What is meant by Sustainable Finance?
Sustainable finance refers to the process of taking Environmental, Social and Governance (ESG) factors into account when making investment decisions, leading to more long-term investments in sustainable economic activities and projects. A sustainable financial system is one that creates, values and transacts financial assets in ways that shape real wealth to serve the long-term needs of an inclusive, environmentally sustainable economy. (Source: UNEP). This type of investment is sometimes known as responsible investment.
When buying a financial instrument or service, you should be aware that it might have different environmental and social impact and therefore you may wish to consider these factors in your investment decision. As an investor, you should be aware that financial instruments with sustainability elements are available in the market.
What are the Environmental, Social and Governance (ESG) factors?
ESG factors are the elements that an investor might want to consider when investing money, covering multiple issues that might have not been previously considered when making investment decisions:
- Environmental factors consider the impacts of a company on the environment and may include the impact on climate change, pollution, use of renewable energy, use of water, land and other natural resources, production of waste, impact on biodiversity, deforestation and carbon emissions.
- Social factors consider the human element and how the company performs in relation to social inequality and social integration, work conditions and employees’ diversity, human rights (such as the use of child labour), investment in human capital or economically or socially disadvantaged communities as well as its impacts on mental health.
- Governance factors deal with how the company is run and may refer to the management structures and diversity, employee compensation, tax compliance, accounting policies and political lobbying.
When taking investment decisions, you may wish to determine the nature of your own sustainability preferences, considering which ESG factors are of importance to you and ensure that the investment is in line with these preferences. When seeking professional financial advice, you should clearly explain your sustainability preferences to your financial advisor.
How can I express my preferences in relation to the sustainability features of financial instruments?
New EU legislation related to Sustainable Finance will require you to disclose information not only about your knowledge and experience, financial needs and investment goals but also about your sustainability preferences when seeking professional financial advice. Service providers are then expected to adequately meet your preferences.
Therefore, think ahead about your sustainability preferences (such as respect for human rights, or the impact on the environment?) before taking an investment decision, so that you will be able to allocate your capital accordingly.
What are ESG risks and why are they important?
When investing you should be aware that the value of your investments is not only affected by the financial performance of the companies you have invested in, but also by Environmental, Social, or Governance risk as well as external shocks (e.g. extreme weather, natural disasters, terrorism etc.).
ESG risks include:
- financial risks arising from the impact of ESG factors on invested assets
- public policy, technological advancements and market sentiment that can lead to some activities or industries being phased out
- the physical impact of global warming that can make some geographic areas higher risk
- negative financial impacts for companies linked to factors such as inequality, health or labour relations
- negative financial impacts for companies linked to factors such as executive leadership or bribery and corruption
What is “greenwashing” and what are the associated risks?
The appetite for sustainable investments has increased. This heightened interest among investors has increased the risk of abuse and led to some businesses taking shortcuts by incorrectly claiming that their products and practices as environment friendly. A business could claim that its product enjoys energy-saving benefits or that it is made from recycled materials. This could be true, partially true, or outright false.
Greenwashing is a marketing and communication strategy which conveys a false or misleading impression about the adherence of a company’s activity to environmentally friendly practices or the environmental benefits of a product or service in order to attract more investors. In other words, companies may make green or sustainable pledges that are inconsistent with what they actually do.
A common example of greenwashing is a fund that is being marketed with a focus on its sustainability goals, despite investing in companies that emit substantial carbon volumes or manufacture products that claim various percentages of post-consumer recycled content without providing evidence.
So how can you distinguish between a sustainable investment, and one which is not so sustainable? The most common red flags that could feature include the following:
- misleading graphics that include the usage of green colour, mountains, trees, natural landscapes;
- usage of vague language such as “Eco-friendly” or “natural”, “green”;
- exaggerated communication on sustainable achievements; and
- awarding of claims without proof or credentials.
Greenwashing can result in investors being unable to allocate capital towards their sustainable preferences. Furthermore, such firms may be liable to regulatory fines and reputational damage which will ultimately impact the company’s share price, and shareholders’ interests.
In order for companies’ claims to be more credible and legitimate, they must abide by measurable metrics and objectives, such as amount of reduction in emissions or target dates. These should be audited and publicly disclosed in order to prove their authenticity.
When you seek professional financial advice, your financial advisor should take in consideration the greenwashing risk and ensure that your investments meet your sustainable preference and goals by investing in businesses that uphold their commitments to sustainable finance.