Several studies have indicated that the future of finance is not in short-term value assets but in medium to long-term value assets. A major reason for the focus on medium to long-term investments is that short-term investments stand the risk of becoming stranded assets over time, as is the case of coal in some regions of the world today, due to the non-integration of externalities associated with the asset. It is therefore important that the players in the financial sector begin to think along the lines of long-term and shared value creation as this can direct investments into sustainable companies and uses. This is also important because it aligns with the aim of sustainable development which is to cater for the needs of the present generation without affecting the opportunities of future generations to meet theirs.
Sustainable finance is the finance which serves the three pillars of sustainable development (economic, social and environmental). While traditional finance serves just financial returns, sustainable finance assesses the true costs of investments and makes decisions that positively impact the three pillars. The main function of the financial sector is to allocate finance to various sectors and companies, and as the chief allocator of finance, the sector has the capacity to monitor and influence the governance and utilisation of funds in companies they invest in. Also, when the financial sector draws up their lending strategies they determine which company or assets to invest in. Hence, they can choose to invest in sustainable companies and push for responsible practices among various sectors. Given these pivotal roles, finance is a major actor in making strategic decisions on the trade-offs between sustainability goals.
Sustainable finance helps in avoiding sectoral errors like short-termism and over-zealous profit maximisation. It is a transition from bottom line (profit) to triple bottom line (people, planet, profit); a shareholder viewpoint to a stakeholder viewpoint; a singular and internal value model to a broader shared value model that accommodates all key stakeholders.
Based on the advancement of a financial ecosystem and its commitment to sustainable development, sustainable finance can exist at various phases. According to the Bruegel framework for sustainable finance, there are four stages in sustainable finance. This framework will be used to further our comprehension of the subject matter.
Framework for Sustainable Finance
The first stage in the above diagram is the conventional financial stage, which represents the business as usual approach of doing business. In this stage, players in the financial sector places financial returns over every other (social and environmental) footprint that an investment may have. The stage is characterised by quarterly financial performance reporting and the long-term effects of investments are not considered. Players in this stage are not accountable to and willfully neglect the externalities of their business.
In some regions and for some financial sector players, the conventional financial stage has transcended to a refined shareholder stage where finance is still prioritised but with consideration for social and environmental footprints. Prof. Dirk Schoenmaker refers to this stage as “avoiding sin companies or stocks” such as alcohol, tobacco, gambling, sex, crime and companies that deal in conflict minerals or animal poaching. Dirk Schoenmaker further explains that investors at this stage also put systems in place to address various social and environmental sustainability issues such as diversity and inclusion, energy, emissions and waste management, and others. However, the focus is still short term and also remains on shareholders’ benefit and profit maximisation for the company.
The next stage of sustainable finance is the true cost stage where the total value of an investment is calculated as its financial, social and environmental values. In this stage neither financial returns nor profit maximisation is given priority rather social and environmental costs are monetised and added to the overall costs. The idea behind this stage is that while financial cost can be easily calculated, social and environmental costs which typically manifest in the long-term cannot, but they can affect the actual viability of a project. Hence, sustainable finance requires that these externalities are internalised and accounted for. Monetisation of social and environmental costs can be done through various techniques such as life-cycle assessments, social life-cycle analyses and several other methods.
The last stage of sustainable finance is the optimisation stage where priority is given to social and environmental returns overs financial returns. This is the stage of opportunity and it involves the proactive identification of and investment in sustainable companies and projects, such as education, healthcare, social housing, renewable energy and other emerging markets. In this stage, the financial sector is more medium and long-term focused and delivers sustainable development gains. This stage works on the principle of “fair financial returns”, which emphasises minimum preservation of capital. Although, studies have shown that the global sector industry is still far from this stage of sustainable finance as most financial investment decisions are still made based on market-rate returns.
Sustainable finance is more impactful than conventional finance. It highlights critical policy blueprints that internalises and monetises footprints, as well as intentionally looks out for ways to create handprints. Each stage is an upgrade of the preceding stage and absolute impact is created as the financial sector matures. Global, regional and local financial institutions, traditional investors, venture capitalists, impact investors and asset managers are therefore encouraged to show more leadership in sustainable finance by operating between the last two stages of the sustainable finance framework.
It is important to note that this is a short review of several scholarly publications on sustainable finance, I therefore urge players in the sector, sustainability professionals and interested individuals to undertake more in-depth study of sustainable finance.
- Investing for The Common Good: A Sustainable Finance Framework. Dirk Schoenmaker, 2017. Bruegel Essay and Lecture Series
- The Principles for Positive Impact Finance: A Common Framework to Finance the Sustainable Development Goals. UNEP Finance Initiative
- 2017 Annual Impact Investor Survey. Global Impact Investing Network. UKaid, The Impact Programme