Responsibility, ethics, and sustainability are some of the words relating to this phenomenon that is causing significant transformations in the way finances are approached. The European Union defines sustainable finance as the environmental, social, and governance considerations that are taken into account when making decisions leading to more long-term investments in sustainable economic activities and projects. The environmental aspect includes climate change mitigation, circular economy, and pollution prevention, the social entails inclusivity, labor relations, and human rights issues while the governance aspect involves shareholder rights, transparency, board independence, and executive pay. In July 2021, the Sustainable Finance Strategy was published encompassing four primary areas: inclusiveness, global ambition, financing the transition to sustainability, financial sector resilience, and contribution.
Over the years, the planet continues to experience global warming causing inevitable disasters and damage worth billions of dollars. In addition, we are experiencing mass extinction that can wipe out thousands of species in the coming decades. This biodiversity loss is already proving costly for human beings as healthy ecosystems provide basic necessities for survival, contributing to most of the world’s GDP. Through the ecological collapse, some nations are at risk of losing them. We can easily combat these issues by restoring the planet’s ecosystem. However, humanity will need to spend more to reverse biodiversity and achieve all the Sustainable Development Goals.
Globally, companies have evolved at the same pace as society bringing themselves up to date according to its demand. They are increasingly considering environmental needs as well as focusing on generating economic value. Moreover, they continue to generate the shareholder’s economic value by attaching increasing importance to the effects of their activities on society.
Sustainable finance helps in plugging these massive gaps and funding through various sustainable financiers. The banking system holds a huge number of financial resources that can be mobilized for great investments. Institutional investors such as insurance companies and pension funds, corporations that engage in sustainable projects through corporate social responsibility initiatives and green bonds. International financial institutions provide financing at regional and multi-national levels and scale up green investments by issuing green bonds, influencing policymakers to support and test new financial projects. Central banks aid in the provision of public funding for green investments through quantitative easing Furthermore, they set financial regulations that deter investors away from fossil fuels by instilling high capital requirements.
By integrating ESG criteria into investment decisions, investors are able to identify potential investments in line with their values. A less polluting company may be given preference over a more polluting one. Also, they may exclude certain investments from their portfolio by ESG screening. In negative screening, they are less likely to invest in companies or sectors that perform poorly in environmental and social sustainability. On the hand, positive screening involves investing in those that perform well in ESG. Rather than only focusing on the above, norms-based entails screening against international standards that are aligned with corporate recommendations such as the United Nations Global Compact or socio-environmental agreement frameworks. Not only does impact investing account for ESG but also aims to solve social and environmental problems.
The funded money gets into these sustainable investments in the form of debt financing where investors lend money to borrowers through loans and bonds which is then repaid with interest while in equity financing, investors are given stocks and shares in the project and receive dividends based on invested capital. Though the latter offers higher potential returns than the former, they tend to be risky as stock prices may fluctuate resulting in the project’s bankruptcy and investors losing their entire stake. In this event, there are strict hierarchies in terms of which shareholders and debtors are repaid first. Most private investors want to be close to the top level to ensure they recover their money. Impact investors and green funds are placed at the bottom level by buying the lowest stocks, meaning they will be paid last if any inefficiencies may occur. By absorbing this risk, they make the projects more attractive to other investors. Another technique to manage risks is taking a guaranteed loan. If the project is unable to pay off its debts, a third-party guarantor steps in to repay the investors. This drastically reduces the risk of investing in the project.
Sustainable investments were once seen as risky since prioritizing ESG could potentially mean lower returns. The field of sustainable finance is growing rapidly following the outperformance of sustainable funds in the recent decade, including the COVID-19 era. Overall, the challenge of investment scale should be tackled by both the public and financial sectors through re-orienting towards more sustainable technologies and businesses, contributing to the creation of a low-carbon, more resource-efficient, and circular economy that builds a financial system that supports sustainable growth.