The term “Sustainability’ has become a loaded one. So, what is meant when we talk about a business transitioning to become more sustainable? In this context we are talking about Sustainable Development as defined by the World Commission on Environment and Development’s back in 1987, the famous Brundtland Report or ´Our Common Future`. It defines Sustainable Development as ‘development that meets the needs of the present without compromising the ability of future generations to meet their own needs’. In essence, companies need to ensure that their business undertakings do not harm the prospects of future generations, in the pursuits of short-term profits. However, this certainly does not mean then that short term growth and profits cannot be achieved, rather the emphasis is on how it is achieved. A business has a fiduciary duty to its shareholders to do everything within its ability to be profitable. However, it is no longer acceptable for this to occur at the expense of future generations. Furthermore, detrimental actions taken today by said business could well impact its own profit seeking ability in the future. This approach is sometimes referred to as the triple bottom line or the “three Ps”: people, the planet, and profit. Essentially a business should endeavour to succeed financially and be socially responsible by additionally measuring success through its impact on people (employees, customers, and the rest of society) as well as the environment.
To understand why it is imperative for businesses to start taking their social and environmental actions seriously, we can look at the future of the lending market and understand the changes that are anticipated to occur with regards to business lending. Bank lending has significant importance for businesses, as it is the most common source of external finance. For example, in UK in 2013 money loaned to British businesses was 3 times larger than that raise through bond issuances and ten times larger than that of public equities. Furthermore, we know that Banks refrain from lending to businesses that are considered overly exposed to various risks such as regulatory risks. For example, in the case of regulatory risks if policies are likely to suddenly change, that would dramatically affect the business and therefore their ability to repay their debt. Currently due to climate change and social pressure, policy makers have finally begun changing policies to take a systematic approach to enable the redistribution of financial investment toward companies who perform better socially and environmentally. The expectation then is that finance will flow more easily to those companies who can effectively show their social and environmental impacts as these metrics will be critical in showing regulatory compliance and risk aversion. There is an investment process that identifies companies with high Environmental, Social and Governance (ESG) scores and invests on this basis. As result, ESG Investing is becoming a major trend in the financial industry and a key research topic in recent years. There is a consensus amongst academic literature that strong ESG performing businesses can yield at minimum market equivalent economic returns and this understanding is now making its way into investment practices.
Financiers have improved their competencies and understanding of these regulatory requirements and will continue to develop new methods of redistributing funds, through mechanisms such as ESG investing. For example, the market is starting to see a clear rise in instruments that support the early stage investment into low carbon innovations and divest from high carbon assists. The future value of assets is now being considered with potential impacts of climate change, as a result there is significant risk that a carbon asset bubble has formed through the historical investment practices which extensively financed carbon intensive undertakings. It is now understood that many of these investments are expected to lose significant value in the medium term, with high carbon assets facing increasing divestment as previous investments which failed to consider the true future asset values are retrospectively reconsidered. An outcome of this new demand has led to the development of methodologies that calculate Climate Value Assets at Risk (C-VaR), which have since gained increasing traction in order to quantify the risks and the real future value of these assets. An example of where this is useful, consider a multibillion Dollar investment financing a new luxury island resort may no longer be consider feasible if it’s expected to be underwater in 20 years due to rising sea levels. Alternatively financing a new off shore oil rig would no longer be worth considering if the decreasing demand for oil in the next decade is taken fully into consideration. Financial considerations such as C-VaR is also becoming incorporated in regulatory requirement for large enterprises to report of the Climate related financial undertakings such as the Task Force on Climate-Related Financial Disclosures (TCFD) reporting requirements.
As ESG metrics such as climate risks become more appropriately included into lending risk profiles, banks will offer more competitive products to clients who show higher environmental and social performance as well as risk adverse practices. It becomes clear then that for a business to attract investment or qualify for competitive lending products, they need to start displaying active social and environmentally conscious efforts.
