The Future of Sustainable Finance

Sustainability is about leaving the earth for our children in the same way as we got it from our parents. Not only have we not retained the earth as we got it, we’ve made it worse. Hence, a lot of work needs to be done to turn the clock back. 

There are five gigatrends that are defining the world today:

Climate crisis: Or weather cycles are changing. We have experienced hotter summers, colder winters, heavier rains in parts and droughts in others. There have also been unusual fires and hurricanes. 

Circular economy: The circular economy is premised on returning to the earth what we take from it. It also aims to reduce the amount of waste that is generated. Corporations around the world have taken initiatives to become circular.

Sustainable transport: Transportation is a major source of pollution. It also uses fossil fuels extensively. To mitigate both concerns sustainable transportation which can be either mechanical (bicycles) or operated with renewable energy (electric vehicles) have become prominent. 

Plastic waste: Plastic was once seen as a wonder material. However, plastic does not degenerate easily and, so, lies in our landfills and oceans causing enormous harm to communities and aquatic life. 

Renewable energy: Fossil fuel supplies are finite and likely to last only a few more generations. They are also polluting. Hence, the world is shifting to renewable energy.

For each of these governments and corporations require large sums of money. So, where does this money come from?

Sustainable finance developed to bridge the gap in funding. Investors who are sustainability conscious and have surplus funds need to reach governments and corporations that are short of funds. Sustainable finance comes in many shapes.

On the financing side are the green bonds that are tied to sustainable actions by companies. Thus, if a company needs to invest in a effluent treatment plant it will fund the financing need by issuing green bonds.

Then there is sustainability linked bonds that pay interest based on performance achieved. Thus, a company that aims to reduce its CO2 emission will set up annual targets that need to be achieved and the interest on the loan will be tied to the achievement of these goals.

Transition bonds help companies move from “brown” to “green.” A coal-based or gas-based power plant shifting to solar power can utilise the transition bonds.

Social impact bonds are raised for social causes and like sustainability linked bonds are a pay-for-performance security. Thus, if a government or an NGO is trying to reduce maternal mortality rates in a particular region, then they can utilise these funds and interest is charged based on targets of maternal mortality declines.

On the investing side, the most popular approach is exclusionary screening. Here banks and fund houses stop investing in companies that are involved businesses like oil, tobacco, and, gambling. This is the most common approach to investing.

Then there is active ownership. Here investors are actively involved in a company’s actions through shareholder activism. This involves attending board and shareholder meetings to ensure that companies act sustainably. 

Finally, we have ESG integration where ESG factors are closely looked at before a decision to invest is made. Thus, a bank may rate a company on the environmental, social and governance parameters and based on the outcome make investment decisions.

Sustainable finance has been on the rise in the recent past with ESG investing being at centre stage.

Covid-19 has led to a change in thinking about sustainability. Many see this as a black swan event a term popularised by Nassim Nicholas Taleb. A black swan event is typically seen as having negative consequences for the economy. John Elkington, on the other hand, sees this as a green swan event. He believes that this is likely to bring about exponential progress in the form of economic, social, and environmental wealth creation.

Currently, economies are in disorder and fragile. The Post-Covid economy will be more than resilient. It is, in fact, likely to antifragile. A resilient system is unaffected by disorder whereas an antifragile system benefits from disorder.

Another key trend is that businesses will be closely looking at stakeholder capitalism. The recent pronouncements of Larry Fink and the announcement of top 200 CEOs through Business Roundtable have helped create a momentum for stakeholder capitalism.

So, what holds for sustainable finance?

  1. Transition finance will help shape the economic recovery. 
  2. Industries are increasingly championing sustainability. Sustainable finance will have to meet the significant scale up in investments by companies to meet their sustainability needs.
  3. Companies are increasingly creating zero-carbon roadmaps for themselves leading to spurt in demand for sustainable finance.
  4. Stakeholder capitalism will become more dominant and there will be increased scrutiny of a company’s actions.
  5. With the development of European union’s taxonomy for ESG investing, ESG investing is likely to get a leg up.

At the same time there will be several roadblocks too. 

Banks will be increasingly risk averse leading to significant focus on exclusionary screening. They will also worry about stranded assets and the ability of companies to repay their debts. 

Large companies tend do well on ESG as they have relatively easy access to funding. Mid- and small-tier companies will need significant support to be ESG focussed.

While measuring ESG, environmental actions of companies easily measured. Measuring social and governance actions, on the other hand, are difficult and complex. This is marred by the fact that there is a multiplicity of reporting documents that, at times, conflict with each other.

The world of sustainable finance is at an important junction and its trajectory is likely to be steep.