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Brief introduction and terminology of sustainable finance

11/08/2020

Sustainability encourages people, governments, businesses and organisations, including financial institutions, to frame decisions in terms of environmental, social, and human impact for the long term rather than for short term. 

It requires them to consider more factors than simply the immediate profit or loss involved. 

Introducing Sustainable Finance; new approach to doing existing things

Sustainable Finance (SF) looks at how investing, lending and financing interact with environmental, social and governance (ESG) issues. It comprises various forms of finance with responsible, ethical or environmentally friendly objectives. 

Sustainable finance also offers market participants a choice to act in a responsible way and to support positive changes in day-to-day business.

Traditionally, the focus of sustainable finance has been to make profit by investing with a ‘green’ conscience. However, a transition is taking place to 'smart' green investments that combine profits with solutions to ESG issues. Sustainable finance is therefore not new, but introduces new approaches to doing existing things. 

Introducing Responsible Investment; an issue of global importance

Responsible Investment (RI) is an investment strategy that integrates ESG factors into investment analyses and decisions. As ESG factors impact on the financial value of an investment, long-term profits in terms of sustainability require a step away from short-term profit as the only definition of value. 

RI has quickly moved from being an outlier in the asset management world to an issue of global importance and a priority on political, legal and market agendas. RI creates long-term social, environmental and economic (sustainable) value. It combines financial and non-financial value creation and correctly prices social, environmental and economic risk.

Sustainable finance terminology in brief:

ESG lending: environmental, social and governance lending is conventional lending that incorporates environmental, social and governance criteria underpinned by bespoke reporting and monitoring obligations. Arguably most commercial financial institutions' green products sit within the ESG framework. 

  • Environmental aspects include greenhouse gas emissions; biodiversity loss; pollution and contamination; carbon regulation exposure and renewable energy.
  • Social aspects include labour practices; community displacement; human rights; health and safety and financial inclusion.
  • Governance aspects include corruption and bribery; reputation; management effectiveness and board diversity.

Ethical lending: ethical lending is conventional lending subject to screening for ethically unsound purposes (e.g. tobacco, alcohol, arms). While a commercial lender funding an ESG loan would typically avoid 'unethical' sectors, there is greater scope within ESG loan market to finance environmental efficiencies or other social or governance-based improvements within those sectors than in traditional ethical lending.

Impact lending: impact lending is the allocation of new capital with a direct and verifiable social or environmental impact. In the current market, impact lending tends to be the domain of microfinance organisations, philanthropic funds and development institutions or otherwise forms the focus of corporate social responsibility policies of larger commercial banks. 

Why ESG and Sustainability are relevant for the financial sector

This is a rapidly growing sector, with international policy initiatives giving rise to changing attitudes in the investment and lending community. Clients are increasingly concerned with climate change and resource scarcity and are looking for ways to invest in clean, sustainable initiatives and banks will be at the forefront of the promotion of industry standards in this area (such as the Green Loan Principles), and the support of United Nations Sustainable Development Goals (UNSDGs). 

Crucially, the negative impact of climate change can be substantially mitigated by banks actively pursuing the opportunities presented by the move to a low carbon economy.

Pressure to start acting now

Financial institutions are experiencing regulatory and commercial pressure to start acting on sustainability, in order to protect themselves from the possible risks of the climate change and to help finance a green agenda. Below we present an overview of some first considerations for financial institutions on how to start acting on sustainability:

  • Developing a deep understanding of the principles of sustainable finance;
  • Developing and offering sustainability-oriented banking products;
  • Engaging with clients on sustainability issues to enable a shift to sustainable technologies;
  • Providing trainings to inform business teams and clients about sustainability risks. 

Moving forward: CMS and sustainable finance

Financial institutions could position themselves in a variety of ways regarding sustainability. They cannot remain silent, as diminishing resources and tighter sustainability regulations impact their clients and their ability to pay off debts. 

Also, the financing of sustainable developments and activities offers a range of new opportunities and clients will expect their bank to reflect on their own approach to sustainability. 

At CMS we are committed to supporting clients implementing sustainable business practice. Therefore we have developed a new cross-disciplinary 'Sustainable Finance' approach which spans regulatory, finance, corporate and energy specialists. Our holistic approach to ESG and climate action draws on specialists from across the firm to advise you.

Authors

Anna-Francesca-Mancosu-CMS-NL
Anna Francesca Mancosu
Professional support lawyer
Amsterdam
Etienne Courbois
Counsel
Amsterdam
Picture of Simon Hardonk
Simon Hardonk
Counsel
Utrecht