportunities into traditional financial-based investment analysis. ESG integration differs from ESG indexing in that it does not rely on benchmarking ESG performance vis-à-vis peers. As with ESG indexing, companies need to understand the how investment analysis taking ESG risks and opportunities into consideration is conducted, not only to gain a better understanding of the expectations of investors but also to potentially improve their own risk-adjusted rate of return on assets and mitigate sustainability-related risks.
- Impact investing: Impact investing has been described as “investments made in companies, organizations, and funds with the intention of generating social and environmental impact (pursuit of positive externalities) alongside a financial return”. So far, impacting investing, which has often focused on microfinance and development investing, has been available mostly through private markets from funds managed by specialized asset managers. Access to capital from impact investors may be limited for companies that lack scalable high-quality investment projects.
- Thematic investments: Thematic investments include investment activities focused on specific high profile sustainability themes such as cleantech, infrastructure, energy-efficient real estate or sustainable forestry and thematic investments are projected to become increasing important for certain long-term oriented investors such as pension funds, insurance companies and sovereign wealth funds.
- Active ownership: Active ownership takes a different approach to sustainable finance by focusing on engagement and dialogue with portfolio companies after an initial investment is made in order to influence ESG strategies and actions through exercise of ownership rights and being a visible activist for change. The growing role of activism can be seen by charting the increasing numbers of proxy votes relating to ESG issues, a trend that has materially impacted how boards and senior executives manage investor relations.
For lenders, as opposed to investors seeking attractive risk-adjusted returns in addition to recovery of their original capital, ESG issues appear in their reluctance to enter into loan transactions that might ultimately involve them in financing controversial activities and/or projects that are overexposed to identifiable environmental or social risks and potential liabilities. Lenders are not only concerns about the possibility that ESG issues for the parties to whom they lend may impact their ability to repay but also fear reputational damage from being associated with such borrowers and their environmentally harmful and/or unethical practices. Many lenders follow an approach similar to the negative/exclusionary screening described above. At the same time, however, lenders are themselves interested in enhancing their sustainability reputations and are adopting various types of positive screening and ESG integration methodologies into their loan analysis and proactively seeking qualified borrowers in the areas of interest to thematic sustainability investors.
The board of directors as a whole, as well as the members of the finance committee, need to understand the role that investors and lenders can play in impacting the future structure of the economy and, in turn, the influence that the priorities of investors and lenders can have on the business and financial strategies of their potential portfolio companies. This means making various adjustments to the how the finance committee approaches some of its traditional duties and responsibilities. For example, companies are being urged to move beyond conventional net present value analysis of projects to implement sustainable asset valuation and capital budgeting techniques such as analyzing projects based on “net present sustainable value”, which has been described as estimating “the net present value added across financial, environmental and social dimensions using a required rate of return that considers not only investors’ opportunity cost for their financial capital, but also the opportunity costs of the environmental and social capital inputs”. With respect to capital budgeting, analysts are beginning to favor in incremental savings of water, energy and waste. Another transition necessary for companies to take advantage of sustainable financing opportunities is shifting toward reporting and disclosure that includes environmental and social matters, particularly when companies are seeking targeted financing for projects based on renewable energy, climate change action, community and economic development and natural resource conservation and management. Oversight of insurance matters by finance committees must take into consideration the evolving needs of insurance companies to mitigate their exposure to sustainability-related risks (e.g., natural disasters, ecosystem and community damage from operational activities and litigation costs associated with claims from employees based on hazardous work conditions and/or consumers based on issues with defective and/or hazardous products).
As mentioned above, finance committee strategies with respect to investor relations will need to take into account the surge of activity with respect to the incorporation of ESG issues into investment practice. The world’s largest institutional investors have signed on global standards such as the United Nations Principles for Responsible Investment developed by an international group of institutional investors through a process convened by the UN Secretary General. Finance committee members need to understand that investors that have signed on to the Principles for Responsible Investment are committed to incorporating ESG issues into investment analysis and decision-making processes and being activist owners through the exercise of their voting rights and engaging with portfolio companies on ESG matters. One of the finance committee members, working with the CEO and CFO, should be responsible for engagement with the company’s largest investors to ensure that investor concerns regarding sustainability are addressed.
Sources for this article included A. Krauss, P. Kruger and J. Meyer, Sustainable Finance in Switzerland: Where Do We Stand? (Zurich: Sustainable Finance Institute, September 2016), 15-20 and Ignited: A Brief Overview of Sustainable Finance.
This article is adapted from material in Sustainability and Corporate Governance: A Handbook for Sustainable Entrepreneurs, which is prepared and distributed by the Sustainable Entrepreneurship Project and can be downloaded here.
Alan Gutterman is the Founding Director of the Sustainable Entrepreneurship Project, which engages in and promotes research, education and training activities relating to entrepreneurial ventures launched with the aspiration to create sustainable enterprises that achieve significant growth in scale and value creation through the development of innovative products or services which form the basis for a successful international business. Visit the Project’s Library of Resources for Sustainable Entrepreneurs to download handbooks, guides, articles and other materials relating to sustainable entrepreneurship and keep up with the Project’s activities by following Alan on LinkedIn, Twitter and Facebook.