What is sustainable finance?Article
Sustainable finance is the inclusion of Environmental, Social, and Governance (ESG) considerations when making investment decisions. If you are a (start-up) business looking to access sustainable finance, you will need to comply with certain sustainability standards.
Importance of sustainable finance
The financial sector is very powerful when it comes to the influence it has on offering funding and bringing awareness to social and sustainability issues. By channelling (private) money into sustainable projects, the sector is spearheading change that delivers increased business value while promoting the power of business to deliver positive impact on people and planet. Moreover, investors with long-term strategies can steer businesses in the direction of more sustainable business practices.
Traditionally, the financial sector is well-equipped to price risk in order to valuate a business. By extending the risk measurements beyond mere financial risk to environmental and social risks, the long-term characters of the financial sector and sustainability initiatives align with one another.
Motivation for sustainable finance: Financial performance and ESG metrics
- Financial Performance and the Environment: Eco-efficient companies (e.g. those that produce a reduced amount of waste) have higher share returns for their shareholders. In 2016, research showed that when measured over a 15-year period, companies that adopt sustainability practices have lower financial volatility, higher sales growth, and higher chances of survival. Moreover, companies that are strongly committed to sustainability have increased chances of receiving financing due to better stakeholder engagement and high levels of transparency. Evidence that sustainable business offer higher returns is also confirmed by BlackRock.
- Financial Performance and Social Metrics: Companies with a high level of employee satisfaction have better share returns, and tend to receive higher valuations.
- Financial Performance and Governance: Good governance leads to a positive increase in company value. Moreover, there is a strong correlation between governance metrics on one side, and the social and environmental metrics on the other. In other words, high-quality governance increases strong performance regarding environmental and social metrics.
More generally across all ESG metrics, asset manager Fidelity tracked ESG investment worldwide between 1970 and 2014, and found that half of them outperformed the rest of the market. Moreover, during the COVID-19 pandemic, more than 8 out of 10 sustainable investment funds performed better than share portfolios not based on ESG criteria. Finally, companies that perform strongly on ESG metrics enjoy increases in their share price during the past 5 years.
Types of sustainable finance (the basics)
A simplified explanation of sustainable finance involves equity and debt as the two main financial instruments available.
Particularly for start-ups, equity is a major investment method used. Through equity investment, investors acquire ownership in the company. Sustainable equity investments are done by funds or individual investors.
Debt finance is where investors lend money to the company, where this money must be repaid with interest at a later date. The main sustainable debt instruments available are green and social bonds, and green loans. Whereas a loan entails the transfer of money from (usually) a bank to the company, a bond is a transfer of money from the public or a market to the company that issues the bond.
Obtaining sustainable finance
In order to get access to sustainable finance, companies have to show strong evidence of their commitment to ESG metrics. This implies that having a mission and a vision is no longer enough. Clear and transparent data that is publicly reported will provide a strong precursor for obtaining funding. Committing to ESG in a measurable way, in relation to finance, will benefit your company because of the following:
- It helps to understand the different risks the company faces, and enables an accurate valuation of environmental and social impact.
- Keeping an accurate record of current risks helps you to address them head-on to prevent future reputational risk and financial damage.
- Transparency and reporting increase investors’ confidence in your company and its approach to risks and opportunities.
- Increased access to (sustainable) capital at a lower cost due to accurate risk pricing.
- Your staff and partners will have a good understanding of your metrics and commitments which lowers the barrier for them to endorse them as well.
- It enhances your company’s credibility with consumers, staff, and partners.