“Sustainable Business Went Mainstream in 2021”, declared by the Harvard Business Review in December 2021.
"We focus on sustainability not because we're environmentalists, but because we are capitalists and fiduciaries to our clients." States Larry Fink – Blackrock Founder, Chairman, and CEO – in his 2022 Letter to CEOs: The Power of Capitalism.
ESG investment flourished in 2021, and many main global market players have committed to taking action against climate change. The Harvard article points out that the leading investment banks have made public pledges for sustainability investments – JPMorgan Chase, Citi, Morgan Stanley, and Bank of America committed to investing from US$1 trillion to US$2.5 trillion in climate action and sustainable development. Reuters also reports that the sustainable finance bond issuance jumped to US$859 billion in 2021, a 61% increase compared to the year before. Also, GlobalCapital estimates global mergers and acquisitions (M&A) activity involving sustainable companies jumped three times in 2021 compared to 2020, reached US$196.5.
The 2021 market data show that these are just smart investment decision-making. The Morgan Stanley analysis of more than 3,000 U.S. mutual funds and exchange-traded funds (ETFs) shows that sustainable equity funds outperformed their traditional peer funds. The S&P Global Market Intelligence analyzed 26 ESG exchange-traded funds and mutual funds with more than $250 million in assets under management. For the first year of the COVID Pandemic, 19 of those funds performed better than the S&P 500. Those outperformers rose between 27.3% and 55% over that period. In comparison, the S&P 500 increased 27.1%.
So, what does that mean? What’s “ESG investment” or “sustainable investing”?
ESG stands for “environmental, social, and corporate governance”. Initially, ESG was considered mainly a risk management issue. But recently, investors and businesses start to recognize its potential to create opportunities and strengthen returns. Essentially, there are two sides to this concept –improved ESG risk management and increased capital flows to activities with positive climate and ESG impacts. Check out my earlier article on “5 Questions about Sustainable Investing” for more details.
In January 2022, the World Economic Forum published its 2022 Global Risk Report, identifying the top ten most severe risks on a global scale in the next ten years. Among them, five are environmental, three are social, and climate change is the number one risk.
These ESG risks can translate directly to financial losses significantly and imminently. Market boycott or stock value plummet can easily be triggered by poor environmental or social practice, such as biodiversity loss, land grabbing, or child labor. More recently, the issue of stranded assets caused by ESG factors - such as climate-induced natural disasters and climate-related transition risks – has also become increasingly high profile. Therefore, it's critical to integrate ESG risk management into the decision-making, operational, and monitoring/reporting systems with clear responsibilities and accountabilities.
Avoiding ESG risk can also improve financial performance. For example, the New York University Stern Business School and the Rockefeller Asset Management jointly published a report in 2021, concluding that ESG Drives Better Financial Performance. For example, ESG initiatives at corporations can drive better financial performance because they encourage factors such as improved risk management and more innovation.
Regardless of the company's size, ESG risk management must start from the top – at the board level. It's beneficial to have written commitments, clear responsibilities, and accountabilities for the board and senior management. This is even explicitly required by national policies in some countries, such as South Africa's King IV Code on Corporate Governance.
At the operation level, it's important to have specific policies and procedures to identify, classify, measure, monitor, report, and manage ESG risks and performance throughout the financing cycle at the client or transaction level. It is also essential to undertake a regular review and monitor ESG risk exposure at the portfolio level.
Investors and financial advisers can actively help improve their clients' ESG risk management. For example, upon understanding clients' significant environmental ambitions, wealth managers and financial services providers can design a guiding framework to improve the clients' ESG management and help them issue ESG reports. .
An international best practice example of ESG risk management is the International Finance Corporation (IFC) Performance Standards and Corporate Governance Methodology. They provide a comprehensive approach to evaluate and improve the ESG risk management and corporate governance of projects and companies. For more, check out the IFC ESG Guidebook published in December 2021.
With risks come opportunities.
The UN estimates that achieving the Sustainable Development Goals (SDGs) could open up US$12 trillion of market opportunities and create 380 million new jobs. IFC estimates over US$23 trillion in investment opportunities in green and climate-related sectors and activities to help achieve national goals aligned with the Paris Agreement.
Many countries provide financial incentives to attract capital flows into these green, climate-smart, and sustainability-linked sectors, such as tax incentives or government subsidies for renewable energy in many countries, the European Green Deal, and the US Green New Deal.
Some countries also offer specific benefits for issuing green bonds. For example, Morocco's Capital Market Authority has reduced approval fees for sustainable financial instruments, such as green bonds. Also, Kenya introduced a withholding tax exemption on green bonds.
The capital markets provide rich opportunities for ESG investment. As of January 2022, 114 stock exchanges have joined the Sustainable Stock Exchange (SSE) Initiative, representing 56,767 listed companies and over US$ 92 trillion domestic market capitalization. The bond markets are growing particularly fast. For instance, the United States in 2020 alone issued the most green bonds globally, valued at $51.1 billion, with most of the proceeds aimed at energy sector investments, followed by low-carbon buildings and low-carbon transport.
These opportunities can come from anywhere in the operational processes and the supply chains. Take, for example, a healthcare venture capital fund – the Berkeley Catalyst Fund (BCF) – was recognized as a featured investment because of their shared ESG visions. BCF is investing in a process that synthesizes the effective components of active medical ingredients and can reduce the farming process's impacts on the environment. In other words, it is realizing the environmental benefits and fulfilling the financial returns at the same time.
A practical tool to help investors to realize these opportunities is the green and sustainable finance taxonomies - a classification of what are eligible green and sustainable activities for investments. Investments in these activities can enjoy green/sustainability-linked preferential treatment provided by the governments and international investors that recognize them. In addition to the EU Sustainable Finance Taxonomy, several countries, such as Brazil, China, and Russia, have also issued green or sustainable finance taxonomy. More countries are developing their own. In late 2021, China and the EU revealed cooperation to compare and potentially align green investment standards.
ESG reporting, or sustainability reporting, is another useful tool. Larry Fink encourages companies to “issue reports consistent with the Task Force on Climate-related Financial Disclosures (TCFD): because we believe these are essential tools for understanding a company’s ability to adapt for the future.” For practical reporting samples, check out the TCFD Recommendations, the IFC Toolkit for Disclosure and Transparency, the EU Regulation on Sustainability-related Disclosure in the financial services sector, and the Conceptual Framework and Industry Standards by the US Sustainability Accounting Standard Board (SASB).
In sum, the 2022 investors will do well to keep in mind that, ESG investment is what makes financial sense, and like two sides of the same coin:
ESG investment = risk management + opportunity realization
Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy & Sustainability writers, their opinions do not necessarily represent those of illuminem.
Holly is an independent sustainable finance specialist. Her roles include U.S. Managing Director at Polymer Wealth Management, a private firm headquartered in Hong Kong; member of the Secretariat team for IFC-facilitated Sustainable Banking and Finance Network; Guest speaker at John Hopkins University, and Board Member at Women Impact Investing Network.