Can the financial system work for our environment?



Coinciding with the opening of the 74th session of the General Assembly in New York, millions of protesters have taken to the streets to demand meaningful climate change action; all boosted by the figure of Greta Thunberg, the 16-year old activist that has become the face of recent climate change mobilizations. Keshav Sompura, an exchange student at Sciences Po, regards the recent protests in Paris as “encouraging and energetic”. Isabel Martínez, student of Law and Political Sciences at Universidad Autónoma, on a similar note, argues convincingly that the climate change strikes that flooded Madrid are “encouraging even though profound changes are still needed, especially when it comes to rethinking our daily habits”. Despite their generally hopeful messages, when asked about how the financial industry could help address the climate change crisis, their answers offer little conviction on how this relationship could work. In fact, their responses implicitly point out to a perceived incompatibility between financial interests and sustainability. But is there such an incompatibility? Or, on the contrary, can finance help tackle climate change? And if so, how?

The answer to these complex questions might be found in sustainable investing, an investment approach that considers environmental, social and governance (ESG) factors alongside traditional investment metrics. In practical terms sustainable investing can encompass a series of different strategies. These include, for example, negative or exclusionary screening (e.g. discarding support for tobacco companies); positive or best-in-class screening (i.e. building a portfolio of companies that outperform their sectoral peers on predefined ESG criteria); impact investing, whereby the portfolio is specifically managed to guarantee a desired impact in development; or active ownership, a strategy by which the investor engages with the portfolio company to guarantee the company’s compliance with certain ESG criteria. 

The growth of sustainable investing in the past years has been outstanding. It has gone from being a marginal practice at the beginning of the century to an investment approach that is shaping how portfolio managers across the financial industry design their investment processes. The growing interest in ESG issues among institutional investors responds to a series of factors, three being particularly important.

First, growing evidence shows that companies committed to fulfilling certain ESG criteria do not need to forego some financial return in order to realize their environmental, social or governance pledges. Indeed, in a 2016 study, professors Mozaffar Khan, George Serafeim and Aaron Yoon demonstrated that companies with a higher performance on material ESG variables (which vary depending on the industry)  often have higher financial performance. According to another study, these companies also show higher Return On Equity (ROE) and Return On Assets (ROA) over the long term. The implications of these findings are huge, as they discard the anachronistic view that sustainable business is incompatible with strong financial performance.

Second, the fiduciary duty (i.e. the legal obligation of the investor to act in the client’s best interest) that institutional investors owe to their clients is increasingly being defined on the basis of the investor’s responsibility to consider ESG factors, not only financial returns. This understanding is far from becoming mainstream, but if this view were to gain more exposure, sustainable investing could see a major boost. The third reason that explains the growing interest among institutional investors for ESG factors is us. Many of us expect these companies to be responsible in their business practices. Indeed, according to a recent study from Morgan Stanley, 95% of Millenials express interest in sustainable investing. If companies wish to retain the talent of our generation, they cannot fail to address sustainability. 

It is clear that sustainable investing strategies that, for example, allocate capital to companies with strong ESG performance relative to their sector peers can aid the fight against climate change. However, there are still plenty of barriers that are limiting the development and implementation of these strategies. Most evident is the poor state of ESG reporting, which prevents capital from flowing into those business activities that can produce the highest value for society. Companies are failing to demonstrate to shareholders that they understand what factors can drive their long-term performance, and the absence of international standards for ESG reporting aggravates this problem. Given this context, governments and international organizations wishing to preserve the environment should attempt to close this information gap via appropriate regulations and international agreements.  

But reform at the institutional level, as people like Isabel Martínez have pointed out, should be accompanied by a parallel transformation at the micro level, especially among us, the young, who have been handed the baton in the race against climate change. Those of us with an interest in finance and business should understand that sustainability and profitability can go in hand. If we convincingly explore the possibilities for a productive relationship between the financial industry and the environment, not only as businessmen, portfolio managers, or analysts, but also as environmental activists, change at the institutional level will follow. Sustainable investing can help mitigate the impact of climate change, but untapping its full potential is, ultimately, our responsibility. 

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