22.1 Introduction to Sustainable Finance

Traditionally, Investors (individual or corporate) have considered only two dimensions when making decisions: risk and return leading to (financial) managers working with only one goal in mind – maximizing shareholder wealth – because this is what shareholders wanted. This proposition has several advantages. First, the (financial) manager’s task is simplified into just one goal: choose those projects or investments that will maximize shareholder wealth. Second, optimization across only two criteria, return and risk, allows for elegant mathematical models of how the (financial) world works.

But things are changing now. The growing awareness of sustainability has changed the landscape in which traditional investors and financial institutions used to work. “It has been stated that, because of the pressure from customers and investors, as well as regulators, banks have already begun to recognize that there are sustainability risks, and they have begun supporting the transition to a more sustainable economy through the integration of sustainability factors into their risk management models and government frameworks” (Coleton et.al., 2020).

The sustainability initiatives by financial institutions are termed sustainable finance or green finance.

In the West, sustainable finance started out as a small, niche market dominated by religious investors who wanted their investments to reflect their religious values. However, sustainable finance is now seen as having become almost mainstream. Indeed, the sustainable finance market has experienced phenomenal growth, particularly in recent years, across all asset classes and across all regions of the world.

According to the United Nations Conference on Trade and Development (UNCTAD), in 2022, the value of the sustainable finance market was US$5.8 trillion – an increase of 18% from the year before. UNCTAD measures the sustainable finance market as comprising funds, bonds and voluntary carbon markets. The number of sustainability funds grew from 189 funds in 2012 to 7,012 in 2022. Europe by far dominates the sustainable funds market (83% of sustainable funds under management are European). Voluntary carbon markets quadrupled in size over the 2012–2021 period. The sustainable bonds market, which is a newer market, grew 500% over the period 2017–2022.

Sustainable Investment

Sustainable investment, just like sustainable management, has many flavours and can mean different things to different people. The basic notion is that companies that are able to manage all their risks (i.e. including sustainability risks) have a competitive edge against their peers and, therefore, a higher chance of sustained business success in terms of sales and profitability. By identifying those sustainable companies, and investing in their shares (or bonds), it is expected to achieve a higher financial return – both in terms of share price development and dividends.

There are three investment philosophies commonly associated with sustainable investment:

• Value-based investment (often referred to as SRI, socially responsible investment or RI, responsible investment): SRI is value-based and most often applies exclusion criteria such as themes-based exclusions (e.g. arms, tobacco, alcohol, pornography) or issue-based exclusion (excluding companies with a negative human rights or environmental track record. SRI is the oldest form of sustainable investment but has remained a niche investment strategy.
• Sustainable investment (also referred to as ESG – environment, social, governance – investment): Sustainable investment is based on identifying sustainable investment opportunities, i.e., identifying companies that are more sustainable than their peers through a best-in-class approach. ESG research now influences investment processes in a significant number of investments, but the extent of the integration into conventional financial analysis remains limited in most cases.
• Themes-based investment: investment in companies or projects that capitalize on sustainability challenges through thematic investment, e.g. in renewable energy, water (water treatment, efficiency, distribution), health, and financial inclusion (microfinance). “Clean-Tech investment” has experienced somewhat of a bubble, with low investment returns due to over-exposure in the solar PV industry that collapsed due to global overcapacities as a consequence of miss-directed subsidies.

References

Coleton A., Font Brucart, M, Gutierrez, M., Le Tennier, F. & Moor, C. (2020). Sustainable finance: Market practices. EBA Staff Paper Series (No.6). European Banking Authority https://data.europa.eu/doi/10.2853/24624

United Nations Conference on Trade and Development. (2023). Chapter III: Capital markets and sustainable finance [PDF]. In World Investment Report 2023. https://unctad.org/system/files/official-document/wir2023_ch03_en.pdf

Attributions

“22.1 Introduction to Sustainable Finance” is adapted from “Introduction” by Jacquelyn Humphrey, from Sustainable Finance © by The University of Queensland is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License, except where otherwise noted.

“Sustainable Investment” is adapted from “Sustainable Investment” on the SolAbility Sustainable Intelligence website. Copyright © SolAbility, licensed under a Creative Commons Attribution-NonCommercial 4.0 International License.