Environmental, Social and Governance (ESG) first appeared in a 2004 report by the UN-Global Compact which argued that how companies manage their environmental, social and corporate governance issues is an indicator of their management quality. It also argued that companies that take these issues seriously can simultaneously increase shareholder value and contribute to sustainable development.
Although there is no universally agreed definition of sustainable finance, the Loan Market Association defines sustainable finance as "incorporating climate, green and social finance while also adding wider considerations concerning the longer-term economic sustainability of the organisations that are being funded".
Clearly climate change has been an important driving force behind the growth in sustainable finance. Most major economies have declared emissions targets that look to limit global warming to no more than 2°C above pre-industrialisation levels by 2050. That target will only be successfully reached with the assistance of financial institutions that can provide the large amounts of funding needed to develop and acquire green technology and facilitate new sustainable business practices.
The UK is committed in law to net zero (reducing the UK's carbon emissions by 100% by 2050) and the government is pushing for the UK to be a net zero financial centre. In March 2023 the Department for Energy Security and Net Zero, HM Treasury and the Department for Environment, Food and Rural Affairs published Mobilising Green Investment: 2023 Green Finance Strategy (the Green Finance Strategy). It details five objectives of the UK government in respect of sustainable finance:
- UK financial services growth and competitiveness
- Investment in the green economy
- Financial stability
- Incorporation of nature and adaptation
- Alignment of global financial flows with climate and nature objectives
The core purpose of the Green Finance Strategy is the development of a net-zero aligned financial centre and the bringing together of public and private sector action in three specific areas:
Transparency - ensuring the correct sustainability data flows from the real economy to financial institutions, and then onto end users.
Transmission channels – using government policy to increase the availability of finance for the transition to net zero by de-risking green investments and lowering their cost of capital.
Tools for transformation – supporting the development of frameworks that financial market participants will need in order to incorporate information into investment decisions and monitor their progress on sustainability.
Sustainable financial products
The financial markets have developed numerous sustainable finance products. Currently the two of the most common types of sustainable finance are green loans/bonds and sustainability linked loans/bonds. The proceeds of green loans/bonds must be used to finance green projects, while the proceeds of sustainability-linked loans/bonds can normally be used for general corporate purposes.
Green loans are any type of loan instruments or contingent facilities made available exclusively to finance, new and/or existing eligible green projects and which are aligned to the four core components of the Loan Market Association's Green Loan Principles: (1) use of proceeds; (2) process for project evaluation and selection; (3) management of proceeds and (4) reporting.
Sustainability linked loans/bonds are differentiated from standard loans and bonds by the inclusion of financial incentives for the loan borrower or bond issuer to improve its sustainability profile. The incentive normally takes the form of an interest rate ratchet, where the interest rate will increase or decrease depending on sustainability target performance.
Additionally sustainable securitisations are now becoming more prevalent in the market. Sustainable securitisations differ from conventional securitisations by (a) the sustainability of the assets backing the securities, (b) the potential to amalgamate sustainable assets into pools to fund sustainable structures, (c) the sustainable use of proceeds of the securities and (d) the constituents of the investor base.
Credit derivatives can be also be used to manage ESG related risks, helping to increase liquidity for ESG investments and support sustainability efforts in the financial markets. For example, where a party's financial performance is affected by climate changes it can enter into an ESG related credit default swap to hedge counterparty credit risk.
Green finance is a growing global market. It will undoubtedly play a significant role in helping the UK to meet the challenges of achieving net zero and take the opportunities that will arise from decarbonisation. At a micro-economic level, as sustainability becomes a key element of business planning and long-term strategy, green finance can help the development and delivery of those plans while the resultant increase in demand for green finance products will also expose new business opportunities, leading to an increased diversification of products and services.