Mobilizing private capital to achieve a more inclusive and sustainable world
As Cicero said, money is “the sinews of war”. For several decades, it has been the sinews of the war against climate change as a consequence of environmental degradation and against all forms of social inequalities throughout the world. The annual financing gap is currently estimated at around 2.5 trillion USD. Yet there is no shortage of money on a global scale, or even of innovative solutions that are being created every day for a more sustainable and fairer world. Investment frameworks (Section I) and approaches (Section II), whose context, main characteristics and challenges will be presented in this article, have emerged, gradually or suddenly, in response to environmental, economic and social crises. They provide a way to mobilize private capital, responding to the inadequate financial resources of the public sector and philanthropy, to support inclusive and sustainable behaviors and address global challenges.
However, most traditional investment professionals seem to still be confused about the different concepts of sustainable finance and are not aware of the extent of their responsibility to achieve the Sustainable Development Goals (SDG). This paper aims to close the knowledge gap to prompt the traditional investors to close the SDGs financing gap.
I. THE INVESTMENT FRAMEWORKS
Corporate Social Responsibility (CSR)
The concept of corporate social responsibility (CSR) emerged in the United States in the mid-20th century. Until the 1970s, the unique priority of the company was the shareholder satisfaction, which was directly correlated to the economic performance and profits. Any societal consideration misled the company from its goal and could even, according to the economist Milton Friedman, be harmful to it. From the 1970s onwards, severe environmental and health disasters have occurred, for which companies have been held responsible (e.g., the Seveso disaster in Italy in 1976 and the Bhopal disaster in India in 1984, the Amoco Cadiz oil spill in France in 1978 and the Exxon Valdez oil spill in Alaska in 1989). At the same time, the theoretical foundations of public intervention and the regulation of capitalism were being overturned, giving way to the privatization of public enterprises and the liberalization of trade. Consequently, the question of the relationship between companies and their environment arose and led to a reflection on their social and environmental responsibility. The concept of CSR really took off in the 1990s, driven by its gradual appropriation by companies in their management methods, often under the scrutiny and pressure of NGOs, trade unions, environmental organizations and consumers. Since the end of the 1990s, CSR has been at the center of discussion in major international bodies such as the OECD, the International Labour Organization (ILO) and the United Nations, and has guiding their respective policies.
The European Commission has defined CSR as “a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis”. CSR is therefore based on 3 fundamental pillars: (1) the economic pillar, (2) the social pillar and (3) the environmental pillar. The sole pursuit of profit by the company is no longer enough. It must now also ensure that its activity does not have any negative impact on society as a whole, on its employees (social pillar), its customers and suppliers (economic pillar) or on the environment (environmental pillar). Ideally, it tries to act in their favor, for example by implementing measures to reduce carbon emissions and limit its waste or by granting some benefits to its employees.
The ISO 26000 standard on social responsibility was established by nearly 100 countries to define a common framework at the international level. It defines the scope of CSR around 7 key issues (governance, human and women’s rights, labor relations and conditions, environment, fair practices, consumers, communities and local development) and specifies the guidelines to be followed by companies in order to adopt socially responsible and environmentally friendly behavior.
By fostering these values, the company is emancipating itself from its initial raison d’être and is now playing a major role in the construction of a more inclusive society and a resilient economic system. At the same time, this approach has become a key element in the competitiveness of companies. Indeed, CSR is beneficial in terms of risk management, cost reduction, access to capital, customer relations, human resources management and innovation capacity. It creates a long-term relationship of trust between the company and its employees, customers and citizens; a solid foundation for establishing a sustainable model and enabling growth prospects.
However, many companies do not integrate CSR into the core of their strategy, but consider it at most as a complementary element and finally reduce it to a footnote in an annual report or to a half-day of effort once a year. In its most subversive form, it has become a marketing tool allowing the company to give itself a nice cosmetic image without having to back up its claims. This is probably the main criticism of CSR; by defining its scope too broadly, it lacks depth and transparency.
Environmental, Social, Governance (ESG)
Unlike the CSR’s approach, although taking root in it, and in order to meet the need for transparency for all stakeholders, environmental, social and governance policies are guided by well-defined ESG criteria — the acronym for “Environmental, Social and Governance” — and are integrated into the heart of the company’s strategy. They come from the “triple bottom line” concept put forward in 1994 by the British entrepreneur and founder of the SustainAbility think tank John Elkington, who believes that “people” and “planet” factors are just as important as “profit” for the long-term success of a company.
While the emergence of CSR has led companies to become aware of their impact on society, without creating a benchmark of good practices common to all sectors and companies, ESG criteria materialize the approach insofar as they make it possible to quantify, measure and compare the extra-financial performance of companies.
ESG criteria thus cover three dimensions:
1) The “environment” dimension refers to the efforts made by companies and their suppliers to protect the environment. More specifically, the environmental criteria focus on the actions taken by these organizations to reduce their CO2 emissions, control their water and electricity consumption, recycle their waste or protect biodiversity. They are also used to assess both the risk linked to the company’s exposure to climate change and its ability to manage it. Companies that place sustainable development at the heart of their strategy set specific objectives and indicators in this matter and report openly the results achieved.
2) The “social” dimension refers to the relationship between the company and its stakeholders — employees, customers, suppliers, civil society — with regard to universal values (human rights, international labor standards, etc.). Social criteria analyze job creation, employee health and safety, employee well-being, the fight against discrimination, the accident frequency rate, the employee turnover rate, the absenteeism rate, value sharing, respect for human rights in the supply chain, the company’s philanthropic approach, its relations with local communities, customer satisfaction, etc.
3) The “governance” dimension concerns the way in which companies are managed, administered and controlled. The governance criteria concern the composition of the boards of directors, the adequacy of the profiles of the management team with the needs of the company, the transparency of their remuneration, the absence of conflicts of interest, the fight against corruption, the gender balance in the governance bodies, the presence of at least one independent member, the existence of counter-powers, the respect of minority shareholders, the use of specific and transparent accounting methods, etc.
Given the scope and complexity of ESG criteria, investors most often rely on ESG rankings provided by external and independent extra-financial evaluation and rating agencies; the two best known global providers being Sustainalytics and MSCI.
The use of ESG criteria to analyze companies in the context of socially responsible investment is developed below.
Sustainable Development Goals (SDG)
On September 25, 2015, as part of the 2030 Agenda for Sustainable Development, all UN Member States adopted 17 Sustainable Development Goals (SDGs), built around 169 quantifiable targets to be achieved by 2030 in all countries. These goals aim to address global challenges, including poverty in all its forms, inequality, climate, environmental degradation, prosperity, peace and justice. The SDGs replace the 8 Millennium Development Goals (MDGs) that ended in 2015.
The SDGs are initially aimed at governments and policymakers, but it is already clear that their efforts will not be enough to achieve these goals. The OECD estimates that the financing gap is around USD 2.5 trillion each year. This is why the SDGs, which have become a universally recognized framework for building a sustainable society, call for the commitment of the public sector as well as the private sector and civil society. Investors in particular have an important role to play by analyzing the societal and environmental impact of target companies through the prism of the SDGs and by financing those that actively contribute to them.
II. THE APPROACHES TO INVESTMENT
Socially Responsible Investing (SRI)
Socially responsible investment (SRI) consists of integrating, in addition to the financial indicators of traditional investment (return on equity, dividend, growth in turnover, etc.), ESG criteria — the three pillars of extra-financial analysis — into the investment cycle, during the pre-investment, post-investment and exit phases. SRI therefore values good ecological, human or governance practices, carried out within companies that are not necessarily sustainable (e.g., oil companies).
In order to guide investors and the financial sector in general in this endeavor, six Principles for Responsible Investment (PRI) were developed in 2006 at the initiative and with the support of the UN. They provide a voluntary framework, rules of good conduct and identify a range of possible actions to take into account environmental, social and governance issues in the investment decision-making process. Their stated objective is to engage responsible investors in working towards sustainable development and thereby align their interests with those of society as a whole.
SRI knows different methods that can be combined or not to select eligible companies for investment, namely (1) the exclusion, (2) the “best in class” and (3) the sustainability themed investing:
1) At the beginning, SRI was mainly to exclude companies whose activities had a negative environmental or social impact or which undermined moral and ethical values (companies operating in controversial sectors such as arms, alcohol, tobacco, pornography, gambling, etc.). However, these “bad” companies could sometimes perform very well, at least in terms of their stock price, so that their ineligibility for extra-financial indicators limited their potential profit according to investors. Indeed, it was widely assumed that ESG funds would underperform the market and thus sacrifice profit on the altar of conscience. Later on, investors understood that the interest of ESG criteria went beyond ethical considerations and made it possible to avoid companies with a significant risk factor. For example, the explosion in 2010 of BP’s Deepwater Horizon oil rig, which caused the oil spill in the Gulf of Mexico, as well as the Volkswagen scandal, also known as “dieselgate”, revealed in 2015, caused the stock market values of these companies to plummet and resulted in losses of several billion dollars.
However, to guard against such incidents, it is no longer enough to avoid risk by excluding companies with negative externalities. Similarly, investing in low-exposure stocks alone is not enough to bring about positive and meaningful change for society. Asset managers have realized this and are increasingly adopting an investment strategy that proactively favors companies that perform best for society. This vision emphasizes the two other methods: the “best in class” and the sustainability themed investing.
2) The “best in class” method is the most preferred by asset managers and aims at choosing only the top — the percentage is to be determined — companies in the ESG ranking in each sector or industry.
3) Sustainability themed investing consists of investing in companies active in themes or sectors related to sustainable development, such as renewable energies, water conservation or sustainable agriculture. This strategy is more widespread in the United States than in Europe, and has experienced strong growth over the last few years.
In this respect, a new movement is growing that sees more and more responsible investors taking up the SDGs as a reference for environmental and societal impact in their responsible investment process. On the one hand, the SDGs embrace, like the ESG criteria, the concept of shared value creation for a sustainable and inclusive approach to well-being and economic growth. On the other hand, they highlight key areas of impact and offer a thematic rather than company-centric reporting framework that helps align sector- or company-specific ESG considerations with broader environmental and societal goals. To deal with this new phenomenon, non-financial rating agencies are adapting and developing a new SDG rating offer. Of course, given the intrinsic qualitative nature of several SDGs, it is not easy to grasp them or to link their achievement to a company’s ESG performance. However, this approach will make it easier for companies to collect and share the numerous SDG-related data relevant to their activities with investors. In this way, it will address the need to quantify progress toward the SDGs.
Refuting the initial reputation of SRI, investment and asset management firms now recognize that companies guided by sound ESG policies are likely to realize greater business opportunities and therefore show better financial performance over the long term, offering their shareholders higher returns than the financial markets in general. This lucrative prospect, combined with better risk management in a crisis environment, explains the explosion of the SRI market in recent years. According to a 2018 report by the Global Sustainable Investment Alliance (GSIA), socially responsible investments in the five major markets globally (Europe, US, Canada, Australia/New Zealand, Japan) stood at USD 30,683 billion at the beginning of that year, an increase of 34% in two years. In Europe, they represented 48% of all assets under management.
Convinced by the ESG approach, or at least by its necessity to remain attractive to investors, 93% of the world’s largest companies by revenue now report on their ESG performance, according to a March 2019 analysis by the Global Reporting Initiative (GRI).
The term “impact investing” was first mentioned in 2007, after the U.S. mortgage credit crisis erupted, at a meeting organized by the Rockefeller Foundation that brought together representatives from the worlds of traditional finance, philanthropy and the development sector. The purpose of the meeting was to explore the possibility of creating a new investment strategy that combines social and environmental purpose with an economically viable model.
The Global Impact Investing Network (GIIN), a leading international NGO, defines impact investing as “investments made in companies, organizations or funds with the intention to generate positive, measurable social and environmental impact alongside financial return”.
Impact investing is thus a sub-category of SRI in the sense that it is also an investment in sustainable development that aims for a financial return, but it differs by two key elements:
1) Visible and verifiable intentionality to generate a positive social and/or environmental impact and;
2) Transparent and continuous measurement of impact throughout the life of the project, using appropriate performance indicators, relevant and reliable information, and pre- and post-action analysis. However, this remains a difficult task, both because of the qualitative nature of some objectives and the difficulty of isolating the organization’s contribution to overall improvement in one area.
Moreover, while SRI targets mainly listed companies, impact investing, although applicable in theory to all asset classes, in practice favors non-listed markets such as private equity, private debt and real assets. In addition, compensation levels range from no profit — the investor only recovers capital — to near-market or market-rate returns, depending on the investor’s strategic objectives.
Impact investing focuses on both for-profit companies and non-profit organizations or funds as long as their business model is profitable and provides sustainable solutions to environmental and social challenges in areas as varied and essential as healthcare and wellness, education, clean and renewable energy, sustainable agriculture, financial inclusion, housing, fair trade and sustainable consumption, biodiversity and natural resource preservation, etc. In developing countries, impact investments are more related to the provision of basic goods and services to the four billion people at the bottom of the pyramid. In developed economies, impact investing tends to focus on sectors such as sustainable development, climate change or education. Impact opportunities therefore vary from region to region, as do the types of risk associated with them, which involves different transaction structures, such as blended finance, different intermediaries and legal issues.
Focusing primarily on private equity asset classes, impact investing remains the privilege of a few very wealthy individuals or institutional investors such as banks, private foundations, family offices, pension funds and insurance companies, NGOs or fund managers. This restricted access to impact investing limits its potential size and scale of impact. As of April 2019, the GIIN estimated that 1340 organizations worldwide currently manage USD 502 billion in assets dedicated to impact investing, or just 1% of global assets (including listed corporate funds). However, this market is growing rapidly. Half of these investors manage less than USD 29 million each, while some players have more than USD 1 billion in assets under management. However, it is still possible for ordinary people to give meaning to their money by investing it, within their means, on crowdlending or social impact crowdfunding platforms or by investing it in products that are in line with their values, such as sustainable investment funds.
Finally, a basic principle in investing is to balance risks and potential returns in order to maximize risk-adjusted returns. Impact investing adds a third variable, that of social impact. Impact investors must therefore take into account three dimensions, the respective weighting of which varies according to the impact strategy pursued. On the one hand, “for impact” investors (formerly “impact first”) aim first and foremost to support, in capital but also often via non-financial support, solutions that respond to a specific environmental or social issue. They are willing to take a higher risk for a certain expected return or to accept a lower financial return in order to bring about a positive change for society. On the other hand, “with impact” investors (formerly “financial first”) focus on the return on their investment, expected at the market rate, by relying on a sufficiently profitable business model while seeking a tangible environmental or social performance.
Philanthropy means, by definition, the love of humanity, and by extension, voluntary actions of charity and solidarity — such as corporate patronage, sponsorship, volunteering or donation — by wealthy individuals and private organizations for the common good and generally for the materially deprived. In this respect, philanthropic action, oriented towards a cause and motivated by an intention of generosity to give back to society, often coupled, in the case of a family foundation, with a desire to honor the memory of a loved one, to strengthen family ties or to transmit certain values to descendants, has always existed in human history.
Over the last twenty years, a new understanding of philanthropy has emerged in Europe, following the evolution of philanthropy in the United States since the end of the 19th century with the first great “philanthro-capitalists”. The world of philanthropy has welcomed new players — entrepreneurs from the new economy, industrialists and private investment professionals — who are increasingly young and have built up their own wealth. They want to use it to generate an environmental or social impact, with the same logic of performance and return on investment as in their business. This new approach, which applies the strategies and methods of traditional venture capital to the non-profit sector, is known as venture philanthropy. It aims to create more added social value than a traditional donor.
In 1997, Christine W. Letts, then a lecturer at Harvard’s John F. Kennedy School of Government, published a seminal paper (“Virtuous Capital”) that identified six specific venture capital metrics that foundations should emulate. They became the key elements of venture philanthropy as defined years later by the European Venture Philanthropy Association (EVPA):
1) Risk Management: Venture philanthropy differs from impact investing in that, since it involves donations, it does not aim for a financial return but only for a positive environmental or social impact. Since the monetary variable is not taken into account, the donor can expose himself to a much higher risk, but always a reasoned one, than the investor. This ability allows the donor to support particularly innovative solutions at the pilot project stage before scaling them up, in association with public administrations and other private investors, if the results are satisfactory.
2) Performance Measures: The foundation sets clear performance indicators and objectives in advance and strives to measure its impact on an ongoing basis, with the same difficulty as in impact investing.
3) Closeness of the Relationship: In the same way as venture capitalists do with the start-ups they finance, the foundation follows the projects closely, monitors their results and, ideally, provides the beneficiaries with the support they need to develop successfully, beyond mere financing. This non-financial support mainly takes the form of access to networks (71% of foundations), strategic advice (57%), mentoring of CEOs (35%) or financial management assistance (23%).
4) Amount of Funding: Venture philanthropy donors focus on one to five areas of impact (education, environment, health, etc.) and prefer large-scale, targeted funding for a small percentage of all the projects in the pipeline rather than diluting their efforts over numerous associations with no thematic coherence.
5) Length of the Relationship: Venture philanthropy is a long-term approach, even if it is not yet the most common practice, since 86% of foundations’ commitments have a five-year horizon at most.
6) The Exit: Non-profit organizations are dependent on donations. There are a variety of reasons why a foundation may decide to withdraw at the end of its commitment. In order to ensure both the sustainability of the work done and the organizational resilience of the grantee, the foundation should work with the grantee to develop an exit plan.
Finally, it is interesting to mention two specific axes around which venture philanthropy can be articulated:
1) Big Bet Philanthropy: Funders provide substantial philanthropic support to a single organization that addresses what they consider to be the key ecosystem lever for solving an important social problem over a limited period of time. These large stakes provide a certain media visibility to the project, ensure its financial stability and facilitate the raising of other philanthropic funds. However, this approach must be careful not to oversimplify an intrinsically complex and multifaceted social problem. In the United States, where this practice is particularly popular, allocations often reach USD 10 million or more, with the Bill & Melinda Gates Foundation leading the way. In this case, when the budgets committed by non-elected private organizations sometimes exceed those of multilateral organizations and thus define the major orientations of global public goods, the question of their legitimacy arises.
2) Philanthropy for systemic change: Funders take an interdisciplinary and holistic view of the problem, taking into account all the levers of the ecosystem. They provide substantial funding to the many actors involved, from the private sector, the public sector and civil society. They thus aim to change the policies, processes, relationships, knowledge, power structures, values or norms of a system. The ambition is particularly high, as is the budget required to achieve it. It therefore requires a coalition of different donors and a convergence of their objectives and means on a sustainable change of the system (and not just on a theme or a geographical area). Implementing this approach, however, is not helped by the fragmentation of the philanthropic sector; most foundations do not seek to align their priorities with one another.
I tend to think that sustainable finance, which has arisen especially since the middle of the 20th century in the wake of the industrial revolution and has really taken off in the 21st century, follows the growth curve of globalized capitalism. For 40 years, this system has favored the concentration of wealth in the hands of a privileged class (1% of the world’s richest people own nearly half of the world’s wealth) as well as the impoverishment of the middle class. This gap between rich and poor is widening even further due to the present ecological crisis. Indeed, the excessive exploitation and appropriation of the limited resources of our world to support some ever-growing and highly polluting economic sectors as well as the degradation of the environment which follows, are likely to result in both a worldwide shortage and an unequal distribution of water, food and energy resources. Yet inequalities in well-being and opportunities both within (in the UK it is now at its highest since the 1860s) and among countries (the global North-South divide) increase political polarization and the spread of extremist movements, hampering social cohesion and undermining the fundamental principles of democracy. Moreover, the excesses of globalized capitalism turn against it insofar as, according to a recent research (Ostry, Berg and Tsangarides, “Redistribution, Inequality and Growth”, 2014), countries with high and rising inequalities generally experience slower growth than those with lower inequality.
In this context, I would not say that sustainable finance is substituting the deregulated capitalism for a brand-new economic system. The different investment approaches I have tried to outline in these lines all borrow from the mechanisms of the capitalist system and their viability is still dependent on it. It is always a matter of generating a financial and/or social return on productive capital. And the money invested in sustainable finance always comes, at the very top of the pyramid, from funders who draw their wealth from their investments in the traditional companies. However, sustainable finance has come to limit and correct the excesses of capitalism, for its own sake as well. It strengthens the environmental and social axis as the economic dimension of sustainable development by fighting against all forms of social inequality and against environmental degradation. CSR was born in the aftermath of ecological and human catastrophes caused by the recklessness of multinationals. Impact investing adopts a long-term approach and emphasizes on human values when global finance has become short-term and dehumanized; the subprime crisis being a result of the speculation of investment funds and the unhealthy securitization of banks.
Finally, as Amit Bouri, Co-founder and CEO of the GIIN, recently said, “the old normal says growth comes first, and only once we’re growing, do we ask, ‘How can we be more inclusive?’ The next normal will demonstrate that inclusivity is the foundation upon which the most widespread economic growth can occur”. This should convince the remaining traditional investors to consider sustainable finance as the new standard and support the transition towards a more inclusive and sustainable world.
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Disclaimer: The information, analysis and opinions expressed in this article are for general and educational purposes only. Nothing contained herein is intended to constitute legal, tax, accounting, securities or investment advice, an opinion regarding the suitability of an investment, or a solicitation of any kind. Any opinion is my judgment as of the date hereof.