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While traditionally, investors used to evaluate their success based on their financial gains only, today things have changed. With climate change becoming an issue of global concern; more and more prominent investors, businesses and institutions are realizing the risks associated with a capitalistic mindset. It is not surprising therefore that the topic of sustainable finance has been gaining a lot of traction over the last decade. So the question arises “What is Sustainable Finance”
Sustainable finance (also known as Green finance) refers to the process of taking environmental, social, and governance (ESG) considerations into account when making investment decisions in the financial sector, leading to more long-term investments in sustainable economic activities and projects. Or in simpler words, Sustainable finance involves making investment decisions that consider not only financial returns but also environmental, social, and governance factors.
Activities that fall under the heading of sustainable finance, to name just a few, include sustainable funds, green bonds, impact investing, microfinance, active ownership, credits for sustainable projects, and the development of the whole financial system in a more sustainable way.
Why do we need sustainable financing?
We are on a brink of a mass extinction event. Global warming is breaking new records; we are witnessing the effect of climate change all over the world. We have been brought to the brink of catastrophic climate change as a result of an economic system that has failed to account for externalities that have negative environmental impacts.
Sustainability is no longer a niche term. It has become a necessity. We need to restore our planet and we need to do it quickly. And that’s where sustainable financing becomes vital. The transformation to a more sustainable economy requires enormous investments (e.g. in energy production or waste management). As per an estimate, humanity will need to spend an additional USD 600 to 800 billion per year to reverse the biodiversity crisis by 2030. This is in addition to the USD 2.5-3 trillion per year needed to achieve the UN sustainable development goal in developing countries.
Finance has to be a key lever to influence sustainable outcomes, and the financial sector, as an intersection for capital allocation, is to play a major role in promoting sustainability and sustainable management.
How does sustainable financing work?
Finance is the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting. Here we are going to keep our focus on sustainable investment.
Sustainable Investments are investments that not only seek to make a financial return but also take into account environmental, social, and governance factors or the impact investment will have on society. At present, the two main financial instruments in sustainable finance are equity and debt.
- Equity financing can be in the form of stocks and shares. It is the main investment method used in the early stages of a project, and investors receive an ownership interest (stocks or shares) in the project in return for the amount of capital they invest.
- Debt: Debt financing is usually done in the form of loans or bonds. Debt financing becomes the predominant investment method in the later stage of the project in which Investors lend money to borrowers, and this money is repaid with interest.
Apart from Equity and debt, there are many institutions like the UN, WWF, and World Bank that provide funding to the green project based on their potential impact in offsetting climate risks or social risks.
The sustainable investment itself is a very broad term and contains a wide range of investment strategies and approaches, with differing degrees of rigor. In general sustainable investment can be divided into three categories namely Environmental, social, and governance (ESG), Socially responsible investing (SRI), and impact investing
I. ESG looks at the company’s environmental, social, and governance practices, alongside more traditional financial measures.
II. SRI involves actively removing or choosing investments based on specific ethical guidelines.
III. Impact investing looks to help a business or organization complete a project or develop a program or do something positive to benefit society.
Key Providers of Sustainable Finances:
- Corporations are the largest source of climate-related funding, both through CSR initiatives and their investments in multiple sectors including renewable energy, transportation, and infrastructure.
- Banks provide a significant proportion of the financial resources that can be mobilized for green investments.
- International financial institutions can support the scaling-up of green investments by testing new ways of financing, channeling funds toward sustainable development through mechanisms such as green bonds, and influencing global financial governance to give more support to sustainable development. These include green investment banks and development banks, which provide funding for sustainability- and development-related projects respectively.
- International organizations such as the U.N., the OECD, and the G20 only provide limited finance but set the agenda on sustainability issues at the international level and help coordinate sources of funding.
- Climate funds, such as the Green Climate Fund, Adaptation Fund, Global Environment Facility, and Climate Investment Funds, are multilateral funds for climate change adaptation and mitigation projects, funded through contributions from individual countries.
- National governments determine the amount of public funding earmarked for green investments, as well as institutional support for them. They can also support the design of dedicated domestic investment vehicles such as national climate and environmental funds.
- Central banks and regulatory authorities can also steer the finance sector toward green investments through policies and regulations.
- Institutional investors, such as pension funds, sovereign wealth funds, and insurers, are another important group of private-sector financiers.
- Stock exchanges also often specialize in green and sustainable investments. For example, the Luxembourg Green Exchange (LGX), attached to the Luxembourg Stock Exchange, operates as a dedicated platform for green, social and sustainable securities. The current state of Sustainable Financing
Today, the value of an investment is no longer just about returns. An increasing number of investors are also calling for their money to make a positive impact on society and the world at large. Investors are realizing that investing in sustainable projects, ESG complied projects is not just good for the environment and society, but it can deliver substantial financial rewards. ESG practices are proven to have reduced the risk and exposure of a company in many ways.
Investments in sustainable projects are increasing at a rapid pace. As per a report by US-SIF, assets under management using sustainable-investing strategies grew 42% from $12 trillion in 2018 to $17.1 trillion in 2020. While Sustainable financing is gaining pace rapidly, it is still not enough. As compared to investment in fossil fuels and other unsustainable sectors and practices investment in sustainable practices are still dwarfed. As per a report by WWF, around $2.4 trillion or roughly 2.5 percent of global GDP annually needs to be invested in the energy system between 2016 and 2035 to limit global warming to 1.5°C, which is unlikely to be met at present levels of investment.
The child of Sustainable finance has moved from crawling to walking, but it’s high time and it needs to start running if we have to meet our SDG goals. Corporations, Institutes, and Governments all need to come together and make policies that further channels the capital into sustainability.