Sustainable Finance
Sustainable finance integrates environmental, social, and governance (ESG) criteria into financial decision-making. By investing in companies with high ESG performance, investors aim to (possibly) increase returns on investments and contribute to increased corporate sustainability. Integrating ESG criteria in investments typically means taking a company’s environmental (climate, environment and resource use) and social impact (stakeholder treatment, human rights, labour practices, etc) into account in investments. Governance deals with how the company is controlled and managed, such as board composition, compensation, shareholder rights, and transparency.
Screening of investments
A central idea in sustainable finance is to invest in the most sustainable companies, avoiding the least sustainable companies, or both (Kempf & Osthoff 2007).
Negative screening involves excluding companies, industries, or sectors that are considered harmful to society or the environment from investment portfolios. Typical examples of negative screening are excluding companies in coal, oil and gas sectors, tobacco or alcohol, weapons or gambling, or companies that have been caught to systematically break human rights or labour rights.
Positive screening involves selecting companies or sectors that contribute positively to sustainability. Typical examples include investing in renewable energy, innovative and green technology, the circular economy, companies that contribute to solving important social issues, or companies that are particularly good in diversity, human rights or other important issues.
An example: DNB Klima Index
DNB is the largest Norwegian bank. DNB offers a range of mutual funds. One of the funds offered by DNB is DNB Klima Index. This is an index fund, a fund that seeks to replicate the performance of a specific financial market index instead of being actively managed by fund managers who pick individual shares.
DNB Klima invests in listed companies that contribute to reducing energy-related climate emissions. The fund’s investments follow an international stock index for low-emission companies aligned with the goals of the Paris Agreement, i.e., a stock index classified as an “EU Paris-aligned Benchmark.”
DNB Klima Index has had annual returns of -13,1% in 2022, +30,5% in 2023 and +23,5% in 2024 (average: +16,6%). DNB Global Index, another index fund offered by DNB without the special focus on climate, has had annual returns of -9,1% in 2022, +27,8% in 2023, and +23,4% in 2024 (average: +17,3%). The costs of the two funds are similar (0,2% per year).
In 2023, the largest holdings of DNB Klima Index were Apple, Microsoft, Nvidia, Amazon, Meta and Alphabet.
Active ownership
Active ownership is investors using their ownership rights and position to influence corporate behaviour on sustainability (ESG) issues. In active ownership, investors engage directly with companies to improve their sustainability performance (Dimson et al. 2015).
Shareholder engagement involves direct communication between investors and company management or boards to discuss concerns and encourage improvements in ESG practices. This dialogue may focus on issues such as climate change, labour rights, executive compensation, or diversity on the board. Investors might ask companies to adopt more sustainable business practices, improve disclosure on ESG-related risks, or set specific targets, such as reducing greenhouse gas emissions.
Voting in shareholder meetings When investors own shares in a company, they are entitled to vote on important issues at shareholder meetings. These votes can relate to executive compensation, director elections, mergers, acquisitions, or ESG proposals. Investors who prioritize sustainability can use their votes support ESG resolutions and influence corporate policies in alignment with their sustainability principles.
Investors can file shareholder resolutions—formal proposals that are submitted to be voted on at a company’s annual general meeting. These resolutions can request specific actions or policy changes on ESG issues. Shareholder resolutions can pressure companies by raising awareness of issues and signalling widespread investor support (even if the resolution in the end is not supported by a majority).
The Norwegian Oil Fund and Sustainable Finance
The Norwegian Oil Fund, officially known as the Government Pension Fund Global (GPFG), is the world’s largest sovereign wealth fund, valued at over $1.4 trillion (as of 2023). Managed by Norges Bank Investment Management (NBIM), the fund invests globally in shares, bonds, and real estate.
The fund uses both negative screening and active ownership. The fund excludes companies based on product criteria (e.g., tobacco, weapons) and behaviour-based criteria (e.g., severe environmental damage, human rights abuses, corruption). From 2019 the fund excluded exploration and production companies solely focused on oil and gas. The GPFG publicly discloses the companies it has chosen to exclude from its investments.
The fund also uses active ownership through company engagement and voting in annual meetings. The GPFG meets with companies to discuss and promote their view on issues such as climate risk, human rights, and executive pay. The fund has significant voting power as a large shareholder in most international companies, and often votes in favour of sustainability-related shareholder resolutions.
Green bonds
Green bonds are a type of fixed-income security where the funds are used to finance projects that deliver environmental benefits. These projects can be renewable energy development, energy efficiency improvements, green technology investments, or other issues. Issuers of green bonds often commit to reporting on the use of proceeds and the environmental impact of the funded projects, providing transparency to investors (Flammer 2021, Maltais & Nykvist 2020). Many green bonds are certified by independent organizations to ensure that they meet specific environmental criteria. Still, there is a risk of green bonds being used for non-green purposes (greenwashing)(Shi et al 2023). Green loans are like green bonds but structured as loans provided to borrowers for projects that generate clear environmental benefits.
Data challenges in sustainable finance
A challenge in sustainable finance is the limited availability of ESG data. Many companies, particularly small and medium-sized enterprises (SMEs) or those in emerging markets, do not publicly report on ESG issues. Even when ESG data is available, data quality often is an issue (Kotsantonis & Serafeim 2019). Much of the ESG data available is self-reported by companies, meaning that the data lacks external auditing, use varying metrics, and can be quite subjective. Related, there has been several different standards for sustainability reporting, making it difficult to compare companies across industries or sectors. Finally, sustainability data is often reported annually, while investors may like more frequent data.
In addition to the company’s own sustainability reporting there is a wide range of external sustainability ratings (ESG ratings). ESG ratings are provided by specialized research and rating agencies. They use sources such company disclosures, media, and other public data to create these ratings, as well as tailored surveys sent out to the different companies. ESG ratings providers vary in methodologies and data and ratings for the same company can vary considerably (Chatterji et al. 2016, Berg et al 2022).
Are sustainable investments more profitable?
The relationship between sustainable investments and profitability is a central question in both academic research and the finance industry. In theory, sustainable investments could be more profitable, since sustainable companies can be better at managing social and environmental risks, since they can take a long-term view, since stakeholders may reward such companies, and since sustainability can reduce costs.
Friede et al (2015) did a meta-analysis of over 2,000 academic studies on ESG and corporate financial performance. The authors found that about 90% of these studies showed a non-negative relationship between ESG factors and financial performance, with the majority indicating a positive relationship. Empirically, this is a difficult question, but the best evidence suggests that the relationship is at least not negative.
Why do investors invest in sustainable finance?
Individual investors may have preferences for higher level of sustainability and therefore choose to invest in more sustainable companies or funds. Empirical studies show that this is the most important explanation (Riedl & Smeets 2017). Many investments are also done on behalf of others, who have expectations of contributing to sustainability or minimizing their negative impact. Institutional investors such as pension funds have a long horizon and expectations from their members and may therefore prioritize sustainability (Dyck et al 2019). Sustainable investments are also done because the investor believes that the investments will be more profitable (in the long run) (Edmans et al. 2024).
Does sustainable finance deliver sustainability?
There is much research on the relationship between sustainability and profitability/financial results, but there is less research on whether sustainable investments lead to more sustainable outcomes (Schlütter et al 2024). Investing in only “good” companies may not mean that the “bad” companies change in any meaningful way. The outcomes of active ownerships are also not clear. In investments, like in other areas, there is the danger of greenwashing, where companies or investment funds exaggerate how sustainable they are to attract investments.
Reflection questions
- How much lower returns on investment (if any) would you accept to invest in a sustainable fund?
- How can sustainable investments reduce carbon emissions from a company? Think about the “mechanisms” or assumptions that need to hold for this to happen.
References
Berg, F., Koelbel, J. F., & Rigobon, R. (2022). Aggregate confusion: The divergence of ESG ratings. Review of Finance, 26(1), 131-174.
Dimson, Elroy, Oğuzhan Karakaş, and Xi Li. “Active ownership.” The Review of Financial Studies 28, no. 12 (2015): 3225-3268.
Dyck, Alexander, Karl V. Lins, Lukas Roth, and Hannes F. Wagner. “Do institutional investors drive corporate social responsibility? International evidence.” Journal of financial economics 131, no. 3 (2019): 693-714.
Edmans, A., Gosling, T., & Jenter, D. (2024). Sustainable Investing: Evidence From the Field (SSRN Scholarly Paper 4963062). Social Science Research Network. https://doi.org/10.2139/ssrn.4963062.
Flammer, C. (2021). Corporate green bonds. Journal of Financial Economics, 142(2), 499-516.
Friede, G., Busch, T., & Bassen, A. (2015). ESG and financial performance: Aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment, 5(4), 210-233.
Kempf, Alexander, and Peer Osthoff. “The effect of socially responsible investing on portfolio performance.” European financial management 13, no. 5 (2007): 908-922..
Kotsantonis, S., & Serafeim, G. (2019). Four things no one will tell you about ESG data. Journal of Applied Corporate Finance, 31(2), 50-58.
Maltais, A., & Nykvist, B. (2020). Understanding the role of green bonds in advancing sustainability. Journal of Sustainable Finance & Investment, 10(4), 306-325.
Riedl, Arno, and Paul Smeets. “Why do investors hold socially responsible mutual funds?.” The Journal of Finance 72, no. 6 (2017): 2505-2550.
Schlütter, D., Schätzlein, L., Hahn, R., & Waldner, C. (2024). Missing the Impact in Impact Investing Research – A Systematic Review and Critical Reflection of the Literature. Journal of Management Studies, 61(6), 2694–2718. https://doi.org/10.1111/joms.12978
Shi, Xianwang, Jianteng Ma, Anxuan Jiang, Shuang Wei, and Leilei Yue. “Green bonds: Green investments or greenwashing?.” International Review of Financial Analysis 90 (2023): 102850.