Sustainable finance, which aims to invest in a way that is aligned with environmental and social objectives, needs to find a second wind.
Recent geopolitical developments, the economic issues arising from them and increasing criticism of ESG (environmental, social and governance) criteria are forcing the finance industry and regulators to be pragmatic. At a time when social and environmental challenges are becoming tougher, the more dogmatic approach to ESG is now less influential and it is time to focus on economic effectiveness rather than ideology.
Initially, sustainable investing consisted of making ESG criteria an central pillar of the asset selection process. This led some financial institutions to exclude investments in sectors considered harmful such as fossil energy and defence.
This was a militant approach that favoured ethics at the expense of returns. Sustainable investment funds adopted a radical stance, only investing in companies with an exemplary record on environmental and social matters.
Criticisms of that approach therefore started emerging. Firstly, that excluding certain sectors denied investors exposure to companies that are playing a major role in the transition. For example, oil companies investing in renewable energies were sometimes penalised, despite their transformation efforts.
Gaining in maturity
Secondly, the real-world impact of those exclusions was limited: selling shares in a polluting company does not necessarily reduce its carbon footprint. The rigid stance taken by ESG investment solutions, combined with their disappointing returns, dampened traditional investors’ appetite for them, showing the limitations of an overly restrictive approach.
Sustainable investment strategies became more mature when they factored in non-financial aspects, such as the impact of a company’s industrial activities (positive and negative) and its exposure to environmental and social risks. However, the rise of regulations designed to combat greenwashing and fund the transition means that sustainable finance teams are often overloaded with reporting and compliance obligations, and less able to identify risks and opportunities. Similarly, implementation costs for companies and the finance industry have risen so far that sustainability targets are now a secondary consideration.
Geopolitics redefining the sustainability agenda
The geopolitical developments of the last few years have profoundly affected the move towards a more sustainable form of finance. The war in Ukraine, tensions between major powers and the energy crisis have prompted many countries to turn temporarily to fossil fuels to ensure their energy security. The situation has clearly underlined how difficult it is to achieve a rapid transition, but has also showed the importance of adopting renewable power sources in order to gain greater energy independence.
More recently, the election of Donald Trump has thwarted hopes of ESG criteria playing a greater role in strategic investment decisions, particularly in the US. The US president has said he wants to dismantle environmental regulations, which he regards as a threat to economic growth. In response, many companies and investors have scaled back their commitments in this area.
Towards a more pragmatic approach
Faced with these challenges, a more pragmatic form of sustainable finance is needed. There should be no need to reiterate the constantly growing cost of natural catastrophes. According to a Swiss Re report, they caused around USD 95 billion worth of insured losses in 2023. Those losses are likely to keep growing because of climate change and the heightened frequency of extreme events. The increasing financial impact emphasises how important it is for companies to adopt business models that limit their negative impact on the environment.
At the same time, sustainable solutions are indispensable for keeping the economy running smoothly. The electrification of cars and industrial processes, the artificial intelligence boom and the rise of cryptocurrencies all require large amounts of energy. To meet that requirement, change is needed in terms of where we get our electricity, achieving the best trade-off between clean, renewable energies on the one hand, and powerful, concentrated sources – nuclear and fossil-based – on the other.
Achieving both returns and impact
The continuing decline in the cost of renewable energies is making them more economically attractive. According to the International Energy Agency (IEA), the cost of generating solar and wind power has dropped by over 60% in the last 10 years. As a result, these technologies are becoming cheaper than fossil fuels in many regions, and increasing numbers of investors are therefore favouring sustainable energy solutions that deliver both good returns and a positive impact.
For clients, therefore, sustainable investment strategies can offer attractive performance. Many studies show that companies applying solid ESG criteria are often more robust and profitable over the long term. That finding is borne out by the growing interest shown by institutional investors in these strategies.
In sum, sustainable finance is moving towards an approach focused on economic realism. The European Union has shown the way forward by simplifying sustainability reporting obligations, allowing the finance industry to focus more on the transition and to reconcile positive impact with economic performance more effectively. This is vital in order to achieve a form of sustainable finance that is more resilient and effective, one that can rise to environmental and social challenges while creating long-term value for investors.
