What Is 'Sustainable Finance' And Why Should You Know?
"It is not the strongest of the species that survives, nor the most intelligent. It is the one most adaptable to change."
What is ‘Finance’?
The term ‘sustainable finance’ is popping up with increasing frequency in the academic, professional, media, and institutional investing worlds. However, it doesn’t take a lot of reading and listening to realize the term still means different things to different people. This is problematic. People writing and talking at cross-purposes are unlikely to move the ‘sustainability’ yardsticks purposefully in the right direction. Thus reaching a common understanding of ‘sustainable finance’ is important, and achieving it is the goal of this Letter.i
A logical place to start is with the term ‘finance’. What do we mean when we write or say it? Think of a mental ‘finance’ filing cabinet with five drawers:
- Primary Investing by directly transforming financial capital into productive capital: this can be done through turning societal savings into debt and equity capital provision, through credit creation, or through reinvesting corporate profits back into the business.
- Secondary Investing by holding outstanding issuer bonds and stocks: this is increasingly done institutionally by long-term investors such as pension funds, sovereign wealth funds, endowments, insurance companies, and some asset management organizations. However, there continue to be large cohorts of short-term investors (Keynes called them ‘speculators’) in the retail investor, asset management, and hedge-fund sectors.
- Price Discovery and Liquidity Provision: financial markets price future cash-flows and facilitate the acquisition and disposition of financial instruments by individuals and institutions.
- Risk Management: through the provision of mortality, longevity, property, and casualty insurance, and through the creation of various derivative instruments (puts, calls, futures contracts) in a long list of financial and commodity markets.
- Financial Infrastructure: such as payment mechanisms, regulatory and central banking facilities, financial disclosure protocols, non-government organizations with a finance focus, and academia through its finance teaching and research functions.
So far so good. Let’s now turn to the word ‘sustainable’. What meaning should we assign to it?
What is ‘Sustainable Finance’?
Wikipedia says sustainability is “the ability to exist constantly. In the 21st Century, it refers generally to the capacity for the biosphere and humanity to co-exist.” Thus sustainability means ‘ability to exist constantly’ at the macro (biosphere/humanity) level. It has a parallel meaning at the micro (individual organization) level. These definitions set us on our way to common understandings of macro and micro ‘sustainable finance’. At the macro level, finance is sustainable when all five of its dimensions facilitate the co-existence of our biosphere and humans in the 21st Century and beyond. At the micro level, individual organizations are sustainable when they are adaptive enough to create continuous stakeholder value in the 21st Century and beyond. Paraphrasing Charles Darwin, sustainable organizations may not be the strongest or the smartest, but they are most able to adapt to changing circumstances.
With these sustainability definitions in mind, let’s revisit the ‘finance’ filing cabinet with its five drawers:
- Primary Investing: ‘green’ labelling processes for investments that reduce GHG emissions or facilitate adaptation to climate change are well underway, with Taxonomy Technical Committees (TTCs) creating standardized definitions of what constitutes an ‘environment-friendly’ investment. However, as was noted in the June Letter these processes are not without controversy. For example, the current European ‘green’ taxonomy does not recognize GHG emission-reducing investments in Canada’s fossil-based energy industry as ‘green’. Canadians beg to differ. The point is that ‘green’ labelling processes are off the ground and taxonomies will hopefully converge over time through discussion, debate, and compromise.
- Secondary Investing: investing sustainably in outstanding issuer stocks and bonds in public and private markets has become has become the most visible face of sustainable finance. The movement towards ‘ESG’ investing is only part of the story. The May Letter showed that a credible transformation to sustainable investing by investment institutions involves board buy-in, specialist staffing, redesigned financial incentives, financial and climate risk modeling capabilities, redesigned performance benchmarks, and a ‘minimum sustainability threshold test’ for eligible investments. The focus of this test is the sustainability of the organizations that are investment candidates for the investment institution. The test logically links micro sustainability at the organizational level to macro sustainability at the biosphere/humanity level. Once again, the specifics of such tests will not be without controversy. On the positive side, the UN’s 17 Sustainable Development Goals (SDGs) offer guidance for how a ‘minimum sustainability threshold test’ for investee organizations might be designed.
- Price Discovery and Liquidity Provision: these are legitimate finance functions. However, it is hard to disagree with the UK’s Lord Adair Turner when he recently wrote: “Financial markets, when left to free market forces, can generate activity that is privately profitable but not socially useful. There can be too much finance, too much trading, and too much market completion.” This is not a new insight. John Maynard Keynes made a similar observation in his opus “The General Theory” over 80 years ago. Once again, on the positive side, the more that ‘Secondary Investing’ becomes sustainable investing as defined above, the ‘too muchness’ that Turner, Keynes, and many others object to should diminish over time.
- Risk Management: will continue to evolve in addressing sustainability issues related to climate change, other biosphere and social limits issues. Rising carbon/methane emissions, loss of sea ice/rising sea levels, falling bio-diversity, increasing droughts/fires, falling soil productivity, and rising environmental toxicity will result in rising rates of property destruction, deteriorating air/water quality, falling crop yields in the face of growing food demand. This in turn increases migration pressures from high-impact/low adaptation areas to lower-impact/higher adaptation areas. These events represent material political, socio-economic, and capital destruction risks at both macro and micro levels. The UN SDGs go beyond climate and the environment, and also cover social risk drivers such as poverty, health, and hunger. The mitigation from, and adaptation to these risks requires decisive action in international, national, and individual organization contexts.
- Financial Infrastructure: an instructive ‘decisive action’ example was the ‘financial infrastructure’ response to the 2008/9 Global Financial Crisis. Its actions at that time stabilized the global financial system, setting the stage for one of the longest global economic recoveries on record. On the sustainability front, the creation of, and the subsequent recommendations from the Task Force on Climate-Related Financial Disclosure (TCFD) offers another ‘decisive action’ example. Expanding organizational disclosure requirements along the lines of the Integrated Reporting Framework set out by the International Integrated Reporting Council (IIRC) is a logical next step, as argued in our January, February, March, and April Letters. On the academic front, the development of sustainable finance courses is high on business schools’ priority lists.
With ‘sustainable finance’ defined, the next logical question is: where does it go from here?
What Is Next for ‘Sustainable Finance’?
The ‘five drawer’ framing set out above helps explain and organize the long, and still growing list of macro and micro initiatives underway to transform ‘finance’ into ‘sustainable finance’. Their focus ranges from ‘green’ taxonomy specification in Primary Investing, to sustainable investing principles specification and their implementation in Secondary Investing, to sustainability integration into business cash-flow pricing and risk models, to sustainability integration into regulatory frameworks and organization disclosure requirements, and to the development of sustainable finance courses in academia.
Given the long list of sustainability-related initiatives already underway, is there a logical next step? I believe there is. It is to integrate this host of initiatives into coherent, compelling narratives that increase the understanding of, and strengthen the commitment to sustainable finance thinking and doing at both micro and macro levels. A powerful means to do this is to continue to develop integrated reporting frameworks that require organizations to coherently compose and publish their value-creation narratives in five parts: 1. purpose and context, 2. governance, 3. business model, 4. backward-looking outcomes, and 5. strategies to achieve forward-looking value-creating outcome targets. Importantly, adopting such a narrative framework requires integrative thinking and actions to create future value. It lays out a structure that connects purpose and aspirations to actions and outcomes.ii
Fortunately, we do not have to invent such a framework. The Letters cited above reported that the IIRC launched their <IR> Framework five years ago, and it is steadily gaining acceptance, including in the asset owner sector.iii For example, the 2017 TCFD recommendations are very consistent with the <IR> Framework. Today, the framework is also the basis for two new initiatives built on its foundations.
Two New ‘Sustainable Finance’ Reporting Initiatives
One of these initiatives is called Reporting 3.0 (r3.0) with the clever 3-R tagline “Redesign for Resilience and Regeneration”. It is an international ‘public good’ venture focused on accelerating the transition to “a thriving regenerative and distributive economy and society” through collaborative research and develpment projects. Why focus on reporting? Because, r3.0 explains, quoting Supreme Court Justice Louis Brandeis, “Sunlight is the best disinfectant”. In other words, greater transparency makes the invisible visible. Three key features of r3.0’s work program are:
- Crowdsourcing of ideas that focus on translating the massive macro changes needed to achieve sustainability on a biosphere/human civilization level into practical steps required at micro organizational levels. Then follow the logical step-by-step redesign sequence of transforming promising ideas into blueprints, business models, pilot projects, and upscaling.
- Boundary setting in natural capital (e.g., air, temperature, water) and in socio-economic conditions (e.g., poverty, health, hunger).
- Threshold Investing creates value in micro contexts while respecting macro natural capital and socio-economic boundaries. This involves consideration of the evolving role of fiduciary duty, redefining ‘capital’ (i.e., not just financial, but also in its manufactured, natural, human, social, and intellectual forms), assessing the macro impacts of micro investment decisions, positive active investor engagement at both macro and micro levels, and clear, compelling reporting on the complete value-creation chain.
Another noteworthy initiative is the FORESIGHT project launched by CPA Canada (Canada’s chartered professional accountants association). Why this project? In its own words, “to transition from being ‘keepers of finances’ to real-time evaluators of organizational performance……” Key elements of the project are:
- Accountants must expand on what needs to be counted………a broader range of advice is demanded, including dealing with concerns about data quality and management, climate change, societal issues, and the growing recognition that sustainability is good for business.
- Two specific project focus areas are 1. Data Governance and 2. Value-Creation.
- Addressing Value-Creation will involve knowing what is already out there (e.g., the <IR> Framework) and setting the proper project scope (e.g., raising organizational effectiveness, supporting long-termism in decision-making, considering societal inclusion, and fostering sustainable development).
CPA Canada is following an implementation plan similar to that of the r3.0 initiative. It comprises a logical redesign sequence including the crowdsourcing of ideas, blueprints, testing, and implementation, all governed by challenging timelines and a strong oversight structure.
The End of the Beginning?
In closing, paraphrasing Winston Churchill once again, the developments set out in this Letter do not document the end of the evolution of ‘sustainable finance’. In fact, they do not even signal the beginning of the end. But perhaps, they represent the end of the beginning. Much work remains to be done, and asset owners must be, and must be seen to be, leaders in doing that work.
- The June Letter covered the recommendations of Canada’s Expert Panel on Sustainable Finance. This Letter is complementary to their Report by focusing exclusively on moving to a common definition of the term. The contents of this Letter are based on a talk delivered on September 27 to a forum on implementing the TCFD recommendations.
- See Roger Martin’s 2007 book “The Opposable Mind” for more on the power of integrative thinking.
- KPA Advisory Services held an Framework workshop for 15 asset owner organizations on September 6 in Toronto. Special guest was Australian CBUS Super CEO David Atkin who shared the CBUS 4yr experience with the <IR> Framework. A key take-away was its integrative power in making the medium the message. That is, the very act of adopting the framework sends a strong ‘sustainability’ message not only to the organization’s own employees and direct stakeholders (i.e., plan members and their employers), but also to the wider community of peers, leaders in the business and NGO sectors, and leaders in government and governmental organizations.
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