Finance has the power to accelerate the transition towards sustainable development, being the “life blood” of any enterprise, and of the economy as a whole.

Let’s look at a real-world example to underline the influence finance has on fostering sustainable development. In order to address climate change, a major sustainable development challenge, there is a need to move away from fossil fuels and towards renewable sources of energy. Yet addressing it is not easy, given how dependent we are on fossil fuels in our daily lives, with the majority of our means of transport depending on it. Its resolution requires “clean” alternative innovations, which in turn requires vast amounts of financial means.

The intersection between finance and sustainability is referred to as sustainable finance and has become quite a buzz word in the financial industry lately. Yet, despite its popularity, what classifies as sustainable finance is broad and not easy to pinpoint.

To shed some light on the term, we can regard finance and its relationship to sustainability as a progression through a series of stages. From mainstream investments, fully focused on financial return, to investments focused towards attaining a specific social or environmental outcome. According to Schoenmaker this progression happens in 3 stages.

In Stage 1 financial institutions exclude endeavours that have a negative social or environmental impact, example tobacco, child labour, cluster bombs and lately even fossil fuels, from their financing scope. In this stage, financial return remains top priority and considering social and environmental factors serves an economic purpose like cost reduction, reputation, tapping into new markets etc. The impact of such exclusion is limited in the context of financing through issuing new shares as just a small amounts of a company’s financing comes from this source in comparison to funding from retained earnings and debt financing, yet, targeting the exclusion of an entire sector can result in setting a standard.

In Stage 2 financial institutions explicitly incorporate environmental and social impacts in the investment decision making process, placing all three aspects, environmental, social and economic on equal footing. This is done by measuring and valuing non-financial impacts. Attaching a financial value to non-financial impacts includes for example accounting for CO2 emissions involved in the transportation of a good. The generated monetary value is then incorporated in a total value, along financial impacts. The stages shortcomings lie in its focus on generating the maximum output of goods with the minimum input of resources, not accounting for ethical aspects such as human rights and viewing social and environmental impacts as substitutable, in the sense that for example the negative impact of deforestation is set off by high financial returns.

In Stage 3 financial institutions change their approach from excluding unsustainable endeavours from the investment scope to exclusively funding sustainable projects. In this stage projects are selected based on their potential to generate a positive social and environmental impact. Sustainable finance thus progresses from solely creating value for shareholders to creating value for the common good.  In this stage finance is not seen as a goal in itself anymore, but as a means to an end, with social and environmental return playing a central role for investors in this stage. Although investors in this stage expect to earn lower financial returns in exchange for their social preference being met, research shows that corporate social responsibility can generate higher returns by raising a firm’s value.

Regarding the adoption of the different stages of sustainable finance in practice the majority of financial institutions are situated in the first stage, 30-40% are between stages 1 and 2 and less than 1% are adopting stage 3[1].

Thus, the traditional risk/return model is still dominating the financial sector, [2] which means that there are certain strings attached to the capital making the addressing of the stringent world issues more challenging.

Further, there is no clear definition of the term “impact investing” or investments that can be placed in the above-mentioned stage 3 of the sustainable finance framework, which leads to it being used interchangeably with other investment products. Because of this public trust is eroded, and risky investments in developing countries are not targeted, even though that would likely have more impact.[3]

When it comes to defining what constitutes an impact investment, there is a general consensus around two core elements: financial return and non-financial impact (social and/or environmental). The minimum requirement for the financial return being the return of the amount invested.

Regarding the expected rate of return, impact investing does not aim to match the expected financial return of mainstream investments.[4]  

Besides the two core elements mentioned above, the non-financial impact must be intentional, and it should be measured. Regarding the later, there have been developments on impact investment metrics in the last years. Global Impact Investing Network (GIIN) has been key to this process, as it developed the Impact Reporting and Investment Standards (IRIS), as a common set of definitions and terms to address this question. Further, the US based non-profit B Lab developed the Global Impact Investing Rating System (GIIRS), a rating system designed to help with the due diligence of funds and social enterprises and to assess their impact potential.[5]

Finally, “Theory of Change” is proposed as a component in the definition of impact investing and refers to the kind of outcomes and impacts investors expect their money to generate. The definition of the outcome from the beginning enables all parties to understand, and strengthen, the process of change. Starting with the outcome in mind also facilitates the measurement of the difference the impact investment really made in the life of the beneficiaries.

In conclusion, although sustainable finance has made its mark on the industry the majority of funds are still being managed in traditional, financial return focused, ways. In order to address this, the desired social impact should be at the heart of the design of the investment instruments in order to contribute to sustainable development. Such an orientation would make the desired impact the starting point of the definition of the investment proposal, rendering the debate on metrics redundant. This in turn would give investors proper information on which to base their decisions and thus lead to attracting more financial means where they are stringently needed and thus generate positive social and environmental impact in the future.

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Bibliography

[1] Schoenmaker D. (2017). From Risk to Opportunity: A Framework for Sustainable Finance, RSM Positive Change Series. Available at https://repub.eur.nl/pub/101671.

[2] Luxembourg Institute of Socio-Economic Research (LISER), (2018), Green Financing: New Potentials for Luxembourg, available at https://www.liser.lu/?type=news&id=1527.

[3] Grabenwarter, U. (2017). Solution-Driven Finance: The New Way of “Impact First”. Available at http://www.impact-investing.eu/blog-publications/article/2017/06/solution-driven-finance-the-new-way-of-impact-first.

[4] Höchstädter, A.K., Scheck, B. (2015). Whats in a Name: An Analysis of Impact Investing Understanding by Academics and Practitioners, Journal of Business Ethics 132:449-475.

[5] Jackson, E.T. (2013) Interrogating the theory of change: evaluating impact investing where it matters most, Journal of Sustainable Finance & Investment, 3:2, 95-110.

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