How did sustainable finance become mainstream?
How sustainable finance became at the forefront of board discussions is through a series of events. In particular, in 2019, when Larry Fink, CEO of BlackRock, an American financial giant, first declared in his highly anticipated letter addressed to all the CEOs of listed companies that "climate risk is investment risk".
In the same year, Norway, the country with one of the world's largest sovereign investment funds, decided to launch a € 5.4 billion divestment plan for fossil fuel companies. Those were declared too risky both financially and environmentally to keep in its investment portfolio. As in the case of Norway, divestments or the exclusion of stocks out of portfolios is often seen as the first step by investors to align their investments with their values. Historically, this negative screening strategy was adopted by religious foundations that excluded "sin-stocks" from their portfolios for religious reasons (such as tobacco, alcohol and gambling stocks).
The fossil-fuel divestment movement and the challenge to the Carbon Majors
From 2013, however, there was a change within the investor community, especially among European ones, who began to adopt exclusion strategies on stocks of companies with high pollution of fossil fuels, starting what was called the "Fossil-fuel divestment movement".
Despite this, this strategy of exclusion or divestment is often criticized as not encouraging fundamental changes in the boardrooms of these companies. It is precisely for this reason that Climate Action 100+, a group of over 450 global investors with stakes in companies predominantly in the energy sector, has openly challenged the 100 most polluting companies (names as the "carbon majors"), to align their strategy with the objectives of the Paris Agreement through a method called corporate engagement, or financial activism.
The group has pushed companies like Total, and British Petroleum to start a process of transition through investments and focused efforts on greener or carbon capture technologies as a way to align to a global "net-zero" agenda.
Investors are seeking more transparency on ESG practices
A third trend linked to the uptick of interest in sustainable finance is related to investors' willingness to gain transparency on management teams' environmental, social and governance (ESG) practices.
This is increasingly relevant as investors' want to align to businesses that are more resilient with respect to environmental supply chain risks, which promote talent growth and retention, and good governance practices, amongst other things. Investors are increasingly looking at material ESG risks which are sector specific by leveraging frameworks such as that of the ESG Materiality Map developed by the Sustainability Accounting Standards Board (SASB).
What is the future of sustainable investment instruments?
The three sets of investment strategies described above fall under the category of "sustainable finance", and have almost tripled since 2012 to reach over 40 trillion dollars at the beginning of 2020. Although the number seems high, in reality, it remains a marginal effort compared to the number of financial investments managed globally. As we speak, financial asset managers are engaging in the creation of new financial instruments and products that have a sustainable angle, contributing to the democratization of access in the retail market. To conclude, there remain significant questions on the future evolution of sustainable finance as an asset class. An important challenge is what concerns the measurement and standardization of the impact and ESG-related assessments. Despite efforts in this regard, through initiatives such as that of the ESG ratings, Global Impact Investing Network or the Impact Measurement Project, the measurement of impact and ESG remains challenging to standardize as often very subjective. Furthermore, the development and measurement of impact metrics require costly monitoring studies over time.
Questions still remain on the topic of impact additionality too.
- How can some projects on a national scale contribute directly to the achievement of pre-established global objectives?
- Another challenge is that of economic incentives: how can the carbon majors invest in their energy transition if doing so would be to the detriment of their profitability in the short term?
- Can investors support this transition even this means taking on larger risks by investing in emerging technologies?
- And how can governments define regulations to accelerate this transition which is not too detrimental to companies' profit and employment?
Sustainable finance can only serve as an enabling tool if coordinated action occurs between the financial sector and other key stakeholders such as governments, companies and civil society to define the strategic priorities for the channeling of capital. Finance, operating independently, risks maintaining short-term oriented compensation structures, and in doing so, may fail to achieve the necessary medium to long term environmental and social impact priorities the world really needs.