In the many discussions surrounding the financing of the Sustainable Development Goals (SDGs), there is consensus on at least one point: traditional sources of public finance simply won’t cut it. Fortunately, in the private sector, we see a shift away from business-as-usual investing toward approaches that generate returns while unlocking benefits for environment and society.
For evidence, we can look to many sources. Fitch Ratings reports that ESG money market funds grew 15% in the first half of 2019, revealing that big asset managers are launching socially responsible options to meet investor demand. In addition, studies by Morgan Stanley, in part through its Institute for Sustainable Investing, further back this claim. A 2018 survey of institutional investors, for instance, reveals that sustainable investments represent more than $27 trillion, or that $1 out of every $4 under management are invested along ESG lines, while another study confirms that there is no financial tradeoff when investing sustainably and that sustainable funds may offer lower market risk.
Yet the unfortunate reality is that private sustainable financing remains limited where it is needed most: developing economies. To learn why, we reflected on this issue with stakeholders in our development finance network and identified key trends, challenges, and solutions related to boosting private financing for the SDGs in the developing world. In this series, “The Road to SDG Financing,” we at the Inter-American Development Bank (IDB Group) will analyze these in turn, with a specific focus on the Latin American and Caribbean (LAC) region.
For the first installment, we decided to look to the evolution of private investment. Just as we’ve seen a transformation in how increasingly conscientious consumer brands interact with society, the role of private investors has also evolved. Originally, companies and investors considered their mandate to be only profit-focused; it was their sole objective to meet the bottom-line and generate returns for shareholders, with little consideration for their impact on society. There has long been evidence of values-based investing, but for generations this was the exception and not the rule.
A key turning point in this evolution was the widespread use of negative screenings, or criteria meant to avoid financing companies engaging in harmful activities. According to Robeco’s Sustainable Investing Glossary, negative screenings “can be a first step for investors to invest sustainably… the downside is that it has no net impact”, this is in part due to their preventive rather than proactive nature.
It is perhaps this limited impact that gave way to the use of positive screenings, or inclusionary criteria that prioritizes investments expected to generate positive non-financial returns. While these screenings require a more detailed analysis of company practices and performance, they also allow for greater diversification and have enhanced potential to incentivize positive corporate behavior.
Similarly, ESG investing, or the integration of environmental, social, and corporate governance (ESG) criteria into investment decisions, has gained momentum in recent years and become the new paradigm for responsible investing. On a basic level, ESG has provided investors the first widely accepted criteria for responsible investing, thereby mainstreaming practices that look beyond the bottom-line. It has been facilitated by the rise of corporate ESG disclosures and growing evidence that ESG does not hurt returns, and rather can enhance them through risk-mitigation filters. For an example we can look to the Journal of Sustainable Finance & Investment, which aggregated more than 2,000 individual studies and confirmed that most found a positive relationship between ESG investing and corporate financial performance.
As an institution committed to expanding private sustainable investing, it would be natural for the Inter-American Development Bank (IDB Group) to applaud the rise and reign of ESG investing. But as the Boston Consulting Group and others have pointed out, ESG criteria generally focuses on how companies operate, not how their core business generates value for society. This means ESG investing provides a partial view of how investments contribute to societal wellbeing, leaving a gap to be filled between responsible investing and truly sustainable investment practices.
In light of these shortcomings, we are encouraging the dawn of a new era: the era of sustainable investing, or what we like to call “SDG financing.” We define “SDG financing” as investment decisions intended to generate measurable impact in line with the SDGs. The word measurable here is key, as investments should be tied directly to SDG targets and indicators.
Like all development frameworks, the SDGs leave room for improvement. However, given the unprecedented public-private sector alignment they have inspired, we see great potential in SDG financing as a new wave of truly sustainable investing. Even so, it remains a relatively untapped investment strategy. According to market figures, impact-oriented strategies represent only $200 billion and are most often pursued opportunistically across fewer asset classes. In comparison to more established strategies like ESG integration, they are usually best pursued in partnership with multilateral development banks like the IDB Group which have the capacity and mandate to address the SDGs as part of their core business.
In this relationship, the investor can put forth its capital and benefit from the IDB Group’s credit rating, unparalleled knowledge of and presence in LAC, transactions that generate both SDG impact and financial returns, and capacity to measure results. In exchange, the IDB Group is able to unlock private capital that complements its own financial resources, thereby enriching its operations and facilitating the entry of diverse private investment to the LAC region.
Already, the IDB Group is actively pursuing activities that encourage the rise of SDG financing as the new normal for investors. One such initiative is IndexAmericas, a corporate sustainability index that assesses companies along ESG lines, but with a twist: a fourth component focused on the development impact of companies operating in the LAC region.
Yet we must do more to ensure private SDG financing becomes a mainstream investment strategy, and a lot of this boils down to both “talking the talk and walking the walk” on SDG action. In our next installment, we discuss just how the IDB Group is working to do both, while encouraging others to do the same.