How to best fund a sustainable future

Environmental, social, and governance (ESG) criteria have become an important theme for companies and indeed societies in contributing to safeguarding the planet we live on.

Financial services cover all aspects of sustainability and address different needs, such as de-risking sustainability projects through insurance and providing capital in various forms to sustainability projects and companies focused on sustainable and ethical business models.

In this context, sustainable finance attempts to consider the full cost of resource utilisation – along with fair and ethical practices – in the mechanism of allocating capital to companies and projects. Today, there is a convergence between the need to anchor the economic growth of our global economy in long-term sustainable foundations and the increasing capabilities of the financial sector to allocate capital in this manner.

The list of commitments by the financial sector is impressive:

• The UN Principles for Responsible Banking now represent 40 per cent of the global banking system by assets and will mobilise $2.3 trillion of sustainable finance
• The Glasgow Financial Alliance for Net Zero covers more than 400 financial institutions and includes the Net-Zero Banking Alliance (43 per cent of global banking assets), the Net-Zero Asset Owner Alliance ($10 trillion of assets under management) and the Net-Zero Insurance Alliance (13 members)
• The UN Environmental Programme Finance Initiative includes 4,000 businesses committed to aligning their business models to net zero by 2050 and aligning with a target to lower global warming by 1.5 degrees Celsius.

A critically important function of financial services in the overall economic system is to ensure efficient allocation of capital to sustainable projects and companies through public and private capital markets. These markets are constituted on the one hand by capital pools (individuals and institutions) looking for ethical, sustainable investment opportunities, and on the other hand, by companies requiring long-term funding to transform their business and industrial models towards sustainability. Capital allocation, therefore, is based on the available information on risks and returns of companies and projects, considering all the cost and revenue items, hence, also those related to sustainability.

The key challenge for capital markets is that this transition has not been made before and therefore, this level of transparency does not yet exist. Hence, capital markets do not fully understand how to measure success or what the rule book for sustainable investing looks like. This challenge must be overcome so that capital markets discharge their function of allocating capital efficiently.

The good news is that capital markets are fast at learning about success factors through trial and error. For example, the automotive sector provides a view on how sustainability can take hold in public capital markets in a big way, with the valuations of Tesla and Rivian indicating substantial market expectations for value being created from sustainability. This value might be tied to electric vehicles and services tied
to them, as well as electric charging station networks, emission certificates trading, and many other businesses.

At this point, it is unclear whether this value will be delivered. It is important, however, to let the market iterate its valuation of projects and companies with their ability to deliver on the valuation and then to update the market valuation accordingly upwards or downwards. This helps markets develop success measures and playbooks on understanding successful sustainable businesses and channeling funding accordingly.

Many of the large pools of capital, such as insurance companies, pension funds, asset managers and banks have already embarked on this journey by defining their investment criteria in a way that excludes polluting industries such as coal or oil and gas from their capital allocation process. This is a fairly rough measure to begin with, but it will become more and more refined as investors learn about sustainability and
the way it impacts business models.

As the primary sources of capital embark on this journey, there will be no turning back, and companies and projects will increasingly need to understand and fulfill the emerging criteria for ESG in order to maintain access to funding for growth and development.

Andreas Buelow is a partner, Financial Services with Arthur D. Little Middle East