Sustainable finance has been a buzzword for many years. However, there are now good reasons to believe that investors are finally putting sufficient resources into environmentally and socially conscious projects for the sustainability sector to really take off. These changes are being facilitated by the rise of Environmental Social Governance (ESG) investing standards that help funds to identify the companies making a positive difference in key sustainability areas.
In this article, I’m going to take a close look at the history of sustainable investing and examine the key sustainable investment trends driving the remarkable development of important markets and technologies.
The sustainable investment backstory
Before diving into today’s leading sustainable investment trends, I want to offer some context by taking a quick look at the history of sustainable investing. Modern sustainability movements can be traced back to the 1800s when the environmental and social impacts of various industries were recognized by enlightenment political economists.
Following the fund management industry’s growth during the 1960s, responsible investment became more formalized. Activists realized that shareholders wielded major influence over corporate behavior and put pressure on funds to stop investing in damaging businesses. In the last decades of the 20th century, this led to impactful campaigns including drives to limit investment in apartheid South Africa and encourage responses to major environmental disasters like the Exxon Valdez oil spill.
In 2006, the United Nations set out the Principles for Responsible Investment (PRI) framework which contains six principles for investors. The 2008 financial crisis led to renewed attention on sustainable financial stewardship causing interest in PRI to grow. As of 2018, $60 trillion of assets were actively managed according to using PRI responsible investing strategies.
Sustainable ETFs and green bonds go mainstream
One area where the PRI guidelines are already having a major impact is the booming market for ESG Exchange-Traded Funds (ETF) which is creating massive funding opportunities for sustainability sector businesses.
The global ETF market is worth about $6 trillion and, according to the 2020 ETF Investor Survey released by Brown Brothers Harriman, almost three-quarters of investors around the world plan to put more of their resources to ESG ETF allocations this year. At the same time, green bonds (fixed-income instruments that raise money for environmental and climate change projects) are growing in popularity. In 2019, a record number of such bonds were issued, raising approximately $185 billion for sustainable projects.
Moving from SRI to ESG
The second major sustainable investment trend I’m going to discuss is the replacement of Socially Responsible Investing (SRI) initiatives with ESG investment schemes.
The ESG investment movement grew out of earlier sustainable investment philosophies like SRI which are, for the most part, exclusionary filters that block businesses from an investment if they don’t meet certain criteria. The key innovation of ESG is that ESG investors look for the positive impacts an investment can create instead of focusing on screening. Global ESG reporting is supported by several institutions such as the Global Reporting Initiative (GRI) and the Sustainable Accounting Standards Board (SASB).
Integrating ESG criteria into investments means considering a series of emission, environmental, social, safety, employee, and governance risks when performing financial analysis and using these to better calculate the economic value of an investment. SRI, on the other hand, is about building specific ethical conditions into a portfolio. In short, ESG investing is about financial performance while SRI is about values.
Overall, ESG ETF funds can outperform SRI funds financially thanks to lower expense ratios: they require fewer costly screening operations and don’t exclude as many business types. As such, growing interest in ESG funds is enabling the expansion of the sustainability sector by making it easier for sustainability investors to accrue assets and capital.
Alternative investment vehicles are becoming popular
Most sustainable investments are made through traditional investment vehicles like stocks, bonds, ETFs, and other prepackaged financial products designed to achieve a high rate of return. However, a recent uptick in sustainable investments made through alternative vehicles has occurred. But what is an alternative investment vehicle? In short, this term covers any non-standard investment such as physical commodities, private equity, hedge funds, and real estate investment trusts.
The 2018 report of the Forum for Sustainable and Responsible Investment (USSIF) was able to identify $588 billion worth of ESG assets under the management of 780 alternative investment vehicles. That’s a nearly 89% increase over the number of alternative funds identified in the foundation’s 2016 report and an almost 200% increase in asset values.
It’s worth noting that the popularity of certain alternative vehicles is growing faster than others. That same USSIF report found that the number of hedge fund vehicles holding ESG assets under management tripled between 2016 to 2018. Meanwhile, the value of ESG assets under management held in the form of venture capital and private equity doubled.
Community investment funds are having more of an impact
Community investment funds are an important type of alternative ESG investment vehicle worth exploring further. These asset management funds transfer capital to local communities from private and public institutions. Like other alternative sustainability investment markets, the community investing sector has expanded rapidly over the last few years, with invested assets doubling between 2014 and 2016.
Done correctly, community investing can help otherwise underserved communities to access credit, skills training, and services otherwise unavailable to residents. Food, child care, housing, and transport businesses are often the focus of community investors. Environmentally-friendly community development projects are becoming increasingly popular as are economic development packages that bring in high-quality jobs and improve infrastructure.
Community investing is clearly in line with many of the UN’s 17 Sustainable Development Goals (SDGs) as this practice can address poverty, healthcare, and other equality issues. Another major draw for investors is the diversity of asset types available with community investing. Fixed income, cash, and private equity real estate community assets are all commonplace, enabling investors to connect with different types of projects. Community Development Financial Institutions (CDFIs) provide affordable loans for disadvantaged communities and often act as go-betweens for community investors wishing to work with cash assets.
Environmental issues are coming first
The UN SDGs cover a full spectrum of different sustainability issues. However, given the scale of the climate crisis and the need for new environmentally-friendly energy generation and transport technologies, environmental impacts are the first thing on fund managers’ minds when it comes to sustainable investing. In 2018, out of 750 alternative fund managers surveyed, 748 said that environmental criteria were a top consideration.
Many green investing opportunities are available for investors focused on environmental impact investing. For example, renewable energy generation businesses, water management, pollution controls, and waste reduction are all rapidly expanding sectors. A report prepared for the UN Environment Programme estimated that $2.6 trillion was invested in renewable energy generation between 2010 and 2019.
Investors exploring new data sources to make smarter bets
According to projections from financer MSCI, the economic benefits associated with climate change solutions could reach $26 trillion by 2030 if investments in renewable energy double. To make this happen, MSCI believes investors need to start looking for new data sources to discover high-value stocks in the sustainability space. While we know that sustainability is more than climate change, this shows that as we learn to address data sources for climate change, we will gradually need to address the other UN SDGs with new data sources too.
Traditionally, investors have sought value in small scale startups that could experience explosive growth. However, MSCI’s research shows that large companies with large research and development budgets are actually leading the way when it comes to filing patents for green technologies. Even though these companies may have environmentally neutral or damaging business practices in the short term, in a decade or two from now these patents may revolutionize green energy.
Alternative data sources like the numbers of patents applied for by a business can, therefore, help green energy investors to make smarter bets. There’s also evidence to suggest venture capitalists are changing their investment techniques when it comes to clean energy technologies: Data from the Council on Foreign Relations shows that venture capitalists reduced their average funding size in these types of ventures from 2008 to 2017. Spending less to explore an emerging business model allows more start-ups to be funded and increases the overall chance of finding a successful investment.
The Active Ownership 2.0 standard is gaining importance
Investopedia’s 2020 report on the state of sustainable investing identified four keys for best practice if sustainable fund managers want to speed up the implementation of ESG principles. Complying with industry codes, improving ESG metric reporting, and guarding against greenwashing were all identified as important steps for investors.
The last enabler frequently mentioned by survey participants was the UN’s Active Ownership 2.0 scheme. This is essentially a proposed evolution of the PRI program, one that would hold members to tougher commitments that address systemic issues. Currently, the Active Ownership 2.0 standard remains in a development phase but there are hopes it will help sustainable funds coordinate impact investing more closely once it has been released.
Final thoughts: Where should sustainable investors look next?
If the UN’s SDGs are to be achieved, there’s no question that investors have a key role to play. As you’ve seen, changing investment patterns, new ESG standards, and harnessing new data sources are all key trends driving growth in the sustainability space.
We would love to hear more about what you think of these sustainability investment patterns.
How do you think the sector will look in five years time from now?