The Challenges and Opportunities of Sustainable Finance
Rajna Gibson Brandon
The last decade has seen a dramatic shift in people's conception of what a company is and what it should do. Businesses are increasingly being judged by what have become known as Environmental, Social, and Governance (ESG) criteria, a framework used to assess the extent to which firms are contributing to the greater good of society rather than simply maximising risk-adjusted returns for shareholders.
Although such judgements are often imprecise and subjective, this framework is increasingly being used to inform “sustainable investing” decisions. The trend is already starting to change the behaviour of large companies, which increasingly disclose things like their environmental and social performance and are increasingly reactive to developments that would traditionally sit outside the remit of corporate boards.
So far, environmental concerns have received the bulk of attention in sustainable investing. That is thanks largely to the fact that climate change presents clear systemic risks to the global economy. This is driving firms to think harder about corporate issues such as the company's carbon footprint or the ecological impacts of its supply chains. But social concerns are quickly gaining traction too, as evidenced by the growth of the FairTrade movement and the large number of companies pulling out of Russia in response to its invasion of Ukraine.
Perhaps even more fundamentally, a renewed focus on how to make corporate governance more socially beneficial is driving a shift from prioritising the interests of stakeholders to also thinking about other stakeholders in a company: the workers and customers, for example. This is helping lay the groundwork for a new form of “responsible capitalism” that optimises for long-term benefits for both shareholders and society at large.
Early evidence suggests that companies that score highly on ESG criteria often outperform those that don't. However, results are far from conclusive and the question of whether there is a clear positive link between environmental, social and governance positioning and financial risk-adjusted performance remains open.
Despite the potentially transformative impact of sustainable investing, it faces numerous interlocking challenges. Solving these will be crucial to ensuring that the ESG framework helps push markets in a more socially beneficial direction, and that it doesn't result in purely performative acts and announcements --- “greenwashing” and “social washing” --- designed to hide the fact that companies are continuing with business as usual.
One of the biggest problems is measurement. Almost all of the outcomes sought by sustainable investors take years, if not decades, to achieve, be that net zero climate emissions or ending child labour. Quantifying many of the ineffable qualities tied up in ESG criteria, such as equity or justice, can also be incredibly challenging.
Even if we could come up with a good metric, gathering data in a useful and comparable form from thousands of different firms is very difficult. The fact that ESG ratings from different ratings agencies often disagree markedly is indicative of the scale of the challenge. The proliferation of products aimed at sustainable investors is only likely to muddy the waters further.
These are complex financial instruments that we currently have little experience in valuing or assessing. Take “sustainability-linked bonds” (SLBs), for example. Traditionally, so-called ethical investments have focussed on simply buying equity in companies with good ESG credentials. But in the last couple of years there has been substantial growth in buying bonds that are used to directly finance the company while reaching environmentally or socially beneficial targets. The issuers of SLBs set key performance indicators that determine whether the issuer lives up to the commitments they made, normally on a horizon of between 5 and 10 years. If they fail to deliver on reaching the KPI then the issuer has to pay an increased amount of interest to the investors.
Early evidence suggests that a non-negligible fraction of the first sustainability bonds were overpriced, essentially giving companies a source of cheap capital due to the huge demand from institutional investors eager to enter the market. A lack of understanding of how such instruments work could also make greenwashing and social washing easier, a growing concern as increasing numbers of less sophisticated retail investors enter this market.
Solving these problems will be difficult without some kind of harmonisation on the standards and metrics by which we create and judge ESG criteria. Markets certainly tend to push towards the certainty and security offered by disclosure and standardisation, but a certain amount of regulation seems likely to be necessary. The fact that research has found greenwashing to be more common in the light regulatory environment of the US than in the more heavily-policed EU makes a compelling case for more government oversight.
The good news is that some efforts are already underway. The EU Taxonomy for Sustainable Activities, for example, helps investors and companies to judge the impact of different businesses behaviour. The EU is also pushing for countries to adopt common accounting principles, which could make it easier to compare progress on environmental or social issues.
But this will only work with global harmonisation of these efforts. If one part of the world regulates and the other part doesn't, loopholes will quickly appear and companies are likely to engage in regulatory arbitrage to circumvent the more onerous ESG requirements.
Given the current geopolitical situation, hopes for such harmonisation currently seem slim. There are big question marks over the future of globalisation, and the fragmentation of the world economy into different blocs operating on different rules is a distinct possibility. When it comes to ESG criteria, it's also important to remember that attitudes can vary significantly across different cultures. Whether we have an effective platform for common dialogue that can unify these disparate voices remains unclear.
The onus is likely to fall on governments and companies in the West, particularly large multinationals with large global footprints. Enforcing a unified set of standards, whether a company is operating in a developed democracy or a developing country with less robust institutions, could help set the tone for a more responsible approach to business worldwide.
Another hindrance to progress is our current understanding of the impact and design of ESG initiatives. At the Graduate Institute of International and Development Studies (IUHEID), in collaboration with several Swiss universities including the University of Geneva, we recently launched the “Swiss Sustainable Finance Lab” to help with this situation. It will have a particular focus on driving progress in understanding and quantifying the social dimension of ESG, but this will require truly interdisciplinary research that brings together scientists, economists, social scientists and policymakers.
As a hub of international finance, cross-disciplinary research and multilateralism, Switzerland has a crucial role to play in driving innovation and adoption of ESG approaches. Given the urgency of the challenges the world faces, we certainly must do everything we can to ensure financial markets are pulling in the same direction as we try and achieve a new more sustainable approach to economic development.