Principles of Sustainable Finance

Cover
Principles of Sustainable Finance
Copyright
Dedication
PREFACE
	How does this textbook compare with other books?
	How to use this book?
ACKNOWLEDGEMENTS
CONTENTS
LIST OF FIGURES
LIST OF TABLES
LIST OF BOXES
LIST OF ABBREVIATIONS
Part I What is sustainability and why does it matter?
	1
 Sustainability and the transition challenge
		Overview
		Learning objectives
		1.1 Why does sustainability matter?
		1.2 Sustainability challenges
			1.2.1 ENVIRONMENTAL CHALLENGES
			1.2.2 SOCIAL FOUNDATIONS
			1.2.3 SUSTAINABLE DEVELOPMENT
				1.2.3.1 Global strategy
			1.2.4 SYSTEM PERSPECTIVE
				1.2.4.1 Examples of cross-system interactions and uncertain thresholds
		1.3 The role of the financial system
		1.4 Three stages of SF
			1.4.1 SF 1.0 PROFIT MAXIMIZATION, WHILE AVOIDING ‘SIN’ STOCKS
			1.4.2 SF 2.0 INTERNALIZATION OF EXTERNALITIES TO AVOID RISK
			1.4.3 SF 3.0 CONTRIBUTING TO SUSTAINABLE DEVELOPMENT WHILE OBSERVING FINANCIAL VIABILITY
			1.4.4 COMPARING THE STAGES: WHERE ARE WE?
		1.5 Challenges to integration of sustainability into finance
		1.6 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
Part II Sustainability’s challenges to corporates
	2 Externalities—internalization
		Overview
		Learning objectives
		2.1 Why externalities matter
			2.1.1 INTERNALIZING EXTERNALITIES
		2.2 Government intervention
			2.2.1 ENVIRONMENTAL EXTERNALITIES
				2.2.1.1 Taxing externalities
			2.2.2 SOCIAL EXTERNALITIES
		2.3 Measuring and pricing externalities
			2.3.1 THE MONETIZATION OF EXTERNALITIES: PITFALLS
			2.3.2 INSUFFICIENT PRIVATE EFFORT
		2.4 Scenario analysis
			2.4.1 UNCERTAINTIES ABOUT EXTERNALITIES
				2.4.1.1 Policy uncertainty
				2.4.1.2 Technological uncertainty
			2.4.2 THE USE OF SCENARIO ANALYSIS
			2.4.3 CLIMATE MITIGATION SCENARIOS
				2.4.3.1 Example of impact on an oil company
			2.4.4 STRESS TESTING
		2.5 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
	3 Governance and behaviour
		Overview
		Learning objectives
		3.1 Behavioural biases against sustainable development
			3.1.1 FROM COMPETITIVE TO COLLABORATIVE CONSUMPTION
			3.1.2 BEHAVIOUR OF COMPANIES AND INVESTORS: TOWARDS INTERNATIONALIZATION OF EXTERNALITIES
		3.2 What is the objective of the corporation?
			3.2.1 SHAREHOLDER MODEL
			3.2.2 REFINED SHAREHOLDER VALUE MODEL
			3.2.3 STAKEHOLDER MODEL
			3.2.4 HOW TO TAKE STRATEGIC DECISIONS THAT ANTICIPATE INTERNALIZATION OF EXTERNALITIES?
		3.3 Corporate governance mechanisms
			3.3.1 INCORPORATING SUSTAINABILITY INTO CORPORATE GOVERNANCE
			3.3.2 GOVERNANCE MODELS
			3.3.3 ORGANIZATION FORMS
			3.3.4 ENGAGEMENT
		3.4 Horizon: Moving from short-term to long-term thinking
			3.4.1 QUARTERLY FINANCIAL REPORTING
			3.4.2 VARIABLE PAY SYSTEMS
			3.4.3 QUARTERLY PERFORMANCE BENCHMARKING
			3.4.4 MARKING-TO-MARKET
			3.4.5 SUPERVISORY TREATMENT
		3.5 Guidelines governing SF
		3.6 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
	4 Coalitions for Sustainable Finance
		Overview
		Learning objectives
		4.1 The increasing role of institutional investors
		4.2 A system approach towards sustainability
			4.2.1 EXAMPLE OF CARBON BUDGET
		4.3 Coalitions for SF
			4.3.1 REASONS TO JOIN COALITIONS FOR SF
		4.4 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
	5 Strategy and intangibles—changing business models
		Overview
		Learning objectives
		5.1 Preparing for transformational change
		5.2 Theories of competitive position, business models, intangibles, and strategy
			5.2.1 COMPETITIVE POSITION
				5.2.1.1 Sources of competitive advantage
				5.2.1.2 Resources
				5.2.1.3 Knowledge
				5.2.1.4 Human capital and culture
				5.2.1.5 Networks/access
				5.2.1.6 Competitive position and financial performance
			5.2.2 BUSINESS MODELS
				5.2.2.1 What is a business model?
				5.2.2.2 Reinventing business models
			5.2.3 INTANGIBLES AND MATERIALITY
				5.2.3.1 Intangible resources versus intangible assets
				5.2.3.2 Materiality
				5.2.3.3 Problems with intangibles
				5.2.3.4 Intangibles and finance
			5.2.4 STRATEGY
				5.2.4.1 Strategy and finance
		5.3 Typical material sustainability issues
			5.3.1 E FOR ENVIRONMENTAL ISSUES
			5.3.2 S FOR SOCIAL ISSUES
			5.3.3 G FOR GOVERNANCE ISSUES
			5.3.4 OTHER ISSUES
			5.3.5 MAPPING MATERIAL ISSUES
		5.4 Circular business models
		5.5 Long-term value creation and the purpose of the firm
			5.5.1 THE PURPOSE OF THE FIRM
			5.5.2 PURSUING LTVC
				5.5.2.1 Example of long-term capital budgeting
		5.6 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
	6 Integrated reporting—metrics and data
		Overview
		Learning objectives
		6.1 Financial reporting: merits and limitations
			6.1.1 WHY REPORTING?
			6.1.2 LIMITATIONS TO REPORTING
		6.2 Non-financial metrics, data, and value drivers
			6.2.1 EXAMPLES OF METRICS IN E (ENVIRONMENTAL DIMENSION)
			6.2.2 EXAMPLES OF METRICS IN S (SOCIAL DIMENSION)
			6.2.3 EXAMPLES OF METRICS IN G (GOVERNANCE DIMENSION)
			6.2.4 RELATION TO THE VALUE DRIVERS
		6.3 The emergence of IR
			6.3.1 WHAT IS IR?
				6.3.1.1 Vision of the IIRC
				6.3.1.2 The IIRC’s approach
				6.3.1.3 The GRI’s reporting standards
				6.3.1.4 The SASB’s industry materiality approach
			6.3.2 IR IN PRACTICE
				6.3.2.1 Examples of companies practising IR
				6.3.2.2 Imagining a six capitals balance sheet
			6.3.3 INCENTIVES AND HURDLES TO IR
			6.3.4 SUCCESS OR FAILURE?
		6.4 Sustainability data providers
		6.5 Conclusions and future outlook
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
Part III Financing sustainability
	7 Investing for long-term value creation
		Overview
		Learning points
		7.1 (Over)reliance on market metrics
			7.1.1 PRICING
			7.1.2 ALLOCATION
			7.1.3 PERFORMANCE MEASUREMENT
			7.1.4 LONG INVESTMENT CHAINS
		7.2 Including ESG factors: The limitations of current approaches
			7.2.1 DESIGN LIMITATIONS
			7.2.2 CURRENT STATE OF PLAY
		7.3 The solution: an active investment approach
			7.3.1 PRICING: FROM EMH TO AMH
			7.3.2 ALLOCATION (1): FROM ESG FACTORS TO FUNDAMENTAL ESG ANALYSIS
			7.3.3 ALLOCATION (2): FROM DIVERSIFIED TO MORE CONCENTRATED PORTFOLIOS
			7.3.4 ENGAGEMENT
			7.3.5 ALTERNATIVE MEASURES OF PERFORMANCE (1): FINANCIAL
			7.3.6 ALTERNATIVE MEASURES OF PERFORMANCE (2): NON-FINANCIAL
				7.3.6.1 Performance on speci˜ c KPIs
				7.3.6.2 Externality valuation frameworks
				7.3.6.3 Contribution to global sustainability goals
			7.3.7 THE IDEAL INVESTMENT CHAIN
		7.4 Conditions for LTVC
			7.4.1 CONDITION 1: LONG INVESTMENT HORIZONS
			7.4.2 CONDITION 2: ACTIVE MANAGEMENT OF A CONCENTRATED PORTFOLIO
			7.4.3 CONDITION 3: EFFECTIVE ENGAGEMENT
			7.4.4 CONDITION 4: PERFORMANCE ANALYSIS OF VALUE ADDED IN THE REAL ECONOMY
			7.4.5 CONDITION 5: LONG-TERM ALIGNMENT OF THE MANDATES OF ASSET OWNERS AND MANAGERS
			7.4.6 CONDITION 6: KEEP THE INVESTMENT CHAIN SHORT
		7.5 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
	8 Equity—investing with an ownership stake
		Overview
		Learning objectives
		8.1 Basics of equities
			8.1.1 TYPES OF EQUITY
			8.1.2 EQUITY VALUATION AND ITS DRIVERS
		8.2 Why does sustainability matter to equities?
			8.2.1 EVIDENCE THAT SUSTAINABILITY MATTERS TO EQUITY PRICING
				8.2.1.1 From sustainability performance to value drivers . . .
				8.2.1.2 . . . To stock performance at the company level
				8.2.1.3 Investor performance
			8.2.2 EVIDENCE THAT E (ENVIRONMENTAL) MATTERS
			8.2.3 EVIDENCE THAT S (SOCIAL) MATTERS
			8.2.4 EVIDENCE THAT G (GOVERNANCE) MATTERS
			8.2.5 EVIDENCE THAT ENGAGEMENT MATTERS
		8.3 Integrating sustainability into equity investing
			8.3.1 HOW: METHODS FOR CONSIDERING ESG ISSUES
				8.3.1.1 Integrating sustainability into fundamental equity investing
					8.3.1.1.1 Step 1: Identify and focus on the most material issues
					8.3.1.1.2 Step 2: Analyse the impact of these material factors on the individual company
					8.3.1.1.3 Step 3: Quantify competitive advantages to adjust for value driver assumptions
					8.3.1.1.4 Step 4: Have an active dialogue with the investee company
				8.3.1.2 Integrating sustainability into quant equity investing
				8.3.1.3 Integrating sustainability into passive equity investing
			8.3.2 HOW SELL-SIDE RESEARCH ANALYSTS (SOMETIMES) INTEGRATE SUSTAINABILITY INTO EQUITY INVESTING
		8.4 Impact investing
			8.4.1 ACADEMIC RESEARCH ON IMPACT INVESTING
			8.4.2 IMPACT INVESTING AND FINANCIAL PERFORMANCE
			8.4.3 CHALLENGES OF IMPACT INVESTING
			8.4.4 MAKING IMPACT INVESTING TANGIBLE
		8.5 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
		APPENDIX: CASE STUDY: HOW TO UNDERTAKE ESG INTEGRATION
			8.1A Business model
			8.2A Value driver: Part 1
			8.3A Sustainability
			8.4A Impact
			8.5A Management quality and corporate culture
			8.6A Reporting quality
			8.7A Strategy
			8.8A Value drivers: Part 2
			8.9A Valuation
			8.10A Investment conclusions
	9 Bonds—investing without voting power
		Overview
		Learning objectives
		9.1 Basics of bonds
			9.1.1 BOND PAYMENTS
			9.1.2 TYPES OF BONDS
			9.1.3 BOND VALUATION AND ITS DRIVERS
				9.1.3.1 Drivers of yields on government and agency bonds
				9.1.3.2 Drivers of yields on corporate bonds
			9.1.4 CREDIT RATINGS
			9.1.5 CORPORATE BONDS AND AGENCY COSTS
		9.2 Why does sustainability matter to bonds?
			9.2.1 SOVEREIGN BOND PRICING AND SUSTAINABILITY
			9.2.2 CORPORATE BOND PRICING AND SUSTAINABILITY
		9.3 Integrating sustainability into bond investing
			9.3.1 ESG INTEGRATION INTO GOVERNMENT BONDS
			9.3.2 ESG INTEGRATION INTO CORPORATE BONDS
			9.3.3 ESG INTEGRATION INTO CREDIT RATINGS
		9.4 Green bonds and social bonds
			9.4.1 GREEN BONDS
			9.4.2 CHALLENGES
			9.4.3 SOCIAL BONDS
		9.5 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
	10 Banking—new forms of lending
		Overview
		Learning objectives
		10.1 Basics of banking
			10.1.1 LENDING BUSINESS
			10.1.2 FEE-BASED BUSINESS
			10.1.3 MONITORING ROLE
			10.1.4 TYPES OF LENDING
		10.2 Sustainability of banks
			10.2.1 STRUCTURAL REFORMS
			10.2.2 MATERIAL ESG RISKS IN BANKING
		10.3 Why does sustainability matter to lending?
			10.3.1 INTEGRATING SUSTAINABILITY INTO LENDING
		10.4 Risk-based approach towards sustainable lending
			10.4.1 COMPETITION IN SUSTAINABLE LENDING
			10.4.2 REGULATORY APPROACH TO SUSTAINABLE LENDING
			10.4.3 EVIDENCE ON SUSTAINABLE LENDING
			10.4.4 BARRIERS TO SUSTAINABLE LENDING
			10.4.5 INCENTIVES FOR SUSTAINABLE LENDING
		10.5 Values-based banking
			10.5.1 FINANCING CIRCULAR BUSINESS MODELS
			10.5.2 MICROFINANCE
				10.5.2.1 Measuring impact
		10.6 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
	11 Insurance—managing long-term risk
		Overview
		Learning objectives
		11.1 Basics of Insurance
			11.1.1 INSURANCE BUSINESS
			11.1.2 DIFFERING PROBABILITY DISTRIBUTIONS
				11.1.2.1 Catastrophes
			11.1.3 RE-INSURANCE
			11.1.4 ASYMMETRIC INFORMATION
			11.1.5 INSURANCE COMPANIES AS ASSET MANAGERS
		11.2 Why does sustainability matter to insurance?
			11.2.1 EVIDENCE THAT E (ENVIRONMENTAL) MATTERS
			11.2.2 EVIDENCE THAT S (SOCIAL) MATTERS
			11.2.3 EVIDENCE THAT G (GOVERNANCE) MATTERS
			11.2.4 SUSTAINABLE ASSESSMENT IN PRACTICE
		11.3 Managing long-term catastrophe risk
			11.3.1 CATASTROPHE MODELLING
			11.3.2 CLIMATE CHANGE AND NATURAL HAZARDS
				11.3.2.1 Example of sea-level rise
			11.3.3 MITIGATION AND ADAPTATION MEASURES
		11.4 Microinsurance
			11.4.1 SUPPLIERS OF MICROINSURANCE
			11.4.2 MEASURING IMPACT
		11.5 ConclusionsInsurers play a crucial role in
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
Part IV How to get there?
	12 Transition management and integrated thinking
		Overview
		Learning points
		12.1 Transition governance
			12.1.1 NEW VISION AND APPROACHES
				12.1.1.1 Vision
				12.1.1.2 Transition agenda and pathways
				12.1.1.3 Concrete actions
				12.1.1.4 Monitoring
		12.2 Transition management
		12.3 A change of mindset: Towards integrated thinking
			12.3.1 PERSONAL CHANGE
				12.3.1.1 Instruments
		12.4 Conclusions
		Key concepts used in this chapter
		SUGGESTED READING
		REFERENCES
NAME INDEX
SUBJECT INDEX