It is time to replace the “companies will fix it” narrative that we have heard for so long with “governments should fix it.”

Harald

Kumar

From the very early days of climate discussions, a basic premise around decarbonization has been that we can only &ldquo;manage what we can measure.&rdquo; So, we started measuring in earnest with model-based emission calculations and other snazzy tools &ndash; and got really good at it &ndash; but after more than two decades, we are still waiting for the much-anticipated managing part to happen.
<h2>The intractability of scope 3 emissions</h2>
Emissions accounting and disclosures have now exploded into a large and growing industry of SaaS platforms, data providers, consultants and ESG ratings services. In the US, the upcoming <a href="https://www.wsj.com/articles/secs-climate-disclosure-rule-isnt-here-but-it-may-as-well-be-many-businesses-say-854789bd">SEC climate disclosure rules</a> will essentially codify the &ldquo;scope 1-2-3&rdquo; reporting standard for all public companies. Since scopes 1 and 2 are relatively trivial to track and report, most of the cost and effort in climate disclosures are going, and will increasingly go, into scope 3 which can exceed 80-90% of the total emissions in many industries.
Since supply-chain data is hard to get &ndash; even for large companies &ndash; most scope 3 estimates use secondary or industry-average data for material production and processing. This alone makes the estimates impossible to interpret or to act on because the numbers have no plausible link to specific suppliers or even geographies. Now, even if a company were able to get precise data from its suppliers (a big &lsquo;if&rsquo;, we think), it should be kept in mind that reducing scope 3 emissions can only be achieved by convincing suppliers to implement vast, disruptive, and costly changes to how they run their companies &ndash; for which they have neither the incentives nor the capabilities.
This <a href="https://illuminem.com/illuminemvoices/corporate-net-zero-is-a-heavy-lift-emission-reduction-pools-could-help">intractability of scope 3 emissions</a> is the fundamental reason that there are few, if any, cases (at least none that we can confidently cite) of large companies that have significantly slashed their supply-chain emissions &ndash; in other words, where measuring scope 3 emissions of a particular company led to a significant, identifiable reduction in those emissions.
Let us talk hypothetically for a moment. What if every company in the world simply focused on its own scopes 1 and 2 so that there would be no need to account for or reduce supply-chain emissions? Everyone&rsquo;s scope 1 and 2 is someone else&rsquo;s scope 3 after all. What would that do &ndash; could that be a solution? Well, it would greatly simplify the reporting. Good news! But it would not get us any closer to decarbonization.
This is because the world of decarbonization is not a conveniently siloed ecosystem of companies that operates separately from society. We should keep in mind that behind all &lsquo;scope 3 emissions&rsquo; there are&hellip; people! Consumers like you. And us. We drive cars, we fly to Bali, we import avocados from Chile, we use air conditioning, we live and work in buildings made of steel and cement. All these activities rely on economic systems &ndash; power, industry, agriculture, transportation, the built environment &ndash; that are hideously complex, driven by enormous and growing demand from all eight billion of us global citizens, and cannot simply switch energy sources overnight. In other words, at the end of the day, the world&rsquo;s consumers are responsible for scope 3 emissions and if we think we can solve this problem by demanding that all companies reduce scope 1 and 2 emissions then we are deluding ourselves.&nbsp;
<h2>Scope 3 reporting has not led to decarbonization</h2>
Three things to note:&nbsp;
<ul>
<li style="font-weight: 400;" aria-level="1">This demand for stuff, travel, housing, and food is not going to decline anytime soon, no matter what advocates of degrowth (that we have a lot of sympathy for) might say. And even if consumers, acting in concert, somehow manage to force some of the production away from the most destructive products (as one of us recently <a href="https://illuminem.com/illuminemvoices/to-address-the-climate-crisis-consumers-must-meet-the-technology-halfway">suggested</a>), companies worldwide will still need to produce huge quantities of products &ndash; products that would then perhaps be marginally less carbon-intensive, but this would never be enough to move the needle as much as it needs to be moved.</li>
<li style="font-weight: 400;" aria-level="1">Individual companies operating within &ndash; and embedded in &ndash; these economic systems can do very little to influence the emissions attributable to their own operations. They would have to take extreme steps, such as seriously slashing production, to get to any serious emission reductions, in which case other companies would simply step in to meet the demand &ndash; so the net result would be zero change to emissions.</li>
<li style="font-weight: 400;" aria-level="1">These complex international economic systems can effectively only be changed through public policies &ndash; i.e., government actions &ndash; that address both supply and demand, through taxes, laws, subsidies, and spurring innovation in low-carbon technologies. This is why governments, not companies, are the signatories to the Paris Agreement, and why academics, thinktanks and trackers who try to determine if we as a planet are in line with Paris goals look almost exclusively at government plans (NDCs, in Paris jargon) to tax, regulate, subsidize and innovate, and do not look at all at companies&rsquo; scope 3 reduction targets or transition plans.</li>
</ul>
All of this brings us back to this simple point. Despite the good intentions, reporting scope 3 emissions has not been a starting point for decarbonization but has largely proven to be a dead end. It is premised on the idea that whoever the emissions can be attributed to can also get rid of them. They can&rsquo;t and won&rsquo;t.
<h2>Decarbonization does not require scope 3 emission disclosures</h2>
We already know how to slow down the emissions trajectory and eventually get to net zero &ndash; this does not require more &lsquo;scope 3 emissions&rsquo; information. And the emissions information that is needed &ndash; at the systems level, not at the company level &ndash; is available. In the US, the <a href="https://www.wri.org/insights/inflation-reduction-act-benefits">Inflation Reduction Act</a> is a clear example of how policies and incentives can turbocharge investments in electrification, renewable energy, batteries, and grid upgrades. It was introduced not a year ago and is already beginning to initiate decarbonization at scale. How much did the IRA depend on scope 3 emissions information disclosed by companies? Zero point zero.&nbsp;
Yet, we are wasting so much valuable time forcing companies to disclose their &ldquo;full&rdquo; emissions and then to commit to &ldquo;net zero&rdquo; targets when they in fact have neither the tools nor the incentives to fix the climate problem on their own. Companies, after all, exist to provide specific goods and services to their customers, and they should be allowed to do exactly that while operating within net zero roadmaps established by governments representing all of us.&nbsp;
In other words, it is time to replace the &ldquo;companies will fix it&rdquo; narrative that we have heard for so long with &ldquo;governments should fix it.&rdquo;
<h2>A smarter strategy: go directly to decarbonization</h2>
A much smarter decarbonization strategy would bypass scope 3 emission disclosures altogether and use laws like the IRA as a template to accelerate decarbonization across economic systems. These incentives would need to be combined with strict standards for direct emissions from critical sectors like <a href="https://www.theguardian.com/environment/2023/may/11/new-rules-us-fossil-fuel-power-plant-emissions">power plants</a> and <a href="https://www.epa.gov/newsreleases/biden-harris-administration-proposes-strongest-ever-pollution-standards-cars-and">transportation</a>. Just imagine the simplicity of being able to set national emission reduction targets &ndash; the models here are the 26 countries that already have <a href="https://eciu.net/netzerotracker">net zero enshrined in law</a> &ndash; and then put in place policies to make the private sector do the actual work of getting us there.&nbsp;
No disclosures required. Go directly to decarbonization.
A closing note: If we let companies off the hook on emission disclosures, how will we assess their climate risk? We will have more to say on that topic in an upcoming piece in which we will make the case that a company&rsquo;s scope 3 emissions bear little or no relation to its physical or transition risk.
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illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.
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The 4 D’s of accelerating the transition: Ditch Disclosures, go Directly to Decarbonization

Changing the world through investing appears to be an appealingly simple idea, but introduces some difficult decisions.

Emmeline

Pension funds have been at the forefront of the responsible, sustainable, ESG and impact investment movement. These institutions, central to the establishment of the Principles for Responsible Investment (PRI), are also driving forces in investment industry initiatives such as the Net Zero Asset Owners Alliance, and many have now also incorporated the UN&rsquo;s Sustainable Development Goals (SDGs) into their investment policies. As a result, many have made significant changes to the way they invest, such as:
<ul>
<li style="font-weight: 400;" aria-level="1">exclusions: divesting from companies, sometimes even entire industries, that they consider unethical or unsustainable.</li>
<li style="font-weight: 400;" aria-level="1">engagement: having dialogues with investee companies with a view to changing them and improving their ESG performance.</li>
<li style="font-weight: 400;" aria-level="1">ESG integration: basing investment decisions explicitly on ESG factors as informed by ESG data, for example carbon intensity of firms.</li>
<li style="font-weight: 400;" aria-level="1">impact investment: allocating capital to companies that support the SDGs in order to &lsquo;make a better world&rsquo;.</li>
</ul>
To support these ESG investing activities, many pension funds now employ dedicated staff and work with data providers and consultants, sometimes at significant expense.&nbsp;
But despite this mushrooming in ESG activity, many are forgetting to make one crucial investment: an investment in connecting with their members &ndash; who are after all the ultimate &lsquo;owners&rsquo; of pension funds&rsquo; capital &ndash; and seeking to fully understand their ESG preferences.
Why is this important? Changing the world through investing appears to be an appealingly simple idea, but introduces some difficult decisions. In fact, there are countless different ways for a pension fund to demonstrate it is a &ldquo;responsible&rdquo; or &ldquo;sustainable&rdquo; investor; countless different norms, principles and guidelines a pension fund can decide to subscribe to (e.g. PRI, SDGs, Net Zero commitments), and countless different ways to reflect these commitments in investment portfolios (e.g. through exclusions, engagement etc.). And sometimes there&rsquo;s clarity as to the likely financial or real-world outcomes of these actions. But just as often, it seems to us, there is not.
Clearly, the main purpose of a pension fund is to provide retirement income to its members and should therefore be seen first and foremost as a fiduciary to those members. And while of course those members have delegated management of the pension pot to a board, the board maintains a duty to keep the interests of members in mind in doing so and &ndash; where there may be doubt as to how members view certain key aspects of pension fund management &ndash; they should also engage with those members.
In other words: ESG investing is all about understanding and making trade-offs. We believe it is essential for pension funds to provide clarity on this to their members, and to seek to understand members&rsquo; views on these trade-offs, to inform the fund&rsquo;s decision making.
<h2>Understanding pension fund member preferences &ndash; it&rsquo;s not straightforward</h2>
However, understanding preferences is not simple and this is especially the case with ESG investing, where there are often questions about how to trade off financial returns, ethical values and real-world outcomes. In some cases members prefer to invest in line with their values, and their pension funds&rsquo; investment strategy aims to reflect this. For example, the health care pension fund in Netherlands states that it does not to invest in tobacco firms.&nbsp;
But when it comes to values-based investing, the question is not only which values are important, but also what the consequences are &ndash; if any &ndash; for the investment strategy, for wider society, or for the environment. Do members still stick with their preferences if it is probable that ESG actions would result in (much) lower financial returns? And what about the real-world impact? What are members&rsquo; views on the matter if they understand that divesting tobacco companies does not result in less smoking? Again, do they still maintain this preference if they understand their action is not part of the solutions needed to eradicate smoking?
To be sure, some pension funds have engaged with members on these questions; for example, by working with market research firms to undertake surveys and organizing focus groups. However, we would argue that these approaches have significant limitations.&nbsp;
First, often there are problems with the research methods employed: self-completion surveys suffer from low response rates and response bias, and ask respondents to answer questions based on their own individual preferences; as a result, results are often limited in their generalizability, and provide little insight into how the collective should balance concerns.
Second, most pension funds do not have the capacity or specialist knowledge to manage market research projects, while many market research consultants lack a specialist understanding of financial, investment and ESG issues.
Third, it is widely recognized that financial literacy levels are low and that pensions topics have limited appeal to the average consumer. At the same time, responding to questions about ESG investing requires a certain understanding of how financial markets and pension funds work and of how to address often complex systemic issues such as climate change or biodiversity loss.
Fourth, members are often not adequately informed about what ESG tools can and cannot achieve in terms of driving behavior change or addressing SDGs. This also has to do with how ESG investing initiatives and questions are usually &ndash; and perhaps unwittingly &ndash; framed: as trade-off-free, &ldquo;win-win&rdquo; solutions, that give members a &ldquo;warm glow&rdquo; from investing in line with their values, boost financial returns and therefore their retirement income, help manage investment risk and &ndash; as icing on the cake &ndash; contribute to a better world! When presented this way, what&rsquo;s not to like?
Finally &ndash; but crucially &ndash; these forms of market research ask members to reply individually; respondents are usually not given the opportunity to engage in a deliberative way with other beneficiaries in a public forum, or to hear the views and recommendations of experts, before offering their views.
<h2>What&rsquo;s a pension fund board to do?&nbsp;</h2>
We believe that beneficiaries need to have a better understanding of what ESG investing approaches can and cannot achieve, and pension funds should listen to their views. Engaging with members in a deliberative way &ndash; involving dialogue rather than asking members to respond to survey questions &lsquo;from the top of their mind&rsquo; &ndash; can address issues such as lack of knowledge or understanding, and can attune members to collective rather than just individual preferences.
In other words, pension funds who want to design ESG investment policies that better reflect their members&rsquo; views and preferences should consider looking at the way in which deliberative democratic innovations &ndash; emerging from theories of deliberative democracy &ndash; have opened up dialogues with citizens and other stakeholders, and what they can learn from them.
<h2>What are citizens' assemblies?</h2>
Deliberative democratic innovations, such as citizens assemblies of randomly selected citizens, offer an alternative approach to engaging with public and understanding public preferences. While citizens assemblies are just one model, and part of a wider family of models known as &lsquo;mini-publics&rsquo;, they are characterised by:&nbsp;
<ul>
<li style="font-weight: 400;" aria-level="1">a deliberative engagement with a public;</li>
<li style="font-weight: 400;" aria-level="1">a focus on plural perspectives; and</li>
<li style="font-weight: 400;" aria-level="1">a focus on matters that are central to their lives as citizens.</li>
</ul>
These approaches inform citizens about complex policy issues, and through deliberation foster shared understandings and agreements that can feed into public policy decisions.
This approach differs markedly from classic market research surveys. Rather than producing a representative, statistically robust analysis, such approaches offer institutions with in-depth understanding of a representative, randomly selected, public&rsquo;s views, and specific recommendations for action.
In other words, a defining feature of all deliberative democratic models is a focus on sustained, in-depth, engagement with a public. In many cases deliberations take place over two to five days, but in some cases, it can involve up to thirty days of deliberation.
This appreciation of the time required to develop good judgements and recommendations is a distinctive characteristic of these innovations, situating them halfway between quick market research and one-off consultation events on the one hand, and the long-term commitment required by an elected representative on a council or committee.&nbsp;
And, crucially, this time investment enables participants to become informed about a complex question; to learn about the issues, about the perspectives of others, and about factors which shape and constrain decision-making. It also offers participants the opportunity to fully express their own opinions and beliefs, including attention to the expression of &lsquo;un-heard&rsquo; and minority views that are often unexpressed, unacknowledged, or misunderstood.
<h2>What are the benefits of deliberation?</h2>
We believe this focus on learning offers unique benefits and is ideally suited to engaging with pension fund members on the question of ESG investment. Not only do many members start with low levels of financial and pensions literacy, ESG and sustainability issues create complexity by layering ethical norms and societal issues on top of &ndash; already complex &ndash; financial considerations. And then there is the need for clarity on the expected real-world impacts of investing that are often hard to establish objectively or to attribute to individual investors.
In the face of these challenges, achieving greater understanding of these issues with pension beneficiaries is essential to ensuring ESG investment is governed effectively, and with transparency.
And by facilitating the expression of opinions, deliberative democratic innovations enable participants to consider not only their own individual position, but also the positions of others, as well as areas where they share common ground. Rather than focusing solely on eliciting individual preferences, these collective processes seek to achieve a degree of convergence &ndash; where diverse opinions and concerns can be brought together into areas of mutual agreement.&nbsp;
With good facilitation, eventually this leads to the formulation of collective recommendations. In contrast to classic market research, we believe these approaches are well suited to collective investment institutions where fiduciary duties require governance decision-making to be in the interests of the membership as a whole.
<h2>All well and good, but does it work in practice?</h2>
Deliberative experiments in public governance have flourished in recent years, providing insight on the potential for the institutionalisation of deliberative democratic ideals. <a href="https://participedia.net/">Participedia</a> offers plentiful examples of the breadth of models instigated across the globe, addressing a host of different, complex public policy questions.&nbsp;
On pensions issues, varied models &ndash; such as citizens' assemblies, along with participatory and representative models &ndash; have already been established to address wicked questions around state pension systems. The Arizona Citizens&rsquo; Initiative Review (CIR) on Pensions Reform, the National Deliberative Poll in Chile, and the Mini-Public on National Pensions Debate in the UK are just three examples.&nbsp;
<h2>Easy when you know how</h2>
While these deliberative forums offer a beguiling alternative to standard forms of market research and consultation, achieving its goals in practice is no simple matter. In practice, social and economic inequalities underscore asymmetries in power, which inevitably find their way into communications between individuals and among groups. Deliberative approaches can&rsquo;t remove these, but practitioners can minimise their impact by designing recruitment procedures that ensure a representative group and not only the &lsquo;usual suspects&rsquo; &ndash; citizens with the time, skills and capacity to be engaged in their community.&nbsp;
Another technique is utilising skilled facilitators to ensure the equal participation of every individual involved, contributing to the realisation of higher-quality deliberations. And at a broader level, ensuring the design, process and outputs and influence of these forums are publicly accessible enhances their accountability and legitimacy to the wider membership.
<h2>So what are the takeaways for pension funds?&nbsp;</h2>
The widespread use of models such as citizens' assemblies in the public sector has greatly improved our understanding of how these models can work in practice, and under what conditions they realise good outcomes. Pension funds can tap into these learnings to understand the value of these innovations, and their relevance for informing pension fund decision-making.
This approach to engaging with citizens also offers two easy takeaways for pension funds who wish to improve their governance of ESG investing.
<h3>1. Address knowledge gaps&nbsp;</h3>
First of all, models such as citizens' assemblies illustrate the value of addressing knowledge gaps in governance. Pension funds should consider how they are informing and engaging members on the question of ESG investing. If they are using surveys, are they considering what questions are reasonable to ask members in a &lsquo;top of mind&rsquo;, 10-minute survey? Pension funds should think carefully about how much, and what type, of information respondents need to effectively grapple with survey questions. They also should consider the thorny issue of bias: how is this risk taken seriously, and addressed? Does the survey address potential trade-offs directly or are they brushed under the &ldquo;win-win&rdquo; carpet? Finally, if members indicate they wish to know more, are they offered the opportunity to access further information about this issue?
<h3>2. Ensure representation and deliberation</h3>
Second, the learnings from citizen assemblies illustrate the added value of truly representative governance bodies &ndash; with not only socio-economic or demographic representation, but with representation of diverse viewpoints. In addition, they illustrate the added value that deliberating issues can have, where beneficiaries provide input to pension funds based on debate with other beneficiaries and informed by subject matter experts. Pension funds should seek to realize similar high-quality deliberations, drawing in diverse perspectives, to enhance decision-making on ESG investing.&nbsp;
In some countries, pension funds already have governance bodies that represent members, such as member councils. As an easy starting point, pension fund boards should assess how these governance bodies can be used more effectively, first, to inform members on ESG investing and thereby close potential knowledge gaps, and second, to gain their considered feedback.
Pension funds have been at the forefront of the shift to ESG investing in the last twenty years. However, we believe there hasn&rsquo;t been enough effort to engage with their members on the complex issues this entails, including hard-to-pin-down preferences, ethical values, and potential trade-offs.
We argue that the pensions sector should be inspired by how deliberative democratic thinking has re-energised public governance &ndash; through pioneering models such as citizens' assemblies. These models, with their emphasis on the need for democratic representation, and the quality of deliberation, show how the governance of ESG investing can better reflect member preferences.
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.

Now we’re talking: why pension funds should engage with their members on ESG investing

It is now clearly documented that, as we move towards the implementation of collective global biodiversity aspirations, and as we consider which tools should be on our table, the answer that presents itself is “blended finance, naturally”. So what are the four things you actually need to think about when considering blended finance transactions for nature?

Robert W. van

Adhiti

In 2022, Robert van Zwieten, Harald Walkate, and Simon Gupta authored <a href="https://route17.world/thought-leadership/">six articles</a> under the header &ldquo;Blended Finance is Like Music&rdquo; &ndash; comparing blended finance investing to symphony orchestras: many different &lsquo;musicians&rsquo; are needed, with different skills and capabilities, and there needs to be a producer and a conductor to make it all happen.
In a new series of articles, Robert and Harald, who have since then also founded the blended finance advisory firm Route17 to put their ideas into practice, continue to explore what is needed to further develop the global infrastructure to enable more blended financing. They have observed that in blended finance discussions, it is often said that &ldquo;more parties should come to the table&rdquo;.
However, what is often not clear is exactly where this &ldquo;table&rdquo; is. And what happens at that table once the necessary people come to it? Also, which people are required to sit at that table &ndash; and for how long &ndash; and what is discussed at that table? And what &ldquo;cutlery&rdquo;, or instruments, are on that table that can be used by those sitting there?
In a next series of articles, they explore these themes, each time working with a guest co-author who brings relevant expertise. For this first article in the series, our guest is Adhiti Gupta who is a sustainable finance expert with a focus on natural capital, climate action, and gender equality. Her clients include UNEP, World Bank, and Climate Policy Initiative. She has previously led a market accelerator at Convergence Blended Finance and advised impact investors at RPCK.
Our species continues to live it up like there is no tomorrow and as if planetary boundaries do not exist. Nonetheless, there have been some promising developments of late, suggesting that we may be turning the corner. Or, at least, approaching the intersection.
In the last few years, there has finally been prominent mainstream attention for sustainable land use, fishery, and forestry; for conservation of marine protected areas (MPAs); and for protection of mangrove forests, to name a few examples. Debt-for-nature swaps, around since the 1980s, are coming into their own, with much larger transactions happening (Belize, Barbados) or on the drawing board (Sri Lanka and Gabon).
The 15th Conference to the Parties (COP 15) to the UN Convention on Biological Diversity (CBD) in Montreal in December 2022 was another such bright spot. It saw record levels of participation from the private sector and business. Participants agreed to the Kunming-Montreal Global Biodiversity Framework to safeguard nature and reverse biodiversity loss, putting nature on a path to recovery by 2050.
Yet another hopeful step forward was the Intergovernmental Conference on Marine Biodiversity of Areas Beyond National Jurisdiction, resulting in the UN High Seas Treaty last month. This historic agreement seeks to protect two-thirds of the ocean that lies outside national boundaries. It enforces the &ldquo;30-by-30&rdquo; pledge made by countries at COP15 &ndash; to protect a third of sea and land by 2030 &ndash; and offers a legal mechanism to set up marine protected areas on the high seas.
These achievements in quick succession were arguably the &ldquo;Paris moment&rdquo; for biodiversity finance. And like the Paris climate agreement, the Global Biodiversity Framework points to the need for &ldquo;leveraging private finance&rdquo;. Yet, however encouraging this might be, we note that the private sector alone cannot solve the biodiversity crisis &ndash; effective partnerships with the public sector are critical.&nbsp;
This is why we are pleased to see that the Global Biodiversity Framework explicitly references &ldquo;promoting blended finance&rdquo;: it highlights the importance of harnessing the combined financial strengths of the private sector, philanthropic, and public sector actors, which can be readily achieved through blended finance.
Also, in other news, a recent <a href="https://www.ecgi.global/working-paper/biodiversity-finance?mc_cid=731eec0c62&amp;mc_eid=9c772b4923">academic paper</a> that compares privately financed and blended finance biodiversity deals points out that while the returns on the blended deals are lower, the risk is also lower, the project size is larger, and &ndash; clearly, most importantly &ndash; the biodiversity impact is significantly higher.
In other words, it is now clearly documented that, as we move towards the implementation of these collective global biodiversity aspirations, and as we consider which tools should be on our table, the answer that presents itself is &ldquo;blended finance, naturally&rdquo;.
But now, for the heavy lifting: what are the four things you actually need to think about when considering blended finance transactions for nature?
<h3>1. Identify credible revenue streams</h3>
A necessary component of any investment, whether or not structured through blended finance, is a revenue stream. If you&rsquo;re trying to fund a project that doesn&rsquo;t generate revenues (yet), you should be thinking more about public finance, philanthropy, or traditional aid than about private sector investments. And if you can achieve multiple revenue streams, that&rsquo;s even better &ndash; they can make a business model less reliant on one revenue stream and therefore more financially viable. For example, financing sustainable land use becomes possible when sustainably managed forests generate timber revenues; sustainably harvested forest products are sold to off-takers; and there is also eco-tourism. But sometimes it may be the avoidance of a loss, rather than a revenue stream, that makes the blending work &ndash; an insurance company may wish to invest in the conservation of flood-preventing mangrove forests now, rather than possibly having to pay out large amounts on account of flood damage claims later on.&nbsp;
<h3>2. Engage with government, indigenous peoples, and local communities (especially women)&nbsp;</h3>
Governments typically have a huge role in natural resource protection and public budgets have also played an outsized role in financing nature. Most blended finance transactions will therefore need to involve the government, perhaps even multiple agencies or levels of government, not only to obtain subsidies or concessional capital, but also to gain access to protected areas, or to obtain permits. Having local teams that know how to engage effectively with the appropriate authorities is critical. Similarly, it is important to involve indigenous peoples and local communities, who are often &ndash; as stewards of their lands &ndash; frontrunners of local conservation efforts, in particular women who in many communities are the &ldquo;natural resource managers&rdquo;. Recognizing the gender dimension of nature and biodiversity and integrating it into your financing approach becomes imperative.
<h3>3. Confront the added complexity&nbsp;</h3>
Investing in nature and biodiversity, especially mitigation approaches is arguably even more complex than climate-related blended finance. Thus, creativity is required in structuring the deal and collaborating with diverse stakeholders. Why are they complex? There&rsquo;s usually no single impact target (such as &ldquo;net zero&rdquo; or &ldquo;carbon neutral&rdquo;) to rally behind and transactions need to be tailored to the specific natural landscapes, to government requirements, and to the interests of local communities. Often, bespoke and previously untested business models need to be designed to create financially viable transactions. This also explains why there appears to be more innovation in structuring transactions for nature than elsewhere. For example, designing parametric insurance products led to the creation of coral reef insurance products that are now being scaled across geographies.
<h3>4. Optimize interconnectedness of climate and nature finance</h3>
Although science tells us that climate and nature are inextricably linked, they are often addressed separately in structuring projects, without considering synergies and efficiencies, which can lead to increased risks and missed opportunities. When sustainable land-use transactions don&rsquo;t realize opportunities to build climate resilience, the deal may fall onto itself as climate change wreaks havoc.
We will soon hear a lot more about blended finance transactions for nature, as the world moves to implement the treaties and frameworks referenced above. As long as sufficient revenues can be generated that derive value from nature, blended finance can help create a return on risk capital. To be successful, parties need to be ready to engage governments and local communities (especially women); confront the added complexity with creativity and innovation; and, finally, heed the interconnectedness of climate and nature in our transaction structuring.
<h2>Why blended finance is critical&nbsp;</h2>
Most projects and activities that are needed to achieve the SDGs are not profitable, not profitable&nbsp;enough, or not&nbsp;yet&nbsp;profitable. Also, most are small-scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that&rsquo;s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it&rsquo;s unlikely we can persuade pension fund boards to make impact-first investments at scale &ndash; their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they&nbsp;do&nbsp;meet institutional investors&rsquo; requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.
Illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.

Blended finance. Naturally.

This is number six, and the last, in our series of articles applying the analogies of music and orchestras to the world of blended finance. In the previous articles we have analyzed what role the different stakeholders – governments, asset owners, development banks, foundations and ESG professionals – can play in order to generate more blended finance and scale it, such that it makes a real dent in mobilizing capital. Capital needed to address the world’s environmental, social and governance challenges.

Simon

This is number six, and the last, in our series of articles applying the analogies of music and orchestras to the world of blended finance. In the previous articles we have analyzed what role the different stakeholders &ndash; <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">governments</a>, <a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">asset owners</a>, <a href="https://illuminem.com/illuminemvoices/4a2e6443-00e9-476e-ad08-943caa32472c">development banks</a>, <a href="https://illuminem.com/illuminemvoices/abc2cf1e-f815-4f60-8a6c-5ab10ec06226">foundations</a> and <a href="https://illuminem.com/illuminemvoices/8c0f921d-f0db-46bc-8978-7a0aadb307d5">ESG professionals</a> &ndash; can play in order to generate more blended finance and scale it, such that it makes a real dent in mobilizing capital. Capital needed to address the world&rsquo;s environmental, social and governance challenges.
We could have gone on to describe the role of sovereign wealth funds, investment banks, private banks, investment consultants, high net-worth individuals and of course entrepreneurs and organizations looking for financing (and perhaps we may still, next year&hellip;!). But in wrapping up the series, for now, there&rsquo;s one important group of actors that we feel deserves coverage: asset managers.
That&rsquo;s because you, asset managers, are in many ways like the conductor of the orchestra: perhaps you didn&rsquo;t produce the concert, you&rsquo;re likely not playing one of the instruments, and maybe you didn&rsquo;t even decide what music was going to be played today.
But there is one crucial thing that you do decide: how the music will be played. You set the tempo, you decide exactly when the violins come in, you cue the trumpets when they need to play a more powerful role; in other words, it&rsquo;s your role to turn music notes printed on the page into a fully-fledged performance that, through dynamics, phrasing and articulation, brings the written music to life and is appreciated and enjoyed by the audience.
So what are the three things asset managers could do to play this conducting role more effectively?
<h2>1. Educate staff and clients</h2>
One of the main challenges in blended finance is bringing institutional asset owners to the table. They, after all, have the deep pockets that can bring the scale needed, while they also, as fiduciaries, need to carefully watch their investment criteria to make sure they invest in keeping with their clients&rsquo; and beneficiaries&rsquo; interests and wishes.
Of all actors in the blended finance eco-system, asset managers have the closest relationships with asset owners, with investment consultants a close second. Asset managers already invest the bulk of asset owners&rsquo; assets and so they regularly meet with them, periodically report on the performance of the assets under management, and advise on how to allocate or re-allocate assets going forward.
Asset managers should educate their staff on blended finance, and SDG-related investment more generally, so that they in turn can advise asset owners: what is blended finance? What are the types of blended finance vehicles that already exist and that might match investment criteria? Which new vehicles can we co-create and tailor to your precise requirements? Ultimately, it is about being an SDG-finance guide for the asset owners interested in taking responsibility for people and planet.
We had a chat with a head of responsible investment at a large asset management firm recently. He told us, &ldquo;I think of blended finance in the context of fiduciary duty, it means doing the best for clients. Blended finance is something that is coming to the agenda more and more frequently, so we have an obligation to advise our clients on what this type of investment can mean for them.&rdquo;
In doing so, it is very important to help asset owners understand the difference between an impact-aligned strategy (investing in impact that is already happening or that would happen regardless of the investment) and impact-generation (where the investments cause or enable the real-world change).
In addition, education of asset owners requires that asset managers should not overstate the contribution they are making to impact goals today through traditional investment methods, including sustainable finance approaches such as ESG integration, active ownership, or public markets impact funds. Doing so risks creating a placebo effect: the collective illusion that asset owners and asset managers are doing something about societal problems when in reality&hellip; we aren&rsquo;t.
<h2>2. Embrace emerging markets</h2>
Many of the societal challenges that we are collectively aiming to address have a common denominator: they are mostly playing out in emerging markets and require solutions, at scale, to be deployed on the ground. This is certainly also true for investments needed for climate mitigation and adaptation. The text of the <a href="https://www.un.org/en/development/desa/population/migration/generalassembly/docs/globalcompact/A_RES_70_1_E.pdf">UN Resolution on the Sustainable Development Goals</a> mentions the words &ldquo;developing countries&rdquo; no less than 69 times.
At the same time, many asset managers do not proactively follow, or allocate to, emerging markets. This is remarkable because nearly half of global GDP is generated in emerging markets and about 83% of the world population lives in these markets. Not investing there means investors miss out on the highest growth countries and companies, and on a considerable chunk of largely un-correlated returns. Yes, there are many reasons why investing in emerging markets is harder and riskier, but aren&rsquo;t you, asset managers, compensated to figure out where the best risk-returns are to be had?
This attitude toward emerging markets is also somewhat paradoxical considering how many asset owners and asset managers have made commitments to &lsquo;impact investing&rsquo; and &lsquo;SDG investing&rsquo;. But what&rsquo;s even more paradoxical is that institutional investors, today, may even be retreating from emerging markets due to ESG considerations: there is some anecdotal evidence suggesting the climate-related decarbonization targets companies set encourage them to avoid those markets.
Emerging markets are like an elephant in the impact investing-room. And asset managers can play an important role in acknowledging its presence.
<h2>3. Enhance capabilities</h2>
If in fact asset owners come to the conclusion that they need blended finance to live up to their impact and SDG commitments, <a href="https://www.unepfi.org/themes/climate-change/scaling-blended-finance/">as seems to be happening already</a>, they will come to asset managers seeking solutions. While asset managers are not paid to innovate by their own initiative, responsiveness to client needs is another matter. On this our friend, the head of responsible investment, said, &ldquo;if clients want this, as seems to be the case, it&rsquo;s simply our responsibility to develop the necessary capabilities.&rdquo;
Asset managers developing blended finance capabilities means, inevitably, developing relationships &ndash; with government agencies, with development banks, with foundations. Because as Peter Drucker, the famous management guru, once said, &ldquo;conductors do not know how the oboe does its work, but they know what the oboe should contribute.&rdquo;
In sum, asset managers have a key role to play in blended finance, as conductors of the orchestra.
But then again, as we&rsquo;ve argued in the other articles in our series, all actors have key roles to play. That&rsquo;s the beauty, but also the challenge, of blended finance: like with a symphony, every instrumentalist has a unique contribution to make, and each is needed to deliver the end result.
And should you still be doubtful as to whether we can rally around this cause, or think that blended finance will always remain what&rsquo;s-most-needed but out-of-reach at the same time, keep in mind Bono&rsquo;s powerful words: &ldquo;Music can change the world because it can change people.&rdquo;
<h2>Why Blended Finance is Critical</h2>
Most projects and activities that are needed to achieve the SDGs are not profitable, not profitable enough, or not yet profitable. Also, most are small-scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that&rsquo;s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it&rsquo;s unlikely we can persuade pension fund boards to make impact-first investments at scale &ndash; their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they do meet institutional investors&rsquo; requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.
Perhaps you haven&rsquo;t seen the first five articles we wrote comparing blended finance to music. The basic idea of the analogy is that to play a symphony you need lots of different musicians, playing the parts only they can play &ndash; it&rsquo;s no different in blended finance. In each article in this series, we&rsquo;re talking about who those different &lsquo;musicians&rsquo; are that are needed on the blended finance stage &ndash; and how to get them on stage! You can find them here:
<ul>
<li><a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">Governments: blended finance is like music</a>​</li>
<li><a href="https://illuminem.com/illuminemvoices/abc2cf1e-f815-4f60-8a6c-5ab10ec06226">Foundations: <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">blended finance is like music</a></a>​</li>
<li><a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">Asset Owners: <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">blended finance is like music</a></a>​</li>
<li><a href="https://illuminem.com/illuminemvoices/4a2e6443-00e9-476e-ad08-943caa32472c">Development Banks: <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">blended finance is like music</a></a>​​</li>
<li><a href="https://illuminem.com/illuminemvoices/8c0f921d-f0db-46bc-8978-7a0aadb307d5">ESG Professionals: <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">blended finance is like music</a></a></li>
</ul>
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.
Cover photo: <a href="https://commons.wikimedia.org/wiki/File:Marin_Alsop_with_OSESP_%2835306231850%29_%28cropped%29.jpg">Marin Alsop with OSESP</a> cropped from the original photo by <a href="https://flickr.com/photos/38014693@N04/35306231850">Governo do Estado de S&atilde;o Paulo,</a> Gilberto Marques (<a href="https://creativecommons.org/licenses/by/2.0/">CC BY 2.0</a>)

Asset managers: blended finance is like music

This is number five in our series of articles applying the analogies of music and orchestras to the world of blended finance. In each article we analyze what role the different stakeholders – governments, asset owners, development banks, foundations – can play in order to generate more blended finance and, in doing so, mobilize capital to address the world’s environmental, social and governance challenges.

And if there’s one group of stakeholders out there that cares about environmental, social and governance challenges, it must be you: ESG Professionals.

This is number five in our series of articles applying the analogies of music and orchestras to the world of blended finance. In each article we analyze what role the different stakeholders &ndash; <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">governments</a>, <a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">asset owners</a>, <a href="https://illuminem.com/illuminemvoices/4a2e6443-00e9-476e-ad08-943caa32472c">development banks</a>, <a href="https://illuminem.com/illuminemvoices/abc2cf1e-f815-4f60-8a6c-5ab10ec06226">foundations</a> &ndash; can play in order to generate more blended finance and, in doing so, mobilize capital to address the world&rsquo;s environmental, social and governance challenges.
And if there&rsquo;s one group of stakeholders out there that cares about environmental, social and governance challenges, it must be you: ESG Professionals.
Since the introduction of the term &ldquo;ESG&rdquo; in the early 2000s, this new professional discipline has ballooned from a handful of people who devoted much or all of their professional time to what we now call &ldquo;ESG&rdquo;, to some 349,000 people who have &ldquo;ESG&rdquo; in their title or job description, according to LinkedIn. We expect that the number has not peaked yet, and many more are yet to come.
So, what are the three pieces of blended finance advice we have for you?
<h2>1. Do soul searching &ndash; is your motivation to&nbsp;make&nbsp;a difference?</h2>
We don&rsquo;t want to wade into the debate of what exactly is &ldquo;ESG&rdquo;, whether we should start calling it &ldquo;responsible investment&rdquo; again, or how it&rsquo;s different from &ldquo;impact investment&rdquo; and &ldquo;sustainable finance&rdquo;.
However, we would argue that for most, if not all of you who identify with the &ldquo;ESG&rdquo; label, one of the main drivers &ndash; if not the main driver &ndash; that brought you to this space is a desire to, through finance and investments, make a better world, generate impact, enable change, move the needle, contribute to the SDGs. In sum: making a difference in the world.
You will detect in these verbs a definitive sense of instrumentality, or agency&nbsp;&ndash; you want to be the &ldquo;means&rdquo; to a certain &ldquo;end&rdquo;; you are aiming for &ldquo;cause and effect&rdquo; or &ldquo;additionality&rdquo;. You know, the idea that if you or the company you work for had not undertaken some action, that positive change would not have happened.
OK, so then think about how much of what you&rsquo;re currently doing has additionality, or actually causes positive change. And just to give you a bit of help here, academic research suggests that the following activities, that many ESG professionals spend most of their time on, have very little to no additionality &ndash; they don&rsquo;t make much, or any, difference in the world:
<ul>
<li>Exclusions / divestment</li>
</ul>
<ul>
<li>Decarbonizing portfolios, making them Paris-aligned, measuring emissions</li>
</ul>
<ul>
<li>Net zero commitments</li>
</ul>
<ul>
<li>Writing PRI / TCFD reports</li>
</ul>
<ul>
<li>Classifying your funds as article 8 or 9 and making SFDR disclosures</li>
</ul>
<ul>
<li>Carbon footprinting</li>
</ul>
<ul>
<li>ESG integration</li>
</ul>
<ul>
<li>SDG-aligned investing</li>
</ul>
To be sure, some of these things may work for values-alignment (i.e., your or your clients&rsquo; &ldquo;warm glow&rdquo;); a number of them might work for risk management (ESG used to be principally a risk management framework, after all); maybe some of it also works for generating better financial outcomes. But do they change the world? Reduce poverty, fix climate change, eliminate hunger? We think you know the answer.
So this would be our first bit of advice: do some soul searching, ask yourself: &ldquo;Why am I in this role, what brought me here? Is it to have impact?&rdquo; And then ask yourself, &ldquo;am I currently making this positive contribution?&rdquo;
<h2>2. Do the impact math &ndash; do &ldquo;returns and impact go hand-in-hand&rdquo;?</h2>
We suspect that the answers to these questions above, for the vast majority of you &ndash; if you&rsquo;re ruthlessly honest with yourself &ndash; are &ldquo;yes&rdquo; and &ldquo;no&rdquo;.
So then our next recommendation would be to do the math on &ldquo;impact investing&rdquo;, and especially to challenge the notion that has become quite popular in impact circles, which is: &ldquo;impact and return go hand-in-hand&rdquo;. Because, while this may be true in a small number of cases, projects and companies where impact and return in fact go hand-in-hand should not have much difficulty in raising capital.
But in the vast majority of cases, as we argue in our sidebar Why Blended Finance is Critical, projects that are needed to reach the SDGs are small, are not profitable (yet), are risky and are in developing countries. In other words, projects where impact and return certainly do not go hand-in-hand. At the same time that&rsquo;s where we need to direct those trillions of dollars.
In other words, if you want to make these investments AND leverage the deep pockets of the world&rsquo;s largest asset owners &ndash; pension funds, insurers, etc. &ndash; you will need some kind of tool or aid that makes the investment possible, because it allows the risk-return profile to start making sense for those asset owners. This is what blended finance does.
The only alternative to this is to hope that pension fund boards somehow start making investments that don&rsquo;t meet their investment criteria, which we believe is exceedingly unlikely. They cannot ignore their fiduciary duty to their beneficiaries.
So, recommendation #2 is: do the impact math, read up on blended finance, sign up for a blended finance course.
<h2>3. &ldquo;Change ESG&rdquo; &ndash; think like miles</h2>
Once you&rsquo;ve completed the thinking on our first two recommendations, you&rsquo;ll realize that you will have to make blended finance part of your toolkit.
But our advice is to go further than that &ndash; we recommend you do everything in your power to &ldquo;change ESG&rdquo;, for all of us (349,000 strong and counting) in order to redirect our collective focus from all those ESG activities conducted today that are perceived as &ldquo;normal&rdquo; but are largely ineffective, to those investments that actually have impact on the ground, that cause positive change.
And to go back to our music analogy, consider the case of Miles Davis, the jazz trumpeter who is generally credited with &ldquo;changing music&rdquo;. Not just once, mind you, but as often as 5 or 6 times. How did Miles do this? At several stages in his career, he burned his bridges, and surrounded himself with young, innovative and creative musicians, who brought new ideas and skills to what Miles was trying to achieve with music. What happened? He didn&rsquo;t only change &ldquo;Miles Davis music&rdquo;, he changed the entire scene, influencing how everyone was playing, and listening to, music.
You can do the same. As Miles said: &ldquo;when you do anything too long, you either wear it out or lose interest&rdquo;. So, instead of writing that tired old PRI or sustainability report, instead of agonizing over that article 8 vs. article 9 decision, instead of worrying about your NZAMI disclosure, try to understand what solutions are available to achieve the SDGs, and try to understand how you can help finance them. You will see that in many cases this requires blended finance.
Then, surround yourself with new &lsquo;musicians&rsquo; &ndash; government officials, development bank representatives, emerging markets specialists, philanthropic foundations and so forth &ndash; and start playing a new kind of ESG music.
Yes, it will be difficult, it will be messy, this is what change and innovation are about. Like any jazz musician, you&rsquo;ll have to improvise. A lot. But we think you&rsquo;ll enjoy this a lot more than what you&rsquo;re doing today.
Because you&rsquo;ll know that you are, finally, making a difference in the world.
<h2>Why blended finance is critical&nbsp;</h2>
Most projects and activities that are needed to achieve the SDGs are not profitable, not profitable&nbsp;enough, or not&nbsp;yet&nbsp;profitable. Also, most are small-scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that&rsquo;s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it&rsquo;s unlikely we can persuade pension fund boards to make impact-first investments at scale &ndash; their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they&nbsp;do&nbsp;meet institutional investors&rsquo; requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.
Perhaps you haven&rsquo;t seen the first four articles we wrote comparing blended finance to music. The basic idea of the analogy is that to play a symphony you need lots of different musicians, playing the parts only they can play &ndash; it&rsquo;s no different in blended finance. In each article in this series we&rsquo;re talking about who those different &lsquo;musicians&rsquo; are that are needed on the blended finance stage &ndash; and how to get them on stage! You can find them here:
<a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">Governments​: Blended Finance is Like Music</a>​
<a href="https://illuminem.com/illuminemvoices/abc2cf1e-f815-4f60-8a6c-5ab10ec06226">Foundations: Blended Finance is Like Music</a>​
<a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">Asset Owners: Blended Finance is Like Music</a>​
<a href="https://illuminem.com/illuminemvoices/4a2e6443-00e9-476e-ad08-943caa32472c">Development Banks: Blended Finance is Like Music</a>​​
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.

ESG professionals: blended finance is like music

In this article, the fourth in our series*, we talk about another group that can play a very important role in the blended finance symphony: development banks. There’s a multitude of actors under this header, with different terms applied: multilateral development banks, international financial institutions, development finance institutions. Some of what we say below applies to all, while other points only apply to select members of this group.

In this article, the fourth in our series*, we talk about another group that can play a very important role in the blended finance symphony: development banks. There&#x27;s a multitude of actors under this header, with different terms applied: multilateral development banks, international financial institutions, development finance institutions. Some of what we say below applies to all, while other points only apply to select members of this group.
To put the role of development banks into further perspective, we want to introduce another analogy besides music – one about the storage vs. the moving business. Because one of many adages in the finance world is that some banks (investment banks) are in the “moving business” – they make money trading assets for clients as an agent, advising clients on transactions, or trading for their own account as a principal – while others (commercial banks) are in the “storage business” – they make money by holding loans and bonds on their balance sheets.
<a href="https://en.wikipedia.org/wiki/Alexia_Latortue">Alexia Latortue,</a> assistant secretary at the U.S. Treasury, said recently: “Private investors want to move away from fossil fuel investments, but they have to move into something. And that’s where the excitement is — how do we find the real economic opportunities for investments in clean energy.” To enable this move for private investors, we argue here that development banks should transition principally from the storage business into the moving business. Their balance sheet and capital base are finite, so their storage capacity will always be limited. “Demonstration effects” can only go so far, and with COP27 and the G20 the expectations placed on development banks are rising fast: they can point the way to that “something” private investors can move into, and they can even supply the vehicles and tools – not moving trucks and lifts but concessional financing and funds – to do the actual relocation.
For development banks to play this moving role effectively, we have four main ideas.
<h2>1. Use your rating and balance sheet to do more</h2>
This report – “<a href="https://g20.org/wp-content/uploads/2022/07/CAF-Review-Report.pdf">Boosting MDBs’ investing capacity - An Independent Review of Multilateral Development Banks’</a> <a href="https://g20.org/wp-content/uploads/2022/07/CAF-Review-Report.pdf">Capital Adequacy Frameworks</a>”, just published last July and presented by the taskforce’s chairwoman <a href="https://en.wikipedia.org/wiki/Frannie_L%C3%A9autier">Frannie Léautier</a> to the G20, offers a number of excellent recommendations. There has already been some debate on the key recommendation: redefining risk tolerance. While we agree with this recommendation and think it is deserving of further consideration, we also want to highlight some of the less eye-catching recommendations, that can do at least as much to generate more blended finance.
<ul><li>Give more recognition to “callable capital” – effectively the capital that signifies the commitment of the development banks’ shareholders (governments) to stand behind them. It should be fully taken into account in assessing development bank’s capital adequacy, as it already is in some credit rating agency methodologies. This should create opportunities for more lending, including the concessional kind.</li></ul>
<ul><li>Pick up the rate of financial innovations – so that the development banks can do more with their current capital base and, again, free up room for additional lending. In doing so, development banks should take some pages out of the playbook of Wall Street and haute finance.</li></ul>
<ul><li>Increase access to data &amp; analysis – private sector investors have capital and are increasingly keen to move it into sustainable purposes in emerging markets. However, they desperately need access to relevant data to assess the risk &amp; reward. You, development banks, have much of it – you should find ways to get it out into the open.</li></ul>
<h2>2. Implement a credible private capital mobilization strategy</h2>
The famous pop singer Sting, after his success with the Police, wanted to make a solo record with “a jazz feel”. So what does he do? He goes out and hires jazz musicians – most notably Branford Marsalis, world-famous in jazz circles, virtually unknown outside it. This approach was practically unheard of – until Sting came along, the worlds of pop and jazz were strictly separated.
Development banks should do the same. If you want to raise private capital for transactions, you won’t succeed if you don’t have a strong grasp of, and connections with, the world of private sector institutional capital. This requires an intentional capital mobilization strategy – developing relationships, convening, organizing events, hiring investment bankers or consultants who can help you design structures that meet private sector requirements. Better yet, up your game in attracting talent: doing deals with the private sector works best with staff who have worked in the private sector. And keep in mind, strategy is 10% planning and 90% implementation. Making promises is a nice prelude but will not deliver the whole symphony.
Meanwhile, be sure to not displace private sector capital, which would defeat the whole point.
<h2>3. Transform to become more nimble</h2>
We know it is a tall order to suggest development banks become more light-footed, but to successfully deal with the private sector and mobilize capital into the deals that you want to see happen, you will have to at least keep pace with the private sector. Right now, many development banks are too slow and bureaucratic, which does not bode well for implementation of your private capital mobilization strategy. Yes, you work with somebody’s tax dollars, which comes with extra oversight and scrutiny. But to meet increased expectations and live up to your missions, you’ll need to strike a better balance between rigorous processes and real-world timelines. You may consider delegated credit authorities, certain projects with higher risk-tolerance, or fast-tracked dealmaking in sectors with urgency such as food security and energy transition. The liquidity operations during COVID showed us you can pull it off.
<h2>4. Do more moving, much less storage</h2>
To extend the analogy introduced above, the most radical idea is to structure your private sector transactions for placement with institutional investors while keeping a portion on your own balance sheet, offload risk exposure from your balance sheet to investors, or securitize certain eligible assets. Investors always complain that there is enough capital but not enough bankable deals in emerging markets – you can change that. A development bank’s balance sheet and capital base are finite resources and should be used selectively. This would be a very different approach to development banking that would require massive upskilling, reskilling and different talent recruitment and management. It also requires very different underwriting and structuring approaches, and deep knowledge of what sells in the marketplace. The rewards include freeing up lots of your capital and a successful private capital mobilization strategy, and, most importantly, more and faster sustainable development outcomes in your markets.
To bring this all back to our music analogy: blended finance is like a symphony – you need many different musicians, all playing their unique part. Development banks should transition from the storage business to the moving business: you can bring the musicians and their instruments to the concert hall; you can hoist the grand piano onto the stage and you can put the sheet music on the stands that allows the orchestra to move to new and unexpected musical horizons.
This requires using your rating and balance sheet to greater effect – the G20 CAF report can be your sheet music – it requires implementation of a credible private capital mobilization strategy, and a transformation into more nimble organizations to at least keep pace with the private sector that you want to involve in the deals you orchestrate.
* Perhaps you haven’t seen the first three articles we wrote comparing blended finance to music. The basic idea of the analogy is that to play a symphony you need lots of different musicians, playing the parts only they can play – it’s no different in blended finance. In each article in this series we’re talking about who those different ‘musicians’ are that are needed on the blended finance stage – and how to get them on stage! You can find them <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">here</a> (on Governments), <a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">here</a>, (on Asset Owners) and <a href="https://illuminem.com/illuminemvoices/abc2cf1e-f815-4f60-8a6c-5ab10ec06226">here</a> (on Foundations).
<h6>[Why Blended Finance is Critical</h6>
<h6>Most projects and activities that are needed to achieve the SDGs are not profitable, or not profitable enough, or not yet profitable. Also, most are small scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that’s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it’s unlikely we can persuade pension fund boards to make impact-first investments at scale – their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they do meet institutional investors’ requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.]</h6>
Illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.
Cover photo: <a href="https://commons.wikimedia.org/wiki/File:Women%27s_Gamelan_Gong_Kebyar_Exhibition.jpg">Balinesisk gamelan</a> by <a href="https://www.flickr.com/people/13456343@N00">Benjamin Hollis</a> <a href="https://creativecommons.org/licenses/by/2.0/deed.en">CC BY 2.0</a>

Development Banks: Blended Finance is Like Music

We’ve been following the GFANZ turmoil with interest, as you all surely have as well. We won’t bore you with a lengthy analysis of what happened, what went wrong, and why, and how US banks can be persuaded to stay in. We don’t think you would read it.

Instead, on the eve of COP27, we wanted to offer some thoughts on what GFANZ should have said (or not said) a year ago, in place of the press release that was actually issued. Because perhaps the only way forward for GFANZ is to start all over again. And if it is too late for GFANZ, we hope future initiatives take note and don’t fall into the same traps GFANZ did.

What GFANZ should have said

In this third article of our series, we talk about another group that can play a valuable role in the blended finance symphony: philanthropic foundations. Many foundations have been active in the impact investing scene for years. One might say “surely they have figured out how to play their blended finance part?” Well, yes and no.

This is number three in our series of articles applying the analogies of music and orchestras to the world of blended finance. In the previous articles we have analyzed what role the different stakeholders &ndash; <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63" target="_blank" rel="noopener">governments</a> and <a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">asset owners</a>&nbsp;&ndash; can play in order to generate more blended finance and scale it, such that it makes a real dent in mobilizing capital. Capital needed to address the world&rsquo;s environmental, social and governance challenges.
In this third article of our series, we talk about another group that can play a valuable role in the blended finance symphony: philanthropic foundations. Many foundations have been active in the impact investing scene for years. One might say &ldquo;surely they have figured out how to play their blended finance part?&rdquo; Well, yes and no.
<h2>1. No one can whistle a symphony</h2>
"No one can whistle a symphony. It takes a whole orchestra to play it," said H.E. Luccock. Many foundations are involved in impact investing but have developed a habit of going solo. That&rsquo;s good as far as it goes &ndash; there&rsquo;s a lot of great work being done. And the impact of these projects can be attributed to you &ndash; and to you only. But you can do more if you would use the magic of leverage. For all of your wealth and scale, your initiatives could reach even greater scale if pension funds, insurance companies, banks and sovereign wealth funds would join you. You can have much more impact if you invest in ways that allow them to come in. Yes, you&rsquo;ll have to share some of the credit with others but you&rsquo;ll get credit for a little part of a much bigger thing and for bringing in the other musicians.
<h2>2. The biggest risk is not taking any risk</h2>
Next in our series, we&rsquo;ll talk about development banks, many of whom have pledged to mobilize private capital by taking risks off the table for others. However, in practice sometimes development banks aren&rsquo;t actually doing that, or doing enough of that &ndash; instead, they&rsquo;re often doing &lsquo;safe&rsquo; deals. You, foundations, have leeway in the degree and type of risk you can accept and you can use it to crowd in others &ndash; your acceptance of risk can be the sparkplug needed to build a larger engine.
You can provide the financing and technical support to get projects to the stage where development banks and commercial private investors will be able to deploy much larger amounts of capital. But you can also take risk off the table by working with developing country governments to address regulatory and institutional weaknesses that have scared off investors.
In doing so, keep an open mind. Many governments, investors and development banks would love to work with you. But they don&rsquo;t know you well. Advertise your wares. We get it, you&rsquo;re wealthy people and organizations, and you probably get bombarded with requests for money. So, a little privacy and discretion is desirable. But this is too much of a good thing. In other articles, we&rsquo;re telling governments, asset owners and others to proactively reach out to other musicians needed in the blended finance orchestra. You should do the same.
<h2>3. Be the speedboat</h2>
One of your magic powers is speed. No one else in the blended finance orchestra has this magic power &ndash; other actors are often burdened by significant formality in decision-making procedures. You can make investment decisions much faster than those others; this means you can do the upfront legwork for projects, giving the big guns the time to go through all their required decision-making.
Also, many of you have the Rolodex &ndash; let&rsquo;s face it, if you call the prime minister of the UK or the president of the World Bank, they&rsquo;ll probably take your call. You can pull strings, grease the tracks.
In sum, we love what you&rsquo;re doing today. But we&rsquo;d like to see you go from playing solo in the subway halls to joining the orchestra in the concert halls. Use the magic of leverage, take risk off the table for other actors, and be the speedboat of blended finance and we have full confidence that you will get there.
<h3>Why blended finance is critical</h3>
Most projects and activities that are needed to achieve the SDGs are not profitable, not profitable enough, or not yet profitable. Also, most are small-scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that&rsquo;s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it&rsquo;s unlikely we can persuade pension fund boards to make impact-first investments at scale &ndash; their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they do meet institutional investors&rsquo; requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.
Perhaps you haven&rsquo;t seen the first two articles we wrote comparing blended finance to music. The basic idea is that to play a symphony you need lots of different musicians, playing the parts only they can play &ndash; and it&rsquo;s no different in blended finance. In each article in this series, we&rsquo;re talking about who those different &lsquo;musicians&rsquo; are that are needed on the blended finance stage &ndash; and how to get them on stage! The first two articles talked about the role of governments and asset owners.
<ul>
<li><a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">Governments: blended finance is like music</a>​</li>
<li><a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">Asset Owners: </a><a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">blended finance is like music</a>​</li>
</ul>
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.
Cover Photo: Stijn Kuiper 2022 / with permission.

Foundations: blended finance is like music

Asset owners can do a lot to advance blended finance. Here are the three most important things – they should deliver on this proactively.

Asset owners can do a lot to advance blended finance. Here are the three most important things &ndash; they should deliver on this proactively.
In <a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">our first article in this series</a> about blended finance, we used the analogy of a symphony: a drumbeat does not suffice, we also need horns, woodwinds, violins &ndash; every instrument making a unique contribution. Blended finance also requires an &lsquo;orchestra&rsquo; with different people making contributions only they can make and there we also need more &lsquo;musicians&rsquo; to get up on the bandstand and join in the playing.
In that first article, we discussed governments&rsquo; role in blended finance. Another key group of &lsquo;musicians&rsquo; that need to get up is the asset owners &ndash; pension funds, insurers and sovereign wealth funds. Mobilizing finance to address societal challenges requires involvement of asset owners, because it&rsquo;s the only way to reach the necessary scale.
While many asset owners want to invest in a way that contributes to solving societal problems, they also have specific investment requirements that need to be met. This is where blended finance comes in &ndash; it can derisk investments, or enhance their return, or both at the same time. It ensures asset owners invest in sustainable outcomes and meet investment criteria at the same time. It makes the uninvestable investable.
In our first article, we said governments should take the lead in blended finance. Does that mean asset owners can sit back and relax? No. Here are three things asset owners can do to play a proactive role in enlarging the blended finance universe.
<h2>1. Open up the circle of stakeholders / revisit your investment beliefs &amp; mandates</h2>
Don&rsquo;t listen only to NGOs who talk about &ldquo;urgency&rdquo; but don&rsquo;t have &ldquo;agency&rdquo; &ndash; they may be right to create awareness about societal problems but usually they don&rsquo;t have the means to solve them, and certainly divestment isn&rsquo;t going to do the trick. And don&rsquo;t listen only to ESG people who might tell you ESG integration and Net Zero commitments have an impact on the world; we are learning that most of these initiatives in fact have extremely little real world impact.
Instead, talk to the regulators; it is often because of scrupulous adherence to their requirement to be &ldquo;in control&rdquo; that blended finance deals &ndash; that can have lots of impact &ndash; don&rsquo;t get done. They&rsquo;re considered too risky, too alien, too difficult to explain to the regulator. Work on this.
Also, revisit your investment beliefs and mandates: often blended finance investments are automatically considered to be in the EM or Alternatives categories, and your mandate may not allow allocation to those buckets. However, much of blended finance is backed by European governments&rsquo; guarantees, first losses, or co-investments and can perhaps be considered to be AAA sovereign debt investments. Often simple rules and labels are inadvertently preventing blended finance from happening.
Finally, be more proactive in speaking with government representatives. Governments often talk about wanting to mobilize private sector capital and are willing to put real money behind this, but don&rsquo;t know how, or don&rsquo;t know who to talk to. You can help them. Don&rsquo;t wait for them to call - take the initiative.
<h2>2. Ask your people to develop expertise, build relationships, and experiment</h2>
You often say you want to contribute to the SDGs, and that you want to work with governments and DFIs, but these things don&rsquo;t happen by magic. Communicate to your staff that building relationships is encouraged or &ndash; better yet &ndash; set up fellowship or secondment programs that allow more networking and collaboration with other organizations, such as development banks.
If you get invited to the blended finance party &ndash; events, conferences or courses where blended finance investing is a topic &ndash; make sure you&rsquo;re represented, if for no other reason than for learning. Send your people to blended finance courses. Getting your people out there and having them collaborate with governments, development banks and others will also contribute to more professionalism and higher standards in blended finance.
<h2>3. Instruct asset managers</h2>
Many of your investments are outsourced to asset managers. Don&rsquo;t tell them you want &ldquo;article 9&rdquo; or &ldquo;impact&rdquo; &ndash; many things they will offer in fact don&rsquo;t generate impact, even with these labels on them. Tell them you want blended finance. If you don&rsquo;t, they won&rsquo;t offer it to you. It&rsquo;s much easier for them to call an existing product Article 9, even if it has no &lsquo;additionality&rsquo; whatsoever, than to create a new product that does.
Work through partnerships like the Net Zero Asset Owner Alliance allowing standardization and scaling. Or, set up partnerships with the asset managers that are most advanced and allow blended finance structures to be set up and tailored specifically for you.
&ldquo;The true beauty of music is that it connects people. It carries a message and we, the musicians, are the messengers,&rdquo; said Roy Ayers, the jazz vibraphonist.
Well, you &ndash; asset owners &ndash; can become messengers too, connecting people and carrying the message of blended finance.
<h3>Why blended finance is critical</h3>
Most projects and activities that are needed to achieve the SDGs are not profitable, not profitable enough, or not yet profitable. Also, most are small-scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that&rsquo;s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it&rsquo;s unlikely we can persuade pension fund boards to make impact-first investments at scale &ndash; their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they do meet institutional investors&rsquo; requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.
Perhaps you haven&rsquo;t seen the first five articles we wrote comparing blended finance to music. The basic idea of the analogy is that to play a symphony you need lots of different musicians, playing the parts only they can play &ndash; it&rsquo;s no different in blended finance. In each article in this series, we&rsquo;re talking about who those different &lsquo;musicians&rsquo; are that are needed on the blended finance stage &ndash; and how to get them on stage! You can find them here:
<ul>
<li><a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">Governments: blended finance is like music</a>​</li>
<li><a href="https://illuminem.com/illuminemvoices/abc2cf1e-f815-4f60-8a6c-5ab10ec06226">Foundations: </a><a href="https://illuminem.com/illuminemvoices/b5f42455-398d-4ee8-b097-bab13e06cc63">blended finance is like music</a>​</li>
</ul>
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.
Cover Photo: Beethoven for The Rohingya at Carnegie Hall on January&nbsp;28, 2019. Credit: Photo; Chris Lee 2019/ with permission.

Asset owners: blended finance is like music

You can start with a drumbeat, but if you want to have real music, you also need horns, woodwinds, violins, and so on, to create a symphony. It’s no different in blended finance. We see that there’s a steady drumbeat – people saying “we need more of it, we need more of it” – but not enough musicians are stepping up and joining in.

You can start with a drumbeat, but if you want to have real music, you also need horns, woodwinds, violins, and so on, to create a symphony. It&rsquo;s no different in blended finance. We see that there&rsquo;s a steady drumbeat &ndash; people saying &ldquo;we need more of it, we need more of it&rdquo; &ndash; but not enough musicians are stepping up and joining in.
Sometimes this is because they&rsquo;re happy playing by themselves. Sometimes because they feel they haven&rsquo;t mastered their instrument, or because they don&rsquo;t yet realize that the world needs more symphonies. Sometimes because there&rsquo;s no producer to make sure all the musicians are booked and show up, and have the same sheet music in front of them.
Well, we&rsquo;d like to call more musicians on stage. Starting with you, Governments, because you have a lot of power to further develop the blended finance marketplace. Here are three ways you can use it.
<h2>1. Use DFIs and MDBs differently</h2>
Development finance institutions (DFIs) and multilateral development banks (MDBs) were set up to finance international development and SDG solutions, and their mandates usually say they should also mobilize private capital for this. To achieve these things, they need your blessing to fail. At scale. Achieving the SDGs is challenging. It requires innovation, trial &amp; error, experimentation, portfolios of projects and investments &ndash; the kind of stuff that Silicon Valley was built on. It might not look good at first, some of your projects will crash, but the end result is likely to be much more beneficial than what you have today: &ldquo;international investment banks&rdquo; doing &ldquo;safe&rdquo; projects.
Allow DFIs to break some eggs and to use their balance sheets more effectively in taking risk off the table for the other actors in blended finance to be lured in. We all know that we have to get more private parties (pension funds, insurance companies) involved to have a chance to reach the SDGs. DFIs can make this happen, with tools like first-loss positions. They need your consent to go all out.
<h2>2. Convene</h2>
You should be the host of the blended finance party: create hubs and platforms for relationship-building, collaboration, and co-investing. Invite the different actors. Ensure that projects and companies seeking capital show up, as well as DFIs, and the pension funds, insurance companies, asset managers and bankers. Everyone who is needed in the blended finance symphony needs to be there.
They will not come up with the idea of throwing the party themselves. You have to do it. But make nice invitations and get good catering, and they will come.
<h2>3. Rethink the regulation of sustainable finance</h2>
You&rsquo;ve been churning out laws, guidelines, regulations, taxonomies and Green Deals and you say the objective is to &lsquo;reorient private capital flows&rsquo; but the mechanisms you use are unlikely to achieve this.
SFDR (Sustainable Finance Disclosure Regulation) is case in point: it is meant to stimulate &lsquo;impact investment&rsquo;, but having actual &lsquo;impact&rsquo; is not even a requirement for a fund to be classified as article 9. It&rsquo;s not going to reorient capital flows.
&ldquo;ESG&rdquo; and &ldquo;impact investment&rdquo; have a nice ring to it and suggest there&rsquo;s a new way of financing the things you care about, but you&rsquo;ve got to realize most of the old rules still apply: institutional investors assess deals primarily based on economics: risk and return. Don&rsquo;t count on altruism and intentionality, or labeling and disclosures; instead use the financial tools at your disposal (taxes, subsidies, guarantees, first-loss) to ensure projects meet private investors&rsquo; risk &amp; return requirements. People respond to incentives &ndash; laws &amp; money &ndash; and you have the power to create them. Do it judiciously.
Are these three things going to solve the blended finance problem? No. Other actors will have to step up too. We&rsquo;ll talk about this as well. But Governments are the first among equals in the blended finance symphony.
When you deliver on these three points, the other musicians will show up and you can strike up the band.
<h3>Why blended finance is critical</h3>
Most projects and activities that are needed to achieve the SDGs are not profitable, or not profitable&nbsp;enough, or not&nbsp;yet&nbsp;profitable. Also, most are small scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that&rsquo;s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it&rsquo;s unlikely we can persuade pension fund boards to make impact-first investments at scale &ndash; their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they&nbsp;do&nbsp;meet institutional investors&rsquo; requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.]
Perhaps you haven&rsquo;t seen the first five articles we wrote comparing blended finance to music. The basic idea of the analogy is that to play a symphony you need lots of different musicians, playing the parts only they can play &ndash; it&rsquo;s no different in blended finance. In each article in this series, we&rsquo;re talking about who those different &lsquo;musicians&rsquo; are that are needed on the blended finance stage &ndash; and how to get them on stage! You can find them here:
<ul>
<li><a href="https://illuminem.com/illuminemvoices/07e2a03e-5d86-44a5-b2df-13840c9dc569">Asset Owners: Blended Finance is Like Music</a></li>
<li><a style="font-family: Inter, -apple-system, BlinkMacSystemFont, 'Segoe UI', Roboto, Helvetica, Arial, sans-serif, 'Apple Color Emoji', 'Segoe UI Emoji', 'Segoe UI Symbol', serif;" href="https://illuminem.com/illuminemvoices/abc2cf1e-f815-4f60-8a6c-5ab10ec06226">Foundations: Blended Finance is Like Music</a></li>
</ul>
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.

Governments: blended finance is like music

“Why?” is the most important question that never gets asked in ESG discussions. Or, at least, doesn’t get asked enough.
Why?
Because asking the question “Why?” more often and earlier would allow us to (1) avoid spending millions of hours and billions of dollars on ineffective, often pointless activities, and (2) focus the mind on those activities that actually matter.
Emissions disclosure seems to me a great example of this general rule.

“Why?” is the most important question that never gets asked in ESG discussions. Or, at least, doesn’t get asked enough.
Why?
Because asking the question “Why?” more often and earlier would allow us to (1) avoid spending millions of hours and billions of dollars on ineffective, often pointless activities, and (2) focus the mind on those activities that actually matter.
Emissions disclosure seems to me a great example of this general rule.
Especially since the SEC’s recent proposed regulation <a href="https://www.sec.gov/rules/proposed/2022/33-11042.pdf">Enhancement and Standardization of Climate-Related Disclosures for Investors</a> was launched, the general sense in the ESG community seems to be that this would put companies and investors on the right track in terms of dealing with climate change. In other words: people feel the proposal makes sense.
But asking the right “why?” questions allows us to see that this is at best relative – whether emissions disclosure makes sense depends on what you want to achieve with it – and at worst is a costly distraction from the real work that needs to be done to address climate change.
(To be fair, the SEC proposal is not exclusively about emissions disclosure and also discusses other, more qualitative measures. Nonetheless, most of the discussion after the proposal was launched has been about – the more quantitative – emissions disclosure elements).
So, what are the right “Why” questions? There are four:
<img src="https://illuminem.b-cdn.net/articlebody/41dae1a695e225deff7e0551e15065633bd8291c.png" alt="undefined">
<h6>To see the full graphic with links to further reading <a href="https://findingwaysahead.com/wp-content/uploads/2022/07/Emissions-Disclosure-Sense-or-Nonsense.pdf">click here</a>.</h6>
<h1>Accuracy</h1>
Proponents of emissions disclosure put much emphasis on the need for more accurate data. On the face of it, this seems smart. Only if you have good data on a given problem you can fix it. But, still, it makes sense to ask the question “why is (more) accuracy important?”:
<ul><li>How accurate, or complete, can we get, or do we need? I’m not a climate scientist or engineer but it seems to me that the concept ‘emissions’ is by nature fuzzy and intangible and defies precise quantification. But also, how accurate is really needed? Of course it depends what you use the data for, but probably with most things that you need emissions data for, 100% accuracy is not necessary. We’ll also revisit this question under 3. below.</li></ul>
<ul><li>How accurate is the data we already have? Again, I’m no expert but I did half an hour of Googling on the topic and found a few websites, including <a href="https://ourworldindata.org/emissions-by-sector">this one</a>, that seemed to offer pretty detailed emissions information, broken down by sector. Also I learned that at least in the US, rules have been in place since 2009 requiring larger companies to report emissions. I have no idea to what extent companies comply with these rules but has anyone checked before writing the new rule?</li></ul>
<ul><li>Who would benefit most from the requirement? In wondering “why” we are confronted with particular laws &amp; regulations it’s always instructive to ask this question too. So, who would benefit most from the requirement to get even more accurate emissions information? Well, I found a <a href="https://www.sustainability.com/thinking/cost-of-climate-disclosure-survey-fact-sheet/">study</a> indicating what the costs of climate disclosure are for corporate issuers and for institutional investors. My back-of-the-envelope calculation of the entire market (in the US alone) is $10 billion. Annually. Now, could it be that the data providers, auditors and consulting firms who would like a piece of this market had anything to do with the creation of this rule, and the emphasis on accuracy?</li></ul>
<h1>Attributability</h1>
The second “why” question has to do with attribution of emissions to particular corporations or investors. This is obviously at the core of proposals such as the SEC’s: it’s not good enough to know at a planetary level how much we’re pumping into the air – which is causing catastrophic climate change – we want to know who is doing it. Again, on the face of it, this kind of makes sense. If you want to solve a problem, first you need to know who caused it. However: questions, questions… Why do we need to attribute emissions to specific companies or investors?
<ul><li>Scope 1 &amp; 2, or Scope 3? If we’re talking about attribution, should we start by distinguishing between Scope 1 &amp; 2 emissions on the one hand, and Scope 3 on the other? The difference is more relevant than you might imagine: scope 1 &amp; 2 emissions are more or less under direct control of corporations – i.e. are easy to attribute – but scope 3 emissions, generally, are not. And in most industries, scope 3 emissions are (by far) the most significant component. You could argue, as people frequently do, that “one person’s scope 3 emission is another’s scope 1 emission”, and that’s certainly true – but how does that help us? What if that second person is YOU, driving your car to work every day. How useful, or ‘correct’, is it to say that your emissions are also Scope 3 emissions of some oil company? I would argue this is not useful at all.</li></ul>
<ul><li>Dog Food Manufacturer’s Scope 3 Emissions? To illustrate the futility of this approach, I sometimes use the “dog poop analogy”. One could argue that dog poop is “Scope 3 emissions of dog food manufacturers”. And we would probably all agree that dog poop is annoying and irritating and something we should do more to address (if obviously not on the scale or urgency of climate change). But who in their right mind – in an effort to do something about dog poop – would start by trying to first attribute specific dog poop to dog food manufacturers? Can you imagine a regulation like “Dog Food Manufacturers’ Scope 3 Emissions Disclosure Requirement”? How would this help us?</li></ul>
<ul><li>Why Attribution? But it’s also worth asking the question if attribution to specific companies is really needed. Do portfolio managers and analysts really need this information to assess climate-related investment risk for a particular company? It seems to me that they are more interested in the likelihood of public policy measures and how they will impact specific industries and supply chains. And to the extent company-specific information is needed, quite a lot of it is already available or can be assessed through proxies (see also question 1.).</li></ul>
<ul><li>Step one towards Carbon Tax? It has also been argued that attribution of emissions is important because it is a necessary prerequisite for introducing carbon taxes. But … if you look at Sweden’s carbon tax for example, the Swedes state explicitly that implementing the tax did not require emissions measurement. You could also, for example, simply levy the tax at … the point of sale? For example, when you buy gas to fill up your tank? Or when you pay your gas or electricity bill?</li></ul>
<h1>Agency</h1>
All of the above prompts questions of “agency”: the unspoken assumption appears to be that we need more accurate emissions information, attributed to specific companies because then … they will do something about it? This, however, assumes those companies have agency, in other words that they can control or influence those emissions. Therefore, it is worth asking the following:
<ul><li>Do companies have agency in systemic issues? Companies can do – and should do – quite a bit to reduce Scope 1 and 2. But Scope 3 is the big problem, because GHG emissions is what we would call a systemic issue; it is a problem associated with the fact that since the industrial revolution most sectors (electricity, housing, transportation, industry) rely on complex international (fossil fuel-based) energy systems, that not even the biggest players in those sectors can do much to change. And in how our society works, most of the agency to change those systems resides with governments, not the private sector. Governments can create laws, taxes and subsidies, or invest in R&amp;D, in order to nudge sectors from one technology to another.</li></ul>
<ul><li>If there’s agency, are companies or investors well-placed to act? This leads to another question: even if firms have agency, are they also incentivized and organized to steward change and innovation? Investors “control” only about 1/3 of emissions (also because many large emittors are government-owned). And incumbent firms likely don’t have the incentives. For example, can we expect large oil companies to put their hearts and souls (and capex) into renewables if oil, today, is vastly more profitable? But also, can we expect oil companies – the ‘winners’ in today’s technology – to be the winners in tomorrow’s technologies, recognizing that those are vastly different technologies requiring vastly different competitive advantages?</li></ul>
<ul><li>Wow - did you see how far questions of “agency” have taken us away from the need to have emissions disclosure?</li></ul>
<h1>Distraction</h1>
Therefore, my last “why” question leads us to the possibility that this emphasis on emissions disclosure is actually a big distraction.
<ul><li>Why is emissions disclosure such a priority? If you start thinking about the question “how will we tackle climate change, and who has agency?”, you start to realize we kind of know how we will tackle climate change (carbon pricing, sector regulation, government-subsidized investment in R&amp;D and new technologies) and that we sort of know who should be taking the lead: governments (you know, they who actually signed the Paris Agreement). And that for all that stuff we don’t really … need more accurate disclosure of emissions, attributable to companies and investors who don’t have agency?</li></ul>
So, think about emissions disclosure again and ask yourself the question “Why do we need it? Why would others demand it? Why should we put so much emphasis on it?”
Think about Accuracy, Attributability and Agency and then ask yourself the question: what are we trying to achieve? Point fingers at companies? Apportion blame for causing the problem? Risk management? Fixing climate change? Are we on the right track?
Or is this just a Distraction?
Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.

Emissions Disclosure: Sense or Nonsense

Something interesting happened in Italy earlier this year and we think you should know about it. One Italian company, Alcantara, took a competitor, Miko, to court, accusing them of greenwashing. Alcantara argued that Miko, in describing its suede-like microfiber product Dinamica as “green” was competing unfairly. The accusation of “misleading advertising” was based on the EU’s Unfair Commercial Practice Directive (UCPD). Alcantara won. And Miko was instructed by the court to immediately change its marketing pitch, or face hefty fines.


Florian

<h2>A novel development</h2>
Something interesting happened in Italy earlier this year and we think you should know about it.
One Italian company, Alcantara, took a competitor, Miko, to court, accusing them of greenwashing. Alcantara argued that Miko, in describing its suede-like microfiber product Dinamica as &ldquo;green&rdquo; was competing unfairly. The accusation of &ldquo;misleading advertising&rdquo; was based on the EU&rsquo;s Unfair Commercial Practice Directive (UCPD). Alcantara won. And Miko was instructed by the court to immediately change its marketing pitch, or face hefty fines.
If you want to learn more, google &ldquo;Alcantara &amp; Miko&rdquo; and you&rsquo;ll find various articles providing the particulars. The reason we bring this up here are:
<ol>
<li>This is the first time, as far as we know, that a civil court orders a company to stop greenwashing, at the request of a competitor. And if this can happen in the world of synthetic suede, it can happen in the world of investing. And if a competitor can take the initiative, so can a customer, a regulator or another interested party. From a consumer protection point of view, that&rsquo;s a good thing. But looking at the need for more innovation in the market for impact investment it may come with challenges.</li>
<li>In reaching its decision, the Italian court relied on what&rsquo;s known as &ldquo;soft law&rdquo; &ndash; guidelines and other quasi-legal instruments that don&rsquo;t have legally binding force but can nonetheless be found to apply to real-life situations &ndash; in the green-suede case a &ldquo;EU Commission Staff Working Document&rdquo; that provides guidelines on how to implement an EU directive. This kind of soft law also applies to ESG funds, even if most banks, fund managers and even regulators may be unaware of this.</li>
</ol>
We&rsquo;ll discuss both points, as well as the implications for the impact investing market.
<h2>Relevance for investors</h2>
Why is the &ldquo;soft law&rdquo; point relevant to investors? Well, because there&rsquo;s a whole universe of rules out there that apply to ESG / impact funds, and that could be used by consumers, competitors, regulators or other interested parties to haul greenwashing financial institutions in front of a judge.
Take, for example, this document: &ldquo;<a href="https://ec.europa.eu/info/sites/default/files/compliance_criteria_2016_en.pdf">Compliance Criteria on Environmental Claims &ndash; Multi-stakeholder advice to support the implementation/application of the Unfair Commercial Practices Directive 2005/29/EC</a>&rdquo;, also known as MDEC, because it was developed by the Multi-stakeholder Dialogue on Environmental Claims.
Subtitled Helping consumers make informed green choices and ensuring a level playing field for business, it sets out a whole range of criteria that apply whenever &ldquo;environmental claims&rdquo; are made:
The expressions "environmental claims" or "green claims" refer to the practice of suggesting or otherwise creating the impression (in the context of a commercial communication, marketing or advertising) that a product or a service, is environmentally friendly (i.e. it has a positive impact on the environment) or is less damaging to the environment than competing goods or services.
In other words, looking specifically at the underlined terms, we would argue that these criteria likely apply to most ESG funds out there. Importantly, &ldquo;creating the impression&rdquo; is enough to qualify as a claim, these do not necessarily need to be explicit. So, what are the criteria?
<h3>The articles</h3>
There&rsquo;s a whole laundry list, we&rsquo;re just summarizing the main ones here:
Article 2.1 &ndash; Content of the claim: &ldquo;environmental claims should reflect a verifiable environmental benefit or improvement and this should be communicated in a precise manner to consumers &hellip; should be clear and unambiguous &hellip; [and] meaningful and relevant to the environmental performance of the product &hellip; should reflect an environmental benefit beyond that which is already considered as a common practice.&rdquo;
Article 2.2 &ndash; Clear and accurate presentation: &ldquo;[The claim] should be presented in a way that is accurate, clear, specific and unambiguous to ensure consumers are not misled about the intended meaning &hellip; wording (&hellip;) should be a truthful and accurate representation of the scale of the environmental benefit, and should not overstate the benefit achieved &hellip; plain language should be used that is clear and easy for consumers to understand.&rdquo;
Article 2.3 &ndash; Claim substantiation and documentation: &ldquo;claims should be based on robust, independent, verifiable and generally recognised evidence which takes into account the latest scientific findings and methods &hellip; must have scientific evidence to support their claims and be ready to provide it (&hellip;) in case the claim is challenged &hellip; should be measured using the most appropriate methods &hellip; independent third party testing should be made available (&hellip;) if the claim is challenged&hellip; [should] communicate about environmental achievements instead of aspirations of future environmental performance&hellip; this does not prevent companies from communicating on future environmental efforts (&hellip;) if they deem this necessary or useful [but] companies should only do this when they have established a realistic plan with clear targets and timescales, involved relevant stakeholders and ensured third party monitoring of commitments.&rdquo;
<h3>Their importance</h3>
Why are we quoting these requirements in such detail? Three reasons:
<ol>
<li>To show that many of the regulations meant to counter greenwashing, such as SFDR, are in many ways redundant &ndash; the rules needed to act on greenwashing already exist and, as the not-really-green-suede case shows, can be applied in a court of law.</li>
<li>Perhaps more importantly, and if this document is any guide, impact funds will also need to be of the &lsquo;impact-generating&rsquo; variety, as compared to the &lsquo;impact-aligned&rsquo; variety. This, we believe, is demonstrated by the use of the term &lsquo;benefit or improvement&rsquo;, which suggests there needs to be a causal relationship.</li>
<li>Even more importantly, launching impact investment funds that can meet all of these requirements is a very, very tall order: even banks and asset managers with dedicated resources, with true intentionality and long track records in impact investment would struggle mightily. This means even funds that deliver the real deal &ndash; genuine, impact-generating, additional, intentional impact &ndash; could be indicted for greenwashing. This is also because, while there is increasing agreement that &lsquo;impact investment&rsquo; requires providing proof of a causal relationship, there is no consensus whatsoever on how this proof can be delivered, just a spreading suspicion that impact measurement isn&rsquo;t doing the job.</li>
</ol>
<h2>Our perspective</h2>
We are supportive of measures designed to protect consumers, and there are enough investment products on the market that would benefit from a higher bar for evidence behind green marketing claims. Yet, we are also concerned that this kind of exceedingly strict set of requirements may stifle the much-needed innovation in the impact investment market.
In the excellent book &ldquo;How Innovation Works&rdquo;, Matt Ridley explains that most innovation is a &ldquo;gradual process&rdquo;, where often trial and error is &ldquo;vital&rdquo;, that &ldquo;use often precedes understanding&rdquo; (in other words, we often use new technologies before we know how and why they work), and that usually any successful innovation is preceded by a &ldquo;pre-history characterized by failure.&rdquo; Ridley says that &ldquo;Innovation is &hellip; a collective, incremental and messy network phenomenon.&rdquo;
If we apply the existing rules strictly to the fledgling market for impact investments, we will almost certainly not enable a messy, incremental process of trial &amp; error and experimentation that celebrates failure as a means to learning and improvement. Instead, we are likely to stifle innovation and discourage budding endeavors to service investors with a desire to contribute to solving societal problems.
<h2>What next?</h2>
What can we do about this? In our view: education, education &amp; education (and research).
Banks &amp; asset managers: should not be too easily tempted by the lure of Article 8 &amp; 9 lucre, or rely too eagerly on their ESG departments&rsquo; impact blessings; rather they should involve their investment teams and product development capabilities and engage with the academic world to educate themselves on evidence-based ways to structure impact-generating investments.
Consumers: should be able to have frank conversations with their banks and financial advisors, where it would be explained that having a substantial impact in the listed equity space is difficult, if not impossible, and that investing with impact may require a different risk/return appetite.
Regulators &amp; judges: should read up on the impact investment literature and be informed by academics and practitioners alike, in order to focus on avoiding true greenwashing while not stifling innovation in the burgeoning impact investment market. This may require more emphasis on solid theories of change and qualitative assessment methods, rather than more binary labels and black or white classifications that fail to capture the subtle balance that needs to be struck between impact, risk, return and client interest.
Academics: should develop practically applicable impact assessment methods for investment products. Some thirty years ago, the need to make informed decisions based on the environmental impact of &ldquo;physical&rdquo; products (think: paper cups vs. reusable cups?) led to the development of life cycle assessment (LCA). Today, LCA is an entire science but is standardized enough to be applied by industry actors and a host of consultancies. We need &ldquo;LCA&rdquo; tools for investments, that set the standard for what &ldquo;evidence for impact&rdquo; should look like in the investing space.
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.

What fake suede and the future of impact investment have to do with one another

Blended finance is gaining interest in ESG, sustainable finance, and impact investing circles. More and more people are realizing that, in order to scale financing solutions to address the world’s most significant challenges, like those captured in the Sustainable Development Goals (SDGs), we need to deploy governmental and philanthropic interventions to make impact projects investable for the deep pockets in finance: pension funds, insurance companies, and sovereign wealth funds. Blended finance is the catalyst for impact: it mobilizes institutional investment by making investable projects that would otherwise be considered uninvestable.


New report: “Blended Finance: When to use which instrument? Clusters and decision-making factors.”
Blended finance is gaining interest in ESG, sustainable finance, and impact investing circles. More and more people are realizing that, in order to scale financing solutions to address the world’s most significant challenges, like those captured in the Sustainable Development Goals (SDGs), we need to deploy governmental and philanthropic interventions to make impact projects investable for the deep pockets in finance: pension funds, insurance companies, and sovereign wealth funds. Blended finance is the catalyst for impact: it mobilizes institutional investment by making investable projects that would otherwise be considered uninvestable.
However, one of the barriers to expanding the blended finance pool is the complexity of blended finance transactions. Typically, a large number and variety of actors from across sectors are needed to structure a blended finance project. These can include development finance institutions, philanthropic organizations, impact-oriented fund managers, governmental agencies, entrepreneurs, sector-specialists and mission-driven organizations.
Another barrier is understanding the different financial contributions or instruments needed to structure a blended finance project. Generally, this is a combination of grants, first-loss tranches, technical assistance, impact-linked finance, and equity and debt (either concessional or not).
In light of these complexities, we should very much welcome the new report “<a href="https://illuminem.com/post/49f5d2ed-5699-41c7-8fb3-bb954772b1bb">Blended Finance: When to use which instrument? Clusters and decision-making factors</a>,” based on a research project by the<a href="https://ibf-uzh.ch/"> Initiative for Blended Finance at the University of Zurich</a>, that was conducted together with the <a href="https://www.csp.uzh.ch/en.html">Center for Sustainable Finance &amp; Private Wealth (CSP) at the University of Zurich</a>, as well as <a href="https://www.roots-of-impact.org/">Roots of Impact</a> and the <a href="https://www.gsb.uct.ac.za/berthacentre">Bertha Centre for Social Innovation &amp; Entrepreneurship at the UCT Graduate School of Business</a>.
The report, co-authored by researchers Taeun Kwon, Barry Panulo, Stephen McCallum, Kelvin Ivankovik and Zaakir Essa, can perhaps best be compared to the “How to Play” instructions that came with this spiffy new board game you got for your birthday.
First, you’ve got your different blended finance instruments: grants, impact bonds, concessional debt, and so forth. The report describes what they are, why you might need them, and how well they go together with other instruments. It also lists some of the points of caution, or safety warnings: potential pitfalls in deploying each of the instruments and their limitations.
Second, you’ve got your different players in the blended finance space. These include philanthropic organizations, development actors, impact spin-offs, and financial intermediaries. The attributes and core competencies of each are explored in turn: what can they bring to the table? This can be capital, structuring capabilities, sector and/or regional knowledge, or reputation and creditworthiness.
Finally, you’ve got a set of 12 questions that can guide you in determining the instruments best suited to a given blended finance project and the institutions which should be involved. These questions include prompts like:
<ul><li>Which role do I (the initiator) play in the transaction, and what can I bring to the table?</li></ul>
<ul><li>How much capital can I deploy?</li></ul>
<ul><li>What is my target financial return / what are my financial requirements?</li></ul>
<ul><li>What kind of impact problem am I addressing?</li></ul>
<ul><li>How does the investee want to scale? What is their growth trajectory?</li></ul>
<ul><li>What is the maturity level of the intervention?</li></ul>
The report also provides insight into why blended finance can be so challenging: the necessity for collaboration between actors. While this has been a barrier to scaling blended finance thus far, it is also the factor that strengthens this approach. Different actors complement one another, as illustrated in the graphic below. Each has different resources to contribute. For instance, actors who have the capital can’t do the structuring, and those that can don’t have the capital.
<img src="https://illuminem.b-cdn.net/articlebody/49b6d0b29221495a7ba2cc1ab4892f6a410e9397.png" alt="Institutional setup and key elements that a stakeholder can bring to the table. Source: Blended Finance: When to use which instrument? report Phase 1, 2022
">
Financial intermediaries, such as asset management firms, often have the necessary financial expertise to structure complex deals, but don’t own capital – at best they manage other organizations’ capital which typically comes with strict mandates and strings attached. At the same time, organizations that have (at least some) capital, such as development organizations, do not necessarily have access to the financial wizardry needed to set up the sophisticated vehicles that will deploy the capital.
There are also cultural considerations. These organizations often operate in different worlds and their employees haven’t necessarily had much contact with people in the other types of organizations. In other words, we need more of an international marketplace where these different actors can engage, learn about possible projects, and see if they can match institutional mandates, financial instruments, and expertise. These ‘macro’ factors – market conditions and sectors – will be the focus of the authors in the next phase of their research.
Nonetheless, this report is already a significant step in the right direction. By reviewing the academic literature and offering a solid taxonomy of the current research, interviewing many leading practitioners, and translating this combined knowledge into accessible explanations and a practical checklist, the authors of this report have made an important contribution to the practice of blended finance.
Every ESG professional, impact investor, and development finance expert would do well to read it.
And is invited to join the other players at the table, to play a couple of rounds of Blended Finance.
 Editorial note: while Harald Walkate is affiliated as senior fellow with the <a href="https://www.csp.uzh.ch/en.html">Center for Sustainable Finance &amp; Private Wealth (CSP) at the University of Zurich</a> (one of the contributors to the report), he had no involvement in the research or writing of the report. Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.

Blended Finance – Excellent New Report Clarifies the Rules of the Game

We’ve just celebrated the first birthday of the Sustainable Finance Disclosure Regulation (SFDR), and we can observe that few things ‘ESG’ have been the recipient of so much praise, time, effort, attention, and money as the SFDR – and this in just one year. SFDR has been heralded by ESG enthusiasts as a key tool to direct capital towards sustainability objectives, most notably the Paris Agreement and the Sustainable Development Goals (SDGs).

<h2>The objectives of the SFDR</h2>
We&rsquo;ve just celebrated the first birthday of the Sustainable Finance Disclosure Regulation (SFDR), and we can observe that few things &lsquo;ESG&rsquo; have been the recipient of so much praise, time, effort, attention, and money as the SFDR &ndash; and this in just one year. SFDR has been heralded by ESG enthusiasts as a key tool to direct capital towards sustainability objectives, most notably the Paris Agreement and the Sustainable Development Goals (SDGs).
Another key objective of the SFDR is countering greenwashing. However, asset managers, rather than taking SFDR as their cue to do some deep thinking about what makes a product genuinely green, embraced it as a convenient labeling scheme allowing them to sell even more funds as &lsquo;ESG&rsquo;, but now rubber-stamped by EU regulation.
But even if there has been some criticism to do with these unintended consequences and the &ldquo;promote&rdquo; language in Article 8, most have fallen all over themselves to hail SFDR as a key milestone, to become SFDR compliant, and to label as many funds as possible as &ldquo;Article 8&rdquo; or &ldquo;Article 9&rdquo;.
<h2>An overlooked design flaw</h2>
However, in this hullabaloo, a small but crucial design error has been largely overlooked. We think fixing it is imperative, if SFDR is to be effective in reaching its two key stated goals of (1) directing more capital towards sustainable investments and (2) preventing greenwashing, or protecting consumers&rsquo; interests. We also think fixing it is simple and requires just six letters.
First a quick recap: SFDR is the 2021 EU regulation that requires financial firms to publish various things: an ESG policy with information on how they integrate sustainability risks; information on how they consider &ldquo;principal adverse impacts&rdquo; of their investments; and remuneration policies that &ldquo;are consistent&rdquo; with the integration of sustainability risks.
Firms also need to provide product-, or fund-level information. And this is where the (in)famous Article 6, 8 and 9 classification comes into play: the required disclosures are different depending on whether a fund &lsquo;only&rsquo; integrates sustainability risks (Article 6); &ldquo;promotes environmental or social characteristics&rdquo; (Article 8); or &ldquo;has sustainable investment as its objective&rdquo; (Article 9). All funds need to disclose how sustainability risks are integrated and what their likely impact on returns are (or why those risks are not deemed relevant); Article 8 funds need to disclose how the &ldquo;ESG characteristics&rdquo; they promote are met. Article 9 funds need to do even more: they need to explain what their particular sustainable investment objective is, how they intend to achieve it, and also measure and report on progress.
The basic design error lies in Article 9 and has to do with the concept of &ldquo;impact&rdquo;.
Even though Article 9 does not mention the word &ldquo;impact&rdquo;, it is clear from the text, and from the additional requirements in Article 10, that Article 9 was intended to serve as the category for what the marketplace refers to as &ldquo;impact investments&rdquo;. So, investments with the explicit objective to generate measurable and additional real-world impact.
<h2>Factors for the rise of sustainable investing</h2>
At this point, it is crucial to consider why many consumers, or retail investors, care about sustainable investing, or have a &lsquo;preference&rsquo; for sustainable investing, to begin with. The available evidence shows that there are different motivations underlying their preferences. First, there are those who care about aligning investments with their values, who for example don&rsquo;t want their investments to be associated with tobacco or weapons manufacturers. Second, there are those who care about financial risks and returns and who want to know their bank or pension fund considers ESG, to avoid risky investments (e.g., coal companies that may go out of business in a Net Zero world), or to select firms that perform well on ESG metrics and may therefore also perform well financially. Third, there are consumers who turn to sustainable investments because they want to contribute to a better world, solve society&rsquo;s problems, help to achieve the Sustainable Development Goals, or facilitate the energy transition. In short, they care about sustainable investing because they want to have &ldquo;impact&rdquo;.
Thanks to the 2&deg; Investing Initiative and their study &ldquo;<a href="https://2degrees-investing.org/resource/retail-clients-sustainable-investment/">A Large Majority of Retail Clients Want to Invest Sustainably</a>&rdquo; we know that, by far, most consumers (at least, in Germany and France) are interested in sustainable investing because of the third reason: because they expect, or are told, that this allows them to have &ldquo;impact&rdquo;.
Now, back to Article 9 SFDR.
Article 9 applies when a fund has &ldquo;sustainable investment&rdquo; as its objective. And &ldquo;sustainable investment&rdquo;, according to SFDR, means an &ldquo;investment in an economic activity that contributes to an environmental objective or a social objective&rdquo;. The operative word here is &ldquo;in&rdquo;, and we will argue that this word should be replaced. Or rather, should be supplemented with our six letters.
Let us explain.
First, it&rsquo;s important to consider the difference between company impact and investor impact. Company impact is where a company undertakes impactful activities. For example, it manufactures windmills or solar panels, or it helps socially disadvantaged communities. Investor impact is the change in company impact you, as an investor, induce, or enable, through your investments. The idea here is what, in impact circles, is often called &lsquo;additionality&rsquo; &ndash; the investment should allow something to happen that would otherwise not happen. There is a causal relationship. Or framed differently: investing in a green firm does not make the world greener, if it does not cause the green firm to grow, or to become greener. And, as our research shows, this additionality strongly depends on the characteristics of an individual investment, and cannot be taken as a given.
Second, you need to know that most funds of the type that are currently classified as Article 9 invest in companies who generally do not have difficulty financing their activities &ndash; usually they are publicly listed, very profitable and very large. Also, usually, when these funds invest in those companies, the money to buy the shares does not actually go into the companies &ndash; it goes to the seller of the shares, often just another investment fund, a pension fund, or an asset manager. In other words, even if those companies are impactful, they don&rsquo;t generally need additional financing to be even more impactful, and even if they do, they don&rsquo;t get the financing by being included in Article 9 funds.
All this is a very roundabout way of saying that:
<ul>
<li>Consumers are drawn to sustainable funds because they want to have &lsquo;impact&rsquo;; and</li>
<li>SFDR Article 9 lets banks and asset managers sell their funds as &lsquo;impact funds&rsquo;; yet</li>
<li>SFDR Article 9 does not actually require there to be &lsquo;impact&rsquo;; and therefore</li>
<li>SFDR does not incentivize banks and asset managers to design funds that in fact direct capital to sustainability goals, and that enable change; and what&rsquo;s more:</li>
<li>SFDR lets financial firms sell &lsquo;impact funds&rsquo; to consumers who want to have &lsquo;impact&rsquo;, and think they are buying &lsquo;impact&rsquo;, but are, in fact &hellip; not getting &lsquo;impact&rsquo;.</li>
</ul>
<h2>Recommendations for the Commission</h2>
All of this can be quite easily fixed by adding just six letters to the SDFR text: A, B, E, G, L and N. The EU Commission needs to make a tiny change to Article 2 (Definitions), paragraph 17, which defines the term &ldquo;sustainable investment&rdquo;: &ldquo;&lsquo;sustainable investment&rsquo; means an investment ENABLinG an economic activity that contributes to an environmental objective, (&hellip;.) or an investment in an economic activity that contributes to a social objective, in particular (&hellip; etc.).&rdquo; In other words, change the &ldquo;investments in an economic activity&rdquo; to &ldquo;investments enabling an economic activity&rdquo;, and we are all set for a financial market with a vigorous and vital competition to fulfill consumers&rsquo; demand for real-world impact.
We believe that this quick fix will go a long way to ensuring that at the second birthday of the SFDR the EU Commission can claim that SFDR is truly incentivizing the financial sector to help direct capital towards environmental and social objectives. And that it can also live up to its promise of end-investor protection. Consumers want &lsquo;impact&rsquo;, and they will know that Article 9 funds provide it.
Now, how much more impactful than that can you be?
Six letters is all it takes.
You can thank us later.
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.

A-B-E-G-L-N: how adding six letters to SFDR can make it ‘work’

I can’t tell you how often I’ve been asked: “How can I tell genuine ESG funds from the … well, not quite so genuine?”Like with pretty much everything in ESG, there are no simple answers. Different people look for different things in ESG: values-alignment, financial performance, saving the planet. 

I can&rsquo;t tell you how often I&rsquo;ve been asked: &ldquo;How can I tell genuine ESG funds from the &hellip; well, not quite so genuine?&rdquo; As with pretty much everything in ESG, there are no simple answers. Different people look for different things in ESG: values-alignment, financial performance, saving the planet. Think about it.
No, but really: think about it!
&hellip;Yes, exactly &ndash; these are radically different things: (1) Some people want to avoid association with what they consider unethical or immoral activities, like tobacco or weapons, through their investments. (2) Some people believe that companies that perform well on environmental, social or governance aspects will also perform well financially. (3) Some people want to direct investments to certain companies or projects that will contribute to solving societal problems like climate change or poverty, and that will make a better world.
With these different motivations, how likely is it that you&rsquo;ll hit on an investment strategy that satisfies these different objectives, and that actually works? &lsquo;Works&rsquo;, in the sense that it avoids the exact categories of investments that large numbers of clients want to avoid; manages to select &ndash; based on ESG factors that are material, or financially relevant &ndash; companies that outperform the market financially; and then provides the financing that allows the development of technologies or solutions that make our world a better place. I would say that the likelihood of this combination is close to zero.
In other words, &lsquo;genuineness&rsquo; in ESG funds is in the eye of the beholder. It all depends on what the beholder, or client, is looking for.
And then, even if there&rsquo;s clarity on the goals, or motivations, there are still lots of different ways to build investment strategies around these motivations, some more credible than others.To sum up the problem with ESG funds: you might be tempted to think &ldquo;all roads lead to Rome&rdquo;, as the familiar saying goes, but sadly this doesn&rsquo;t fly in ESG. Because, in ESG, not everyone wants to go to Rome, some want to go to Tokyo, some to Rio.
So I think it&rsquo;s good people are coming round to the view that it&rsquo;s pointless to try to agree on what constitutes a genuine &ldquo;sustainable fund&rdquo;.
This is also because all the ways we&rsquo;ve tried to classify ESG so far have pretty much failed. A quick classification of the classifications:
SFDR article 8 &amp; 9: these are the two articles of the EU Sustainable Finance Disclosure Regulation that attempt to define ESG funds. However, the criteria for article 8 (the fund needs to &ldquo;promote ESG characteristics&rdquo;) are so laughably lenient that almost any fund can be classified here. And the criteria for article 9 are muddled and internally inconsistent, so clients looking for some guidance as to what&rsquo;s &ldquo;ESG&rdquo; about the fund are none the wiser.
Labels: there&rsquo;s a whole plethora of ESG labels out there but they&rsquo;re not much help either &ndash; they do not clearly distinguish between the different things that different ESG funds are trying to enable, so it&rsquo;s not clear to clients exactly what the label signifies.
Morningstar Globes: like a host of other ESG scores and indicators, the Morningstar Globes are an indication of how &lsquo;sustainable&rsquo; a particular fund is. But, first, the assessment is just a subjective view of one data provider (in this case, Sustainalytics) on what &lsquo;good ESG&rsquo; looks like. And, second, the assumption is that clients looking for ESG investing aim to invest in a portfolio of companies that are already sustainable, as compared to &ndash; for example &ndash; investing in companies that need to be helped on their sustainability transition, or companies that have some kind of societal impact.
These experiments also suggest that it is unlikely that we&rsquo;ll come up with an objective and universal measure or label of &lsquo;genuineness&rsquo;. So the least I can do is give people some tools to deal with the complexity. In other words, this was ideal content for one of my &ldquo;capture ESG complexity in one slide&rdquo; Powerpoints.
A couple of years ago, to help people with the question above, I developed the Conviction &amp; Narrative checklist: 10 questions to ask the manager of an ESG fund, to determine if it is in fact 'genuine'.
And, building on the reasoning above, the idea is not to have one monolithic, objective set of criteria that will lead to an unassailable assessment that the fund &ldquo;is ESG&rdquo;, but rather a set of questions that will lead to a thoughtful and productive conversation allowing the asset manager to explain &ldquo;what&rsquo;s ESG about the fund&rdquo;, and enabling the prospective client to see if this is where (s)he wants to go, and if this sounds like a credible way to get there.
In short, these questions should tease out the &ldquo;conviction&rdquo; that underpins the strategy, and elicit a solid &ldquo;narrative&rdquo; about how that conviction drives the investment decision-making and how it is expected to lead to the desired outcomes.
But obviously this set of questions can also be used by asset managers who came up with an ESG strategy and want to generate some inflows. What questions should you be prepared for? What should you cover in your documentation? What&rsquo;s the latest in terms of market standards, regulation or regulatory guidance that you should be aware of?
The slide also has a couple of links to accessible and helpful reports, papers and articles that provide further background and detail.
So, I present to you: Finding ESG Authenticity in 10 Simple Questions! &ldquo;A child can do the laundry,&rdquo; as we like to say here in the Netherlands: it&rsquo;s easy to do. Still, should you get lost on your way to Rome, Tokyo or wherever you want to go, you know where to find me.
<img src="https://illuminem.b-cdn.net/articlebody/18bddf7a875ecda7fd807076b241adfacd99dd95.png" alt="undefined" />
<h2>1. Conviction</h2>
Please describe what role ESG considerations play in the investment strategy, what ESG-related investment conviction this is based on, and how this is reflected in the investment research and decision-making process.
<h2>2. Objectives</h2>
Please indicate what the <a href="https://www.responsible-investor.com/articles/investment-motivations-are-being-ignored-in-esg">objectives are of incorporating ESG considerations in the investment strategy</a>, i.e. one or more of:
(1) Alignment with values &ndash; please specify what &amp; whose values, and how they have been determined (2) Generating (financial) out- performance (3) Influencing company behavior (4)Risk management (5) <a href="https://2degrees-investing.org/resource/retail-clients-sustainable-investment/">Having positive social or environmental impact</a>​
For each objective, please indicate as much as possible how the chosen ESG approach will help achieve the objective &ndash; describe what your theory of change is, or what &ldquo;cause &amp; effect&rdquo; chain of events your investments are intended to trigger.
If it regards an impact fund (5) &ndash; would you consider the strategy to be <a href="https://link.springer.com/article/10.1007/s43546-020-00033-6">&ldquo;impact-aligning&rdquo; or &ldquo;-generating&rdquo;</a>?
<h2>3. Data, ratings &amp; research</h2>
Please indicate which data or ratings you use to implement the chosen ESG approach, and why. Is there (academic) research that you use as input for the strategy and/or that supports the validity of your investment strategy?
<h2>4. Team</h2>
Please describe the team that is responsible for managing the investment strategy, and indicate which members of the team are responsible for the ESG aspects of the strategy, and what ESG-related knowledge or capabilities they bring to the team.
<h2>5.&nbsp;Reporting</h2>
Please indicate what kind of reporting you make available to clients on the strategy and in particular on the ESG approach.
<h2>6. Measurement &amp; attribution, frameworks</h2>
Please indicate if you do attribution assessment (to determine which investment results are attributable to the ESG aspects) or measurement of the targeted outcomes of the strategy, whether quantitatively or qualitatively. Please describe metrics used, who conducts the attribution or measurement, and the results to date. If you reference the Sustainable Development Goals (SDGs) as a framework, please provide detail referencing goals and sub-goals of the <a href="https://www.un.org/ga/search/view_doc.asp?symbol=A/RES/70/1&amp;Lang=E">UN 2030 Agenda for Sustainable Development</a> and discuss causal mechanisms.
<h2>7. Regulatory guidance</h2>
Please indicate if you have followed specific regulatory guidance in establishing or documenting the strategy, e.g. from <a href="https://www.finma.ch/en/news/2021/11/20211103-finma-aufsichtsmitteilung-05-21/">Finma</a> (CH), <a href="https://www.fca.org.uk/news/news-stories/guiding-principles-on-design-delivery-disclosure-esg-sustainable-investment-funds">FCA</a> (UK), or <a href="https://www.sec.gov/files/spotlight/amac/recommendations-esg.pdf">SEC</a> (US)?
<h2>8. Ratings/assessments/labels</h2>
Does the fund have any (external) ESG ratings, assessment, or <a href="https://www.privateequityinternational.com/looking-beyond-the-sfdrs-esg-labels/">SFDR classification (art. 6/8/9)</a>? Do you feel they adequately capture the essence of your approach? <a href="https://qontigo.com/an-impossible-product-comparing-europes-dissonant-esg-fund-labels/">Does the fund have a label? Why that label? </a>Please indicate what the requirements are to obtain the rating, classification or label and how you meet them.
<h2>9.&nbsp;Backstop</h2>
Please indicate if your fund has investments (or might allow investments in the future) that would be considered controversial if found in an ESG fund. Are you prepared to explain why these investments can in fact be justified based on alignment with your ESG approach?
<h2>10. Supporting activities</h2>
Do you undertake activities that support investment research and decision-making, e.g. company-, industry- or public policy engagement; or support the further development of sustainable finance practices/markets, e.g. by working with NGOs, governments or academics?
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.​

The “Conviction & Narrative” checklist: 10 questions to ask the manager of an ESG fund

MiFID should require financial firms to ask about consumers’ sustainability objectives instead of preferences. Because what motivates most consumers about sustainable investments is having impact.

MiFID should require financial firms to ask about consumers&rsquo; sustainability objectives instead of preferences. Because what motivates most consumers about sustainable investments is having impact.
A couple of weeks ago, there was some good news for those who believe that ESG investing, or sustainable investing, should be even higher on the agenda than it already is: the European Securities and Markets Authority (ESMA), the EU&rsquo;s securities markets regulator, is&nbsp;<a href="https://www.esma.europa.eu/press-news/consultations/consultation-guidelines-certain-aspects-mifid-ii-suitability-requirements-0">consulting</a>&nbsp;on suitability requirements under the Markets in Financial Instruments Directive (MiFID II), in order to update its guidelines relating to sustainability.
Under the proposed rules, financial firms will need to collect information about their clients&rsquo; &ldquo;sustainability preferences&rdquo; and recommend only financial products that fulfill those preferences.
What are ESMA&rsquo;s aims with this new rule? As we&rsquo;ve come to expect with ESG or sustainability-related regulatory initiatives, there is a whole laundry list: facilitating the transition to a low-carbon, more sustainable, resource-efficient, and circular economy in line with the Sustainable Development Goals (SDGs); strengthening the response to climate change by, among others, making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development; giving clear signals to investors that they should avoid stranded assets; raising sustainable finance to reorient capital flows towards sustainable investments to achieve sustainable and inclusive growth; ensuring sustainability factors are taken into account by investment firms as part of their duties. And last but &ndash; we would argue &ndash; certainly not least, investor protection and countering greenwashing.
Worthy goals and laudable steps, no?
Yes, but the MiFID proposal misses the mark by a wide margin on two points: First, it is based on a rather technocratic understanding of sustainability preferences, focusing entirely on alignment with existing, complex regulation, instead of straightforwardly asking what investors expect from sustainable investing products. Second, it rests on opaque and largely unrealistic notions of how sustainable investment products, today, actually contribute to solving societal problems.
On the first point: over the last few years, academics, investment firms, and sustainability professionals have come round to the view that consumers have different motivations to engage in sustainable investing. Basically, there are three: (1) &lsquo;impact&rsquo; &ndash; contributing to a better world through investments; (2) &lsquo;values-alignment&rsquo; &ndash; avoiding association with &lsquo;bad&rsquo; or &lsquo;amoral&rsquo; companies through investments; and (3) &lsquo;performance&rsquo; &ndash; optimizing financial risks and returns by considering sustainability aspects.
A 2020 study, &ldquo;<a href="https://2degrees-investing.org/resource/retail-clients-sustainable-investment/">A Large Majority of Retail Clients Want to Invest Sustainably</a>&rdquo; (2&deg; Investing Initiative), shows rather convincingly that, yes, about 2/3 of consumers are interested in sustainable investing, or have &lsquo;preferences&rsquo;. But in that group, most consumers are driven by the first motivation. That is, they are drawn to sustainable funds because they hope that this allows them to have impact, in other words, to contribute to a better world. To be sure, the second and third motivations also play a role, but a smaller one.
The study is based on a survey asking probing questions about consumers&rsquo; specific preferences and reasons why they decided to buy, or not to buy, sustainable funds. The answers are revealing. When offered sustainable funds, about half of respondents said they wanted more information, in particular to &ldquo;know more about the potential consequences on my profits; know what exactly are the activities and how they help with addressing these social and environmental issues; see hard evidence of their effectiveness in addressing these issues.&rdquo; When asked why they decided not to invest in impact funds, about half of respondents said, &ldquo;It looks like a marketing trick, not sure those funds have any concrete impact.&rdquo;
Another study by the 2&deg; Investing Initiative, &ldquo;<a href="https://2degrees-investing.org/resource/marketing-claims/#:~:text=EU%20Retail%20Funds'%20Environmental%20Impact%20Claims%20Do%20Not%20Comply%20with%20Regulatory%20Guidance,-Report%20Retail%20investing&amp;text=To%20draft%20this%20report%2C%202DII,%2Dthemed%22%20European%20investment%20funds.">EU Retail Funds&rsquo; Environmental Impact Claims Do Not Comply</a>,&rdquo; shows that &ndash; while over half of a sample of 230 ESG funds make environmental claims, most claims remain entirely vague. And hardly any fund provides evidence backing up the impact claims that are made. So why do consumers who, if probed in-depth, say they are mainly interested in real-world impact still flock to such funds that do not provide it?
The explanation can be found in the pivotal role that social norms play in responding to questions such as &ldquo;are you interested in investing sustainably?&rdquo; When asked, consumers usually respond affirmatively and&nbsp; even seem willing to sacrifice thousands of euros for &lsquo;green&rsquo; products, even if those do not deliver any substantial evidence for their green credentials. In fact, most consumers may never have dedicated any time and brain space to the topic or may have never considered this arguably complex issue before. And when faced with complex new questions, they tend to adhere to the social norm: what is &lsquo;the normal thing&rsquo; to do? In these situations, financial firms may be able to sell anything that looks remotely green to consumers who want to make the world a better place.
Instead of protecting consumers in such situations by forcing financial firms to clarify clients&rsquo; motivations and to be transparent about how their products satisfy them (or not), the MiFID proposal makes things easier for financial firms, and more difficult for consumers. If the aim is to protect consumers, MiFID should require discussing &ldquo;sustainability objectives&rdquo; in easily understandable terms, instead of &ldquo;sustainability preferences&rdquo; defined with reference to complex regulatory initiatives such as SFDR and the Green Taxonomy. This may seem like a subtle difference, but it would be a much better way of framing the issue, and would likely lead to better conversations with clients.
But how difficult would it be to go slightly further and to include in MiFID the requirement to discuss the three motivations of sustainable investing? Asking consumers whether they want to a) have impact, b) align their portfolios with their personal values, or c) use ESG factors to optimize risk and return would be much more effective in teasing out their true motivations. These objectives were first mentioned in research years ago and have by now been widely accepted by sustainability professionals, academics and financial firms.
This leads to our second, and perhaps more important, argument: the fact that the MiFID rule appears to assume that inflows into sustainable investment funds, as they currently are, will make a substantial contribution to fixing societal problems. In contrast, various studies have shown that most &ldquo;ESG,&rdquo; &ldquo;impact,&rdquo; or &ldquo;sustainable&rdquo; funds, in fact,&nbsp; contribute very little to solving those problems.
Firstly, this is because asset management firms currently have few incentives to structure funds for them to have a meaningful impact. Asset management firms need to up their game in this area, and having discussions triggered by MiFID &ndash; at least if it follows our recommendation above &ndash; would help them see that this is what their clients demand. What we would hope for is a market that competes for risk, return, and real-world impact &ndash; instead of merely finding the easiest ways to get products classified &lsquo;sustainable&rsquo; in line with Article 8 or 9 SFDR.
Secondly, this is because many of society&rsquo;s significant problems, like those captured in the SDGs, do not yet come with simple solutions that can be implemented by listed companies or easily packaged in conventional investment strategies and sustainable funds. Most require highly complex financing solutions involving governmental agencies, development banks and NGOs. Today, institutional investors like pension funds and insurance companies, let alone retail investors, hardly ever cooperate with these actors.
If ESMA and the EU want to reach all those laudable goals mentioned in the MiFID proposal preamble, it will take much more than mapping investment customers&rsquo; sustainability preferences or objectives, as important as that is. It requires the facilitation of complex public-private partnerships in order to structure solutions to these problems and finance them, at scale. And we don&rsquo;t have to argue here that this work is urgent: every day, we are reminded that the 2030 deadline for the SDGs is coming closer and closer and that we are nowhere near meeting the Paris climate goals.
ESMA should focus on investor protection and the countering of greenwashing and bring MiFID in line with emerging best practice by referencing the three investor motivations for sustainable investing. This should also incentivize asset management firms to expand their impact offering. But ESMA should also be more transparent and realistic about what this will do to solve society&rsquo;s problems &ndash; and that much more is required. EU agencies and national governments should establish collaborative platforms to solve urgent problems and find workable solutions to fund them.
illuminem Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.

MiFID misses mark: ESG motivations matter

"Net zero" is everywhere. Generally, that’s a good thing, because it is a neat shorthand, and reminder, of the action we urgently need to take to address climate change. Investors have also embraced net zero. And they have a role to play in addressing climate change, so that too is encouraging. However, the way investors embrace net zero is often sub-optimal.

&quot;Net zero&quot; is everywhere. Generally, that’s a good thing, because it is a neat shorthand, and reminder, of the action we urgently need to take to address climate change. Investors have also embraced net zero. And they have a role to play in addressing climate change, so that too is encouraging. However, the way investors embrace net zero is often sub-optimal, for two reasons:
<ol><li>They seem to think they need to demonstrate that portfolios are net zero on paper, today, which results in mathematical gymnastics using questionable metrics and methodologies, and based on dubious plans and pledges. Whereas in fact what they need to demonstrate is that they understand what needs to happen to get the global economy to net zero in real life, in 2050. And one can ask the rhetorical question: which of these is more important?</li></ol>
<ol><li>They confuse objectives in committing to net zero investing, resulting in a strange muddle of virtue-signaling, financial-performance-improving, risk-management and world-changing rhetoric that does not result in, but distracts from, the very important supporting role that investors can play: by being active owners, by finding ways to invest in and scale technologies that replace or remove emissions (for example through blended finance) or by supporting governments in developing effective public policy.</li></ol>
So, in my series of 1-slide PowerPoints that try to make sense of ESG complexity, I tried to capture all the moving parts in this ostensibly simple mathematical equation. In 10 text boxes (and a Bonus Box thrown in) I try to capture the intricacies of net zero investing:
<ul><li>What happens to emissions when you divest from them? Do they disappear?</li></ul>
<ul><li>What actually drives down emissions?</li></ul>
<ul><li>How much can the private sector really contribute to net zero?</li></ul>
<ul><li>How much should you bank on the ‘right’ side of the equation (offsets and removals) as compared to the &#x27;left&#x27; side (emissions)? Are we fooling ourselves when we need to rely on offsets to get us to zero?</li></ul>
<ul><li>What should you look for when scrutinizing a company’s net zero plans?</li></ul>
<ul><li>What should you know before making a net zero-investing commitment?</li></ul>
<ul><li>What are the reputational benefits – or, perhaps, liabilities – in making net zero pledges?</li></ul>
<ul><li>What more can an investor really do to get the economy to net zero in 2050, in the real world?</li></ul>
As much as possible I’ve backed this up with hyperlinks to papers and articles by (or interviews with) experts, and one podcast series, that provide more of the necessary background and detail.
Each box in this slide is a rabbit-hole you can easily fall into, especially because the links to background publications themselves lead to further publications and background reading. While of course I’ve made this slide and the 11 boxes so that not everyone has to wander around these rabbit-holes, I would encourage you to do a bit of burrowing or tunneling yourself. In doing so, you’ll get a sense for the complexity underlying this seemingly simple equation, and you’ll become familiar with some opinions, facts and concepts that are plainly obvious to many climate experts, engineers, economists and political scientists, but are not part of the popular discourse for whatever reason.
More importantly, I feel that any investor (or company, or country) making commitments linked to net zero, has an obligation to really try to understand which claims they’re making, especially if they are managing other people’s money. In short, by clicking on some of these links and doing some of this further reading, you&#x27;ll be able to distinguish &quot;Net Zero&quot; from &quot;Not Zero&quot;.
And not only will you fulfill your fiduciary duty to the clients who gave you their money to look after, you’ll likely also be making a bigger contribution to addressing climate change than by simply becoming a part of the net zero chorus, which would likely result in net zero becoming – as some climate scientists have warned – an empty slogan.
<img src="https://illuminem.b-cdn.net/articlebody/24adeffee7f34b891ce45c50ad27fd58d73c8b7c.png" alt="undefined">
1. Net zero initiatives essentially encourage ‘divesting emissions’, which <a href="https://www.responsible-investor.com/articles/where-do-carbon-emissions-go-when-they-re-no-longer-in-your-portfolio">moves them to someone else’s portfolio</a>, not from the atmosphere. Larry Fink: “<a href="https://mitsloan.mit.edu/ideas-made-to-matter/blackrocks-larry-fink-dont-divest-fossil-fuels-stay-game">Nothing is more greenwashing than divestiture.</a>”
2. Net zero initiatives encourage engaging with companies in order to reduce emissions. Great! But, while companies can often reduce Scope 1 &amp; 2 emi<a href="https://www.nytimes.com/2021/02/22/business/energy-environment/corporations-climate-change.html">ssions, reducing Scope 3 emissions is much more difficult</a>, and that is the <a href="https://www.economist.com/briefing/2020/06/20/how-much-can-financiers-do-about-climate-change">crucial part</a>.
3. Experts seem agreed that reducing emissions (especially Scope 3) will primarily require government action: <a href="https://www.energypolicy.columbia.edu/our-work/topics/carbon-tax-research-initiative">carbon taxes</a> or <a href="https://www.lse.ac.uk/granthaminstitute/wp-content/uploads/2016/02/Working-Paper-224-Baranzini-et-al.pdf">pricing</a>, industry policy (or industrial policy) &amp; <a href="https://www.econstor.eu/bitstream/10419/225183/1/10_3790_vjh_88_2_073.pdf">stimulating innovation in green tech</a>. Most net zero initiatives don’t mention this, or don’t recommend companies and investors contribute to effective government action e.g. through blended finance or PPPs.
4. The emphasis in net zero commitments tends to be on the right side of the equation, which <a href="https://www.carbonbrief.org/guest-post-the-problem-with-net-zero-emissions-targets">scientists</a> say diverts attention from the the left side: reducing emissions, which is the crucial part.
5. Studies routinely show that most offsets (e.g. planting <a href="https://www.bloomberg.com/features/2020-nature-conservancy-carbon-offsets-trees/">lots</a> <a href="https://www.bloomberg.com/news/features/2020-12-17/the-real-trees-delivering-fake-climate-progress-for-corporate-america">of</a> <a href="https://www.science.org/doi/10.1126/science.aay8060">trees</a>) in fact <a href="https://theconversation.com/outdated-carbon-credits-from-old-wind-and-solar-farms-are-threatening-climate-change-efforts-151456">do</a> <a href="https://www.theguardian.com/commentisfree/2021/mar/03/climate-crisis-carbon-accounting-tricks-big-finance">not</a> <a href="https://www.volts.wtf/p/carbon-offsets-arent-working-and">‘offset’</a>– that is, they are ineffective. This makes most net zero commitments meaningless. Some academics have recommended <a href="https://www.sciencedirect.com/science/article/pii/B9780123750679001650">abolishing offsets</a>.
6. Often net zero investor commitments are (also) made for PR purposes. However, &quot;<a href="https://www.kekstcnc.com/insights/net-zero-from-reputational-liability-to-reputational-asset">Only 4% of the UK population believe that when a CEO makes a public commitment to net zero this means the company is serious about climate change</a>,”i.e. this could be more of a liability than a benefit.
7. <a href="https://pod.co/the-carbon-removal-show">Removal technologies</a> (“negative emissions tech” or NETs) are non-existing, in their <a href="https://www.businessinsider.fr/us/carbon-capture-storage-expensive-climate-change-2021-9">infancy</a>, or have <a href="https://www.nature.com/articles/s41558-021-01061-2.epdf?sharing_token=9nMWnp-NkkoV1B91l5W8CdRgN0jAjWel9jnR3ZoTv0MsF9C-5-lW4e8WuWcsjUmFXNP3-oLLKv4JnBbVyydJ-hj0VqLQpXr5vL9kOyapBeMvMoG9tNQFZUEw1oXHG7P1VF0QfDPE56ATEmEGBoQlqDWOhtwjHrJnFY_NRC--9pN6NIs7Hq-i1ogqjk3ftyJ6_PKBj781BO6vUX_qf1aNqU0l9myAjeWF77NXEWgv0cw%3D&amp;tracking_referrer=www.technologyreview.com">other </a><a href="https://www.c2es.org/document/carbon-dioxide-removal-pathways-and-policy-needs/">limitations</a>. Some scientists call for <a href="https://www.bloomberg.com/news/articles/2021-08-12/with-new-urgency-climate-scientists-recommend-carbon-removal">significant investment </a>in NETs; others <a href="https://www.theguardian.com/commentisfree/2021/sep/10/net-zero-2050-deadly-procrastination-fossil-fuels">argue</a> this side should be left out of the equation.
8. Scientists have called the net zero concept a ‘<a href="https://theconversation.com/climate-scientists-concept-of-net-zero-is-a-dangerous-trap-157368">dangerous trap</a>’ and warned that without clarification it becomes an <a href="https://www.washingtonpost.com/opinions/2021/03/22/net-zero-pledges-carbon-emissions/">empty slogan</a>.
9. Even if you can find a credible way to get your portfolio to zero, that doesn’t mean you got the economy to zero. Investors or companies can do little to change the bigger system –but <a href="https://theconversation.com/climate-change-focusing-on-how-individuals-can-help-is-very-convenient-for-corporations-108546">governments</a> <a href="https://www.economist.com/schools-brief/2020/05/23/the-worlds-energy-system-must-be-transformed-completely">can</a> do a lot.
10. “Net zero aligned” means investments aligned with plans to do things in the future but most <a href="https://climateactiontracker.org/global/cat-net-zero-target-evaluations/">country</a> and <a href="https://www.nature.com/articles/d41586-021-00662-3">company</a> plans are <a href="https://time.com/6117635/companies-net-zero-greenwash/">vague</a> or infeasible.
(Bonus) 11. Data, metrics and methodologies used to measure a portfolio’s ‘temperature’ are shaky. <a href="https://www.louisbachelier.org/wp-content/uploads/2020/07/rapport-0207-mis-a-jours.pdf">Experts have cautioned</a> about basing investment decisions on them, saying they may “<a href="https://www.responsible-investor.com/articles/why-portfolio-temperature-ratings-should-be-taken-with-a-pinch-of-salt">give a false sense of certainty</a>”.
Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.

Harald Walkate

Harald Walkate

The 4 D’s of accelerating the transition: Ditch Disclosures, go Directly to Decarbonization

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