Tools for Substainable Finance

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With climate change, finance just as other economic sectors has no choice but to become sustainable. But using which tools?

What is the point of sustainable finance?

There are various definitions of sustainable finance. In this article we have opted for a definition that is straight to the point:

Sustainable finance is broadly defined as the whole range of financial instruments and mechanisms for sustainable development.

In the eye of the general public finance suffers from its image as a soulless entity driven exclusively by profitability. Let’s break with convention for a moment: it is precisely this purely rational vision that is its force and of interest to us in this context… as long as the "extra-financial" criteria: human costs and environmental costs, are correctly reintegrated in the long-term profitability studies.

And that is exactly what is happening, spurred by institutional investors such as insurance companies. Here is what Henri de Castries, CEO of AXA, has to say about the matter:

"We do not have the choice: a world +2°C warmer could be insurable, but a world at +4°C would certainly not be. "

Sustainable finance as a sort of "gentle" financing, intended to meet the demands of a few hipsters eager to ease their conscience by investing their money in an "ethical" and "responsible" way? This is over. The purpose of finance is to optimize the allocation of disposable income to financing needs. From now on the environmental aspects will form part of the optimality criteria.

This also means that finance can no longer be considered as an enemy of sustainable development but instead as a powerful means to facilitate energy transition… as long as the right tools are targeted, because it is true that the tools for sustainable finance continue to coexist with those for "mainstream" finance.

Rating the issuers: SRI labeling and sustainable indices

Handing out awards: SRI labels

Keep these two acronyms in mind: ESG – Environmental, Social and Governance criteria – and SRI : Socially Responsible Investment. For an asset manager SRI means including ESG criteria as part of the selection process of issuers.

Note the extra-financial and therefore intrinsically non-measurable – and claimed as such – selection criteria (impact on the environment, social policy, governance). Also, the mix of ethical, social and environmental criteria undermines transparency for the investor. The recent (November 2015) AMF report on Socially Responsible Investment points out the "diverse and difficult to grasp" nature of the approach. Especially, the coexistence of SRI funds and "conventional" funds in companies that offer both, raises questions: how much of the offer is truly socially responsible, as opposed to tactical marketing and in other words just greenwashing? Well, in any case let us not forget that "hypocrisy is the homage vice pays to virtue"!

In order to have a clearer picture let us take a look at an outside source like Novethic. Novethic awards an "SRI fund" label to a UCITS that takes into account ESG criteria when selecting portfolio issuers. This label certifies that the SRI approach is not merely a secondary factor in portfolio management.

The SRI uses various methods to select issuers, the best known being the best-in-class approach. Admitting that it is not possible to totally exclude certain controversial issuers, the idea is at least to select the "best bidder" (or the least worst one) in each category or sector, in terms of environmental, social and governance criteria.

Promoting healthy rivalry: sustainable indices

This "best-in-class" approach is used by sustainability indices, such as the Dow Jones Sustainability Index (DJSI), which gathers a family of such indices. In order to compile these indices, one of its promoters, RobecoSAM, publishes an annual review of the 3,400 largest global companies based on extremely comprehensive ESG criteria. The methodology and results are presented in detail on this website:  http://www.sustainability-indices.com/.

As far as environmental criteria are concerned, the questionnaire stresses the importance of the company’s transparency in this area, and the presence of quantitative measures enabling the assessment of its environmental impact.

As the indices gather best-in-class companies in each category, the approach promotes a healthy rivalry between the largest global issuers who are encouraged to strive for a spot on the index and then to maintain it. It is worth noting that Volkswagen was immediately removed from the index in October 2015. The latest annual review, which included Volkswagen, had just been published!

The European equivalent is proposed by Vigeo who uses a similar assessment method. Vigeo is also a rating agency that measures the ESG performance of companies, states and public organizations. There is also a special carbon index, the "Low Carbon 100 Europe", developed by Euronext.

Financing green growth: green bonds

Green bonds enable investors to finance projects or activities from companies, local authorities and international organizations that have direct environmental benefits: renewable energy, energy efficiency, climate change adaptation, etc. Issuers adhere to the "Green Bond Principles", whereby they commit to inform investors on the "green"use of the collected capital, not only in the bond issuance prospectus but also over the entire bond lifecycle.

Green bonds only represent 0.5% of the global bond market but investment figures tripled in 2014 and continued to increase in 2015. 

Integrating the cost of pollution: emission allowances

In the absence of a regulatory framework, companies and consumers only internalize their direct costs. The externality problem of greenhouse gas emission (GHG) is therefore not taken spontaneously into account. The economic analysis calls for regulation by means of two regulation tools: carbon tax or emission allowances.

It appears that emission allowances are politically easier to implement. The European Union pioneered the implementation of GHG emission allowances. In terms of regulation, governments set a limit or cap on the quantity of carbon dioxide that can be emitted and allocate a certain number of emission permits to companies that are subject to the emission allowances. At the beginning of the year companies are handed out a certain number of allowances corresponding to their objectives. By the end of the year they must return the number of allowances equivalent to their actual emissions during the year. 

Companies who have emitted less GHG emissions than expected thus have a surplus of allowances that they can sell to those who have exceeded their objectives via an energy trading platform on dedicated markets such as the EEX. By acting on the number of allowances in circulation, governments exert pressure on prices in such a way that it is actually more profitable for companies to invest in reducing emissions than to buy allowances.

Emission allowances and the related markets are tools for businesses. There are other tools more appropriate for the general public, such as the CO2 compensation platforms, which are still confidential but could develop in the future.

Financing, is it the problem or the solution?

According to a recent survey by the Paris Europlace Sustainable Finance Committee, "52% of private investors say that they consider environmental, social and ethical criteria as important or very important when making investment decisions" – but "94% said they had never heard of the SRI and would not know how to define it"!  And yet according to institutional investors, "the SRI approach helps investors reduce their risks thanks to the extra-financial criteria that are taken into account".

Finance is changing. Driven by the principle of reality, it is far removed from the incantatory speeches of NGOs that sometimes make you wonder if they don’t want to abolish finance instead of trying to understand how it works. As investors we also have a role to play. Besides waste sorting and carpooling we should also ask ourselves where we should place our money!

  1. What economists call the « externalities»: all the human (health) and environmental (pollution) costs engendered by a company and borne by society.
  2. La Rochefoucauld
  3. Meaning "issuers that emit financial instruments » although there is a good chance that these major companies also emit large quantities of greenhouse gases!