Private financial flows that are tracked against certain Environmental, Social and Governance (ESG) criteria reached record highs in 2020. But this boom may not be having a material impact, especially in low-income countries (LICs) which are most in need of it. Identifying and managing unknown financial risks can help re-balance the risk-reward ratio for sustainable investors.
Sustainability-linked investments have doubled in size since 2014, reaching $35 trillion in 2020. This growth has been driven by a growing number of ESG funds, which now account for over two thirds ($25.2 trillion) of the market. Growing at an annual rate of 25%, it is estimated that ESG-mandated assets could soon reach $34.5 trillion in the United States alone.
ESG investors screen risks in their portfolios and monitor performance on a range of (mostly self-selected) criteria linked to environmental, social or governance outcomes. Commonly used scores include the diversity of board members, estimated carbon emissions or health and safety incidents.
But most of these sustainable investments are aimed at developed markets. Doubts have also emerged about their real-world impact, especially in addressing the most pressing social and environmental issues in low- and low-middle income countries. The OECD estimates the Sustainable Development Goal (SDG) financing gap in these countries to have risen from $2.5 trillion to $4.2 trillion, meaning that we are massively off-target in achieving the goals of the 2030 Agenda.
How can we ensure that the ESG boom helps countries most in need?
The risk-reward ratio of sustainable investing
One of the central pillars of ESG integration is the idea that purpose and profit overlap: doing good makes financial sense because it increases returns and reduces risks, such as those associated with the escalating climate crisis. For example, an agricultural investment that screens the risk of water shortages, or workers protesting over poor labour conditions, is likely to perform better than those that do not.
It has been shown that investors with good ESG scores can therefore outperform firms with poor ratings, and are more stable during periods of extreme volatility. In the long-term, sustainability-linked investments may enjoy other benefits, such as productivity gains related to staff and skills retainment, protecting against regulatory risks or greater resilience to extreme weather events.
This has resulted in ESG performance standards rapidly becoming the mainstream, replacing divestment strategies. However, because ESG investors simply collect baskets of shares already traded in public markets, investing in an ESG fund does not necessarily provide additional capital to more sustainable companies or causes.
Without clear definitions of what it means to be sustainable, much of the ESG boom might also result in a surface-level, box-ticking compliance activity. This leads to greenwashing: the idea that existing financial products are labelled as green or sustainable, an issue that is compounded by poor data and confusion over which metrics to use, although efforts are underway to streamline them.
These issues do not favour sustainable investment in emerging markets, where the quality of data to monitor investments is even less advanced. Risks are often perceived as being higher, requiring longer lead-in times and costly due diligence processes.
Furthermore, most of the longer-term financial benefits of ESG are not relevant within the short timeline of investment strategies. Within a fixed period, attempting to reconcile purpose and profits will almost inevitably favour the latter, given financial institutions’ fiduciary duty to maximising shareholders’ profits.
Moving past the purpose and profit mantra
Two strategies have emerged that can help overcome this. The first is, simply, to focus on values rather than (financial) value. The approach is best represented by a fast-growing number of impact investors, who prioritise stakeholders over shareholders. The value of sustainability-themed funds has been growing fastest in relative terms, but $3.7 trillion (roughly 10% of the sustainable investing market) represents only a relatively small drop in the bucket – albeit one that will continue to grow as more young people support investments that align with their values.
The second is to capture and regulate the long-term systemic risks for investors, such as those posed by the imminent climate collapse or rising inequality. Although these risks affect whole economies and societies (and therefore financial markets), new rules and regulations are being introduced that can significantly tip the risk-reward ratio in favour of truly sustainable investment.
Governments’ rapid introduction of voluntary and mandatory disclosure requirements, following recommendations made by the Taskforce for Climate-related Financial Disclosures (TCFD), represents a first brave step in this direction. Additional requirements will follow the creation of the Taskforce on Nature-Related Financial Disclosures (TNFD) in 2021.
Although similar disclosure requirements could be introduced for financial investors in emerging markets, the approach has its downsides. Firstly, it may encourage further divestment since low-income countries face some of the greatest social and environmental risks. Recent research shows that 47% of agricultural investors in sub-Saharan Africa experienced some form of dispute with local communities. Second, even where those risks can be identified, disclosed and managed by investors, they often lack the means to do so. Investors may therefore have no other choice to divest from them to meet increasingly strict disclosure requirements.
Further action is needed to improve data infrastructure in low-income countries
Improving the quality of social and environmental risk data in low-income countries would not only help enforce disclosure requirements, but private investors to mitigate risks. Once identified, project-level ESG risks can be managed successfully. A recent analysis of 137 investments in emerging markets showed that the costs of managing material risks is just a quarter of the potential financial damage caused by them.
While public finance institutions offer a range of risk sharing products to offset this issue, such as public credit guarantees, research has shown that for every $1 of public money invested, just $0.37 of private finance in low-income countries was incentivised. This indicates that despite guarantees, ESG risks are still perceived as being too high.
However, enormous potential exists to improve the infrastructure for sustainable investors, especially in emerging markets. Mobile or voice-based data collection is being used to measure performance on social impact, as is geospatial data to track deforestation risks. The further development of public capital markets (i.e. stock exchanges) in emerging economies can also give potential investors a track-record of how existing assets and securities are performing, and help them assess risks and returns accordingly.
Further barriers exist, but there is potential to address them
The growing influence of impact investors and improved data infrastructure will help mobilise sustainable investment in emerging markets. However, other changes will be needed to facilitate that investment at the speed required to meet the 2030 Agenda.
First, most investments in emerging markets are simply too small for mainstream institutional investors to consider. Micro-, small- and medium-sized enterprises (MSMEs) form the backbone of most low- and low-middle income economies, but they are locked in a “financing trap”: without access to finance, they can’t grow. But they are not big enough to attract finance. Digital platforms similar to those used by Bangladesh’s Grameen Bank, and other forms of community development finance, may help to overcome these bankability constraints.
Second, if we want private investors to help tackle the systemic risk of climate change we need to go beyond project- or portfolio-level disclosure standards and towards the creation of natural capital asset classes. These include asset classes for carbon, biodiversity and ecosystem services. Pricing natural capital accordingly has significant potential for changing the existing behaviour of investors, especially in low-income countries: these contain some of the largest and most diverse ecosystems on earth.