Sustainability and Sustainable Finance
Finance has been dealing with the term 'sustainability' and its uptake into financial areas for many years. But what does 'sustainable finance' or 'sustainable investing' mean? There are different views on this. Generating a sustainable profit – does this mean that a profit is achieved repeatedly forever, i.e. durable, and/or that profit is increasing forever, i.e. durable, through economic growth? This simplified equivalence of durability and sustainability would only be legitimate insofar as all the externalities generated by our economy would have been internalized into the economic system. That is very far from reality.
‘The sky has no limits’ – maximizing profits at the expense of the environment and society? / © M. Semadeni
The origin of the term 'sustainability' came from environmental and social science research, whereby the term is understood as an encompassing view of our economic activity effecting the environment, society and the economy (three-pillar principle). Some terms used in financial areas seem to distort or confuse sustainable finance, for example the terms 'responsible investing' or 'impact/targeted investing' versus the term 'sustainable investing'. The latter is for example based on so-called ESG standards (esg: environmental, social, governance). The confusion has recently led to complaints and accusations against financial institutions and intermediaries systematically destroying investors' values, reducing profits or – from a very different perspective - practicing so-called “greenwashing” with financial products.
However, sustainability is an important key concept because the planet’s natural resources are being severely threatened or lost at a breathtaking speed due to anthropogenic activities. Negative consequences of anthropogenic activities, which affect - as with anthropogenic emissions of climate-forcing gases (climate change) - the environment and the social and economic components of society, are likely to increasingly lead to significant (systemic) burdens on society and the economic system in the future. Accordingly, standards are developed to counteract such negative effects (mitigation) or even to legally prohibit certain activities. It is also observed that economic entities are increasingly concerned with adjusting their structures and activities to rapidly changing environmental conditions (adaptation). Hence in the corporate world environmental management and sustainability are moving closer together.
The sustainability reporting of companies is based on data collected from environmental as well as social and economic areas of the company. This data is regularly checked and reported in accordance with specified standards. The reports can be compared with other companies in the industry (evaluation against benchmarks) to identify potential for improvement. It would also be important to take into account the company's financial areas (e.g. the way of internal investing) and the way the company is managed (governance, leadership), as well as to include its supply chains in the assessment (sustainable supply chain management). With the inclusion of finance and supply chain management, the requirements for sustainability reporting are expanded enormously.
In order to meet such requirements, so-called ESG standards can be used. ESG criteria or factors (environmental, social, governance factors) are based on the “three-pillar principle of sustainability”. It is important to differentiate between the extent to which sustainability based on the ESG standard is considered by companies and investors when evaluating their business activities and investments, and – on the other side - the one based on the 17 UN goals “Sustainable Development”; so-called SDGs (Sustainable Development Goals). These are used as well in assessing contributions of economic entities to improve the environment, society, and the economy. It should be added that SDGs in the context of the assessment of ‘sustainable development’ are particularly about reducing wealth gaps between developed, developing and underdeveloped states.
Companies' sustainability reporting can also be interpreted as part of risk management, which involves assessing a company's financial risks in relation to the three ESG factors. Thereby corporate responsibility is promoted; on one hand by analyzing relevant effects from the environment and society onto the company's business and, on the other hand by analyzing the relevant effects of the company's business model (operation, products and application of their products) on people and the environment, i.e. "double materiality". In this context, “simple materiality” means that when assessing financial risks, only the relevant effects from the environment and society onto the company's economic activity are considered.
Of course, sustainability is also taken into account in the financial sector, as financial flows play a central role in the economic system and therefore can have a positive impact on the environment and society. For example, a financial institution could work out a sustainability report about its own business processes and assets/properties. But how are their financial products (e.g. funds, loans) assessed in terms of a ‘double materiality’? To achieve this, the underlying values of their financial products would have to be assessed using the sustainability reporting of the companies that make up the underlying values. From the perspective of financial institutions or intermediaries, this would be a kind of a ‘supply chain assessment’ i.e. assessing the “suppliers” of underlying values.
In this regard, there are different perspectives among investors. Some are of the opinion that such ‘double materiality’ is simply not feasible and would also lead to certain underlying values being excluded in a more “arbitrary” way – for example via an ESG rating – which would lead to a reduction in returns. It is said that the task of evaluating financial products in terms of risk management must be limited to a ‘simple materiality’ and must focus purely on maximizing returns. For the companies in selection as underlying value, this would mean minimizing risks and maximizing profits - a constellation that incentivizes to externalize risks for instance related to the environment and society as much as possible and/or simply get rid of exposed units. Furthermore, it is said that financial products that are evaluated (ESG-rating) and marketed using ESG standards in the sense of ‘double materiality’ would only appear to have a positive effect on the environment and society and would not be more profitable than conventional products; hence all being nothing more than “greenwashing”.
Although this view or criticism may apply in certain cases, ESG is fundamentally about introducing the concept of sustainability into the financial sector to create incentivizing systems and framework conditions that encourage the development towards a sustainable economy with true prices and towards a ‘Green Economy’. This also includes the introduction of standardized sustainability criteria in financing and in the classic lending business (e.g. sustainability-related loans and bonds, i.e. green loans and green bonds). In order to counteract criticism of ESG ratings, international standardization (ISO standards) and accreditation of ESG rating specialists are a prerequisite (see EU parliament).
Interestingly, ISO standardization initially focused primarily on environmental protection and the aspects of environmental pollution (ISO 14000 series). Only later, the term sustainability was included in the sense of the three-pillar principle. It was recognized that opposing effects can develop between the different aspects of environment, society and economy and that the correct definition and choice of sustainability criteria - for example within the framework of the ESG standard - and their measurement are essential. Sustainability criteria must be able to be presented in terms of their functionality, importance and significance and should be able to be effectively measured and/or derived in a comprehensible manner in the sense of ‘double materiality’.
But it remains difficult to capture the relevant sustainability aspects due to their complexity. ISO recommends that sustainability indicators and metrics should build on existing monitoring and evaluation procedures. However, a robust measurement always depends on the effective availability of data, in turn qualitative key values often have to be included besides quantitative key figures. It is important to ensure that sustainability indicators and metrics focus on what is realistically feasible, and - to simplify matters – that they are followed by a relative, rather than absolute assessment. Comprehensible sustainability goals must be set for the assessment procedure so that the sustainability performance can be qualified.
Nevertheless, the complexity remains insofar that activities, operations and products in the three different sustainability areas can have different and opposing effects or impacts on the environment and society. Be these positive and/or negative, differentiable effects, which are relevant for the assessment of financial risks and opportunities; - risks and opportunities with an impact on the company from the outside or risks and opportunities having an external impact on the environment and society (‘double materiality’). For financial products, the analysis of companies being the underlying values is central, leading to assessments, which allow a skillful balance of positive and negative effects and thus develop robust offers in the spirit of sustainable finance. The aim is not to simply exclude sectors or certain companies per se, but rather to determine to what extent companies can create together the most positive effects possible in all three areas of sustainability.
The current discussion on ‘circular economy’ offers an interesting approach, as this approach fundamentally requires the cooperation of companies from different sectors to achieve circularity (systemic circularity approach or the 'ecology of economic entities'). It should be noted that ISO standards (ISO 59000 series) for ‘circular economy’ are currently being developed (compare following links: ISO, International Organization for Standardization; SNV, Swiss Norms Association; Circular Globe). A financial product that includes the underlying values of companies that cooperate within the framework of ‘circular economy’ could be a future-oriented offer for sustainability-oriented investors. The maturity of the circular business models and the value-adding networking of these companies would have to be analyzed and evaluated in order to be able to qualify their joint “circularity performance”.
In addition to fundamental requirements to increase energy efficiency and promote sustainable investing (climate- and nature-related financial disclosures on risks and opportunities), a ‘circular economy’ promises to achieve positive effects in the sense of sustainability, particularly in the environmental area - improving the sustainable use of natural resources, the protection of the quality of water, soil and air, the mitigation of climate change, and improving biodiversity (TNFD, Task Force on Nature- related Financial Disclosures).
Marco Semadeni, Dr. Sc. nat. ETH
06-03-2024