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Impact and community investments are initiatives that allocate resources to projects that are intended to have a positive impact on our infrastructure, our communities and society at large.
The purpose of finance is to allocate scarce resources to productive uses with the goal of benefiting society and its progress. In the process, finance is responsible for helping individuals and businesses reduce risk through diversification and insurance thus creating value, both tangible and intangible, in stable markets. Growing awareness of the global problems of anthropogenic climate change and poverty has raised questions regarding finance’s contributions to society’s welfare. The urgent need to reduce the risks of extreme weather, a changing climate, social unrest and violence, which threaten our lives and ecosystems, has motivated the search for a more responsible and holistic approach to financial analysis and practice.
In addition to the economic and financial dimensions, business professionals are increasingly expected to consider and incorporate environmental and social dimensions in their decision-making processes. In a finance context, this implies a need for internalizing externalities through awareness and valuation, regulation or taxation. Consistent with “corporate social responsibility” and the “triple bottom line,” finance professionals are analyzing environment, social and governance (ESG) factors and recognizing and assessing the value of our environmental and social capital in addition to our financial capital. This paper provides an overview of the broad shift to a more sustainable practice of the profession that appears to be occurring in all areas of the finance discipline: Asset valuation and capital budgeting, financing, investing, financial intermediation and insurance, as well as foreign direct investment.
Sustainable Asset Valuation and Capital Budgeting
Conventional net present value analysis focuses on forecasting initial cash outflows associated with installation or project set-up, and present values of future net cash flows associated with operations or project termination, calculated with rates of return required by investors. A more comprehensive measure, suggested by Andrea Liesen, Frank Figge and Tobias Hahn in a 2013 article in the journal Strategic Change, would be the Net Present Sustainable Value. This concept estimates the net present value added across financial, environmental and social dimensions using a required rate of return that considers not only investors’ opportunity cost for their financial capital, but also the opportunity costs of the environmental and social capital inputs. It is no longer uncommon for analysts to recognize incremental savings of water, energy and waste in capital budgeting processes. Beyond that, emerging methods of ecosystem valuation, estimates of the social cost of carbon, the social cost of atmospheric release, a living wage, and broader awareness of the connection between productivity and work-life balance are resulting in more comprehensive estimates of the incremental cash flows associated with individual projects. Value that previously had been considered “intangible” and arbitrarily set to zero is now receiving more attention. While the accuracy of any given estimate may well be debated, at least attempts are made to produce dollar estimates based on the best information that is available without simply ignoring variables that are “too difficult to measure.”
Awareness of ESG factors is an absolute necessity for the more comprehensive and more detailed analysis that is required by the increasing complexity of issues in all of our critical industries. In energy production, distribution and conservation, value comparisons need to be made between renewable sources of energy and various fossil fuels. New alternatives in distribution are emerging centered on a “smart grid” that is distributed (decentralized) and allows for two-way power flow. In food production and distribution, local and fair trade sources of food are increasingly preferred over alternatives, while the environmental and health benefits of organic production are receiving greater attention. In agriculture, research is ongoing regarding the costs and benefits of GMO versus non-GMO crops while, in farming, consumers seem to increasingly demand the humane treatment of animals. The commercial and residential real estate and related industries are focusing on the value of LEED certification in new construction and retrofits, while health care providers are asked to consider alternatives, whenever possible, that go well beyond pharmaceutical products and include healthy food, exercise and therapy. In the transportation of people and freight, a ranking of costs would prioritize rail/ship/barge over truck/bus and then plane. But, of course, the best possible solution would have to be identified on a case-by-case basis.
Beyond costs and benefits at an individual firm level, investors are also increasingly interested in assessing risks in global supply chains. This requires transparency and value creation at all stages of the production and distribution processes, and strong relationships with suppliers and vendors all over the world. Innovation in finance is accompanied by innovation in the collection, storage and interpretation of “big data,” which adds to the complexity but also raises the possibility of better solutions. In response to financial decisions that increasingly reflect value previously considered intangible and ignored, market prices and cash flows will change and further facilitate better decision-making in the future.
The issuance of socially- and environmentally-focused fixed-income securities has been growing in recent years. The instruments are termed sustainable bonds, socially responsible bonds, green or climate bonds and may be issued by municipalities, non-profits, public-private partnerships, or corporations. In 2013, $14 billion in green bonds were issued, and forecasts for 2015 range from $45 billion to $100 billion. Uses for the funds from socially- and environmentally-focused bonds include, for instance, affordable housing, community and economic development, renewable energy and climate change action, natural resource conservation and management.
In 2014, a group of financial institutions created voluntary process guidelines for issuing green bonds, the “Green Bond Principles.” Key recommendations stress the need for transparency and disclosure to ensure integrity to facilitate market transactions. Specifically, the guidelines address the use of proceeds, a process for project evaluation and selection, the management of proceeds, and reporting practices.
Sustainable investing is not new. It has previously been referred to as socially responsible investing (SRI). An article by Dale Wannen in the Winter 2015 issue of the Conscious Company Magazine describes three main areas of activity: ESG screening, shareholder activism, and impact or community investing.
Data bases that help identify high performance along ESG dimensions include, for example, Bloomberg, KLD, and Sustainalytics. Examples of environmental variables include greenhouse gas emissions, energy and water consumption, hazardous waste, number of chemical spills, climate change policy, biodiversity policy, green building and sustainable packaging. Examples of social variables include the percentage of employees that are minorities, accidents per 1000 employees and number of fatalities, employee training on corporate social responsibility, fair remuneration policy, and health safety policy. Examples of governance factors include financial ratios measuring profitability, financial leverage and asset utilization, as well as measures of the effectiveness of the Board of Directors. Companies that disclose and measure their ESG performance and perform at the top of the range, not surprisingly, turn out to provide financial returns that are at least as good as the performance of companies in control groups of samples examined by academic researchers. In other words, firms that manage their financial resources in a responsible and productive manner will do the same with their non-financial resources. Also, these firms are most likely to be more resilient during financial crises and recessions.
Shareholders are taking a more active role in holding directors accountable as reported by an article in the Wall Street Journal on shareholder activism by Vanguard and BlackRock on March 4, 2015. Shareholder resolutions have also led companies to integrate more sustainable practices into their business operations. Examples are the recycling program started by Best Buy, the use of cage-free eggs at Denny’s restaurants, and Dunkin’ Donuts’ decision to stop using a whitening agent in some of their sugars – all in response to shareholder proposals.
Impact and community investments are initiatives that allocate resources to projects that are intended to have a positive impact on our infrastructure, our communities and society at large. Examples are investments in the education sector, agriculture, clean transportation, clean energy and ecological stewardship. Investment vehicles come in a wide variety of forms from all over the world and include equity, debt, lines of credit, or loan guarantees. Institutional investors often wish to align their missions with their investments, while individual investors select investments consistent with their personal values. An overriding goal may be to exclude greedy, destructive and criminal market participants from access to funding, which would help public law enforcement and the judicial system accomplish their objectives and make the world a better place.
Great improvements have been made in recent years, and promise to continue, in the area of transparency and disclosure. The CDP (formerly, Carbon Disclosure Project) has operationalized reporting and performance evaluation for action on climate change risk, water, forests, and supply chain management. The Sustainability Accounting Standards Board is currently in the process of defining reporting standards for each individual industry sector. Firms’ efforts in this area are currently voluntary but may become mandatory at some point. For the companies that have participated on a voluntary basis, initial research suggests that valuation effects have been positive. This holds great potential for improving valuations for participating firms in the future.
Sustainable Financial Intermediation and Insurance
A stable financial system and stable financial markets are prerequisites for a sustainable economy and society. The financial crisis of 2007-2009 raised concerns about risks to the stability of the domestic and global financial system emanating from financial institutions, both inside and outside the regulated commercial banking industry, that are “too big to fail.” Congress and regulators have responded with the Dodd-Frank Act of 2010, the creation of the Financial Stability Oversight Council chaired by the Secretary of the Treasury, and proposals for significantly higher capital requirements. The overall objective is to improve the quality of financial institution assets. While this may reduce the ability of financial firms to increase growth and profits in the short-term, the benefit would be greater resilience during shocks to the financial system and, therefore, greater financial and economic growth in the long term.
Financial intermediaries like banks and credit unions have access to the private information of their clients and are in the best possible position to allocate resources to sustainable businesses by identifying, monitoring and helping to grow responsible borrowers. The chairperson of the Federal Reserve, Janet Yellen, has publicly acknowledged a concern with Wall Street’s culture and ethics that raises questions regarding this sector’s ability to live up to expectations. From a safety-and-soundness point of view, questionable financial valuations pose risks of market crashes and economic instability, not just for the firms involved, but for the economy and society at large.
Insurances companies, in particular, could be exposed to the threat of fossil fuel and related assets becoming “stranded” or unusable, if regulations were to change in response to climate change, as recently pointed out by the Bank of England. The property-casualty industry is preparing for these risks with the Actuaries Climate Index Research Project that was recently introduced to the Saint Joseph’s University community by Mike Angelina, Director of the Academy of Risk Management and Insurance. The actuaries are planning to provide an internet-based index to provide information on climate risks and serve as a monitoring tool for all affected parties as well as the public.
Sustainable Foreign Direct Investment
In the area of international finance, sustainability becomes very important when firms consider investments in developing countries. Projects need to be profitable enough to allow firms to continue operations while simultaneously producing net benefits for the host countries’ long-term development goals. A recent guidance paper on evaluating sustainable foreign direct investment by John Kline of Georgetown University suggests that sustainable projects will meet goals that span economic, environmental, social and governance categories. Examples of goals in the economic category are capital and technology transfers, employment, taxes, infrastructure and exports. Goals in the environmental category may include pollution controls, water usage, carbon footprint, and waste reduction. Examples of social goals are labor rights, skills enhancement, public health and non-discrimination. And in the governance area, sustainability would require external transparency, local management, supply chain standards and stakeholder dialogue. Firms that endorse international standards, such as the Global Reporting Initiative, the UN Global Compact, or Principles for Responsible Investment, tend to have priority during a search for a good company – host country match.
Value that is created, both tangible and intangible, is ultimately shaped by the awareness, the quality of the information, the skill and the judgment the analyst or decision-maker brings to the table. Managers must disclose relevant financial and non-financial information and act responsibly by taking into account the consequences of their actions. Investors, consumers, suppliers and potential employees must seek and value responsible companies. Last but not least, we need the legal and regulatory framework able to support responsible firms and markets. The journey to sustainability may be long, but many are already on the way.