The Business Case for Sustainable Finance

Iveta Cherneva, Iveta Cherneva

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781136278198
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

In the world of finance, environmental, social and governance (ESG) factors have until recently really only impinged upon the 'soft' domains of public relations, philanthropy and corporate social responsibility. The existing literature focuses on issues including how finance can contribute to environmental governance, the need for investment to mitigate climate change and how financial institutions should act in a responsible way when conducting their operations.

However, very little literature focuses solely on why exactly, and under what circumstances, ESG factors influence the profitability of investment, insurance and lending activities and a systematic, rigorous business case for ESG finance analysis is largely missing.

The aim of this book is to tackle and answer the question: 'when and why is it profitable to incorporate environmental, social and governance factors into financial operations?' and brings together fifteen original chapters written exclusively by leading finance executives, practitioners and scholars.

Part I

The business case for sustainable finance

Beyond public relations, reputation and philanthropy

1	The business case for sustainable finance
	Beyond public relations, ethics and philanthropy
	Iveta Cherneva

1 Introduction

In December 2010, the United States Department of Justice announced the commencement of proceedings against British Petroleum for economic and environmental damages following the oil spill in the Gulf of Mexico in April that year. Among the counts is failure to utilize the safest drilling technology to monitor the well’s condition.

Throughout 2010, metro, train and airline strikes in France, the US and Spain led to losses of millions of dollars as a result of dissatisfaction with working conditions.

A United Nations-backed report showed that environmental costs from global human activity equate to an estimated US$6.6 trillion, or 11 per cent of global GDP in 2008.¹

In September and October 2011, thousands of protesters came out on the streets of New York and elsewhere under the motto ‘Occupy Wall Street’ to protest Wall Street’s dealings, which were some of the stepping stones leading to the 2008 financial crisis.

2011 was also a year of floods, tsunamis, tornadoes, typhoons, mudslides, earthquakes and other disasters.

The year witnessed the demise of the Greek financial system, posing a threat to, and questions about, the eurozone as a whole, and having an impact on world economy and international trade through currency devaluation.

These events, although at first sight unrelated, have a common denominator that this book intends to address. The global financial industry, which is at the heart of an increasingly globalized and interrelated economy, faces a number of direct and indirect challenges. They broadly fall along the lines of environmental, social and governance (ESG) issues and questions of financial sustainability in a time when the industry is coming out of the worst financial crisis of our time.

In the world of finance, ESG factors until recently have been only present in the soft domains of public relations, ethics and philanthropy. Existing literature focuses on responsible and ethical investment and on why finance should contribute to environmental governance and societal needs. Very little academic literature is dedicated to why sustainable finance makes sense commercially. A systematically presented business case is largely missing. There is need for sector-specific, topic-specific and region-specific perspectives that build the business case for sustainable finance. The post-crisis period, marked by reflection and analysis of ‘what went wrong’, offers an unprecedented opportunity for its articulation.

1.1 Defining ESG factors and sustainable finance

Numerous attempts have been made to define sustainable finance and ESG factors, terms often used interchangeably. ESG factors are treated here as issues traditionally seen as public interest issues relating to the well-being of humans, society and the environment, and which now are increasingly relevant to the operations of business and finance. ESG factors and sustainability issues are industry, region and context specific. It is considered that individual financial institutions should decide the ESG factors most relevant to their specific operational contexts. In other words, sustainability issues cannot be painted with the same brush, with a claim for universal applicability.²

2 The state of debate on sustainable finance

The debate about financial sustainability and ESG factors is often accompanied by a certain public interest rhetoric of ‘should’, which largely also informs the concept of corporate social responsibility (CSR), to which businesses and financial institutions become increasingly desensitized. One often hears that the private sector has societal responsibilities greater than just making money and this discourse stretches to cover financial institutions, too. In turn, private actors have fought back with variations of the classical argument that the business of business is business,³ pointing to the sector’s primary and only role. In this sense, trying to impose (moral) obligations of public character on inherently money-making private entities has backfired and led to a superficial debate in which neither group is convinced by the other group’s discourse. The public sector tries to convince the private sector that considering public interest issues is in the private sector’s best interest. The private sector tries to convince the public sector that private sector cares and self-interest is not the reason why the private sector is involved. This social construction proves inherently unproductive. It presents a series of arguments, none of which play on genuine incentives.

It should be understood that asking a private enterprise to make a sacrifice beyond what is required under law, when this goes against its financial interest, is rightly seen as unreasonable by financial institutions and their shareholders. On the other hand, when financial institutions remain passive on environmental problems that affect all, including businesses and the economy, the public understandably sees that as unreasonable. It is suggested here that private and public spheres should own up to their character through recognizing the other’s role in society and moving forward. In this context, commercial incentives remain the most – and some might add only – convincing argument to a financial institution.

The articulation of commercial incentives for sustainable finance might meet an expected criticism. When it comes to people’s well-being for example, discussing commercial profitability may be seen as mercantilist and immoral. It should not be money that drives an entity to do the right thing, some would submit.

Ethical considerations and appeals to morality, however, might not be sufficient to facilitate change. Individual ethical persuasion might not be able to surmount structural challenges, such as institutional, legal or social dynamics and obligations. On a case-by-case basis, ethical arguments might resonate with some financial practitioners, but perhaps not be convincing to others. A pension fund CEO who enjoys spending time in the mountains on weekends may notice adverse environmental effects from global warming and biodiversity loss, and in this way may become personally convinced that something needs to be done. He or she, however, might be different from a CEO living a dynamic life in a big city. In order to yield results, persuasion needs to transcend individual ethics and interpersonal value differences into a more universal rationale that speaks on business grounds. A business case that sounds convincing to both types of executives is needed.

While academic and non-profit circles present various arguments as to why finance should look into ways of improving the impact and sustainability of the industry, it should be noted that unless an entity realizes and internalizes on micro-level the business benefits for an approach, rarely does outside rhetoric result in a genuine and meaningful change. (An exception to this is outside regulatory compliance pressure, where potential sanctions cannot be ignored by the industry.) Therefore, it is legitimate and necessary to ask if sustainable finance makes commercial sense for the industry.

A difference from the ‘should’ is to be made. The ‘inventive’ ratings, securities and unregulated derivatives schemes that marked the 2008 financial meltdown should be a clear reminder as to why rules exist. It is unarguable that a private sector industry is constrained by rules and that there are certain ‘shoulds’, which in fact are actually ‘musts’. The questions at hand are instead: What are the specific intersections of private capital and public interest, and what are the commercial incentives from the finance industry’s point of view that underpin these intersections? The goal here is a discussion of the genuine business arguments for ESG analysis and sustainable finance, rather than an articulation of what the public needs from the finance industry.

3 In search of the holy grail: is there a business case for sustainable finance?

Major empirical questions challenging the business case for sustainable finance are: Beyond reputation and public relations, are there quantifiable commercial incentives for sustainable finance? If a business case indeed exists, are financial institutions working in that direction already, and if not, why not, or why only partially?

3.1 Rational choice and rational action?

Among the most challenging questions posed by rational choice and rational action theories are questions concerning the level at which sustainable finance is actually practised. According to rational arguments depicting actors as profit maximizers who act in the most advantageous way, if a practice does not take place, it simply must not be profitable. The greatest test for the business case for sustainable finance, therefore, would be the empirical state of affairs related to the level of sustainable finance practised in financial institutions.

The rational action argument, however, may be expected to display behavioural limitations with regard to sustainable finance. Actual practice may be the mechanism that identifies profitability, but sometimes even the ‘invisible hand’ needs a helping hand in terms of information. Numerous contemporary environmental, social or governance crises that affect returns, and which financial institutions had not anticipated and were not prepared for is the evidence. There is imperfect information distribution among different actors in the financial system in relation to the importance of ESG issues, which leads to an informational gap and difference in levels of preparedness.

The gap is a product of a number of dynamics. On a practical level, financial institutions are comprised of individuals with their own views, agendas and deadlines. Even if driven by best intentions, individuals performing their duties on a daily basis might not have the time or direction to look at additional relevant information. On an organizational culture level, that produces organizational inertia whereby work is carried out in a particular way not necessarily because it is the optimal way, but simply because it is the way things have always been done. Apart from institutional and individual inertia, groupthink⁴ applied to the operations of financial institutions may also account for situations where although different thinking might be present, the group is not encouraged to voice disagreements and works according to the leadership-imposed model enshrined in the social hierarchy of the institution. Dissenting, innovative opinions are not considered or even voiced in such contexts although they may be relevant.

Furthermore, adequate human resources or sustainability expertise simply might not exist in many financial institutions; and even if present, the institutional channels do not always allow the entry of sustainability expertise into core operational phases. Sustainability units in financial institutions are reportedly isolated from the mainstream operations.⁵ The relationship between shareholders and investors’ fiduciary duty imposes extra obligations on investment institutions – obligations not applicable to other financial institutions. As far as investment needs to be in harmony w...