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Sustainable Finance: What Is It and Why Is It Important?

Article Overview

Sustainable financing is an umbrella term for any financial activity (loans, investments, and others) that take into account environmental, social, and corporate governance (ESG) factors.

The financial sector will play a considerable role in contributing toward a sustainable future, whether by investing in renewables that will speed up the transition to a low-carbon economy or by supporting companies that follow diversity, equity, and inclusion. Sustainable finance drives sustainability and mitigates climate risk for the global financial system, which relies on healthy ecosystem services for over half (55%) of GDP.  It also provides investors with increased transparency and accountability for companies they are investing in, especially those with a central focus on sustainable finance or who consider ESG factors in investment decisions.

The market momentum of sustainable investing - which could reach $41 trillion by the end of this year and become a third of all global assets under management - is shifting the global investment focus towards sustainable finance.

What is Sustainable Investing?

Sustainable investing is one of the main examples of sustainable finance. It includes any investment that provides both financial returns and the promotion of ESG factors. Sustainable investing ensures companies are not just prioritizing profit over everything, but considering how their operations affect the environment and society.

Sustainable investors use different strategies based on their ESG goals. For example, they can choose to invest in companies or funds that have a good impact on the environment or society or that are governed toward driving a positive impact. Investors can use negative screening, which excludes companies with poor ESG practices, or positive screening, which includes companies with a good ESG score. Sustainable investing is another umbrella term that encompasses many other investment types with a positive ESG outcome.

Examples of Sustainable Finance

Under the umbrella terms of sustainable finance and sustainable investing, there are many different types of sustainable finance. Some of these examples include:

  • Sustainable Foreign Direct Investment (SFDI) - SFDI is when an investment is made across borders, usually from a developed country to a developing nation, which has a sustainable goal. SFDI is seen as a way to meet the goals of the UN’s 2030 Sustainable Development Agenda.
  • Impact Investing - Impact investing aims to create a financial return as well as drive positive social or environmental impacts. Impact investors consider companies' ESG performance and corporate social responsibility credentials when making investment decisions.
  • Socially Responsible Investing (SRI) - SRI is selecting investments based on specific social or ethical criteria. SRI can involve avoiding investments that contribute to some sort of negative social outcomes, like arms manufacturing or tobacco, and seeking out companies that engage with social justice.
  • Green Finance - Green finance is any financial activity used for the environmental part of ESG. With a narrower scope than sustainability, green finance allows investors to focus solely on financing environmental issues, such as decarbonization and biodiversity loss. There are many examples of green finance, such as green bonds, green loans, and green mutual funds.  

These are just some of the many ways the financial sector can ensure their financial activity is sustainable and responsible.

UN Sustainable Development Goals and Sustainable Finance

The UN estimate that to meet the SDGs by 2030, the world would need to spend between $3-5 trillion per year. As referenced above SFDI contributes to fulfilling the UN’s 17 Sustainable Development Goals (SDG), however, SFDI is just one of many public and private financial levers the UN Development Programme describes, as a means of realizing the SDGs by 2030:

  • SDG Bonds: the SDG bonds market was created to attract private capital to invest in the SDGs. It aims to provide a market for mainstream SDG investments that are diversified enough to attract large financial institutions to invest.
  • SDG Impact: SDG Impact aims to help private investors direct their investments to where they can make the biggest impact on people and the planet. It achieves this through two core streams of work: the SDG Impact Standards and SDG Investor Maps.
  • Insurance & Risk Finance Facility (IRFF): IRFF supports the development of insurance products that enable the protection of communities and build resilience in support of the SDGs. The IRFF aims to build insurance markets in developing nations in collaboration with industry and government through five focus areas broken down into a set of interlinked workstreams.

As global financial markets increasingly align themselves with sustainable finance to meet sustainability goals, such as the UN’s SDGs and minimize sustainability risks, global regulators are beginning to create rules to ensure that sustainable financing is what it says it is, and that investors are making investments that align with their sustainability goals. Both the SEC and the EU are set to implement new regulations on sustainable finance - the rules aim to provide consistent, comparable, and reliable information to investors on financial activities labeled sustainable and prevent greenwashing.

What are the SEC’s Names Rule and ESG Fund Proposals?

In May 2022, the SEC created two proposal recommendations surrounding transparency and disclosure for sustainable finance criteria and the underlying data of ESG factors. These two fund proposal amendments aim to enhance and standardize disclosures related to ESG factors as well as expand the regulation of the naming of funds with an ESG focus.

The Names Rule Proposal, an amendment of the “Investment Company Names” Rule, seeks to curb greenwashing by investment funds. The proposals will require funds with a label that includes sustainable, ESG, green, and others to have at least 80% of their assets by the investment focus the fund’s name suggests.

The SEC’s ESG Fund proposed rule titled "Enhanced Disclosures by Certain Investment Advisers and Investment Companies About Environmental, Social, and Governance Investment Practices" aims to standardize the disclosure of metrics and underlying data related to ESG factors considered by funds. The proposal would require funds and advisers that claim to use ESG strategies to provide more information on how they incorporate ESG factors into decision-making.

(EU) Sustainable Finance Disclosure Regulation

The EU’s Sustainable Finance Disclosure Regulation (SFDR) was created to increase transparency and prevent greenwashing of investment products labeled sustainable. Adopted in March 2021, the SFDR requires comprehensive disclosure of sustainability information at both the financial institution and financial product levels.

The SFDR aims to allow investors to choose investments closest to what they want to achieve from their investing. It mandates the disclosure of sustainability information based on the level of consideration for sustainability a financial institution or product has. All companies must disclose sustainability information at the financial-entity level. From a product perspective, all products must disclose some level of sustainability risk information. “Green” products that promote ESG or have a sustainable investment objective must provide additional information. The SFDR is a key part of the EU’s wider Sustainable Finance Action Plan.

(EU) Sustainable Finance Action Plan

The EU’s Sustainable Finance Action Plan is a broad strategy developed by the EU, which aims to support sustainable investment across the EU’s 27 member states. As well as the SFDR, the plan includes the EU Taxonomy and EU Benchmarks.

The EU Taxonomy came into effect in July 2020. It serves as a classification system for environmentally sustainable financial activities. The Taxonomy is a list of clear definitions that would help investors, policymakers, and companies understand which economic activities are sustainable. The clarity in defining what financial activities can be considered sustainable reduces greenwashing and helps investors make better-informed decisions based on their sustainability goals.

The new EU Benchmarks ruling adopted in April 2020, amends the EU's Financial Benchmarking rule by introducing climate benchmarks and ESG disclosures for all benchmarks. The amendments recommend minimum standards and methodologies for climate-related and ESG benchmarks. For climate-related benchmarks, such as a Paris-aligned benchmark, they must demonstrate a reduction in GHG intensity compared with their parent indexes (S&P 500), be exposed to sectors relevant to climate change (oil and gas, transport, etc.), and demonstrate they can reduce their GHG emissions intensity year-over-year. From an ESG benchmark perspective, asset disclosure of ESG data is done on a case-by-case basis depending on the maturity of the ESG data of each asset.

The Role of Finance in the Transition to a Sustainable Economy

Sustainable finance will play a key role in switching the economy from one that exploits nature and society to one that is a restorative positive influence. The financial sector will play a pivotal part in diverting capital toward a sustainable future through investing, loaning, and insuring only in companies and projects that mitigate sustainability risks and capture opportunities.

The financial implications of an unsustainable economy have mobilized finances toward a transition to a low-carbon, sustainable economy. Financing the transition to a sustainable economy has financial benefits as well as environmental and societal ones, which is why growth in the global market for sustainable finance products has compounded over recent years.

As financial institutions attempt to ensure a just transition to a low-carbon economy, it will be important for them to first measure the impact of their financed emissions (the emissions from their financial products and services) which make up the vast majority of their carbon footprint. To find out more about financed emissions, download our free white paper. And to discover how Persefoni can help financial institutions reduce their financed emissions, reach out for a demo.

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