In a recent post, we briefly touched on the topic of sustainable savings and investments. It’s such a big topic, we thought that it warranted its own dedicated article. Furthermore, a recent study by the Responsible Investment Association Australasia (RIAA) found that 83% of Australians and 73% of Kiwis expect their savings and investments to be used responsibly and ethically, to make a positive impact on the world we live in. Yet, only 36% of Australians and 48% of Kiwis are confident in their knowledge about ethical and sustainable investing. That’s a big (knowledge) gap. So, today’s (comprehensive) post is all about demystifying sustainable finance.
What is sustainable and ethical finance?
Sustainability and sustainable finance
The Brundtland Report, commissioned by the UN in 1987, defined sustainability as meeting the needs of the present without compromising the ability of future generations to meet their own needs. The needs of current and future generations hereby boil down to three interrelated elements: economic prosperity, social justice and a healthy environment.
Sustainable finance thus, by definition, requires us to
- take a long-term and holistic view with regard to risks and returns (beyond the traditional focus on profits to include the environmental and social impacts of our economic activities), and
- use savings and investments to fund a world in which people and the planet are on par with profits (achieving a triple bottom line).
Ethics and ethical finance
Ethics by definition are moral principles that govern a person’s behaviour and actions. Ethical finance thus means aligning our savings and investments with our values and moral principles. Our values and moral principles become the primary filters when making savings and investment decisions.
While there is considerable overlap between ethical and sustainable finance there are subtle differences.
What are ESG criteria?
To generate long-term financial returns as well as positive environmental and societal impact, players in the sustainable finance space consider environmental, social and corporate governance (ESG) criteria (in addition to traditional risk/return criteria to maximise shareholder value) when assessing financing opportunities:
- Environmental factors (E) affect the natural world. They include aspects like a company’s carbon and water footprints, and activities to reduce both.
- Social factors (S) concern local and global communities, and include a company’s workforce diversity and inclusion, working conditions and compensation.
- Governance factors (G) relate to a company’s inner workings and decision-making processes. They include things like the make-up of its board, and how transparent it is about its policies and activities.
How do ESG criteria relate to ethical and sustainable saving and investing?
Incorporating ESG criteria when assessing a company becomes a tool to assess and manage risks and opportunities holistically and with a long-term view. Bringing the ethical element into the equation means applying the ESG criteria in a way that represents our moral principles and values as savers and investors.
To give you an example:
Let’s say there is a managed fund with sustainable or ESG in its name. With one of our core values being sustainability, we could assume that by investing in the fund, we’re aligning our investments with our moral principles and values. However, when we have a closer look at how the fund applies ESG criteria, we find that it excludes companies that make weapons or extract fossil fuels but invests in fast fashion brands we know exploit their workers and pollute the environment.
So, while the fund may be considered ‘sustainable’ by excluding certain industries or companies, it may not match OUR definition of ethical and sustainable investment.
While the concept of sustainable finance is aimed at the right outcomes, sustainable investing, in particular, comprises a range of strategies, and unfortunately, companies and investment managers may also use sustainability as a marketing ploy (we’ll talk about greenwashing and other concerns a bit later in this post).
As with other decisions we make on a daily basis: it pays to look under the hood and go into it with our eyes wide open.
Why is saving and investing ethically and sustainably important?
As outlined in the simple and effective ways to reduce your carbon footprint,
- publicly-listed investment finances 20% of global industrial greenhouse gas emissions, and
- the world’s 60 largest banks funded fossil fuel projects to the tune of $4.582t in 2021 (an increase of 20% compared to 2020), despite a world-wide commitment to phase out fossil fuel.
These are our savings and investments contributing to emissions we work so hard to reduce.
Fortunately, we do have a choice. We can (re)direct our savings and investments to help build a healthier, more equitable world. Global ESG assets under management (AUM) accumulated to USD35.3t in 2020, more than a third of all AUM worldwide, and are set to surpass USD53t by 2025.
Our financial system is contributing to environmental degradation and entrenching inequality across many measures […] Sustainable finance is a key component in a society where nature and all communities thrive. (Toitū Tahua Centre for Sustainable Finance New Zealand)
That may all be well and good, you might think, but wouldn’t investing ethically and sustainably mean sacrificing financial returns? Let’s spend a moment addressing this concern.
How do financial returns of sustainable funds compare with traditional investments?
Taking a holistic and long-term approach and investing ethically and sustainably is not only the right thing to do. It also seems to lead to better outcomes for people, the planet and profits.
A study published in 2016 found that ESG companies
- showed lower volatility in their stock performances than their peers in the same industry, and
- achieved better financial returns than their peers in eight out of 12 industries. Only in automobiles, durables, and banking and insurance, ESG-companies underperformed their peers.
A study conducted by the Morgan Stanley Institute for Sustainable Investing, covering more than 10,000 mutual and exchange-traded funds (ETFs) between 2004 and 2018 confirmed:
- the returns of sustainable funds were in line with their traditional counterparts, and
- sustainable funds experienced a 20% lower downside risk than traditional funds.
Especially during periods of higher market volatility, sustainable funds seem to perform better than their traditional counterparts. In 2020, for example, 75% of sustainable funds outperformed their traditional peers.
And finally, the MSCI KLD400 Social Index, one of the first indices measuring ESG performance of US companies, shows not only better annualised returns of ESG focused companies over 3, 5 and 10 years but also lower maximum drawdowns (losses) during the Global Financial Crisis than its (unscreened) parent index, the MSCI USA IMI.
While there is clear evidence that sustainable funds don’t disadvantage investors from a return or risk perspective, what constitutes a sustainable fund is defined quite broadly, and not all sustainable funds are created equal. Let’s spend a moment elaborating.
How do investment funds incorporate ESG factors?
Sustainable investment strategies
There are (almost) as many investment approaches as there are fund managers on the planet. Which doesn’t make comparing investments any easier.
However, based on the investment strategy applied, sustainable funds can be grouped as follows:
|ESG Integration||Negative/ Exclusionary Screening||Norms-based screening||Corporate engagement and shareholder action||Positive/ Best-in-class screening||Sustainability-themed investing||Impact Investing|
|Explicitly and systematically including ESG risks and opportunities into financial analysis and investment decisions||Excluding specific countries, sectors and/or companies based on activities considered not investable due to unacceptable risk or values misalignment (for example, weapons, fossil fuels, tobacco)||Excluding companies that do not meet minimum standards of business practice based on international norms and conventions||Executing shareholder rights to drive desired corporate behaviours in line with comprehensive ESG guidelines||Intentionally investing in industries or companies assessed to have better ESG performance relative to benchmarks or peers||Intentionally investing in companies that provide solutions to specific sustainability themes (for example, climate change, gender equity)||Investing to achieve specific positive social and environmental goals, demonstrated by measuring of investment intent and impact (for example, BlueOrchard Finance and Triodos Investment Management)|
What sustainable investment strategy has the biggest impact?
While not clear-cut (and bearing in mind that a fund can apply more than one of these strategies), there is a bit of an evolution from left to right:
- Investment managers, as they first embark on assessing investment opportunities beyond their financial value, start by measuring their status quo based on ESG criteria to understand what they are invested in.
- As they find pertinent risks from an ESG perspective, they exclude the highest-risk companies to reduce their exposure. Or they dial up their corporate engagement. This means they drive change through actions like voting for the adoption of an ESG-based remuneration framework or an independent review of a company’s OHS framework.
- With investors increasingly interested in investments that (pro-actively) contribute to change in specific areas (like clean water, regenerative agriculture or green transport), investment managers use ESG criteria not only to mitigate risk but also to identify opportunities and create portfolios that meet investor demands.
On the right side of the table, for example, you would find investments in companies that develop carbon sequestration technologies. As these technologies are relatively new, these companies tend to be start-ups or early-stage businesses. And as they are not (yet) publicly traded, this is the space where Private Equity funds and Venture Capital firms operate.
What sustainable investment strategies are most prevalent?
Looking at the chart below, you will notice that the most common sustainable investment strategy globally is ESG integration, followed by negative/exclusionary screening, and corporate engagement and shareholder action:
This is representative of a market that is still young and evolving, in comparison to traditional investment approaches. While not new, investing sustainably has really only taken off since the beginning of the 21st century – especially in the past decade.
How to save and invest ethically and sustainably?
As with so many things in life: start with your values. Work out what is important to you and what you won’t compromise on. Only once you have clarity about your core values, proceed to the next steps.
Choosing a provider for your transaction and savings account
Most of us already have a transaction and/or savings account (or even multiple). So, start by looking up your bank/s in tools like
- Rainforest Action Network’s annual Fossil Fuel Finance Report
- Morningstar Sustainalytics ESG Risk Ratings and/or
- 350 Aotearoa’s annual assessment of New Zealand banks based on research from Market Forces.
If your bank is not listed, check their website and ask them a few in-depth questions, including:
- What is the bank’s lending policy?
- What industries or companies do they not lend to?
- Do they specifically focus on lending to small and medium-sized enterprises to help create jobs in local communities?
- Do they issue social and/or green bonds to finance specific projects that help people and/or the planet?
- Do they pay fair wages and their fair share of taxes?
Another indicator that your bank takes sustainability seriously, is the way it reports crucial ESG information, including
- Does it report its loan portfolio based on its contribution to the 17 UN Sustainable Development Goals (SDGs) and/or its alignment with the Paris Agreement to reach net-zero by 2050?
- Is the Bank measuring and reporting its own carbon footprint (and how it has been changing year on year)?
- Does it have a net-zero emissions target?
- How is it tracking against that goal? And how much of that goal is achieved by actual emissions reduction vs purchase of carbon offsets?
- Does the bank measure its performance and actively pursue improvements around pay equity, diversity and inclusion?
- Does sustainability form part of the bank’s remuneration framework?
It may not be easy to track down that information. But the fact that a financial institution has a lot of it on its website and in its annual reports already tells you a lot. Transparency is key: Banks that don’t have anything to hide and which are passionate about contributing to a better world will talk about it openly (and will track their contribution).
A final note: No financial institution is perfect when it comes to sustainability. And the most sustainable financial institutions may not operate in your country. It’s important that you are comfortable with how your savings are being used. Choose the best alternative for your country and review your decision every few years.
Choosing a company or product to invest in
If you are already an investor (whether through your pension/superannuation fund or directly), start by checking where your money is invested. If you are new to investing, do your homework. And choose a company, investment manager or investment product that aligns with your values.
“It’s not an investment if it’s destroying the planet” (Vandana Shiva, Author and Environmental Activist)
If you (want to) invest in individual companies, check their investor communication. Especially their annual reports should include chapters that talk in-depth about their sustainability policies and principles, supply chain, board make-up, etc. If you (want to) invest in an investment fund that comprises a collection of companies (for example, an ETF), read the fund’s information memorandum and annual reports, with a specific focus on the following questions:
- What is the fund’s investment philosophy and process? Does it screen out certain companies (and on what basis)? Or does the investment constitute a portfolio of companies specifically chosen for their best-in-class ESG credentials?
- What companies does the fund invest in? Ideally, you’d want to see the whole portfolio, not just the top 10 companies, to ensure the portfolio aligns with your expectations (values and moral principles).
- What data sources do they base their investment decisions on? Larger investment management firms will have an in-house research team, smaller ones are more likely to utilise 3rd party research.
- How long have the fund managers (the actual staff members managing the investment fund) been managing ESG funds?
- How do fund managers vote on key issues? Are they taking an active stance and voting in line with ESG expectations of their investors? Do they challenge controversial issues and vote against board recommendations where required?
ESG Rating Tools
Here are some useful tools that might help you assess an investment fund/investment manager:
- TrackInsight ESG Investing Channel – This free tool provides access to institutional-level research around ESG investing. It allows you to look up a specific ETF using its ticker/name and region. Or search their ETF database (comprising over 6,500 funds) based on a number of filters, including investment strategy, ESG score and the specific SDG/s a fund may support.
- FinanceMap – The tool assesses investment funds globally based on their alignment against the Paris Agreement of achieving net-zero carbon emissions by 2050.
- Climetrics – Powered by data from the Carbon Disclosure Project (CDP), the Climetrics database provides climate ratings for 18,000 investment funds globally. The ratings assess the funds’ portfolio holdings based on their contribution to reducing GHG emissions, managing water resources and tackling deforestation.
- Ethical Consumer – If you’re a UK investor with stocks and shares ISA, Ethical Consumer research might help you assess the credentials of your fund.
- Mindful Money – This is a New Zealand-focused tool, allowing Kiwi investors to check the ESG credentials of their investment fund and/or KiwiSaver fund.
A final note: The number of investment funds with best-in-class ESG credentials is small. And those funds may not be available in your country. Choose a fund/funds that most closely align with your values and moral principles. Every year or so, check how your fund is performing from an ESG perspective. And if you are not happy with your findings, see if there are better investment options out there.
A word on ESG scores
When assessing companies and investment funds, at one point or another, you’ll come across the concept of ESG scores. An ESG score is a data point intended to rate and compare companies and investment funds based on their performance in relation to the ESG factors we mention above.
There are two worthwhile things to note:
- An ESG score is a single score that represents three different aspects (environmental, social and governance factors) and many measures within each aspect. That’s like describing a person using only one word.
- There is no universal framework that scores the ESG performance of a company or fund (but a myriad of methodologies), which makes comparing investment funds that are rated by different methodologies difficult.
So, when assessing companies or investment funds take the ESG score with a grain of salt. (At the very least) check what drives the score and how do the underlying elements compare between companies or funds you might want to invest in.
This brings us to the final chapter of this post.
Sustainable finance is not without criticism
Let’s talk about greenwashing
According to Investopedia, “Greenwashing is the process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound [than they actually are].”
With the proliferation of ESG investing over the past decade, in particular, standards and regulations have not been able to keep pace, leaving (a lot of) room for abuse and leading to
- Companies misleading lenders and investors about their ESG performance,
- Banks misleading their customers about the sustainability of their lending portfolio and their own ESG performance, and
- Investment managers misleading (retail) investors about the ESG credentials of their investment products – especially if there is a monetary incentive for fund managers to channel investor money into a more expensive ESG portfolio (over a comparable traditional product).
Specifically, we need standards and regulations
- around what constitutes a sustainable activity,
- how ESG performance is measured, and
- how sustainable investment products are marketed.
Standards and regulations are tightening around the globe – the EU’s Taxonomy for Sustainable Activities is one of the more recent examples. But there is a lot more work to be done to get the industry on the straight and narrow.
Greenwashing is not easy to identify. But asking questions like the ones we have listed above will point out the bad apples. As mentioned before: Transparency is key. Companies, financial institutions and fund managers that are not forthcoming with information or whose responses are generic/deflecting might be hiding something.
“Thirty years down the line, it’s hard for me to imagine an investment that does not take into account some combination of ESG […]. It’s going to become the norm.” (Ioannis Ioannou, Professor of Sustainable Investment at London Business School)
Other arguments against sustainable finance
Some big-name investors and (ex-)investment professionals discourage the focus on environmental, social and governance factors, and we’d like to finish today’s post by assessing the top 3 arguments we’ve come across during the research for this article:
Argument 1: Investment managers have a fiduciary duty to those whose money they are managing. ESG criteria can therefore only be incorporated insofar they don’t detract from an investment manager’s focus on maximising profits for the shareholder.
Our Thoughts: Fiduciary duty doesn’t mean sole focus on maximising shareholder profits (though it has been the focus traditionally). By definition, fiduciary duty obligates one party (the investment manager) to act solely in the interest of the other (the investor). Therefore, if the investor’s interest is to invest ethically and sustainably (with a focus on a triple bottom line), under their fiduciary duty, an investment manager would have to incorporate ESG criteria.
Argument 2: Divesting from high-risk companies doesn’t introduce any new capital and thus doesn’t really make a difference. Stocks are traded on exchanges and those divested shares are just held by someone else.
Our Thoughts: Granted, divesting bad apple stocks from a portfolio doesn’t wipe the company off the face of the earth. Someone else will continue to hold that stock. But, imagine that company is an energy company reliant on fossil fuels (with no intention to adapt to a low carbon economy). Now imagine a carbon tax was introduced, and the energy sector would move to renewables. Do you think consumers will continue to buy their electricity from that provider? Do you think the company will remain competitive?
By divesting the bad apple stocks from your portfolio, you remove the risk. If someone else is happy to hold that risk, it’s their decision. Divesting won’t have an immediate impact, but as markets change (through consumer pressures, legislative changes, etc), companies that don’t adapt will be losing (and so will their investors).
It is also correct that divesting in itself doesn’t introduce new capital. The majority of retail investors don’t have the kind of cash sitting around that lends itself to impact investing. And they don’t have the risk appetite that comes with more illiquid investments either. However, as Private Equity funds and Venture Capital firms help new businesses reach scale, these companies will eventually make their appearance on the stock market. And divested capital can then be reinvested to continue to support these companies.
Argument 3: Relying on companies and investment managers to do the right thing by people and planet is like asking sharks to tame their appetite in a feeding frenzy. Real change can only be achieved through mandatory and systemic changes to the rules of competition. That is, by pricing in externalities through introduction of a carbon tax. And making those mandatory and systemic changes is the role of elected governments, not investment managers.
Our Thoughts: Totally agree that we need (significant and immediate) system change. Not only do bad apple companies produce negative externalities people and the planet are paying for, they often exploit legislative loopholes to exacerbate those negative externalities or are subsidised to make their products cheaper compared to more sustainable alternatives.
We need an equal playing field. We need to close loopholes, and end (the wrong) subsidies and price externalities. And yes, only governments can implement those changes. But we also can’t wait for governments to do their bit. Especially not when powerful industry groups lobby and financially support those elected officials. How likely are these officials to bite the hand that feeds them?
It’s not a choice between one OR the other. We need to take action on ALL fronts.
Want to learn more?
Our article today (while longer than usual) really only scratched the surface of sustainable finance. If you’d like to learn more, here are some worthwhile resources to check out.
- Investing To Save The Planet by Alice Ross
- Sustainable Investing by Hanna Silvola and Tiina Landau
- Your Essential Guide to Sustainable Investing by Larry E. Swedroe and Samuel C. Adams
- McKinsey: Five ways that ESG creates value
Podcasts and Courses
- Finance4Good podcast by the European Federation of Ethical and Alternative Banks and Financiers
- Making Money a force for good – A free seminar series by Mindful Money
- Principles of Sustainable Finance – A free course by the Rotterdam School of Management
- Master’s Program Sustainable Finance and Investments by Utrecht University.
Feature photo by Kervin Edward Lara on Pixabay