Sustainability has become a significant theme for asset owners, asset managers and financial advisers in recent years. In broad terms, the sustainable finance movement stems from concern about climate change, but it also reflects the perception that an economic model needs to be developed that can provide social stability and economic opportunities while at the same time operating within the environmental limits of our planet. This article provides a brief overview of sustainable finance with a focus on its implications for the charitable and philanthropic sectors.
A recent EY survey (EY 2022 CEO Outlook Survey) of more than 2,000 CEOs across the globe indicated that more than half of respondents would prioritise investment in existing businesses, digital transformation and sustainability. The survey also reported that Environmental, Social and Governance (ESG) and sustainability concerns are becoming more important for dealmakers – an overwhelming 99 per cent of responding CEOs said that they factor these issues into their buying strategies. That said, more than a fifth of investors (21 per cent) were considered by survey respondents to be unwilling to support a long-term growth strategy and fixed on short-term earnings instead.
The sustainability arena is generally jargon-heavy. The range of descriptive terms risks causing confusion (and contributing to greenwashing). Few of the terms have a fixed legal meaning and many definitions vary depending on the entity which framed them (for example, the UN, the EU and the G20). Further information on certain key terms relevant to sustainable investing is set out below; where necessary for a particular term, for example ESG, I have drawn on core elements common to various definitions.
ESG means Environmental, Social and Governance and is an acronym which came into being in 2005. It refers to strategies and practices that incorporate material ESG factors in investment decisions. To that extent, ESG issues are factors which can be taken into account in connection with the making of investments, but they are not investments themselves. The range of issues covered by the term is wide. ‘Environmental’ covers climate change, resource depletion, waste, pollution and deforestation. ‘Social’ includes human rights, modern slavery, child labour, working conditions and employee relations. ‘Governance’ relates to issues such as executive pay, business conduct, the management of conflicts of interest, political lobbying, tax strategies, safeguarding, and board oversight and diversity. The UN (in its Principles of Responsible Investment) defines responsible investment as a strategy and practice to incorporate ESG factors in investment decisions and active ownership.
Ethical investment was the term which came into being in the 1980s when investors made ethical choices in the context of their investments by excluding certain asset classes (for example, tobacco, arms and pornography) in their investment decision-making. The aim was to avoid investing in activities that had a social cost. The issue of ethical investment has generated case law and commentary in the charitable sector, with the broad position being that when trustees seek to exclude certain assets, they must balance all relevant factors including the likelihood and seriousness of conflict with the charitable objects and the overall financial impact (to include reputational damage and loss of donors) of excluding the investments in question.[i]
Climate Finance does not have one recognised definition. In its High Level Definitions 2020, the International Capital Markets Association (ICMA) has proposed a definition encompassing financing that supports the transition to a climate resilient economy by enabling mitigation actions, especially the reduction of greenhouse gas emissions, and adaptation initiatives promoting the climate resilience of infrastructure as well as generally of social and economic assets.
Green Finance is defined by the G20’s Sustainable Finance Study Group as the ‘financing of investments that provide environmental benefits in the broader context of environmentally sustainable development’. ICMA considers Green Finance to be broader than Climate Finance in that it also addresses other environmental objectives such as natural resource conservation, biodiversity conservation, and pollution prevention and control.
Social Investment by charities is empowered by the Charities (Protection and Social Investment) Act 2016 where it is defined as an act of a charity carried out with a view to directly furthering the charity’s purposes and achieving a financial return. Broadly speaking, social investment will cover activities by charities which: (1) constitute an investment (for example, loans, share subscriptions, investment in bonds); and (2) further a charitable purpose. Social investment has been used by charities to make mission-aligned investments (for example, microfinance or loans to a community enterprise) which may not produce a market return and would be difficult to justify as a grant.
Impact investment or impact finance is focused on both the intention and consequences of an investment. It is defined by the Global Impact Investment Network as ‘investment made with the intention to generate positive, measurable social and environmental impact alongside a financial return’. Impact investment has been a feature of charity investing for many years, particularly following the introduction of the statutory power for charities to make social investments.
Social finance is an umbrella term covering financing which deals with particular social issues and/or aims to achieve specific social outcomes, for example in the areas of housing, healthcare and the creation of employment opportunities. Examples of social finance products include social impact bonds where return is based on achievement of particular performance benchmarks or outcomes (for example, improvements in health outcomes). Social investment and impact investment are forms of social finance.
Sustainable finance is most likely the term with the broadest remit. It is defined by the UN Environment Programme as ‘the financing of investments that provide environmental benefits in the broader context of environmentally sustainable development (green finance) as well as finance for education, social development, health and other aspects of sustainable development as defined by the 2030 agenda and the UN Sustainable Development Goals’. The International Capital Market Association considers sustainable finance to incorporate climate, green and social finance while also including wider considerations concerning the longer-term economic sustainability of the organisations that are being funded, as well as the role and stability of the overall financial system in which they operate.
There are a number of ways in which sustainability issues can be incorporated into existing investment practices, with ESG integration and screening being the most widely used strategies.
ESG Integration involves considering material ESG factors in investment analysis and investment decisions[ii]. It involves reviewing the activities carried out by the investee company or companies, collating data from various sources and scoring activities in accordance with certain metrics so as to enable a determination of material ESG issues in a company or sector. This area is complex and is one of the areas of sustainable finance which has generated most discussion and debate.
Screening involves applying filters based on certain criteria. Screening can be applied at the level of certain sectors, business activities, products, a particular company or particular jurisdictions.
Positive or best-in-class screening focuses on positive attributes of performance against certain key criteria, for example, minimum safety standards, employee relations and environmental impact. It does not exclude any particular sectors or industries but focuses on companies making the most effort to meet the ESG criteria which are relevant to the industry in question.
Negative screening involves removing certain asset classes or companies from a portfolio on the basis of the investor’s values or certain ESG criteria. Negative screening arguably most closely correlates with an ethical investment approach. However, arguments have been advanced that negative screening is less effective than other strategies as the practice of avoiding investment in companies means that those companies are discouraged from improving their business practices.
Norms-based screening involves screening investments against a set of business practices or standards based on national or international norms e.g. ILO, OECD or UNICEF. While screening can be helpful, there is always a risk in taking a partial view – for example, positive screening in some areas will not necessarily take account of poor practices in other areas.
Thematic screening involves seeking out investments that contribute to a particular social or environmental outcome, for example, in connection with energy, agriculture or water. Examples are green bonds or social impact bonds.
Stakeholder involvement generally consists (whether collaboratively as between shareholders or by individual shareholders) of engaging with company boards/management in connection with ESG issues, to include discussing ESG issues with companies and formally voting on or proposing shareholder resolutions on specific ESG issues. It is an area which is growing in importance and is being used by both asset managers and individual shareholders.
Many of the challenges currently faced by sustainable finance relate to issues with data and the measurement of data. These challenges may, in future, be resolved by technological developments.
Data sources for ESG metrics include websites, annual reports, public filings, survey responses and media reports. Data collection is hindered by incomplete and poor quality data, inconsistent reporting and limited transparency. While there are well established systems for measuring greenhouse gas emissions, it is much more difficult to measure diversity and human capital. For example, there is currently little reliable data on the ‘Social’ element of ESG and excessive reliance is placed on surveys of employees and social media reviews. The risk which arises from unreliable data is that the emphasis is on available data, rather than on what is most important. Data needs to be sufficiently accurate so as to predict business risk.
Future developments in the area of Big Data and the Internet of Things are likely to result in both more data and more reliable data. Remote sensing will likely allow enhanced measurement of environmental data, for example, pollution levels in rivers. Blockchain technology, in turn, may transform data in the context of complex international supply chains.
For charities and philanthropists, improvements in the measurement of data may mean that impact investment opportunities grow, on the basis that impact investment relies heavily on data to demonstrate and measure impact.
The range of ESG-related investments is likely to widen in the coming years and charities may find that new investment opportunities become available. Blended finance involves the use of catalytic capital from public or philanthropic sources to increase private sector investment in sustainable development. Where the overall aims of a blended finance project provide public benefit, there are arguments that philanthropic or charitable capital is an appropriate source of patient capital or first loss capital (i.e. the first to be called on if the investment fails). For charities to be able to participate in these opportunities, it is likely that there will need to be some regulatory clarity on this, particularly in relation to the area of private benefit. There are also likely to be more opportunities for charities to play a similar role in public private partnerships, for example around delivery of an infrastructure project.
New Standards and Shared Policy
It is likely that the coming years will provide a common language of policy and shared standards. The UK Government has stated that it will be implementing a green taxonomy (being a common framework for classifying the activities which can be defined as environmentally sustainable). Similarly, it is intended that Sustainability Disclosure Requirements will be implemented for companies, some financial institutions and pension schemes. Climate-related financial disclosures are required for certain large UK companies for financial years beginning on or after April 2022. However, more remains to be done in this space. It is also likely that there will be greater clarification, through case law and legislation, around fiduciary duties for trustees in connection with the ESG aspects of investments.
As sustainable finance is an emerging area, it will be important for participants in the charitable and philanthropic sectors to input into the development of policy in the wider arena of sustainable finance. This is partly because the charitable sector holds significant sums of assets under investment and it is important that developments in the investment space take proper account of the requirements of charity law and the needs and mission of charities. It is also important that charities are aware of areas which may need charity regulatory intervention so as to enable charities to participate in new developments.
[i] Butler-Sloss & Others v Charity Commission  EWHC 974
[ii] PRI definition www.unpri.org
Neasa is a charity and philanthropy lawyer with extensive experience advising grant makers, operational charities, public sector bodies, social enterprises, commercial clients and philanthropists on governance, regulatory and commercial issues. She provides tailored advice on governance and regulation, including on directors’ duties and liabilities, board policies, board remuneration, investment-related matters, and engagement with both stakeholders and regulators. She advises regularly in connection with sustainable finance (including impact investment and venture philanthropy). She also advises on not-for-profit mergers and project structuring, including on matters with a real estate and tax backdrop. She assists corporates and corporate foundations on charity law and practice, with particular focus on fundraising and sponsorship matters. Neasa has a particular interest in developments in technology, including FinTech and cryptocurrency, as applicable to the not-for-profit sector. She is recognised by the main legal directories and regularly writes and presents on developments affecting charities and not-for-profit organisations.