In this article we explore the world of sustainable investment, the scope of the challenge and the barriers faced today. We discuss how growing awareness and technology are working together and how current developments in financial technology will help remove some of the barriers.
The Sustainable Development Goals and investment
Meeting the UN’s 17 Sustainable Development Goals (SDGs) by 2030 is looking challenging. While nearly every country signed up to the Paris Climate agreement in 2015, the USA, has since announced it will be pulling out, causing a schism in the G20 group of nations and consternation at home and abroad. While many US businesses have confirmed that they will continue to work to achieve these goals, and the vast majority of the rest of the world’s countries are still signed up, as the second highest source of CO2 emissions globally (after China) at over 14% and one of the highest emitters per capita, the domestic policy of the USA directly affects the whole planet. As the largest single contributor to development aid, changes in US policy impacting medical services and women’s health also threaten many of the SDGs.
Although some critics have said they are not sufficiently aggressive, the SDGs set out an ambitious agenda, and even without the withdrawal of US support for some key areas, present a challenging set of targets. Some, such as no. 1 (No Poverty), are further challenged by global events such as climate change and war. While global trends are largely positive in areas such as equality, poverty, education and sanitation, further progress needs significant support, estimated at 2% of world GDP, of which around half needs to come from the private sector. Governments have been broadly supportive, although commitments have been matched unevenly, and private investors are increasingly eager to support the SDGs as the impact of climate change becomes more obvious and the urgency greater.
Several investment strategies and vehicles exist which support sustainable development investment, giving investors confidence that their money is going to sustainable activities. And while these have in the past been regarded as niche, strong track records mean they are now attracting the interest of ordinary investors, because sustainable investments are typically with companies that are run not just sustainably, but well.
Sustainable investment vehicles include:
- Stocks (equity) in green companies: many investors choose to purchase shares in companies engaged in sustainable activity, such as renewable energy or circular economy activities, however there is also a wide range of opinions about what constitutes a green company: a mining company that invests heavily in community development may be offsetting some of its negative impact by benefiting education or health, or an oil company may be cleaner than other oil companies. Purists would argue that neither of these counts as “green”, although there is also an argument for encouraging companies to move towards more sustainable operation in any industry.
- Green bonds: bonds (fixed income products) which are subject to tax exemption, issued by banks or companies that are engaged in sustainable activities; many of these today are issued by construction companies building sustainable buildings, or green energy companies, in developed economies. A subset of green bonds are “climate bonds” which may be issued by banks based on running businesses sustainably. Although green bonds have been successful in limited areas, there is both a growing demand and a large need for sustainability investment which they have not been able to cover.
- Social Impact Bonds (SIBs) are bonds issued by governments on behalf of charities addressing quantifiable social problems. If the charities meet their goals, investors are paid back by the government with an additional bonus. Although they have seen early success, measurement is extremely challenging and they tend to be highly localised to the countries whose governments issue them.
- Green Foreign Direct Investments (FDIs): these are investments by large companies, usually in developed economies, building or acquiring businesses in other countries, usually developing economies. Examples include a manufacturer building a factory in a developing economy, or a bank or telco buying into a parallel industry such as a bank or telco in a developing economy. Green FDIs can be difficult to validate in some countries and industries, especially in some of the more needy countries where corruption and government intervention create barriers, and FDIs tend to be concentrated in areas with a strong history of FDIs, such as South-East Asia, leaving other areas relatively neglected.
- Green Exchange Traded Funds (ETFs): these are instruments that mimic an exchange made from a bundle of stocks in green companies – because of the lack of consensus on what defines a sustainable company, the underlying businesses tend to be from a narrow range of “safe” sustainable businesses.
The sustainable investment scene is facing challenges; because of the complexity of proving investments are sustainable, and the lack of consensus over what a green company is, most investment vehicles tend to be focused on companies that would probably be operating in a sustainable way regardless, and on “safe” green targets such as renewable energy. Even within this range, however, investment is not reaching areas where it is most needed, particularly in funding for sustainability infrastructure in developing economies, because of currency volatility and concerns about corruption.
Meanwhile, the demand for green investments is growing worldwide as people become more aware of the impact of climate change and the SDGs. Whereas in the past, investors in green securities were large funds, government controlled or otherwise, with the availability of green ETFs and opportunities offered by technology such as robo-advisors, members of the general public are becoming increasingly aware of green investment opportunities and choosing to invest in them.
Evolving perceptions of sustainable investment
For many investors, especially in the early days of sustainable investment, green investments were perceived as an alternative to profitable investments; funds wanting to present themselves as ethical would choose them, assuming that they would be less profitable than alternatives but because they wanted the positive association. Governments provided incentives to encourage issuers and investors to participate.
As a result of this perception, early investors in sustainable products tended to be from forward-thinking institutions with a clearly articulated sustainability or green agenda, while other investors overlooked them in favour of more traditional instruments. Subsequently, as ordinary consumers and investors became more articulate about their desire not to support businesses that invested in “dirty” industries, more institutions started to invest in green instruments to gain public approval. Over the last few years, however, there has been a visible shift away from this type of “lip service” investment in many large global corporations. We think this is for a variety of reasons:
- Growing awareness of the visible impact of climate change, including to developed nations
- Greater visibility of environmental scandals thanks to social media
- Some high profile scandals about FDIs, particularly associated with child labour, unsafe working practices and chemical exposures
- Greater economic rewards from sustainable investments
This has led in turn to high profile pronouncements from industry leaders about their commitment to the green agenda, which then raises awareness and acceptance. As noted above, most “green” investments are actually safe investments in well-run businesses that will generate positive returns – with some exceptions such as SIBs, which remain more altruistic/risky. Many large corporations now have internal teams dedicated to sustainability, and are “walking the talk” in the way they run their own businesses as well as their investment portfolio.
This move into the mainstream and general public perception of sustainable investments provides a positive outlook for sustainable investment instruments. However there are, as outlined above, challenges to growing the scope of sustainable investment instruments, because of challenges with transparency, categorisation and risk in many economies and industries. As the pool of investors grows, it will be important to increase the availability of instruments, moving from a fringe investment choice to the mainstream. As one contributor described it, “we need to move from the concept of green investment, to this is just how investment works”, with all investment in businesses having an element of sustainability provenance.
Barriers to growth
As described above, there are some challenges to overcome in order to increase the range of investments under the sustainability umbrella. This change is needed because there is an imbalance globally, with some of the most vulnerable countries and industries with the greatest need for reform not attracting desperately needed investment. There is an estimated annual USD 2.5 trillion funding gap to achieving the SDGs, with renewable energy alone representing an annual USD 1 trillion gap.
What do we mean by Green?
One of the biggest challenges that we’ve heard discussed at G7 and G20 meetings, and hear repeatedly from investment managers, is that there is no commonly agreed standard for what is meant by sustainable, or green, investments. While some areas are obvious, such as building a renewable energy generation facility, others may be borderline, such as making an existing business more sustainable by reducing its resource usage, installing green roofs, etc. without fundamentally changing the nature of the business to be more sustainable – they are still worthwhile things to do and to be encouraged, but potentially subject to reversal. This leads to a lowest common denominator approach being taken to instruments such as ETFs, which play it safe rather than excluding investors because of underlying assets that may not appear sufficiently green.
In many countries, overseas investors are discouraged from investing by the inappropriate level of involvement of government in investment decisions, particularly when selecting vendors for major infrastructure and industrial projects. While government undoubtedly has an important role to play in these decisions, in many countries there is a perception, usually justified, that decisions are made based on relationships and bribes.
As well as governments, other political or corporate interests, military and private influence may also threaten the integrity of investments in many countries, with attractive financial incentives for those who can engineer the awarding of contracts or siphoning off of funds to non-sustainable activities or non-activities. In some countries, corruption is so endemic that outside investment is routinely redirected, meaning funding sustainable enterprises is effectively impossible.
Currency and economic risk
Many of the countries which need significant investment also suffer from currency volatility caused by financial instability, wars, corruption or GDP issues. High inflation, liquidity concerns or other volatility makes investment inherently risky, especially where projects will also need to purchase goods or services from additional countries, amplifying the exchange and transaction cost risk.
As well as the core challenge of defining what is meant by green, in some cases businesses are creating sustainable solutions in one area, while reducing sustainability in others. There are many businesses in the energy sector in this position, expanding drilling or fracking, while at the same time investing heavily in renewables, while others may be inherently “brown” industries such as mining, but investing in community projects, education and healthcare. As with the “less green” sustainable initiatives, the question arises whether the positives offset the negative behaviours, and environmentalists and investors are divided on this.
A by-product of corruption is that it becomes hard to validate that money is being spent on what the investors intend; companies may claim green credentials for activity that doesn’t happen, or conceal negative behaviours, such as pollution, from investors. This creates an understandable reluctance in investors, leaving countries already suffering from corruption and volatility problems, doubly disadvantaged.
All of these challenges can be summarised as:
- Lack of confidence that money will be invested appropriately
- Lack of agreement over what investors want to support
It has been assumed that at some point in the future, there will be agreement about what “green” or “sustainable” means, however this debate has been raging for over 20 years, and hasn’t been resolved by the SDGs or any of the other milestones that have been put in place beforehand, while the problem of transparency is as old as investments.
UNEP, the G7, the G20 and fintech
Over the course of 2016-2017, we’ve seen a growing convergence between the world of sustainable investment, and the financial technology solutions that can help address these barriers. The UN Environment Programme’s Inquiry into the financial system we need has been researching fintech opportunities, which it summarised in a report in December 2016, Fintech and Sustainable Development: Assessing the Implications, UNEP has been working with fintechs over the course of the development of this report and beyond, bringing fintechs to the table with policy makers from other NGOs and governments to start identifying solutions. What was striking about those meetings to us, as technology people, was the huge gap in understanding about technology opportunities in policy makers. However, as more fintechs were engaged, and through a variety of workshops and expositions, it became clear that policy makers are keen to engage technology in overcoming these challenges.
One of the themes that has emerged, is that there is no clear distinction between what’s green, what’s sustainable, and what’s inclusive; although clearly they’re not all the same thing, the edges are so blurred that it is hard to separate one from the others. We also believe that achieving one requires the achievement of the others, so it is neither helpful nor easy to separate them. Taken from this perspective, the SDGs are a good place to start when it comes to categorising and measuring sustainability, even if you can’t put them all in a single bucket.
In parallel, the growing number of practical implementations of technology in support of the SDGs, and in particular financial technology, has given policy makers confidence that these solutions can be implemented to solve real problems. We’re describing a few here, knowing that many others which we haven’t yet thought of are likely to emerge before the year is out!
Emerging fintech solutions
Solutions to the classification challenge have already emerged, thanks to big data analytics. There is a small number of platforms already available, that enable investors to select their investment criteria and see a match, for example if they favour projects supporting gender equality or eradicating poverty, or for emission reductions, so that investments can be tailored to the investor. These solutions enable a wider body of investors to access a wider variety of sustainable investments, increasing the scope of sustainable investments, although provenance and corruption may still be an issue for riskier countries or industries.
Tokenisation of green initiatives over blockchain is also becoming more common, with a variety of initiatives involving tokenisation of renewable energy or carbon offset schemes emerging, enabling community ownership of energy resources, facilitating targeted investments in green projects. While tokenisation in itself is effectively a type of securitisation giving confidence to purchasers that the underlying asset is clean, these tokens are also easier to transact than traditional securities, as they can be traded over blockchain for other cryptocurrencies, or for fiat currencies via cryptocurrency exchanges.
Meanwhile, robo-advisors are starting to make it easier for normal people to participate directly in green investments, via ETFs, and we have already seen the mainstream robo-advisor WealthSimple trading a Green ETF as part of its standard portfolio of products.
In addition, a body of research and some emerging solutions take these trends further, combining blockchain, smart contracts, cryptocurrency and analytics to build investment instruments such as green bonds, or funds, with a high degree of traceability and auditability. Hiveonline is engaged with several such initiatives, using blockchain and contract technology to add confidence to investors seeking new sustainable investments where previously some of the barriers described in this chapter have proved to be too great a risk. The case study below demonstrates how the technology can be employed to increase transparency and reduce risk in a green bond scenario, and similar applications are also in development for green FDIs and overseas SME community investment. These applications carry the same benefits of traceability and auditability as the solutions described above.
Case study: Green Bond benchmarking and validation over blockchain
This case study describes a green bond platform hiveonline is building on behalf of Stockholm Green Digital Finance, in partnership with a Swedish asset manager.
Green bonds have attracted positive results with investors keen to support them. However, the issuance of green bonds is subject to a complex validation process which disincentivises organisations from issuing them, and results in limited availability for investors. Additionally, because of challenges of validation and auditing, the issuance of green bonds outside of low-risk countries creates further barriers as investors cannot be confident that the outcomes will meet sustainability criteria.
Blockchain technology offers an opportunity to add transparency and confidence to green bonds by defining and measuring criteria associated with sustainability. These have traditionally required significant administrative effort to measure in a transparent and low-administration way. The combination of blockchain technology with business logic, further ensures that confirmation, payments and other events can be tied to firm evidence that sustainability objectives have been achieved, as well as offering the opportunity to solicit additional evidence where required.
Advanced contract technology also offers an opportunity to automate much of the administration underpinning management of investors in green bonds, including terms, rights and the management of financial transactions.
The solution is a hybrid, where a technology platform, enabled by blockchain and automatically executing contracts, supports traditional actors in the green bond lifecycle by reducing administration and increasing transparency. This results in reduced challenges associated with setting up, investing in and administering green bonds, so that the market can expand both to a wider range of issuers and a broader geographical spread.
The system can capture and measure criteria for non-financial achievements, provide full transparency of financial interactions and the assets that they were exchanged for end to end, together with reputation management that evaluates the quality of performance. The measurement and reputation system are based on assets relevant to the achievement of SDGs, while the underlying cryptocurrency provides the full traceability of transactions via blockchain technology.
The system is based on contracts underpinning the bond, which can be set up to execute based on the provision of evidence in the form of documents and other digital assets, that are measured by the system against the criteria based on the SDGs. For example, an underwriter may choose to evaluate a bond based on zero emissions, certificates demonstrating renewable energy production facilities or insulation criteria for buildings. Once set up and agreed with the fund, this information is written to the blockchain as a transparent and immutable record.
When the criteria have been achieved, the issuer uploads assets demonstrating that the criteria have been achieved, which triggers positive feedback and can be configured to execute payments, press releases, or other transfers of assets. This ensures that pre-agreed criteria are met, reducing ambiguity and the risk of fraud and providing confidence for investors.
The system also manages the transfer of value via cryptocurrency, which can be created based on input of fiat, e.g. USD, and released as local currency (USD or other), minimising exchange risk and providing full traceability for every transaction. The advantage of using cryptocurrency over blockchain, in addition to reducing currency risk, is that every point of exchange for any unit of currency is recorded in a block of transactions that can be accessed by any party to the agreement, which allows full audits and confidence that funds are being used appropriately.
This platform, including setup of the contracts and provision of evidence, is delivered via a simple mobile interface, allowing multiple participants to interact with the contracts including, if required, crowdsourced evidence based on input from independent third parties such as local witnesses.
The reputation management system evaluates the quality of any completed contracts, assessing how well conditions have been met and the quality of assets received in evidence. Investors can then see how well their investments are performing based on factual, like for like evaluations.
- Increased transparency and confidence for investors
- Significantly reduced administration around audit and reporting
- Clarity or purpose for issuers and underwriters
- Guarantees for issuers that funds are from reliable sources
With solutions like these, the need for standard definitions of green or sustainable doesn’t vanish, but multiple standards can co-exist comfortably, as investors have good visibility of what they are investing in, and can choose their risks accordingly.
The future of sustainable investing
Blockchain, Artificial Intelligence (AI), machine learning (ML), big data analytics, IoT sensors, behavioural reputation systems and other solutions we don’t know about yet can all help to expand the range of investment products and investments available to investors, while reduced administration and transparency provided by blockchain open up many more potential investment opportunities. However, this additional transparency has big implications for the way that capital markets run, in that it also facilitates a much more direct relationship between investor and the end recipient of the investment.
We think that this is likely to result in more peer-to-peer investment, particularly across business communities, and a convergence of “green investment” with “investment”, as the additional transparency gives greater visibility to investors of exactly what they are funding. While not all investors may choose to go green, most will be uncomfortable participating in unethical or actively dirty investments, especially as green investments perform as well as, or better, than brown ones.
We therefore anticipate the future that our contributor envisaged, where it will be in the interest of all organisations issuing securities to demonstrate sustainability in some form, in order to attract investment.
Beyond this, however, the additional transparency is likely to have an impact on the way that capital markets work; products that today require specialist knowledge can be largely automated, while transparency and the ability to maintain complex portfolios in tokenised forms, is likely to have an impact on the demand for many types of derivative products. We address some other potential developments facilitated by blockchain and related technologies in the Money Revolution, and together we expect they will start to have far-reaching implications for sustainability investment, as well as the overall impact on capital markets. We don’t anticipate an overnight revolution, but the growth of sustainable investments, coupled with the increased transparency available to investors and lowered administration costs, is likely to drive the next evolution in how capital markets work.
A number of investment products are available to support the development of sustainable businesses and infrastructure projects, however there is still a huge investment gap, particularly in countries where it is hard to demonstrate provenance or where corruption and currency volatility are a challenge. Investors and environmental experts can’t agree on the meaning of “green”, or what the minimum and maximum criteria will be.
Technology is already helping spread the range of investments, and broaden the range of investors who can participate in green investments. We see the work of fintechs like hiveonline in building end to end investment systems based on blockchain and AI as a continuation of this trend, and expect to see many more participants emerging with similar products and approaches to investment in the future.
While a solution for the funding gap must, necessarily, be the priority, we can also look to longer term implications of increasing transparency and rebalancing investments. The future is looking brighter for green infrastructure projects in emerging economies, but it is also going to be an interesting journey for global capital markets. Watch this space.