RELEVANCE OF SUSTAINABILITY | Major Sustainability

FINANCE & SUSTAINABILITY

Understanding Risk, Return and Sustainability

Finance courses often begin with an exploration of a key overarching concept for the field: risk and return. This core concept states that financial returns rise as risks increase and drop as risks decrease. This risk-return relationship is central to finance–and to sustainable finance.

In light of this risk-return relationship at the center of finance, environmental, social and governance (ESG) factors are a new, more sophisticated way of identifying risks and opportunities to earn returns. For financial management, including ESG is important for three main reasons:

ESG factors represent material financial risks for businesses and shareholders

ESG criteria and investments are increasingly demanded by investors

ESG tools are filling the financial manager’s toolbox and today’s professionals use them effectively

Each of these three factors is explained in more detail below.

BlackRock CEO Larry Fink Says “Climate Risk Is Investment Risk”
(1:36 min)

Improved Risk Assessment: ESG factors represent material risks

Establishing and growing a company requires capital, often from the outside via equity investment, bonds or a bank loan. This exchange of funds creates a risk for both the source of funds and the company. Financial risk is the probability that an investment will fail to provide returns: a capital project doesn’t provide the planned savings or a new product falls short of earnings forecasts. Traditional sources of financial risk include credit risk, currency risk, price volatility risk, supply chain risks, and many more.

Sustainability issues across environmental, social and governance aspects of business present new areas of financial risk. In other words, social issues like inequality, labor rights abuses, or the gender earnings gap aren’t just “social issues” but material financial risks to an enterprise. Likewise, environmental pressures from climate change to water security are now regarded as financial risks as they can increase cost of capital, insurance costs, input costs and regulatory costs. For example, “$11.8 trillion worth of assets world-wide [are] at risk of being stranded by climate change and rules put in place to try to limit it through 2050.” (Wall Street Journal)

Understanding how ESG factors create risks starts with understanding the relationship between industry, nature, and society. See image below from S&P Global Trucost’s “Natural Capital at Risk Report” and see what financial risks you can spot.

Financial Risks Revealed: The Interaction of Ecosystem Services, Pollution and the Economy (S&P Global Trucost)

How industry interacts with society and nature

The key lesson: what business and economics used to identify as “externalities” like pollution, waste, and income inequality, are now being internalized through the valuation of ESG factors.

Meeting Demand: ESG criteria and investments on the rise

Financial Times has reported that ESG investments drew “$20.6 billion of new money in 2019 – almost four times the 2018 figure of $5.5 billion” and that “85 percent of investors are interested in sustainable investing, up from 71 per cent in 2015.” The connection between risk, returns and sustainability are becoming more and more apparent driven by competitive returns (see image below from McKinsey & Company). Also driving this sea change is the demand for socially responsible investing especially among Gen X and Millenials who value purpose-based companies and brands and will inherit 68 trillion dollars over the next 25 years.

ESG also has its weaknesses and blindspots.

The wise financial manager tracks and studies the trend toward ESG but is also wary of its false promises and the arguments of its detractors. While ESG promises to provide returns while making the world a better place, some observers say the “big concern about ESG investing is that it distracts everyone from the work that really needs to be done.” (Wall Street Journal).

As in all things, understanding the arguments for and against something improves decision-making, and this is no different in sustainable finance. Ultimately, the goal of sustainable/ESG-directed finance is to improve the conditions of people’s lives, remove or avoid pollution, and protect natural areas while also earning a fair return. Knowing the weaknesses of ESG can help financial and investment managers realize these goals while avoiding common pitfalls.

Mastering New Financial Tools: the expanding ESG finance toolbox

Sustainalytics, the ESG data firm, lays out the range of emerging new tools like sustainability bonds, green bonds, green loans, sustainability-linked loans and bonds, and more. Along with these debt and fixed income tools is a growing market of ESG equity products in mutual funds and ETFs. Financial managers use these tools along with rating companies and indices such as MSCI, FTSE4Good, CDP, GRESB and the Dow Jones Sustainability Index.

In the end, mastering these new ESG financial tools allows financial and investment managers to meet the growing demand for responsible investment–and the growing evidence that finance is a source of positive social and environmental change.

Finance for Social Justice (Opportunity Finance Network)