Tag: #finance

Environmentally sound and financially rewarding? Key findings from an exploratory study on the Science Based Targets Initiative (SBTi)

By Milena Bar, Ottilia Henningsson, & Dr. Kristjan Jespersen

◦ 5 min read ◦

The Science-Based Targets initiative aligns firms’ emission reduction targets with a net-zero emissions pathway. Firm commitment yields significant abnormal returns which are larger for firms committed to larger emission reductions and for high-emitting firms. 

The IPCC’s sixth assessment established a code red for humanity and provided mounting evidence of widespread, rapid, and intensifying climate change. The Paris Agreement, ratified by over 190 states and non-state actors in 2015, formally stipulated the goals of limiting global warming to ideally 1.5°C and at a minimum well below 2°C with the aim of reducing the most catastrophic damages related to climate change onto the natural environment, human health and global financial market. The need for climate action is urgent and requires engagement from governments, individuals as well as corporate and investor participation.

Combatting climate change requires voluntary private sector engagement

Incentivizing corporations and investors to act voluntarily on climate change is critical to redirect private capital towards environmentally responsible business practices. The Science Based Targets initiative (SBTi) is becoming the global standard for firms seeking to set emission reduction targets aligned with the required global decarbonization targets established in the Paris Agreement. By encouraging voluntary corporate carbon emission reductions, the SBTi is a critical tool to reduce the private sector’s reliance on fossil fuels. 

2021 record year for new approved targets and committing firms for SBTi

Since its founding, just seven years ago, SBTi has experienced exponential growth in the number of committing firms and has mobilized firms representing more than a third of global market capitalization to reduce their carbon emissions. In 2021 the initiative took steps to increase the ambition level of firms’ emission reduction targets. When first established, firms could commit to reduce their emissions either aligned with the reduction targets of 1.5°C or 2°C. However, from summer 2022, the initiative will only be accepting the more ambitious emission reduction target, as set out in their campaign Business Ambition for 1.5°C.

Since company engagement ultimately comes down to whether committing to SBTi will drive wealth for shareholders, understanding the stock market response to firm commitment to the SBTi is essential not only for businesses looking to commit, but also for investors. To justify the integration of a climate credential such as the SBTi in investment management, it needs to be able to provide excess returns. To understand the stock market reaction to firms’ announcement of SBTi commitment, we conducted a short-horizon event study on a portfolio of 1.535 firms.

Firm commitment to the Science Based Targets initiative aligns environmentally sound practices with financial viability 

Firm commitment to the SBTi indeed yields a positive announcement abnormal return and thus speaks to the credibility of SBTi in constituting a credible signal of firm commitment to sustainable business practices. Even more encouraging is the finding that firms committed to the 1.5°C target experienced substantially higher returns, indicating a stronger positive market reaction when exhibiting a higher cost of commitment and higher target ambition level. The market evidently differentiates between ambition levels by rewarding businesses that are pledging themselves to more demanding emission reductions and a more climate-friendly business strategy. These findings are particularly relevant in light of the SBTi making the more stringent emission reduction target the new standard for all firms via their campaign Business Ambition for 1.5°C and may encourage more firms to increase their efforts in reducing their greenhouse gas emissions.

Stock price reaction in response to commitment to the Science Based Target initiative

In turn, high carbon emitting firms, proxied here by firms identified by the CA100+ list, reaped the largest reward in their stock price following commitment. This finding further confirms the market’s more sensitive reaction to costlier commitments, but also creates concern about whether the SBTi may have to rethink a recent strategic decision. The SBTi announced that they will not be accepting targets set by firms operating in the Oil and Gas industry, thus abandoning the industry specific methodology for fossil fuel firms which had been in development for several years. Fossil fuel firms have a key role to play in successfully achieving the goals of the Paris Agreement, thus begging the question of whether the SBTi is not missing out on covering an industry critical to combatting climate change and a sector of firms who are highly rewarded by the market for committing to reduce their emissions. 

As climate disasters become more prevalent and more severe, firms who fail to transition to a low, or zero, carbon business model can be expected to become more vulnerable in the long run. To expand the analysis, we further tested the performance of a portfolio strategy screened for firms committed to the SBTi. Despite the underperformance of an SBTi screened portfolio against a portfolio consisting of only non-committed firms in the medium-term, there is reason to believe that a portfolio with SBTi committed firms may provide higher returns in the future. Given that SBTi commitment represents a commitment to aligning the firm’s operations with the net-zero emissions pathway, it can be perceived as a safer bet in the long run. Moreover, portfolios consisting of SBTi firms were shown to be characterized by lower volatility. The objective of investors is shifting to increasingly sustainable and impact focused investment profiles, hence portfolio and asset managers may use SBTi commitment as a filter in security selection to achieve their client’s demand.

Looking Ahead

Financial institutions have a key role to play in driving systematic economic transformation towards a global net-zero carbon emissions economy in their power to lend and invest. As evidenced, firm commitment, ambition level and cost of commitment are reflected in the stock’s pricing mechanism, making the business case for the firm to set ambitious targets for decarbonization, and providing rationale for investors to in the short run utilize the market’s reaction to firm commitment in investment processes and strategies. 

About the Authors

Milena Bär is a recent graduate in MSc Applied Economics and Finance and is working as a student researcher in ESG and Sustainable Investments at Copenhagen Business School. Her research projects are mainly within the field of ESG metrics and regulation, with a focus on the investor’s side.

Ottilia Henningsson recently graduated with a MSc in Applied Economics and Finance from Copenhagen Business School with a keen interest in the transition towards a more sustainable financial industry. 

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo by Matthias Heyde on Unsplash

Constructing Social Portfolios: A Quantitative versus Screening Approach

By Alina Hofer, Lea Katharina Kasper & Dr. Kristjan Jespersen 

◦ 5 min read ◦

When we talk about ESG, one could argue that there is a strong bias focused on climate investing, reaching net zero targets as well as good corporate governance and diversity themes. But there is much more to ESG. The “Social” dimension of ESG is hugely under explored and developed and covers under studied issues such as how companies treat their employees and care for the responsibility of their products. Still further, assessments linked to human rights codes and social impacts is only now receiving the attention it truly deserves. Although the importance of these topics is undisputed, we see that attention to particularly address the social dimension has been lacking, whereas awareness of other ESG risks has been rising immensely during the past years. 

Not only is the general knowledge and focus on the social dimension of ESG limited, its overall  implementation in portfolio management has not been sufficiently experimented with and addressed.

The delay to properly implement the “S” in ESG is often explained because of the challenges to quantify, assess, and integrate social factors generally.

However, this argument should not be a sufficient justification for neglecting the “S” in ESG and for investigating a possible relationship between a good social rating and superior financial performance. To tackle this lack of awareness, we constructed two portfolios which integrate Refinitiv’s Social ratings based on different integration strategies and test their performance towards the market between 2012-2021.

When integrating social – or other ESG – ratings into the investment process, we find there is often disagreement on how to best consider these factors in portfolio construction. Currently, it is most common to apply screening or best-in-class strategies. These approaches aim to remove assets that do not fulfill certain criteria from a defined investment universe. Negative screening would mean to remove those companies that perform worst from the pool of assets. Inversely, an investor could also only continue with those firms who at least have a certain minimum rating. For both approaches, the portfolio weights are then allocated to the assets that remain. This is done using conventional indicators such as value, size or expected risk-adjusted returns. In our study, we, however observe a clear shortcoming of this approach: After screening out the worst 10% “social performers” and allocating weights based on a risk-return trade-off, the portfolio does not necessarily promise a higher overall ESG score than a portfolio would reach which does not consider the ratings at all. Although the portfolio yields a solid financial performance, this raises the question whether any ESG-related impact has been made with this integration approach.

To make sure an investor can improve his exposure to assets that score well in the social dimension, we integrate the rating scores directly into the optimization problem of our second portfolio. This leads to a very different outcome on the social rating:

Looking closer at the mechanics of this approach, we extend the traditional Sharpe Ratio with the ESG factor, meaning to add by how much it a company “outscores” the market average. This results in the following “Social Sharpe Ratio”:

We add a fifty percent weight split, which can be flexibly adjusted towards investor preferences. And we now balance a risk-return-social trade-off. This explains why the second approach over 9 years constantly beats the market average in respect to the integrated Social factor without sacrificing any performance on the financial side. In fact, we find that in 5 out of 9 years, the second strategy would have also led to higher risk-adjusted returns measured by the Sharpe ratio. Moreover, returns were consistently higher compared to the market benchmark. This result is quite remarkable, given that it is often questioned whether investors need to sacrifice returns in order to make their investments more socially responsible. 

Lastly, our study resulted in one more unforeseen twist when it comes to integrating ESG ratings. That is, the question whether we can actually trust the rating scores. To answer this, we must first understand how scores are created. Rating providers look at an immense amount of publicly disclosed information, reports and policies. And based on what company’s report, rating scores are aggregated. However, it is clear that a firm would only report on things they do well. In fact, we observe that with increased reporting, ESG scores also improve. But what about the real-life actions and impacts? Some rating providers offer a combined score, which also considers media reports on the involvement in controversial actions. As these scores are only available at an aggregate level, we calculate them on a single-pillar level using Refinitiv’s methodology, which adjusts for firm size and industry. Looking at specific examples in our portfolios, we found that the impact of such controversy involvement on the overall score could still be larger. Nevertheless, we stress that in order to have a complete picture of a firm’s ESG behavior, the impact of these controversies needs to be reflected in investment decisions. 

To sum up, given the results of our research, there are three things we aim to highlight:

  • It is crucial to increase investors’ awareness of “Social” matters and provide a better landscape for impact investments in this specific dimension.
  • Integrating ESG ratings does not always promise a better ESG performance for the whole portfolio. Therefore, it is necessary to focus on strategies that lead to actual impact.
  • Third, looking beyond the information that is disclosed by companies themselves, more attention should also be addressed to “real life actions” when making investment decisions. 

About the Authors

Lea Kasper has recently graduated with a MSc. in Finance and Investments (cand.merc.) from Copenhagen Business School. Her interest and enthusiasms about sustainability and how to more efficiently integrate non-financial factors in investment decision-making contributed to her choice to further investigate this topic throughout the master thesis. 

Alina Hofer has recently graduated with a MSc. in Finance and Investments (cand.merc.) from Copenhagen Business School. Being passionate about creating impact through ESG-aligned investments, she was excited to further focus on her interest in this field throughout the master thesis.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Image source: SustainIt

ESG investing in a changing regulatory environment: investing in active or passive ESG financial products?

By Marco Morazzoni and Dr. Kristjan Jespersen

◦ 8 min read ◦

The impending climate crisis emphasizes the need to mobilize large-scale investments to finance the transition towards a more sustainable and inclusive economy. The financial sector plays a pivotal role in this context, as it allocates capital from investors who wish to pursue financial and non-financial objectives to corporations and stakeholders who need these resources to empower the sustainability transition.

Over the past decades, individual investors have become aware of the risks inherent in unsustainable business practices, being increasingly interested in financial products that combine a competitive risk-adjusted return with Environmental, Social and Governance (ESG) criteria. Despite the increase in funds, indices and benchmarks that include ESG dimensions, the universe of ESG financial products remains difficult to navigate for individual investors due to the range of investment strategies that can be used to pursue ESG goals, such as negative and positive screening, best-in-class, ESG integration, impact investing and ESG engagement. In addition to ESG strategic considerations, investors ought to consider the level of active management inherent in their ESG products, since it has considerable implications for financial returns and the ESG objectives pursued.

In fact, while some financial products have an active investment approach, trying to beat a reference benchmark, others merely aim to replicate the ESG impact and financial performance of an index.

‘Active versus passive’ debate

The literature on conventional active and passive investing is almost unanimously in favour of long-term passive investing, due to active managers’ inability to consistently beat the market and to the lower fees charged by passive funds. However, the ‘active versus passive’ debate in the context of ESG investing is more nuanced.  This is because ESG investing entails the pursuit of intangible and hardly quantifiable goals that go beyond the achievement of mere financial returns. Furthermore, due to the different definitions and methodologies used in the assessment of ESG performance and the resulting unrealiablity of ESG data, the trade-off between impact and financial returns can be difficult to reconcile. 

A study conducted on 78 ESG active mutual funds and 15 ESG exchange-traded funds (ETFs) seeks to contribute to the debate by illuminating the financial and non-financial features that characterize these sustainable financial products. The funds were selected from Morningstar Direct according to specific criteria, such as: availability of an ESG rating, European domicile, invested in equity, active investment approach (for mutual funds) and passive investment approach (for ETFs).

By constructing an equally-weighted portfolio for the selected ESG active mutual funds and ESG ETFs, the study used the CAPM, three-factor, four-factor and five-factor model to compare the portfolios’ risk-adjusted perfromance before and after fees. To increase the robustness of the study, the regression analysis was conducted on various market benchmarks, such as MSCI World, STOXX Europe 600, MSCI World ESG Leaders and MSCI Europe ESG Leaders.  

The regression results indicated that the ESG active portfolio outperformed the ESG passive portfolio both before and after accounting for management fees. Controlling for the criteria used in the selection of the funds, the active outperformance could be attributed to the funds’ instrinsic characteristics, such as investment orientation, ESG investment approach and ESG scores. Accordingly, 77% of the ESG active portoflio had a global investment orientation compared to 27% of the ESG ETF portfolio. This entails that the active portolio covered more geographies, exhibiting higher diversification and improved risk-mitigation.

Further, 83% of the active portfolio practiced ESG engagment, a strategy that previous literature associates to superior financial returns and improved ESG impact.

By engaging with companies on ESG issues, ESG active funds may have been able to help ‘lagging’ firms improve their ESG performance, while enabling ‘leading’ firms to address their ESG issues. With respect to ESG scores (Morningstar and MSCI), the active portfolio displayed a lower overall ESG score compared to the ESG ETF portfolio. This finding could suggest that the active portfolio invested in lower rated companies on average, with the objective of helping them transform their ESG strategy and thus pursue higher risk-adjusted returns.

Insights to individual investors in ESG financial products

Recognizing the limitation derived from the small sample size and the fact that the active outperformance might be due to the specific funds selected, the findings were used to provide a set of insights to individual investors who wish to invest in ESG financial products.

Firstly, individual investors were categorised into ESG-unaware, ESG-aware and ESG-motivated, according to the investor labels used by Pedersen et al. (2021) “Responsible investing: The ESG-efficient frontier”. This categorization simplified reality to the extent that it became easier to derive actionable insights. Furthermore, it provided more granularity with respect to investors’ prerogatives regarding the trade-off between the pursuit of an ESG impact versus a risk-adjusted return.

Based on this categorization, investors who disregard ESG information (ESG-unaware) should invest passively in broad conventional ETFs or in a diversified portfolio of more specific conventional ETFs.

Investors who consider ESG information for risk-mitigation purposes (ESG-aware) ought to focus on the level of selectivity displayed by active managers in their stock-picking activity, measured in terms of high/low R-squared. If active managers are highly selective (low R-squared), ESG-aware investors may consider foregoing part of their return, due to the higher active management fees, and thus benefit from managers’ ability to pursue a greater ESG impact and potentially higher risk-adjusted returns.

Conversely, if active managers exhibit low selectivity with respect to a reference benchmark (high R-squared), investors would be better off investing passively in broad ESG ETFs or in a diversified portfolio of more specific ESG ETFs. Lastly, ESG-motivated investors may be better off investing in ESG active funds who practice ESG engagement, as the higher fees charged by these funds would worthwhile, given the superior ESG impact inherent in ESG engagment strategies.

Regulatory considerations

In addition to the empirical findings, the study also included regulatory considerations in the assessment of the suitability of active versus passive ESG financial products for individual investors. This was critical, since the new MiFID for sustainability preferences will come into force on the 2nd of August 2022.

According to this regulation (2021/1253), investment firms will be obliged to ask their clients about their sustainability preferences and find out whether they are interested in sustainable financial products. If the answer is affirmative, financial advisors will only be allowed to offer MiFID-aligned products to their clients. A MiFID-aligned product will have to include a minimum portion of ‘environmentally sustainable Investments’ (SFDR article 9), EU Taxonomy-aligned investments, or enhanced article 8 investments, consisting of article 8 investments (SFDR article 8) which also include Principal Adverse Impact (PAI) indicators.

Linking the new regulatory requirements to the findings of this empirical research, it is reasonable to expect that ESG-unaware investors will no longer exist, as investment firms will be legally required to inform these clients about the ESG implications inherent in their investments. This will give rise to an increase in supply of sustainable financial products (MiFID-aligned), as investment firms strive to keep up with the increased demand for these products. The rise in supply will most likely be larger than the increase in demand, since a portion of the new ESG-aware investors might continue disregarding ESG information, if ESG financial products are priced unreasonably (excessively high management fees). This will ultimately lead to higher competition among investment firms, with a consequent downward pressure on fees in the long-run. Lower investment costs could subvert individual investors’ incentives, as they decide on whether to invest in ESG active or passive funds. Accordingly, it might become desirable for ESG-aware investors to invest in ESG active funds who practice ESG engagement, as opposed to it being a strategy exclusively suitable for ESG-motivated investors.

The information contained in this blog post is not to be taken as constituting the giving of investment advice or recommendation. The reader is acting for its own account, and they will make their own independent decisions as to whether any investment is appropriate based upon their own judgment.

About the Author

Marco Morazzoni is a recent graduate in MSc Applied Economics and Finance from Copenhagen Business School. Having an interest in finance and ESG, he wrote his master’s thesis on “ESG exchange-traded funds versus ESG active funds: how can individual investors pursue ESG objectives while achieving competitive risk-adjusted returns?”

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo: Khanchit Khirisutchalual on iStock

Institutions matter: The importance of institutional quality when embedding sustainability within the capitalistic realm

By Lisa Bernt Elboth, Adrian Rudolf Doppler, & Dr. Kristjan Jespersen

◦ 5 min read ◦

Institutions not only structure any sort of social interaction [1], but are also essential in solving societal problems [2], such as climate change and the associated threat towards a fair and just future. It is not without reason that the United Nations particularly emphasized institutional progress within SDG 16 [3] to advance to a more effective, inclusive, and accountable society. In a recent study, it was found that institutions matter to a great extent when scrutinizing the relationship between corporate financial performance (CFP) and ESG performance. More specifically, the institutional environment a company finds itself in determines whether sustainable business practices get transformed into financial returns.

The claim that more sustainable companies are outperforming their not so sustainable peers is not new [4] and the consequent shift of investors’ preferences towards more sustainable companies has been taking place with increasing speed over the last decade [5]. Associated wake-up calls and the urge to take ESG into consideration are not surprising either. Besides the alleged desire of investors for a just and sustainable future, this shift is more likely based on the theory that sustainable finance delivers abnormal returns [6]. But is the relationship between sustainable behavior and financial performance as straightforward as it is disseminated? Are more sustainable corporations indeed more likely to achieve better financial results regardless of where they are and what they do?

In fact, when utilizing ESG scores, rankings, and performance as a proxy for sustainable behavior, two meta-analyses [7] [8] concluded that in most empirical studies the resulting relationship was not as simplistic, universal or linear as it is often propagated. In a corresponding literature review, the researchers also identified a large number of discrepancies among scholars in how to statistically model the relationship, what control variables to use and how to even quantify the dependent and independent variables of focus. Following these insights, the researchers uncovered a determining factor in establishing and shaping the emphasized relationship – institutional quality.

Key Findings

The final sample consisted of datapoints from 6,976 corporations, situated in 75 different countries over a period of eleven years or, specifically, from 2009 to 2020. Subsequently, these were analyzed applying fixed effects panel regression models. Both an accounting- and a market-based measure were used to quantify corporate financial performance, respectively, Return on Assets (ROA) and Tobin’s Q. Meanwhile, ESG performance was proxied by ESG scores from Refinitiv (former Thomson Reuters). The variables associated with institutional environment were split into 

  1. Institutional Quality, calculated through a factor analysis and based on the World Governance Indicators from the World Bank and 
  2. Industry Sensitivity, a dummy variable equal to 1 if the GICS industry of a firm was deemed sensitive towards ESG.
Institutions are among the determinantal factors for the link 

Interestingly, the general statistical analysis of ESG and CFP did not yield any significant results, however, when moderating effects stemming from the institutional environment were introduced, this changed. Under high institutional quality, the researchers found a positive relationship between ESG scores and financial performance. Contrarily, the relationship was negative under low institutional quality. Exemplified below by the case of Finland 2012, Argentina 2018 and Zimbabwe 2012, institutions can be seen as the determining factor for direction of the focal link. Furthermore, the industrial environment a corporation finds itself in was found to affect the relationship ambiguously. Generally, sensitive firms seem to receive relatively less financial gain for improved ESG performance, and it may even be negative.

Possible explanations for such dynamics
  • Legal institutions, such as environmental regulations, labor laws or health and safety requirements, can serve as the means of reflecting sustainable behavior inside a company’s balance sheet. Finland was for instance the first country to introduce a carbon tax capturing corporate pollution by giving it a price and hence affecting accounting profits.
  • In highly corruptive settings, where the trust of the general public is lacking, the likelihood of sustainable activities being perceived as greenwashing and thus not rewarded by investors, could be another reason for an inverse relationship in low institutionally developed regions. 
  • In line with the previous, when accountability is low, and corporate entities can disclose information without third party verification, it could be relatively easy to stay focused on short-term profits through unsustainable practices but still receive a better ESG rating.  
  • In environments with low institutional quality, banks tend to only give out short-term loans in order to reduce their own risks. This can lead to a vicious cycle of corporate lenders also only focusing on short-term profit maximization which then again decreases their access to capital, constraining their ability to engage in long-term sustainable practices.
Putting the SO WHAT into practice

When setting out for systemic change, it is important to ensure the necessary institutional environment in order to encourage individuals, as well as corporate entities to act in the best interest of the entire society and the planet. Thereby, a bottom-up approach focusing on incentivizing every individual and a top-down approach, fostering legal macro-level change can be synthesized, leading to the best possible outcome. These institutions should seek to maximize accountability, transparency, and mechanisms to internalize negative externalities. Corporations within such environments should fully leverage opportunities associated with sustainable practices, such as cheaper access to capital, in order to incrementally advance the progress towards a just space for humankind. Corporations, which are especially sensitive towards ESG related elements irrespective of their ESG scores, should aspire to enhance their own credibility, as this might award them with a competitive advantage. Lastly, societies with high institutional quality should strive for teaching about their institutions and the associated benefits to everyone else, as a global problem can only be solved on a global level. 

References

Doppler, A.R., & Elboth, L.B. (2022). Institutional Quality, Industry Sensitivity and ESG: An Empirical Study of the Moderating Effects onto the Relationship between ESG Performance and Corporate Financial Performance (Unpublished master’s thesis). 22098. Copenhagen Business School, Denmark.

About the Authors

Lisa Bernt Elboth recently graduated with an M.Sc. in Applied Economics and Finance as well as a CEMS Master’s in International Management from Copenhagen Business School and Bocconi University. Her interest in global matters and sustainability has flourished during her studies impacting the choice of master thesis topic and this subsequent blog contribution.

Adrian Rudolf Doppler works as a research assistant for the Department of International Economics, Government and Business at Copenhagen Business School and had just graduated with a Master’s in Applied Economics & Finance and the CEMS Master’s in International Management after a two-year journey. He had always been passionate about ESG, Sustainability and the existing links with the capital markets, as well as the complex system dynamics arising form it.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo credit: Galeanu Mihai on iStock

How do we think about sustainable investing? Suggestions from an exploratory study

By Margherita Massazza & Dr. Kristjan Jespersen

◦ 4 min read ◦

From the outset, this blog post takes the perspective that behavioral finance is required to assess the perceived tension in sustainable investing (SI). Our work investigates the extent to which sustainability considerations are included in investment decisions, and the drivers behind SI approaches.

Sustainability is increasingly integrated in financial markets, with the acronym “ESG” (Environment, Social, Governance) becoming an all-encompassing term widely used in all phases of the investment process. According to a recent global review, sustainable assets [1] reached USD 35.3 trillion at the end of 2019, representing 35% of total professionally managed assets, and they are set to grow further in the coming years. Yet, despite its growth and the positive sentiment associated with it, there is an inherent tension in sustainable investing.

This tension stems from the apparent disconnect between the theoretical assumptions of classical financial models, focused on risk and financial returns as the predominant determinants of investment decisions (e.g., Capital Asset Pricing Model, Modern Portfolio Theory, etc.), and the empirical evidence of SI, where portfolio allocations are affected by non-financial aspects like personal values and social pressures. How can we make sense of this tension? 

Usually, the contradiction is formulated in terms of a tradeoff between financial returns and ESG impact: in order to achieve one, investors must forego the other. However, this view is still rooted in a traditional finance perspective, according to which including ESG considerations or seeking a non-monetary impact comes at the expenses of returns.

There needs to be more nuance in how sustainable investing decisions are investigated and assessed. Given the pervasive and engaging nature of ESG issues, sustainable investing is likely shaped by internal and external forces that go beyond the financial-vs-impact debate. By acknowledging the role that cognitive limitations, biases, and the external context play for investments, behavioral finance allows to capture the financial impact of factors that tend to be overlooked in mainstream financial theories. 

Under this perspective, the authors carried out a study based on primary data from European retail and professional investors. It focused on two main questions:

To what extent are sustainability considerations included in investment decisions?

Firstly our analysis broke down the relative importance of four attributes for the investment choice, i.e. the relative weight (expressed in percentage) that each characteristic exert on the investment decision. Sustainability attributes carry a relative importance of about 38%, with ESG score displaying a 26% relevance, and the investment’s end objective a 12% relevance. Taken together, these parameters display a larger role than standard financial attributes of risk level (relative importance of 33%) and expected returns (relative importance of 29%) (Figure 1). The results confirm the significance of ESG aspects for a well-rounded assessment of an investment, arguing against the traditional perspective of risk and returns as the sole determinants of investment choices.

Figure 1 – Relative importance of investment attributes for investment choice, by investor type
What drives investors to invest sustainably?

Secondly, we identified the main tendencies leading investors to engage in SI. Starting from a set of 16 heterogeneous motives, 4 main drivers emerged: a desire for self-expression, a financial-strategic rationale, the influence of the external context, and an opportunistic motive (Table 1). These drivers depict SI as a multifaceted phenomenon that unfolds along various dimensions, and not only on the financial and impact layers. They propose a novel perspective to think about SI, which takes into consideration how endogenous (e.g., alignment with values) and exogenous (e.g., role of regulation) forces may affect investments. 

Table 1 – Drivers of Sustainable Investing
How can the findings help us better assess sustainable investing?

This analysis shows the extent to which ESG aspects are integrated in investments, confirming their importance for investment choices. It also shows the multidimensionality of SI drivers, which eschews the rigid perspective of traditional finance and accounts for the impact of relevant internal and external factors. 

With this understanding, it is possible to formulate practical insights for industry participants to address the current challenges of SI. In fact, there are concerns related to the over-inclusion of sustainability in investment decisions at the expenses of fundamental financial analysis, which may lead to mispricing, inflated asset evaluation, and potentially an “ESG bubble”.

  • Standardize definitions and improve sustainability communication. Social context emerged as one of the drivers of SI, and regulators have a strong role to play in harmonizing the meaning of sustainability in finance. Legislative and non-governmental bodies are working to overcome the lack of standard definition and frameworks in SI – e.g., via the European Union’s Sustainable Finance strategy. Their effort to create a common vocabulary and shared understanding of what SI entails will help to align incentives, concepts, and strategies. In parallel, the financial-asset supply side (e.g., fund providers, financial advisors, etc.) should communicate clearly and extensively on the sustainability aspects of financial products. Given the importance of ESG characteristics for investment choices, this will ensure investors have reliable and trustworthy information to guide their investments. Together, the agreement in terminology and the availability of sustainability information will reduce the possibility for misinformation and opportunistic tendencies to sway investment decisions.
  • Recognize the existence of complex drivers behind sustainable investment decisions. Investors, both professional and retail, should evaluate how different motives affect their investment choices. Knowing that multiple drivers exist will ensure that investment are aligned with goals, limiting the influence of irrationality and misinformation. This will not only benefit investment strategies, but also curb counter-productive results such as the emergence of an ESG price bubble. To explore what drives investor’s decisions, an ad-hoc survey could be submitted ahead of opening investment accounts, mirroring the logic of the MiFID directive. This may have positive effects, such as involving more retail investors in sustainable investing [2].
  • Finally, consider adopting a behavioral approach when studying sustainable investing. The flexibility of behavioral finance may allow to grasp further insights and help to think about this timely topic in a novel way.

References

[1] The Global Sustainable Investing Alliance (GSIA) considers defines “Sustainable” all assets that integrate ESG factors in the analysis and selection of securities. More detail in their latest global report.

[2] Retail investors still face barriers to fully engage in SI: the topic is investigated in the paper “Investment Barriers and Labeling Schemes for Socially Responsible Investments” by Gutsche and Zwergel (2020).

About the Authors

Margherita Massazza is a CBS and Bocconi graduate in Economics of Innovation, with a focus on Sustainability. Her research investigates the links between traditional investments and behavioral finance to understand how sustainability decisions unfold. She is currently working in the Foresight team of AXA, an insurance company, where she studies the role that corporations will play in the future and how the concept of sustainability will evolve. 

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo by PiggyBank on Unsplash

No Trees, No Future: How can we unlock the full potential of conservation finance?

By Dr. Kristjan Jespersen, Dr. Izabela Delabre, Dr. Caleb Gallemore, and Dr. Katryn Pasaribu

◦ 3 min read ◦

Tropical deforestation continues at alarming rates, with 12 million hectares of tropical tree cover loss recorded in 2018. Much of this deforestation is linked to large-scale agricultural development. Palm oil companies are seen as key deforestation culprits due to high-profile media campaigns being led by NGOs and, in response, recent years have seen the proliferation of private sector pledges and initiatives to address deforestation in the palm oil value chain. There has also been growing international focus on forest conservation in the context of climate mitigation, with countries at 2021’s United Nations Climate Change Conference (COP26) pledging to halt deforestation by 2030. Multi-billion dollar initiatives, such as the Bezos Earth Fund are investing in nature-based solutions to address climate change, including through the protection and reforestation of forests and other ecosystems. 

Given these ambitions, an important question for corporate sustainability and conservation research and practice is how to link financing mechanisms for conservation and value chains, two policy streams that are generally disconnected. Actual methodologies for understanding appropriate, long-term financing for forest conservation remain elusive, and this knowledge gap hinders the clear assignment of responsibility, accountability and sustainability of conservation efforts.

Articulating “conservation finance” (the “mechanisms and strategies that generate, manage, and deploy financial resources and align incentives to achieve nature conservation outcomes”) with value chains could help align incentives between actors and facilitate increased financial flows from the private sector to conservation. 

Introducing No Trees, No Future – new research project

An ambitious new research project “No Trees, No Future – Unlocking the full potential of conservation finance”, funded by the David and Lucile Packard Foundation, seeks to design and test a rigorous methodology for understanding the responsibility for conservation finance of influential firms in the palm oil value chain. It addresses important knowledge gaps that currently impede effective conservation finance, examining questions such as: Which firms are responsible for financing conservation? What are the motivations of firms to engage in different types of conservation finance initiatives? To what extent are companies willing to internalize conservation costs? What might cost-sharing models look like? 

This novel, interdisciplinary research project uses a mixed-methods design that combines in-depth case studies, surveys and remote sensing to explore how the costs of conservation may be shared effectively and equitably between palm oil value chain actors, and provides a resource for external stakeholders seeking to identify firms’ contributions to land cover change, in Indonesia to start with.

The research will involve the development of data-intensive methods to assess the spatial footprint of the supply chains of a set of lead firms in the oil palm value chain, as well as in-depth interviewing of stakeholders across the palm oil value chain to identify the feasibility and possible impacts of adopting new methods for conservation finance. 

Our goals are: (1) to develop a methodology that can be readily applied to estimate lead firms’ responsibility for contributing to conservation finance in the palm oil sector, and (2) that business models and strategies integrate conservation finance effectively, supporting more equitable cost sharing. 

The research will identify several possible models for assessing spatial footprints of firms’ supply chains in the oil palm sector, testing their feasibility with a selected group of investors and conservation project proponents. Following this initial project, which focuses on the palm oil value chain, we intend to explore possibilities in other commodity sectors, and how to scale up efforts to support effective and equitable conservation finance.

To what extent will companies be willing to absorb the costs of conservation finance into their supply chain transactions? How might potential barriers be overcome? It is our intention that the project contributes to companies taking on greater responsibility for conservation finance, embedding long-term conservation costs into the palm oil value chain (that are currently externalized), disrupting ‘business as usual’ to support forest conservation, given their critical role in climate mitigation and biodiversity conservation. 

We will share our interim findings on this blog as the project progresses. We would be delighted to hear from researchers from different disciplines and practitioners working in this field. If you have any questions or comments, please get in touch! 

About the Authors

The two-year project is led by Dr. Kristjan Jespersen, Associate Professor at the Copenhagen Business School (CBS). The research team includes Dr. Izabela Delabre, Lecturer in Environmental Geography at Birkbeck, University of London; Dr. Caleb Gallemore, Assistant Professor in the International Affairs Program at LaFayette College, Pennsylvania; and Dr. Katryn Pasaribu, seconded from Universitas Prasetiya Mulya to CBS.

Photo by Franz Schäfer on Unsplash

Social impact bonds in the Nordics: insights from ‘Copenhagen Impact Investing Days 2021’

By Mikkel M. Andersen and Ferran Torres

◦ 5 min read ◦

A social impact bond (SIB) is an innovative model for public service delivery characterized by flexible service interventions and an outcomes-based payment structure. SIBs use private investments to drive new types of welfare activities, shifting the risk from the public to the private sector. Today, several SIBs are emerging in Nordic countries, but do rich welfare states even need these financing mechanisms? And in case they do, for what? These questions were discussed by three leading SIB-experts during the ‘Copenhagen Impact Investing Days’ 2021.

During the last few years, the use of social impact bonds (SIBs) and other social finance-instruments has increased dramatically in Nordic countries. SIBs were originally used as financing tools supporting public organizations in the UK experiencing budgetary restraints. Thus, as the model spread into other contexts, the question begged whether this tool would be appropriate for Nordic countries as well. The following piece summarizes some key reflections from the panel discussion regarding this question at Copenhagen Impact Investing Days 2021 (CIID). 

SIBs in the Nordic countries: an emergent but fast-growing field 

While more than 200 SIBs have officially been developed worldwide, they are still an emergent phenomenon in most Nordic countries. Currently, 17 SIBs have been initiated in Finland, Sweden, Denmark, and Norway – primarily within employment, preventive health, and social welfare. Also, at least 7 additional SIB-projects have been announced. The first SIB-evaluations are also starting to come up; for example, the assessment of the first Swedish SIB in Norrköping shows promising social effects, despite not creating a financial return for investors. Finnish intermediary-organizations are also planning to develop SIB-projects within environmental areas, including recycling and energy efficiency in housing.

Overall, Finland seems to be on the forefront in the Nordic regions, followed by Sweden, while Denmark and Norway are a few years behind. On the investment side, significant progression is also being made. A Finnish fund-of-funds is currently being developed with an expected capital of 100 million Euro. In Sweden, work is also being done to set up a national outcomes financing structure to ensure the scaling of future outcome-based initiatives. Last, legislative action to ensure social finance practices has been taken – most recently in Denmark with Børnene Først promising more focus on social investment-practices to ensure preventive social welfare.  

Emerging practices for Nordic SIBs 

Some early experiences regarding the relevance and usage of SIBs in the Nordic countries were discussed during the CIID-conference. First and foremost, SIBs seem to be a part of a much larger trend in public welfare, oriented towards measuring, incentivizing, and resourcing towards long-term social outcomes. While SIBs might constitute effective solutions in themselves, they are also catalysts for evolving social investment practices because they can 1) showcase the benefits of new types of welfare services by linking social and economic outcomes, 2) provide practical solutions for realizing preventive and proactive welfare services, and 3) facilitate cross-sectoral coordination through new procurement frameworks by bringing new stakeholders to the table. 

The SIB can be a useful way to show the municipalities, and the government, how to buy the solutions that actually work. 

Hans Henrik Woltmann, Investment Manager, The Social Investment Fund (DK)

What seems to be critical is also the perception that SIBs in the Nordic countries should not function as a replacement to or a privatization instrument for public welfare services. Instead, SIBs should be understood as a supplement to these, allowing public actors to change how they buy public interventions while testing new welfare solutions through de-risking strategies. Still, the novelty of the method, and its experimental character, makes it challenging to assess its true potential.

Does the SIB really allow us to scale or is it just a fancy way of financing projects? I think the question is still out there 

Tomas Bokström, Project Manager, Research Institutes of Sweden
Looking into the future: necessities for a social finance-ecosystem 

Summarizing the points from the debate, SIBs in the Nordics are on the rise and have the potential to become welfare instruments themselves, and a vehicle for promoting a social investment agenda. Looking ahead, three key aspects will be important for enhancing the Nordic social finance ecosystem: 

  1. Establish more evidence from practice and leverage these actively with public organizations to spark discussions. 
  2. Insist on experimentation and a methodological openness towards the SIB-model. Its value also resides in its ability to test innovative social interventions to later diffuse them through public practices fitting better into specific welfare situations. 
  3. Follow and engage in political discussions regarding the ambitions for SIB-practices. The SIB market is still in its infancy and relies heavily on market-maturement initiatives to develop better infrastructure.

Panelists for the discussion of Nordic Impact Bonds at ‘Copenhagen Impact Investing Days 2021’:  

· Tomas Bokström, Project Manager, Research Institutes of Sweden
· Hans Henrik Woltmann, Investment Manager, The Social Investment Fund 
· Mika Pyykkö, Director, The Centre of Expertise for Impact Investing, Finland
· Mikkel Munksgaard, PhD Fellow, Department of Management, Society, and Communication, CBS (moderator)
· Ferran Torres Nadal, PhD Fellow, Esade Entrepreeurship Institute & Institute for Social Innovation, ESADE (moderator)

About the Authors

Mikkel Munksgaard Andersen is PhD Fellow, at CBS Sustainability, Department of Management, Society and Communication (MSC) at CBS. Through his PhD-project, Mikkel studies the development and implementation of social impact bonds and payment-by-results methods in Denmark. His work centralizes around the distinct characteristics of Scandinavian impact bonds and their role in supporting and financing public services. The research is driven by a participatory research design and is co-financed by Region Zealand. Mikkel has earlier worked in the social finance-field both on an academic and practical level.

Ferran Torres Nadal is PhD Fellow at the Entrepreneurship Institute and the Institute for Social Innovation, ESADE Business School in Spain. His PhD advisors are Lisa Hehenberger and Tobias Hahn. His work is focused on understanding and explaining tensions and paradoxes around complex phenomena. He is particularly interested in studying the challenges and opportunities that come with cross-sector initiatives, such as social impact bonds.   

Photo by Katt Yukawa on Unsplash

SFDR, NFRD and the EU Taxonomy – What is their relationship?

By Andreas Rasche

◦ 5 min read ◦

The new Sustainable Finance Disclosure Regulation (SFDR) is on the minds of many investors these days. While a lot has been written on SFDR itself, I discuss how it relates to the Non-Financial Reporting Directive (NFRD) and the EU Taxonomy on sustainable economic activities. Taken together, these regulations can be overwhelming and maybe even confusing. While this is not the right place to comprehensively discuss all three regulations, I make some clarifications on their interlinked nature. 

SFDR, NFRD, and the EU Taxonomy – What are we Talking About? 

To start with, let us briefly review the three legal instruments, all of which belong to a series of EU regulations under the EU Action Plan on Sustainable Finance.

  • NFRD is the EU legal framework for regulating the disclosure of non-financial information by corporations. It was adopted in 2014 and states that corporations have to report on ESG information from 2018 onwards (for the 2017 financial year). NFRD is rather flexible – it applies only to so-called “public interest entities” (basically rather big corporations) and it contains so-called comply-or-explain clauses (allowing for non-disclosure of information if this is made transparent and reasons are given). 
  • SFDR is the new EU regulation that introduces rules for financial market participants (FMPs) and financial advisers (FAs) to report on how they account for sustainability risks. SFDR applies at the “entity level” (i.e. requiring financial firms to report on how the whole organization deals with such risks) and also on the “product level” (i.e. requiring firms to report on how their financial products are affected by such risks). SFDR contains few comply-or-explain clauses (e.g., smaller firms, with less than 500 employees, can opt out of reporting on due diligence processes). The regulation asks all FMPs and FAs to report on sustainability risks even if they do not offer ESG-related products. If an entity offers ESG-related products, SFDR requires additional disclosures depending on how “green” the product is considered to be. SFDR came into force on 10 March 2021. 
  • The EU Taxonomy regulation (hereafter: the Taxonomy), which entered into force 12 July 2020, reflects a common European classification system for environmentally sustainable activities. Basically, the Taxonomy tried to answer the question: What can be considered an environmentally sustainable activity? Answering this question is essential for investors to prevent “greenwashing” – i.e. a situation in which financial products are marketed as being sustainable without meeting sustainability criteria. The taxonomy defines six environmental objectives, and it defines an economic activity as sustainable if this activity contributes at least two one of these objectives without, at the same time, doing significant harm to any of the other objectives. 
Differences and Commonalities 

To start with, it is important to note the different legal status of SFDR/the Taxonomy as well as NFRD. NFRD is based on an older EU Directive (2014/95/EU). Directives imply that EU member states have to translate the broad requirements into national regulation. By contrast, SFDR (2019/2088) and the Taxonomy (2020/852) are both based on European regulation, which is immediately enforceable and does not require transposition into national law. 

To understand how the three legal frameworks relate to each other, look at the Figure below. NFRD applies to corporations of all kinds. Hence, for investors NFRD is mostly relevant because it stipulates how investee companies report ESG data. SFDR, by contrast, most concerns financial market actors and ensures transparency about how these report on sustainability risks to their audiences (e.g., retail investors). The Taxonomy was introduced to have a common reference point when trying to figure out whether an economic activity really is sustainable. The Taxonomy therefore has the power to further specify the regulations set out in SFDR and NFRD. 

source: Andreas Rasche
Emerging Relationships  

The linkages between the three frameworks will be further specified throughout the coming years. While SFDR has been in force since 10 March 2021, it is only in the so-called “level 1 stage of development”. As with many EU regulations, level 1 development sets out the basic framework principles for a regulation, however without specifying technical details. SFDR level 2 will come into force once the regulation is complemented with Regulatory Technical Standards (RTS), which are developed right now. The RTS will also specify the linkages to the Taxonomy in more detail (e.g., related to the “do-no-significant-harm” concept inherent in SFDR). 

So, what can we say right now? The current versions of SFDR and NFRD do not yet link disclosures to the Taxonomy. This is likely to change, especially with the SFDR RTS being further specified and rolled out (in early February the European Supervisory Authorities released their final draft of the SFDR RTS). Moreover, the NFRD regulation is currently under consultation and will be revised in the near future. However, two important linkages are important to consider right now.  

  • First, the scope of the Taxonomy is defined through NFRD and SFDR. In other words, if an organization is affected by NFRD and/or SFDR, the Taxonomy will also be relevant for its disclosure practices. It is important to note here that the EU Taxonomy defines further mandatory disclosures in addition to what is laid out by NFRD and SFDR. 
  • Second, the Taxonomy asks companies (incl. asset managers) to report the percentage of their turnover and capital as well as operational expenditures that are aligned with the Taxonomy. It also asks asset managers to report the percentage of their portfolio which is invested in economic activities that are aligned with the Taxonomy. 
The Future

We will witness a good deal of technical specifications of all three regulations throughout the next years. SFDR level 2 reporting will kick in once the RTS standards are part of the reporting (probably by mid-2023); also by 2024 year-on-year comparisons of data points under SFDR will be likely mandatory. The six environmental objectives of the Taxonomy will be specified through technical screening criteria, some of which will be released very soon. 

It is good to see non-financial reporting and sustainable finance being backed by strong European regulations. It allows for more comparison and benchmarking and hence transparency. But, of course, we should also be prepared for a good deal of clarifications that will be necessary until institutionalized reporting cycles can fully kick in and unfold their potential. 

About the Author

Andreas Rasche is Professor of Business in Society at the Copenhagen Business School (CBS) Centre for Sustainability. His latest book “Sustainable Investing: A Path to a New Horizon” (with Georg Kell and Herman Bril) was published recently. Email: ar.msc@cbs.dk Homepage: www.arasche.com

Arguing for Climate Adaptation

By Stella Whittaker

◦ 3 min read ◦

This month saw the publication of the Climate Policy Initiative’s (CPI) long awaited analysis of climate finance flows in cities.  Each year the CPI publish an analysis of the global landscape for climate finance but this year that work was supplemented by this urban analysis.  There will also be another forthcoming CPI report  due in April 2021 – State of Cities Climate Finance Report which will help paint the full picture.  

Cities and urban communities across the globe are highly vulnerable to climate change – heat waves, extreme weather volatility, floods, droughts, coastal inundation, and vector borne diseases. The Carbon Disclosure Project (CDP) data indicates that in 2018, 85% of cities reported major climate-related disruptions, including flash and surface flooding and extreme weather events like heat waves and droughts.

There is an urgency for much more discussion, research and attention on climate finance to address climate adaptation needs in cities. While many cities have begun planning policies and programs to build resilience towards climate hazards, the how and where of finance for those activities is less understood.  

It is plain to see from this practitioner-based work that climate finance for adaptation is not being supplied or demanded at a scale that is commensurate with the size of the impacts of climate change.  Scholars have found that here are significant data and reporting challenges and a myriad of policy challenges and barriers.  I am stressing here the need to argue loud and long for adaptation along with mitigation activities.

CPI recorded annual global climate finance flows of USD 546 billion in 2018. Of this only 4% can be attributed to adaptation. Finance flow in cities for adaptation is particularly problematic. The CPI also found:

Between 2010 and 2014, cities received less than 5% (in the range of USD 109 Million) of global adaptation finance.

Morgan Richmond, Nidhi Upadhyaya and Angela Ortega Pastor, CPI, 2021

So, based on current estimates, despite all the difficulties with measurement and tracking, potentially less than 1% of global climate finance is flowing to cities each year for adaptation, which is much less than the USD 11-20 billion that what the World Resources Institute (WRI) stated be needed on an annual basis to protect global urban infrastructure from climate risks (WRI, 2019).

This month I launched a new Linkedin Group Adaptation Finance – this is a discussion, research and professional development group for investors, governments and academics alike dedicated to developing an understanding of climate finance for adaptation. By following the Group there is an opportunity to participate in my PhD climate finance research (survey, interview, focus group or information provision), whilst learning and sharing in the latest research and trends from various industries. As climate adaptation practitioners, investors, governments, academics, scientists and researchers we rarely meet to share knowledge and experiences, please join in this unique collaboration. I want to build an active research environment for both investors and city government focused on climate adaptation. 

In addition, in the Group:

  • WE will analyse climate finance flows in cities.
  • WE will also analyse activity against internationally recognized benchmarks for appropriate urban climate change adaptation financing. 
  • WE will collate innovative climate finance practice.
  • WE will generate new knowledge on how to deliver and finance large-scale innovative city financing solutions through public and/or private stakeholders. 

In Arguing for Adaptation there are five practical things to think about in getting the balance right:

  1. Make climate adaptation an equal priority to climate mitigation
  2. Understand future climate risks to your business and/or constituency (look at the guidance from the Taskforce on Climate-Related Financial Disclosures (TCFD)
  3. Understand climate finance flows in your city and region(s) you operate in
  4. Enter into a dialogue with investors and cities to understand each other’s challenges and opportunities
  5. Look for and prioritize climate initiatives that deliver dual or even multiple benefits – climate resilience, mitigation, natural capital etc. such as nature-based solutions NbS

If you like a good cause and a good argument, then please join me. 

About the Author

Stella Whittaker is a PhD Research Fellow who is undertaking a PhD in climate finance at Copenhagen Business School, at the department of Management, Culture & Communications. Stella is a specialist in the field of sustainability, circular economy and climate change. She has worked for over 30 years as a senior executive in sustainability, climate change, infrastructure sustainability & environment.

Portfolios at risk of Deforestation

How can financial investors better understand underlying risks and act accordingly

By Amanda Wildhaber, Dominik Wingeier, Jessica Brügger, Nico Meier, and Dr. Kristjan Jespersen

◦ 4 min read ◦

Forests play a crucial role in tackling climate change and protecting biodiversity. Around 12 million hectares of tropical forest worldwide were lost in 2018 and approximately 17% of the loss stem from the Amazon alone. The main drivers of deforestations are soy, palm oil, cattle and timber production. As deforestation may harm a company’s reputation, directly affect its supply chains and increase regulatory risks, many institutional investors are concerned about the impact deforestation can have on their portfolio companies.

How can deforestation be measured?

The definition of deforestation risk from an investor’s perspective is difficult to lock-in because different frameworks and approaches focus on different aspects of the risks. The amount of information and the lack of transparency can be overwhelming to financial investors. Therefore, a helpful framework for financial institutions to systematically evaluate the deforestation risk management of portfolio companies has been developed. The framework is divided into two parts, an internal assessment of a company’s commitments and achievements regarding deforestation and an external assessment of outside policies related to deforestation, namely binding laws and private sector initiatives. The framework may serve to complete a scorecard which gives an overview of how well prepared a specific portfolio company is and if it is able to deal with deforestation risks and future regulatory changes. The final scorecard reflects the deforestation risk of financial institution’s portfolio companies.

Is voluntary support sufficient?

Many companies voluntarily support sustainability initiatives and follow zero deforestation commitments (ZDCs) to signal their intention to reduce deforestation associated with the commodities in their supply chain. The reasons behind their commitments include demonstrating corporate social responsibility (CSR), reducing the risk of potential reputational harm and supply chain disruptions. To understand the value of these commitments in mitigating deforestation and associated risks, it is important to critically analyse them in terms of their scope, effectiveness, monitoring and achievements. This includes for example, assessing how companies define deforestation and whether they systematically measure the compliance with their commitments.

External pressure to facilitate internal commitments

It is valuable to see companies implementing robust internal policies and commitments to manage and monitor their deforestation risk. However, it is also important to have external policies in place to hold companies accountable. There are two types of external policies the proposed framework is based on.

  1. The first type are binding laws which apply for portfolio companies and thus represent a regulatory risk. The EU Timber Regulation (EUTR) of 2010, which prohibits the sale of illegally logged wood in the EU, is one example for such a binding law.
  2. The second type are initiatives by third parties, which are of a non-binding nature and complement the binding law. One such initiative is the Roundtable for Sustainable Palm Oil (RSPO), which is an initiative by private companies as well as external parties targeted to eliminate unsustainable palm oil production.
How do the companies score?

Based on the assessment of the two pillars of the framework – internal and external – a scorecard is derived which assists investors to better understand how a portfolio company or a new potential investment is managing its deforestation risk. Answering questions with scores from 1 to 3, whereby 1 is the best score and 3 the worst, the proposed scorecard allows the quantification of the deforestation risk management of a company. While the distinction between 1, 2 or 3 is not always straightforward, the final score gives a tangible assessment of how well a company is positioned to manage its deforestation risks and associated future regulatory changes. The following scorecard provides an overview of the assessment and indicates how well Nestlé is managing deforestation risks.

Having such a scorecard allows investors to manage and mitigate the deforestation risks they face in their portfolios. In addition, the final scorecard enables investment analysts to directly compare potential investments with other companies and can be used as a parameter in the investment process.

The call for action is getting louder

New regulatory requirements, growing public scrutiny and extended private sector initiatives (such as the investor-led initiative Climate Action 100+), mean that it is becoming increasingly important to properly manage deforestation risks. This is also becoming a key concern for financial investors and it is time to think about systematic approaches on how to include deforestation into the investment process. The proposed framework is intended to serve as a starting point for just that. It allows a quantification of deforestation risk and the identification of critical factors. Building the basis upon which investors can engage with companies. This is a first step to support the mitigating of not only financial but also ecological risks.

About the Authors

Amanda Wildhaber is completing her masters in Economics at the University of St. Gallen. She works as a Junior Consultant in the Strategy team of Implement Consulting. Her interest in ESG and sustainable investments developed when she wrote her bachelor thesis on social enterprises in India.

Dominik Wingeier is studying master’s in Banking and Finance at University of St. Gallen. Dominik has been working for BlackRock where he was responsible for executing and monitoring primary, secondary and direct investments in infrastructure projects.

Jessica Brügger is studying master’s in Business Innovation at the University of St. Gallen. Jessica is currently a board member of the Private Equity & Venture Capital Club of the University of St. Gallen and is particularly interested in making the financial industry more attractive to women.

Nico Meier is studying master’s in Accounting an Finance at the University of St. Gallen. Nico has been working at BLR&Partners where he is responsible for private equity investments. Additionally, he has experience providing M&A, ECM and DCM services.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Source: photo by Justus Menke on Unsplash

Delivering and Financing Better Societies

How can cities self-finance environmental and social solutions?

By Luise Noring

Every week, more than three million people move into cities looking for places to work and live. This puts an enormous strain on cities’ finances and capacity to provide for their residents. We can no longer – if we ever could – assume that taxes will pay for growing urban populations with growing demands for public infrastructure, goods and services. We need to find new ways of delivering and financing good societies for the billions of people living and working in cities.

Therefore, the challenge is not only to find the best environmental and social solutions for cities, but also to address how these solutions can be delivered and financed. All too often, for example, brilliant climate solutions are presented, but nobody wants to take responsibility for delivering and financing them. All too often, we hear of good solutions for social preventive action and public health that are never put into action. The solutions are there. The challenge is that the business case and investment proposition are either weak or non-existent. As a result, the only one with the incentive to implement the solutions is the cash-strapped government itself.

Hopeful scholars demonstrate how investing taxpayers’ money today could prevent massive expenditure tomorrow. Yet today’s tax revenues are already accounted for to pay for schools, roads, housing, hospitals, etc. This leads me to my principal research question and mission in life:

How do we deliver and finance better societies?

All too often, the only financial solution on the table is to increase and spend tax revenue. But there is no financial innovation in increasing and spending taxes. This ‘solution’ just means that bonds are repaid with future taxes even though we know full well that, in the future, taxes will still be needed to finance schools, roads, housing, hospitals, etc. Spending future taxes today only jeopardizes future generations’ ability to finance their schools, roads, housing, hospitals, etc. The same applies to tax increment financing (TIF), which is a common practice in urban development and economic revitalisation used in the US and subsequently adapted across much of the world.

The idea behind TIF is that local governments issue bonds based on future tax revenue increases. TIF assumes that urban regeneration can be financed by bonds that are serviced and repaid by future tax revenue increases. The proceeds of the TIF bonds are thus used to stimulate economic development through investments in urban regeneration, infrastructure and other public goods. The bonds are repaid mainly through property taxes resulting from investments and development activities. What happens though when the public investments fail to increase tax revenue paid by private owners? In such cases, local governments remain obliged to repay the government- guaranteed bonds.

Conventionally, in the US, local property taxes fund elementary and secondly education, supplemented by federal and state contributions. However, when future property taxes are used to finance infrastructure, public investment capital is in effect flowing from elementary and secondly education to infrastructure and other development activities in order to secure projected tax increases.

Thus, while TIF creates new economic development opportunities in one area, such as derelict neighbourhoods, it hollows out potential future investments in other areas, such as education.

Finally, it is common in many US cities for governments to woo private investment by offering tax reductions or exemptions. This amounts to making investments today with the tax revenues of tomorrow. This is how cities acquire unfunded liabilities.

The above paints a bleak picture of future financing of good solutions for better societies. However, during my research, I have come across many sound finance mechanisms. For instance, land value capture (LVC), which is commonly used in Northern Europe. LVC bundles publicly owned land, such as former port and military areas, or areas over which the public can take ownership, such as derelict areas. Once the local government has secured land ownership, it rezones and repurposes the land.

For example, former industrial land can be repurposed for commercial and residential use. This increases land values, which enables the government to take out loans based on the increased value of the land. With renewed borrowed capital, local government can make infrastructure and other investments in the land. This again increases land values. Once the land has been properly matured, it is sold to private investors and developers, including institutional investors, such as pension funds. Revenues from land sales are used to service and repay the debts. You can read more about this model in my Copenhagen City & Port Development report.

Another solution is for local government to raise seed capital, for instance from philanthropies, pension funds and other large institutional investors that invest with long time horizons. This seed capital is used in projects as low-yield and high-risk investment capital that is capable of attracting other investments that are more high yield and low risk. Once projects have been realised, they are refinanced, and the seed capital is withdrawn and put into another project. This is a kind of project-by-project financing. You can read more about this model in my Cincinnati Development Corporation report.

This blog post has offered a snapshot of several research projects I have conducted over the years. All my works contain key enabling features for replication, which allow me to scale solutions to other cities. If you want to learn more, please visit this page or get in touch with me: lno.msc@cbs.dk.

Further Reading

Luise Noring (2019) Public asset corporation: A new vehicle for urban regeneration and infrastructure finance. Cities.

Bruns-Berentelg, J., Noring, L., & Grydehøj, A. (2020). Developing urban growth and urban quality: Entrepreneurial governance and urban redevelopment projects in Copenhagen and Hamburg. Urban Studies.

About the Author

Dr. Luise Noring is an Assistant Professor at CBS, where she also attained her Ph.D. in supply chain partnerships. Noring challenges taken-for-granted and commonsense solutions – which are only ever taken-for-granted and commonsense within their specific contexts. Part of what makes her work innovative and has assured its impact in research and practice is precisely her insistence on reaching across national and sectoral contexts, drawing experiences from a great diversity of urban systems. This has allowed Noring to identify what kinds of city solutions work best in particular contexts and how certain kinds of institutional vehicles and finance mechanisms can be adapted to diverse cities and countries.

Photo by Denys Nevozhai on Unsplash