“I believe we are on the edge of a fundamental reshaping of finance.” Stated the CEO of Blackrock, Larry Fink, in his annual letter to the company. This declaration has been embodied in the announcement that BlackRock would cut from its managed portfolio all the companies that derive more than a quarter of their revenue from coal. Furthermore, they will double the number of sustainability-focused exchange traded funds and increase sustainable assets to 1 trillion dollars within a decade.
The aforementioned reshaping of finance relates to the incorporation of sustainability parameters in the financial evaluation of companies. It implies the recognition of the interconnectedness of the three main pillars of sustainability: environmental, social and economic.
“Companies that don’t adapt [to climate change] will go bankrupt without question.” Concluded Mark Carney, governor of the Bank of England (BoE). History proved his point quite clearly in the past. Let’s take the Volkswagen diesel scandal of cheating emissions tests for which its share value fell by 30% in one year.
On the other side, companies actively focused on the environmental and social aspects of sustainability positively influence their financial sustainability as well. The Unilever case can represent a suitable event, since their shares have been increasing by 18% each year stock price, after winning the sustainability leadership award.
Once proved the strict connection between sustainability and financial performance, financial institutions started developing new methodologies to embed environmental and social parameters in their assessment of companies. There are several strategies to do that, but the two most commone ones are negative and positive screening. The first method is to perform a negative screening and deny investment to companies, sectors or activities that could imply risks on the environmental, social or governance (ESG) dimensions.
The second option relates to positive screening in which the focus of investment is on companies that have high ESG metrics or are focused on improving more specific themes across the three dimensions (for example in terms of emission reductions, clean tech, positive social impact, etc).
The European Investment Bank (EIB) is applying negative screening by choosing to support only projects that meet high environmental and social principles and standards. Consequently, corporations with high carbon emissions will not be able to access credit or will suffer from higher interest rates. On the other hand, it is also applying positive screening allowing corporations with high sustainability achievements to benefit from special funds such as the EIB €1 Trillion fund as part of the Green Deal Investment Plan. This made EIB the world’s first “Climate Bank” with the objective of driving the transition toward net-zero by 2050.
- Financial sustainability: One of the main reasons is that CSR activities and over compliance with regulations, can communicate relevant information over an enterprise to an uninformed investor, since they will be more incentivized to invest in companies that reinvest actual potential profit in long term activities aimed at more sustainable results in the future. Companies that can afford the expenditure in CSR activities, separate themselves from the ones that cannot, thus CSR investments can be seen as a signal for unobservable profitability and lead to better financing conditions. In the definition of sustainability the environmental, social and economic side are strictly interlinked in the so-called triple-bottom-line.
- Higher returns: Furthermore, research showed that the probability of higher quality of goods supply in higher in corporate responsible-oriented companies, due to the importance they stress on environmental protection, sustainable and healthy sources of materials, treatment of coworkers and so on, in this way CSR may serve as a mean of vertical differentiation in a market in which quality is difficult to evaluate. Researchers in ongoing the relationship between ESG and CSR performance and financial performance, but for now results have shown that sustainable investing appears to have a positive correlation with increased returns. It has been proved that consumers are willing to pay more for sustainable and ethical products. As a result of an increase in customers' perceived value, brand reputation and “goodwill” increase as well and constitute a valuable tool to capitalize on. People want to feel good about what they buy and where it comes from and their literacy increases substantially through the use of internet sources.
- Risk management: Lastly, firms are evaluated in terms of resilience to climate risks and how vulnerable they are if hit by the extreme consequences of climate change. Investors recognize the impact of ESG related risks on companies’ value and reputation. It has been proven that companies have seen their revenue decline after, for instance, worker safety incidents, waste or pollution spills, weather-related supply-chain disruptions, and other ESG-related incidents have come to light.
The screening process contributed to create a perception of risk around fossil-fuels related projects. “Investing in a company that doesn’t disclose its pollution is like investing in a company that doesn’t disclose its balance sheet.” declared Christopher Hohn, that established the prominent value-based investment called The Children's Investment Fund Management. Disclosure and transparency represent a strategic way to create trust among investors, consumers, employees, NGOs and the business ecosystem in general.
This can allow to overcome the gap of information between companies, consumers and also investors, reducing the asymmetry of information, theorized by Joseph Stiglitz in his Nobel Prize winning work, for a better and “healthier” functioning of the market. Stiglitz believes that every information gap between buyer and seller represents an imperfection of the market and inhibits market efficiency, because information is translated into market power. Even if consumers and investors can have access to a great quantity of information there is still a perceived asymmetry of information, clear example of which is the widespread phenomenon of Greenwashing: pointing out one “green” characteristic of a product to give a positive image of it, hiding other negative aspects in the dark, consumers became skeptical about companies and are leaded to perceive all of them as unethical to some extent.
In line with this, The Task Force on Climate-related Financial Disclosures (TCFD) released a recommendations report to provide a framework for companies to develop more effective climate-related financial disclosures and reporting techniques. The main focus of the report is around the importance of transparency in pricing risk—including risk related to climate change—to support informed, efficient capital allocation decisions. David Schwimmer, the head of the London Stock Exchange, declared to the Guardian that “Companies needed to conform with the TCFD rules before they were forced to by governments. Mandatory disclosure is the direction of travel.”
At the present moment, reforms to improve transparency and standardization of climate related data will help to incorporate climate risks into financial regulatory framework and ultimately align capital allocation decisions and loan pricing with climate policies and regulations (CDP, 2020).
In conclusion, corporates have realized that meeting sustainability goals is not about creating “marketing” campaigns any more: it truly drives the financial agenda of a company by affecting stock prices, interest rates and access to capital. Voluntary transparency on non-financial disclosure is key for that. If your C-level executive has not yet asked you about this topic, it’s the time to prepare before it’s too late. Laggards in sustainability will have hard times surviving in times of crisis.
Capitalism in the past has put in opposition the pursuit of the common good for society and the pursuit of profit, creating an antagonism between different companies’ objectives, that results in an unsolvable dilemma. Voluntary transparency could offer a new perspective to the market: good behavior pays back and becomes synonym of success. This conceptual reversal would reorient capitalism in virtue of public interest and a new arena of competition would emerge, in which ethics, innovation and initiative gain actual rewards.