Sustainable finance refers to an approach to investing that focuses on sustainable and socially responsible activities, projects, and companies. It encompasses several different sets of principles, most notably ESG, socially responsible investing, and impact investing – all designed to create a more sustainable future.
Below, we cover the definition of sustainable finance, official supervisory bodies, common product types, and key numbers that demonstrate what sustainable finance looks like and what real-life effects it has.
The most common way to measure the sustainability of an investment is ESG, or according to environmental, social, and governance principles.
Annual global investment in clean energy will have to double to $4.5 trillion in the next decade.
Regulations are rising and becoming more stringent, and ESG jobs will have to increase to meet the demand.
European sustainable funds make up two-thirds of the world’s total and are the most resilient, remaining attractive in 2023 even when conventional funds saw outflows.
The US market saw a significant decrease, partly due to states creating 156 anti-ESG bills.
The global ESG funds landscape saw a drop of 0.1%, compared to the 0.05% drop for conventional funds.
Sustainable Finance: What Is It and Why Is It Important?
Sustainable finance pays attention to the environmental, social, and governance standards of the organizations it’s investing in. This is the ESG framework for analyzing investments and it’s also the most widely used sustainable finance framework globally.
Below, we will look more closely into each set of standards and expectations – also known as the three pillars of ESG.
1. Environmental
Environmental principles in sustainable finance focus on incorporating ecological considerations into investment decisions and business practices.
Climate Change Mitigation
Biodiversity Conservation
Resource Efficiency
Preventing Pollution
Thorough Environmental Impact Assessment Process
Sustainable Supply Chains
Renewable Energy Transition
Green Building and Infrastructure
2. Social
Social principles in sustainable finance revolve around incorporating considerations for social impact, human rights, and community well-being into financial decisions and business practices.
Social Equality, Diversity, Inclusion
Labor Standards, Human Rights, Employee well-being
Local Community Engagement
Improving Access to Education and Healthcare
Affordable Housing and Livable Wages
Ethical and Transparent Customer Relations and Data Privacy
Community Development and Philanthropy
Responsible Sourcing and Supply Chain Practices
Crisis Response and Resilience
3. Governance
Governance standards focus on corporate practices regarding management, designing company policies, transparency, reporting, and compliance with laws and regulations. Here are key aspects of governance principles in sustainable finance:
Board Independence and Diversity
Executive Compensation and Performance Metrics
Ethical Business Practices
Shareholder Rights and Engagement
Risk Management and Disclosure
Anti-Corruption Measures
Data Privacy and Cybersecurity
Stakeholder Engagement
Environmental and Social Responsibility Oversight
Compliance with Regulations
What Does ESG Mean in Practice?
In practice, companies and investors consider ESG factors to assess the long-term sustainability and ethical impact of an investment or business.
They incorporate international agreements, standards and regulations into their strategies, with the most important being the Paris Agreement, focusing on mitigating climate change and keeping the global temperature increase under 1.5 degrees.
However, the standards that companies and investors follow also vary by geography. For example, the European regulation on ESG reporting, SFDR, is a major standard that products and businesses need to follow to be considered sustainable, created to improve the practice and prevent greenwashing. According to the SFDR, market participants are responsible to research and disclose their practices. Otherwise, they are liable in court.
ESG businesses take a proactive approach to preventing negative environmental and social impacts. However, in practice, this also means preparing for increasingly stringent legislatures on international and national levels regarding ethical business practices.
Two of the most important documents for businesses that aim to improve their practices, which are also the foundation for the legislature, are the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises on Responsible Business Conduct.
Some companies measure ESG KPIs to provide ratings and rankings of organizations based on the three pillars of ESG. For example, MSCI is one of the top organizations measuring ESG ratings, and it places businesses into three main categories depending on the score:
SCORE | CATEGORY | DESCRIPTION |
|---|---|---|
CCC | LAGGARD | A company with high exposure and failure to manage major ESG risks |
B | ||
BB | AVERAGE | A company with a mixed or unexceptional track record of managing the major ESG risks |
BBB | ||
A | ||
AA | LEADER | A company that’s a leader in managing major ESG risks and opportunities |
AAA |
While ESG rankings have been the cause of controversies regarding greenwashing, the quality of reporting, and criticism on real-world impact, they are a step in the right direction, at least in regions where governments step in and enforce regulations and standards.
For example, in the EU, the number of litigations against banks for negative environmental and carbon impact has grown twelve times between 2020 and 2023.
Why Is Sustainable Finance Relevant?
Sustainable finance is moving from niche investing products to a more mainstream approach as stakeholders — out of necessity — increasingly demand companies to change and improve their business practices.
And the necessity is there, as the International Energy Agency shows that organizations aligning with Paris Agreement goals have to invest 50% of their capital expenditures into clean energy projects by 2030, in addition to reducing their own carbon emissions.
On the other hand, the risks of not following ESG standards are significant for companies, too. As we move to a low-carbon economy, with increasingly strict regulations on carbon emissions, companies that do not improve will face fines, higher costs of production, and reputation issues, which often directly impact investments.
ESG statistics show over 90% of executives expected to increase their spending on ESG data in 2023 to maintain a competitive edge, but also for compliance purposes. As we’ve mentioned, the banks that are facing litigations for greenwashing are losing reputation, facing fines, and experiencing reduced consumer trust. Other risks for companies involve extreme climate events that create issues in all business aspects.
Other approaches to sustainable finance
Sustainable finance has two other forms, which often overlap with ESG:
Socially Responsible Investing (SRI): SRI focuses more on the individual investor’s values when choosing investments. For example, along with principles such as ESG, it could include investments such as gambling, adult entertainment, weapons, and alcohol.
Impact Investing: Impact investing focuses on impact and intent, and less on ROI when choosing investments. Unlike ESG which is more focused on complying with a set of rules, impact investing aims to provide funding to projects working on clean energy, healthcare, education, equality, and more.
Official Bodies in Sustainable Finance
Sustainable finance is supervised by a significant number of international and national bodies. There is an increasing number of regulations to prevent greenwashing which has been rampant as the trend caught on, causing damage to the entire industry and massive divestments, especially in the UK.
Luckily, governments and international organizations are improving their supervisory role, as investing in sustainable products and companies is still a necessary tool. Some of the official bodies that regulate sustainable finance include:
UNFCCC
UNEP
G20
International Financial Reporting Standards Foundation
Global Impact Investing Network
Global Reporting Initiative
Climate Bond Standard and Certification
Sustainability Accounting Standards Board (SASB)
National financial regulatory bodies such as the Financial Conduct Authority, SEC, Canadian Securities Administrators, China Securities Regulatory Commission, Japan FSA, and others.
What Are Sustainable Finance Product Types?
Sustainable product types include sustainable debt and sustainable investments:
Green stocks: Stocks in companies dealing with renewable energy, energy efficiency, pollution mitigation, and other environmental issues.
Green bonds: Bonds issued by private or public organizations to improve or reduce their negative environmental impact.
Social bonds: Bonds focusing on social issues.
Sustainability-linked bonds: Bonds dependent on the sustainable behaviour of the borrower.
Green loans: Financing products for green projects.
Sustainability-linked loans: Loans to businesses with interest rates based on pre-agreed sustainability-linked goals.
Ethical investment funds: Investment funds avoiding industries such as fossil fuels or military, and/or including companies that have positive impacts.
ESG ETFs: Ethical exchange-traded funds contain various stocks, bonds, or commodities with a focus on ESG or ethical concerns.
Investment savings accounts: Ethical stocks and shares ISAs invest your savings into ethical financial products.
Sustainable Finance Jobs Are on the Rise
Sustainable finance jobs and jobs connected to sustainable investing, such as ESG officers in companies, are becoming more important, as only 12.3% of workers in all industries have sustainability-related skills. This is even more true in the finance sector, where it refers to only 6.8% of workers.
The lack of ESG finance experts is visible in the paycheck difference: in the US, for ESG finance experts, the pay is approximately 20% higher than for other employees. According to the Revelio Labs Report, average ESG salaries in April 2023 were $110,348, while the average salary for non-ESG finance employees amounted to $90,283.
At the same time, in the UK, 40.8% of the UK’s LPs and GPs agree that their organisation will increase its ESG reporting efforts, while 16% strongly agree. This points to a growing demand for ESG specialists. The need for better ESG reporting is also evident in other countries and regions, according to the PwC global report.
Key Facts & Figures on Sustainable Finance
Sustainable finance, including green and sustainability-linked financial products, whether they are investments or debt products, is a way for the finance industry to align with global efforts to mitigate climate change and other social and environmental risks.
Annual global investment in clean energy will need to double in the next decade.
Global and listed-company greenhouse gas emissions are still rising.
One-half of the world’s professional investors plan to increase their socially responsible investments.
In 2023, there was a $13 billion outflow from ESG funds.
By contrast, EU ESG funds performed better than conventional funds.
By share of total assets, European funds hold 84% of all sustainable assets.
Reaching the 1.5°C target will require annual global investment in clean energy to double to $4.5 trillion in the next decade.
The efforts to reduce carbon emissions in the energy sector will require a significant effort not just from governments, but also from investors and capital markets participants in general, according to the IEA. So regardless of short-term ROI which is the focus for several investors, the need for reducing carbon emissions remains a critical global goal in the medium- to long-term.
Listed companies will spend their emissions budget by April 2026.
Despite goals, a significant share of listed companies will decarbonise more slowly between 2022 and 2030 than in the five years after the Paris Agreement. The report shows that only 22% of listed companies align with the 1.5°C goal, while only 19% have goals that align with scientific targets. At the current rate, listed companies will warm the planet by 2.5°C within this century.
(MSCI)
Global and listed-company greenhouse gas emissions are still rising.
In 2023, listed companies were projected to emit 11% more greenhouse gasses compared to 2022. 55% of companies align with the 2°C target. However, all of the projected company targets are viable only if the companies act immediately. This is why sustainable finance, as a form of pressure from shareholders, can be an additional way of holding companies responsible.
(MSCI)
In 2023, there was a $13 billion outflow from US ESG funds.
According to the research company Morningstar, 2023 marked the first time ESG funds experienced outflows, mainly due to political backlash in the US which saw 165 anti-ESG bills, but also greenwashing and performance concerns, as well as BlackRock selling one of its ESG ETFs.
European sustainable funds had a $76 billion inflow, while conventional funds saw an outflow of $50 billion.
European ESG funds performed well thanks to passive funds, which saw a $21.3 billion inflow, while active funds lost $18 billion in the last quarter of 2023. Overall, passive ESG funds showed more resilience last year.
By fund count, 73% of all sustainable funds are based in Europe.
The vast majority of ESG funds are Europe-based, given that Europe is the home of many large companies but also a market encouraging ESG investing, unlike the US market which has been experiencing a major anti-ESG movement. North America only has 9% of sustainable funds, Asia without Japan has 8%, Australia and New Zealand account for 4%, and the remaining 4% and 3% are Japan and Canada, respectively.
Total sustainable assets globally amounted to $2,967 billion in 2023.
By share of total assets, European funds hold 84% of all sustainable assets. This amounts to $2,492 billion in 2023. Again, the US lags behind with only 11% or $324 billion, while the rest of the world holds the remaining 5% of sustainable assets.
Globally, sustainable funds mirrored conventional funds and also saw redemptions.
A redemption of $2.5 billion in Q4 2023 was the first time ESG funds experienced a net negative. It also experienced a stronger decrease compared to conventional funds amid the global crisis which typically pulls investors closer to more traditional investment opportunities. The growth rate of both sustainable and conventional funds was negative in 2023. However, the drop is more pronounced for sustainable funds at -0.1%, as opposed to -0.05% for the wider fund landscape.
One-half of the world’s professional investors plan to increase their socially responsible investments.
In 2023, 50% of investors said they would increase ESG investments in their portfolios, while 34% said the proportion would remain the same. However, 9% said they would decrease their ESG allocation. The survey included portfolio managers from Europe, the US, and Greater China.
(Statista)
60% of banks have pledged to become net zero.
However, there was a rise in greenwashing litigations in 2023. The increase in litigations was twelvefold, showing a rising skepticism over the banking sector’s climate efforts. The UK and the EU banks saw the largest rise in litigations, especially due to more stringent regulations compared to the rest of the world.
Due to increased regulation, the share of assets defined as ‘sustainable’ has been dropping by around 5% annually.
To fight greenwashing, international and national regulatory bodies improved their grasp of financial institutions and their products. For example, the FCA looked more closely into sustainability-linked loans, while the SEC did the same in the US, enforcing new disclosure and labelling regulations.
(GSI)
Wrapping Up
Sustainable finance represents a pivotal shift towards integrating economic growth with sustainable development, ensuring that financial investments not only yield returns but also contribute positively to society and the environment.
By emphasizing the principles of ESG, socially responsible investing, and impact investing, it underscores the necessity of supporting renewable energy projects, ethical business practices, and social equity. This approach not only aligns with the urgent need for climate change mitigation but also fosters a resilient, inclusive economy that benefits all stakeholders.
As regulations tighten and the demand for sustainable investment options grows, the financial sector is positioned to play a crucial role in driving the transition to a more sustainable and prosperous future for all.
