BACKGROUND PAPERSustainable Finance:A Primer and RecentDevelopmentsAlex NichollsDISCLAIMERThis background paper was prepared for the report Asian Development Outlook 2021: Financing a Green andInclusive Recovery. It is made available here to communicate the results of the underlying research work withthe least possible delay. The manuscript of this paper therefore has not been prepared in accordance with theprocedures appropriate to formally-edited texts.The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of theAsian Development Bank (ADB), its Board of Governors, or the governments they represent. ADB does notguarantee the accuracy of the data included in this document and accepts no responsibility for any consequenceof their use. The mention of specific companies or products of manufacturers does not imply that they areendorsed or recommended by ADB in preference to others of a similar nature that are not mentioned.Any designation of or reference to a particular territory or geographic area, or use of the term “country” inthis document, is not intended to make any judgments as to the legal or other status of any territory or area.Boundaries, colors, denominations, and other information shown on any map in this document do not imply anyjudgment on the part of the ADB concerning the legal status of any territory or the endorsement or acceptanceof such boundaries.
Sustainable Finance: A Primer and Recent DevelopmentsProfessor Alex Nicholls, MBAI. INTRODUCTION TO SUSTAINABLE FINANCEA.Historical ContextThe development of innovative finance tools and instruments to address social and environmentalproblems is nothing new. Historically, such finance has focused on concessionary finance,including grants, and mutual finance to support the “social economy” or “social and solidarityeconomy”. In many countries, the social economy has long played an important role in theprovision of nonmarket goods and services outside of government or mainstream markets. Forexample, the cooperative and mutual sector represents an important element of many economiesglobally, employing more than 1.2 billion people (one in six of all employees) in more than threemillion organizations. In 2019, the largest 300 cooperatives had a turnover of more than 2trillion, 1 of which 41 were in Asia. 2 The key sectors in which cooperatives and mutualorganizations operate are work integration, agriculture, microfinance, and consumer groups. Mostcooperatives and mutual organizations are small, but a number operate at significant scale. Forexample, Amul Dairy is the largest dairy producer in India. 3 Moreover, the larger social economyin the European Union (EU) 4 represents an important element of the overall economy, both interms of its economic impact (13.6 million jobs, 8% of gross domestic product across the EU), 5but also its wider social impact in terms of innovations designed to address intractable social,community, and environmental issues. 6 In the post–COVID-19 world, the social economy alsooffers an alternative economic model that connects actors from government, not-for-profit, andfor-profit organizations; and may provide important insights into how to increase the resilienceand heterogeneity of business ecosystems more generally and to reduce the risk of exogenousshocks to the economy as a dairy.com.The social economy in the EU consists of 2.8 million social enterprises, mutual and cooperative associations and cuments/20182/313344/SEE-Action Plan for Social cuments/20182/313344/SEE-Action Plan for Social Economy.pdf.DG CLIMA Climate and DG ENVIR Environment; DG EAC Education, Youth, Sport and Culture; DG SANTI Health and Food Safety; DGENER Energy; DG FISMA Financial Stability, Financial Services and Capital Markets Union, and DG ECFIN Economics and FinancialAffairs; DG CONNECT Communications Content, Networks, and Technology; and DG RTD Research and Innovation.1
B.TerminologyDespite the long history - and continued growth -of the social economy globally, it is onlyrelatively recently that a market of finance specifically aimed at creating social and environmentalimpact, as well as a financial return, has emerged. However, today, this market remains somewhatconfused and under-institutionalized - lacking a consistent terminology, consolidated financial orimpact performance data sets despite a plethora of competing reporting standards and principles(for example, the UN Principles for Responsible Investment [PRI], 7 the Global Reporting Initiative[GRI], 8 and the Social Accounting Standards Board [SASB]. 9 ) and limited regulation around))disclosure (though see recent EU and UK regulatory models).10 Variously, the finance that isdeployed for social and environmental impacts has been categorized as grants (philanthropicfinance); 11 venture philanthropy (long-term start-up grants plus other pro bono support); 12 missionand program-related finance (charitable asset finance); 13 development finance (from transnationaldevelopment finance institutions [DFIs]); 14 ethical finance (that is based upon moral judgementsof performance, often linked to faith systems); 15 social (impact) finance (that supports the socialeconomy more widely, particularly in Europe); 16 green finance (that is focused on the climatecrisis and associated issues of pollution); 17 and impact finance (that is focused specifically onmeasurable impact). Table 1 summarizes these types of finance with example ate-sustainability-reporting hropy/ubs-optimusfoundation.html?ef id anJ0fwAgCLk1HEYaj8NCgkDOZJevEaAgBAEALw wcB:G:s&s kwcid ance.org.uk/investors-advisors/social-finance; eenfinanceinstitute.co.uk and https://greenfinanceplatform.org.782
Table 1: Terminologies for Sustainable FinanceType of FinanceGrantsVenture PhilanthropyProgram-related investmentMission-related investmentDevelopment financeEthical financeSocial (impact) financeGreen financeImpact financeSocially responsible financeExample OrganizationRockefeller FoundationNew Philanthropy CapitalFord FoundationKL Felicitas FoundationCenters for Disease Control and PreventionFaith InvestRBC Wealth ManagementResonance FundBridges Fund ManagementNutmegSource: Author’s own research.Despite this variety of definitions, some consistency of terminology has coalesced around theconstruct of “sustainable finance” in terms of a range of environmental, social, and governance(ESG) variables that are material in terms of investor decision-making around asset allocationstrategies:Sustainable finance generally refers to the process of taking due accountof environmental, social, and governance (ESG) considerations when makinginvestment decisions in the financial sector, leading to increased longer-terminvestments into sustainable economic activities and projects. 18The market for sustainable finance can be divided into two subcategories: negative sustainablefinance that is characterized by investments screened according to their material risk profile on thethree ESG dimensions (“do no harm”); 19 and positive sustainable finance that is characterized byinvestments identified according to their potential for significant, additional, social, orenvironmental impact 20 often aligned with the United Nations (UN) Sustainable DevelopmentGoals (SDGs). 21 For example, whereas the former would screen out tobacco companies or overview-sustainable-finance en.This is categorized as an exclusion strategy. -to-the-sdgs-2020-spread.pdf.This is categorized as an integration strategy. -to-the-sdgs-2020-spread.pdf and pact-investing.pdf.https://sdgs.un.org/goals.3
carbon intensity companies from a portfolio, the latter would invest directly into health careinnovations to address lung disease or green technology to replace petro-chemicals. 22C.Investor PreferencesA key driver behind the emergence of sustainable finance has been changing investorpreferences, notably from the millennials who will benefit from the largest transfer of inheritedwealth in human history over the two decades, 23 accounting for 68 trillion. Of thesemillennials, 45% stated that they wished to invest their funds to help others and considered socialresponsibility a key factor in making investment decisions. 24 Moreover, 90% of women investorsalso believe making a positive impact on society is important. In addition, institutional investors,such as pension funds and insurance firms, are recalibrating their long-term investment riskmodels to include social governance and, particularly, environmental factors as material for theirinvestment portfolios. 25II. SUSTAINABLE FINANCE INVESTMENT STRATEGIESSustainable finance investment strategies are either negative/exclusionary or positive/integrated.A. Negative (Exclusionary) Sustainable FinanceThis category is typically risk screened against a range of non-financial performancemetrics across ESG categories, that leads to a recalibration of the long-term risk profiles of, forexample, high-carbon intensity companies. Strategically, such screening results in divestmentfrom, or the avoidance of, ESG high risk investments. The most common risk screen is highcarbon intensity, but other risks include failures in: Internal organizational structures, practices, and processes, such as effective internalaccountability and transparent governance; strong worker relations; fair pay and safeworking conditions; clear strategies to improve the inclusivity and diversity of lid jALIDvJ745GkaWjlU7T0979Kdjz0aAj43EALw wcB.According to Forbes, Millennials will inherit over 68 trillion from their Baby Boomer parents by the year nvestors.4
workforce; committed investment in human capital and local communities; usingrecycling models to maximize the effective use of resources External organizational effects and outcomes, such as respect for human rights andstrategies to tackle inequality; and minimizing pollutionAn extension of passive screening that developed more recently is the more active use of votingrights to challenge corporate behaviour. 26B. Positive (Integrated) Sustainable FinanceThis category typically aims to achieve a ‘Double Delta’ 27 of impact by providing bothnew, additional, capital and by focussing on high potential start-ups or high growth potentialimpact companies. Positive sustainable finance is often aligned with making an additionalcontribution towards one or more of the 17 UN SDGs (Figure 1). This is sometimes calledSocially Responsible Investment. 28 To date, the main categories for SDG investing have28 Fbeen SDG 8 (decent work and economic growth), 12 (responsible consumption andproduction), and 13 (climate action) with the least prioritized SDGs including 1 (no poverty),2 (zero hunger), and 10 (reduced inequalities). 29 Growing this market is of central2 9Fimportance to the achievement of the SDG targets by 2030, since there is currently anestimated annual shortfall of 3 trillion– 4 trillion in available finance. 30 Positive sustainable3 0Ffinance investment strategies focus on providing new capital into high impact dviser/responsibleinvesting?gclid Cj0KCQjwlvT8BRDeARIsAACRFiViyk2kUXQvp8PJWbmjhM53W 5
Figure 1: United Nations Sustainable Development GoalsSource: United Nations. https://sdgs.un.org/goals.III. SUSTAINABLE FINANCE CATEGORIESA. Environmental (Green) FinanceIn terms of ESG categories, environmental finance is more commonly described as ‘greenfinance’. Green finance provides start-up or growth capital into innovative enterprises that addressclimate related issues (positive/integrated) or divests from companies that perpetuate the climatecrisis (negative/exclusionary).Negative - exclusionary - green finance typically focuses on moving investments from high carbonintensity to low carbon intensity companies (as divestment) or allocating capital to companies thatare aiming to reduce their overall carbon footprint. A particular issue here is the long-term riskprofile associated with investments in petrochemicals companies has been categorised as reflectingthe mispriced balance sheet value of so-called ‘stranded assets.’ These are future extractions ofexisting oil and gas deposits that will not be able to be used without precipitating a total climatecollapse. Carbontracker has estimated that this will result in the price of oil dropping below the6
marginal price of production by 2050, making it unviable and significantly downgrading the valueof petrochemical stocks today.31Positive – integrated- green finance typically invests in companies that provide green technology,such as solar or carbon capture technologies to address the climate crisis. Green investments alsofocus on companies working on environmentally sustainable management of natural resources,biodiversity conservation, renewable energy, energy efficiency, the circular economy, cleantransportation, and pollution prevention and control. 32 The positive green finance market isdominated by debt products, notably green bonds. 33 Broadly speaking there are six forms of greenbond: 34(i)Corporate bonds issued by a corporate entity to finance asset acquisitions(ii)Project bonds backed by single or multiple projects for which the investor has directexposure to the risk of the project(iii)Asset-backed securities collateralized by one or more specific projects, usuallyproviding recourse only to the assets(iv)Supranational, sovereign, sub-sovereign, or agency bonds issued by internationalfinancial institutions such as the World Bank or the European Investment Bank(EIB)(v)Municipal bonds issued by a municipal government, region, or city, which alsoincludes sovereign bonds(vi)Finance sector bonds issued by a financial institution to raise capital to finance on–balance-sheet lending (such as loans) to green activitiesSome carbon-intensive or high-polluting companies have raised green “transition” bonds to funddecarbonizing projects. For example, in 2020, Cadent Gas, a British firm, raised a 500 milliongreen bond to fund works on reducing the leakages from its pipelines. In 2019, Enel, an Italianelectricity firm, issued a green bond index that is linked to increasing the share of renewables inits generation capacity. 35 Related to this form of green finance has been the move towardsdivestment from carbon-intensive companies. s06-2019-100619.pdf.33Though equity issues in green technology companies are also used. cker.org.31327
Green bonds provide new flows of debt capital to support start-ups or high-growth green energytechnologies, water management models, meat analogues, or carbon capture. 37 More recently,there has been a growing interest in blue bonds and blended finance models that are focused onthe “ocean economy” and issues of biodiversity and marine sustainability. 38 Overall ‘sustainable’debt issuance (including green bonds) reached 732 billion in 2020 – a 23% increase comparedto the year before (see Figure 2).39Figure 2: Sustainable Debt Issuance 2013-2020.Source: Sustainalytics (2021)B. Social (Impact Investment) FinanceSecond, social finance provides start-up or growth capital into innovative enterprises that addressa social market failure in the provision of welfare in sectors such as health, education, andemployment (positive/integrated) or divests from companies that increase inequality of perpetuatesocial welfare failures (negative/exclusionary). As a result, finance deployed intentionally forsocial impact is sui generis positive social finance. In this context, over the past 20 years, a newmodel of positive social finance has emerged: impact investment. The Global Impact n-economy c59ce972-en wealth/. With support from the WorldBank, in 2018, the Republic of Seychelles launched the world’s first sovereign Blue Bond raising a total of 15 million to advance the island’sblue -how-sustainable-finance-shaping-banking37388
Network (GIIN), 40 a not-for-profit organization dedicated to building the infrastructure of the fieldvia convening and research, defined impact investment as:Impact investments are investments made with the intention to generate positive,measurable social and environmental impact alongside a financial return.More recently, the Global Steering Group for Impact Investment (GSGII), 41 a transnationalcoalition of 33 national advisory boards that supports the development of the impact investing fieldglobally, has extended this definition:Impact investment optimizes risk return and impact to benefit people and the planet.It does so by setting specific social and environmental objectives alongside financialones and measuring their achievement.The emphasis in both definitions on measurement as an integral element of the impact investmentmodel further confirms it as positive social finance that deploys capital to address social issuesdirectly.A more recent innovation in social finance has been the emergence of social bonds. Social bondsare any type of bond where the proceeds will be used exclusively to finance (or refinance) projectsfocused on water infrastructure, health or education sectors, affordable housing, work integration,food security, and access to services. Social bonds are designed directly to address or mitigate aspecific social or environmental issue often involving a particular target population. In 2020, theInternational Capital Market Association (ICMA) published a set of Social Bond Principles, 42 withfour core components to be calibrated to the stated social or environmental purpose of the bond:the use of finance, the processes for project evaluation, the management of finance, and thereporting impact.404142Established in 2009, the Global Impact Investing Network (GIIN) is a not-for-profit organization with 280 members across 41 countries thatbuilds industrial infrastructure and supports activities, education, and research to help accelerate the development of the impact investmentindustry. https://thegiin.org.The GSGII was established in August 2015 as the successor to, and incorporating the work of, the Social Impact Investment Taskforceestablished under the UK presidency of the Group of Eight (G8). Currently, the GSGII’s membership consists of 32 countries plus the nciples-sbp/.9
C. Governance (Stakeholder) FinanceThird, governance finance - which is sometimes elided with environmental or social finance -isdistinctive in that it focuses on stakeholder finance that invests in companies that adhere tointernational standards of employee welfare (such as those set by the International LabourOrganization), 43 or that have a strategic aim to incorporate elements of purpose 44 into theirgovernance structures for example, by establishing employee representation on the managementboard (positive/integrated) or divests from those that do not (negative/exclusionary).Governance finance relates to the effects of investment on a range of key stakeholders around thefirm. In this regard, it has many overlaps with the impact objectives of green and social finance,both negative and positive. These also link to issues around stakeholder finance that have beenconceptualized in terms of a wider set of debates around corporate “purpose”. 45 However, the mostdistinctive features of positive stakeholder finance relate to organizational ownership and forms oflegal incorporation.In terms of stakeholder ownership, cooperative and mutual finance represent a significant driverof stakeholder impact. 46 This is a product of investment into an organizational structure, basedupon equal membership, that is designed to address market failures or pattern of monopsony inmarkets. Cooperatives and mutual organizations play a key role in several impact sectors,including housing, 47 agriculture, 48 health, 49 work integration, 50 insurance, 51 and banking. 52 Manyof these sectors are substantial. For example, the global market share of mutual and cooperativeinsurers stood at 26.7% (2017), in more than 90 countries, with assets worth 8.9 trillion. Thismarket employs more than 1 million people and serves 960 million people as members s/default/files/centers/mrcbg/files/Mayer 2.19.19.transcript.pdf. An good example is the B-Corps r-colin-mayer-said-business-school/.Michie /Financing Co-operative and Mutual Housing-1.pdf. Also, note Big Society Capital’s strategicfocus on investing in the social housing sector and housing associations: /2019/03/190326 ihco 99ae02abadf18489/cooperatiestudie-200910 tcm64-94102.pdf.10
policyholders. 53 Similarly, the global cooperative banking sector had assets of 7.4 billion(2018). 54In terms of stakeholder forms of incorporation, several legal forms for social purpose organizationsexists globally that are designed to attract stakeholder focused finance. These include benefitcorporations (in the United States [US]), 55 community interest companies (in the United Kingdom[UK]), 56 and social cooperatives in Europe. 57 Each of these legal forms of incorporation havevarious disclosure and financial requirements that are consistent with being a legitimate socialpurpose organization. For example, community interest companies have an asset lock provisionswhich protects them from a hostile takeover to access the value of a real asset such as property. 58Figure 3 summarise the categories of sustainable finance as a taxonomy by ESG category andinvestment approach with indicative investee profiles and investment strategies.Figure rket-infographic-2016.McKillop et al. ean-cooperative-society en.In terms of attracting stakeholder finance, community interest companies also attract social investment tax 11
IV THE SPECTRUM OF SUSTAINABLE FINANCE: MARKET SIZEAn important and distinctive feature of the sustainable finance market is the variety of types ofcapital available to be deployed (and co-invested in blended structures) for sustainable impact.These range from grants, foundation assets deployed as program-related investment (PRI) ormission-related investment (MRI), sub-market and market return impact investments,development finance, green and social bonds, and market rate return screened investments inpublic and private equity and debt. Figure 4 sets out the spectrum of sustainable finance in termsof both the broad positive/integrated and negative/exclusionary ESG categories set out above. 59Figure 3. The Spectrum of Sustainable FinanceFigure 4: The Spectrum of Sustainable FinanceESG environmental, social, and governance.Source: Author’s own research.Next, each element of the spectrum is considered, in turn, with respect to the approximate marketsize of each.A.Positive/Integrated Environmental, Social, and Governance Finance: Market Size1.GrantsGrants, which play an important role in structuring blended sustainable finance deals asconcessionary capital have an expected return of -100% as they are never repaid. The market sizefigure - 75 billion - is approximated from 5% of total foundation assets globally. This is the legal59See: nce/.12
requirement for charitable status in the US, though not elsewhere. 60 This figure also excludesgovernment grants to social enterprises, although these may be quite substantial sums. Forexample, the Government of the UK has deployed in excess of 1 billion of public money tosupport the development of the social enterprise sector and impact investing infrastructure since2010. 612.Program-Related Investment and Mission-Related InvestmentPRI and MRI form a part of a foundation’s overall invested assets by using endowment capital togenerate impact. PRIs typically take the form of debt capital to fund programmatic activities, oftenin concert with grants, and may make a financial return.62 In the US, PRIs can be included in theannual 5% allocation of “grant” capital.63MRIs take the form of debt or equity and typically aimto further the foundation’s mission and make a competitive financial return. 64 Potentially, thepotential market size of MRI investments could equal the total assets of all foundations, or roughly 1.5 trillion globally. 653.Impact InvestingFollowing the definition noted above, in the 2020 annual report, the GIIN estimated the coreimpact investing market size at 715 billion of assets under management in 2020. 66 However, the6061636465Calculating the total value of philanthropic assets globally is difficult, since there is no single data set available. This figure is, therefore, anestimate based upon P. Johnson. 2018. Global Philanthropy Report (Hauser Institute for Civil Society) valuation of global foundation assets at 1.5 trillion, see https://cpl.hks.harvard.edu/files/cpl/files/global philanthropy report final april 2018.pdf. This is likely to a larger figure in2020.This figure includes: the endowment of UnLtd ( 100 million); grants from the Futurebuilders ( 215 million) and Investment and ContractReadiness ( 60 million) Funds; co-investments with Bridges Fund Management ( 20 million); unclaimed bank account assets to the ReclaimFund ( 850 million) of which Big Society Capital has deployed 600 million to 2019.62In the USA, the IRS defines PRIs ‘as investments in which: the primary purpose is to accomplish one or more of the foundation's exemptpurposes; production of income or appreciation of property is not a significant purpose; influencing legislation or
Social (impact) finance RBC Wealth Management Green finance Resonance Fund Impact finance Bridges Fund Management Socially responsible finance Nutmeg . Source: Author's own research. Despite this variety of definitions, some consistency of terminology has coalesced around the construct of "sustainable finance" in terms of a range of
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