Principles of Sustainable Finance Dirk Schoenmaker
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PrinciplesofSustainableFinance
PrinciplesofSustainableFinance isalsosupportedbyteachingmaterialsand casesavailableathttps://www.rsm.nl/erasmus-platform-for-sustainable-valuecreation/our-work/book/
PRAISESFORTHEBOOK
‘Sustainable financehasemergedasamajornew fieldforpractitioners,buthas largelybypassedtheclassroomforlackofagoodtextbook. Principlesof SustainableFinance isanimpressivetextbookthat fillsthisimportantgap.It lucidlyexplainsthefundamentalchallengeclimatechangeposesfor financial markets.Itisextremelywell-informedaboutthelatestdevelopmentsand weavestogetheracoherentaccountofwidelydispersedapproaches,including researchthatisotherwiseinaccessibletothelayman.Itisessentialreadingfor anystudentseekingtounderstandthemainideasandtrendsinsustainable finance. ’
PatrickBolton,ProfessorofBusinessatColumbiaUniversity
‘The financialsystemisintegraltoachievingasmoothtransitiontoalow carboneconomy.Basedontheirextensivecareersin financeandacademia, SchoenmakerandSchramadesetoutaninsightfulvisionforasustainable financialsector,onewheresocialandenvironmentaldimensionsareintegratedwithin financialdecisions.Atatimewhentheneedforasustainable financialsystembecomesevermorepressing,thisbookfurthersthedebateon howtogetthereandwhatroleeach financialmarketparticipanthastoplay.’
MarkCarney,GovernoroftheBankofEngland
‘TheUNSustainableDevelopmentGoals2030arepredicatedontheideathat currentandfuturegenerationshavetheresourcesneededtoensureaccessto cleanwater,food,shelter,health,educationandenergy,irrespectiveofthe placeofbirth,whilecaringandpreservingourcommonhome:theEarth.In PrinciplesofSustainableFinance,DirkSchoenmakerandWillemSchramade discusstheimportanceofsustainable financeandhowitcanhelpallocate resourcestoindividualandsocialneeds,overtime,whilerespectingour planet’sboundaries.Itisanindispensablereadforstudents,professionals andpolicy-makers.’
VitorGaspar,DirectorFiscalAffairsDepartment attheInternationalMonetaryFund
‘IamsometimesaskedwhatabiologistisdoingattheMinistryofFinance. Theanswerissimple:thereisnobetterplaceforabiologistthanworkingwith finance.Withthemonumentalchallengeswearefacing,suchasclimate changeandthelossofbiodiversity,mainstream financeneedstobecome trulysustainable.Thisimpliesthatalargerskillsetisneededforthosedealing witheconomics.Thistextbookcontributestothechangeneeded.’
PerBolund,MinisterforFinancialMarketsinSweden
‘Theinvestmentdecisionsoftodayshapeourfuture.Wehaveachoice.Dowe maximiseshort-termreturns,orcreatelong-termsustainablevalue?Itis becomingincreasinglyclearthatsocietyisreachingecologicalandsocial boundaries,andthatwecanonlyprosperifwerespecttheseboundaries. PrinciplesofSustainableFinance providesinvestorsand financierswiththe toolstomaketherightdecisions,nowandinthefuture.’
EloyLindeijer,ChiefInvestmentOf
ficeratPGGM
‘Withthiswork,SchoenmakerandSchramademakeaninvaluablecontributiontotheroleof financeinthetransitionoftheglobaleconomytoalow carbongrowthpath.ItshouldberequiredreadingintheC-suiteofanybank grapplingwithwhatclimatechangemeansforitslendingstrategy.’
StewartJames,ManagingDirectorPublicAffairsatHSBC
‘PrinciplesofSustainableFinance comeswithaperfecttiming:allaround theplanetanew,long-termandresponsiblecapitalismisemerging.Itrequires combininganewacademicperspectiveandattentiontoitsconcreteimplementation.Thisisexactlywhatthisimportantbookachievesandmakesitso valuableforbothstudents,researchersandpractitioners.’
FrédéricSamama,Co-HeadofInstitutionalClientsatAmundi
Principlesof SustainableFinance
DirkSchoenmakerand WillemSchramade
GreatClarendonStreet,Oxford,OX26DP, UnitedKingdom
OxfordUniversityPressisadepartmentoftheUniversityofOxford. ItfurtherstheUniversity’sobjectiveofexcellenceinresearch,scholarship, andeducationbypublishingworldwide.Oxfordisaregisteredtrademarkof OxfordUniversityPressintheUKandincertainothercountries
©DirkSchoenmakerandWillemSchramade2019
Themoralrightsoftheauthorhavebeenasserted
FirstEditionpublishedin2019
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PublishedintheUnitedStatesofAmericabyOxfordUniversityPress 198MadisonAvenue,NewYork,NY10016,UnitedStatesofAmerica
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Ifyourplanisfor1year,plantrice. Ifyourplanisfor10years,planttrees. Ifyourplanisfor100years,educatepeople.
Confucius
Asateamofauthorswehavefollowedtheemergenceofsustainable finance (SF)fromdifferentangles.Wehavebeenteachingacourseon financeand sustainability,fromwhichthisbookhasemerged,andwehavecontributedto theacademicliteratureonthistopic.Onthepolicyside,wehaveadvisedthe governmentontheroleoflargeshareholdersinlong-termvaluecreation. MovingtothepracticesofSF,wehavebeendirectlyinvolvedinimpact investingatleadingsustainableassetmanagersandhaveadvisedbanksand pensionfundsonsustainabilitypractices.
Howdoesthistextbookcomparewithotherbooks?
PrinciplesofSustainableFinance differsfromothertextbooksinitswide coverage,asitdealswiththevariouselementsofSF,supportedbyexamples. Thiscoverageimpliesthatwenotonlydiscusssustainabilitychallengesbut alsoapplythemtothecorporateand financialsector.Wecoverthefullrange of financialintermediaries,frominstitutionalinvestorstobanksandinsurance companies.Basedonnewdata,wedocumentthegradualshiftfrom financeas usualtoSF.
Whilethereareseveralsustainabilitybooksinthe fieldofbusiness(e.g. BusinessSustainability,byRezaee,2017)andeconomics(e.g. EcologicalEconomics,byDalyandFarley,2011),the fieldof financeisonlypartlycovered. Therearetitlesinsustainableinvesting(e.g. EvolutionsinSustainableInvesting:Strategies,FundsandThoughtLeadership,byKrosinsky,2012; Sustainable Investing:RevolutionsinTheoryandPractice,editedbyKrosinskyandPurdom,2017)andsustainablebanking(e.g. SustainabilityinFinance:Banking onthePlanet,byJeucken,2004; SustainableBanking:ManagingtheSocialand EnvironmentalImpactofFinancialInstitutions,byWeberandFeltmate, 2016).However,manybooksareeditedvolumescomprisingacollectionof papers(e.g. DesigningaSustainableFinancialSystem,editedbyWalker, Kibsey,andCrichton,2018).Thesebooksarenotprimarilymeantforpedagogicalpurposes.
PrinciplesofSustainableFinance isdifferentin fiverespects: 1)it firstdealswiththematicissues(sustainability,externalities,governance, strategy,andintegratedreporting)beforemovingontoSF;
2)itcoversthefullscopeofSF:investing(bothequitiesandbonds),banking, andinsurance;
3)itadoptsaninterdisciplinaryapproach;
4)eachchapterstartswithanoverviewandlearningobjectives;attheendof eacharesuggestionsforfurtherreadingandalistofkeyconceptsused;
5)thereisextensiveuseof figures,boxes,andtablestoclarifyconceptsand provideexamples.
Howtousethisbook?
PrinciplesofSustainableFinance isanaccessibletextbookforundergraduate, graduate,andexecutivestudentsof finance,economics,businessadministration,andsustainability.Eachchapterinitiallyprovidesanoverviewand identifieslearningobjectives.Throughoutthebookweuseboxesinwhich certainissuesareexplainedinmoredetail,byreferringtotheoryorpractical examples.Furthermore,wemakeabundantuseofgraphsandtablestogive studentsacomprehensiveoverviewofthesustainabilitychallengesandtheir applicationto finance.Attheendofeachchapterweprovidesuggestionsfor furtherreading.OxfordUniversityPressprovidesasupportingwebsiteforthis book.Thiswebsitecontainsexercises(andtheirsolutions)foreachchapter.
Averybasicunderstandingof financeisneededtousethistextbook,aswe assumethatstudentsarefamiliarwithwell-known financetools,suchasthe discountedcash flowmodelandthecapitalassetpricingmodel.Thebookcan beusedforthird-yearundergraduate,graduate,andexecutivecourses.
DirkSchoenmaker WillemSchramade Rotterdam, April2018
■ ACKNOWLEDGEMENTS
WewouldliketothankourcolleaguesattheRotterdamSchoolofManagement, ErasmusUniversity,fortheirverygeneroussupportandguidanceinshaping thisbook,whichdrawsondifferentdisciplines.SpecialthankstoDion Bongaerts,MathijsCosemans,MathijsvanDijk,GianfrancoGianfrate,Abe deJong,andMarnoVerbeek(finance),SteveKennedyandEvaRood(businesssustainability),PaoloPerego(accounting),DerkLoorbach(transition management),andourstudents,whocommentedondraftchaptersand providedvaluablefeedback.WearegratefultoPeterRoosenboom,chairof theFinanceDepartment,whoprovidedanexcellentteachingandresearch environmentforwritingthisbook.
AtNNInvestmentPartnerswewouldliketothankinparticularHendrikJanBoer,BramBos,JeroenBos,JeroenBrand,AdrieHeinsbroek,Faryda Lindeman,JohanVanderlugt,HuubvanderRiet,andAlexZuiderwijkfor theirfeedbackandsupport andforbeinggreatcolleagueswhohelpshapethe practiceofsustainableinvesting.
WewouldalsoliketothankAndrewCoburn,JaapvanDam,Adriande GrootRuiz,HanvanderHoorn,MarcelJeucken,JanvanderKolk,David Korslund,RobLake,KarenMaas,RolandMees,SimonMoolenaar,Andrew Newton,IlanNoy,PauldeRuijter,FrédéricSamama,HansStegeman,Thomas Steiner,andRensvanTilburgforvaluableadviceandcommentsondraft chapters.
DirkSchoenmaker WillemSchramade Rotterdam, April2018
■ LISTOFFIGURES
6.5 Exampleofacompany’
6.6 Exampleofacompany’ssixcapitalsbalancesheet
6.7 Exampleofacompany’ssustainabilityscoringbyasustainability ratingagency
7.1 Astylizedinvestmentchain
7.2 FinancialimpactofqualitativeandquantitativeESGinformation191
7.3 TheincreasingavailabilityofESGdata
7.4 Diminishingbenefitsfromdiversification
7.5 Idealversusactualinvestmentchainsandtheircomponents
7.6 ConditionsforLTVC
7.7 AlignmentintheinvestmentchainonLTVC
8.2
8.3 Whysustainabilitymattersforshareholdervalue
8.4 IndirectlinkbetweenESGandinvestorperformance
8.5 Internalizationtoalign fi
8.6
9.4 CorrelationofmeancountryESGmomentumandGDP
9.5 Controlofcorruptionversusforeigncreditrating
9.6 Investmentmanagersconductingresponsibleinvestment
9.7 ToptencountryESGscoresintheRobecoSAMcountrysustainability
9.8 RobecoF-score
■ LISTOFTABLES
■ LISTOFBOXES
■ LISTOFABBREVIATIONS
ABSAsset-BackedSecurities
AMHAdaptiveMarketsHypothesis
AUMAssetsUnderManagement
BII BiodiversityIntactnessIndex
BRIBankRakyatIndonesia
CAPEXCapitalExpenditures
CAPMCapitalAssetPricingModel
CDPCarbonDisclosureProject
CDSCreditDefaultSwap
CEOChiefExecutiveOfficer
CF CashFlow
CFCsChlorofluorocarbons
CIOChiefInvestmentOfficer
COPConferenceoftheParties(governedbytheUN)
CSRCorporateSocialResponsibility
DCFDiscountedCashFlow
DUDobsonUnit
EBITEarningsBeforeInterestandTaxes
ECCEEuropeanCentreforCorporateEngagement
EESEconomic,Environmental,andSocial(Factors)
EMHEfficientMarketsHypothesis
EMSEnvironmentalManagementSystem
EPSEarningsPerShare
ESGEnvironmental,Social,andGovernance(Factors)
ETFsExchangeTradedFunds
ETSEmissionsTradingSystem
EV EnvironmentalValue
FCFFreeCashFlow
FCLTGlobalFocusCapitalontheLong-TermGlobal
FV FinancialValue
G20GroupofTwenty
GAAPGenerallyAcceptedAccountingPrinciples
GABVGlobalAllianceforBankingonValues
GDPGrossDomesticProduct
GHGGreenhouseGas
GIINGlobalImpactInvestingNetwork
GRIGlobalReportingInitiative
G-SIBsGlobalSystemicallyImportantBanks
GVAGrossValueAdded
IASBInternationalAccountingStandardsBoard
ICMAInternationalCapitalMarketsAssociation
IEAInternationalEnergyAgency
IFCInternationalFinanceCorporation
IFRSInternationalFinancialReportingStandards
IIRCInternationalIntegratedReportingCouncil
IOSCOInternationalOrganizationofSecuritiesCommissions
IP&LIntegratedProfitandLoss(Account)
IPCCIntergovernmentalPanelonClimateChange
IPOInitialPublicOffering
IR IntegratedReporting
IV IntegratedValue
KPIsKeyPerformanceIndicators
LTIFRLostTimeInjuryFrequencyRate
LTVCLong-TermValueCreation
M&AsMergersandAcquisitions
MDGsMillenniumDevelopmentGoals
NGONon-GovernmentalOrganization
NOPLATNetOperationProfitLessAdjustedTaxes
NPSNetPromoterScore
NPVNetPresentValue
OCFOperatingCashFlow
P&CPropertyandCasualty(Insurance)
P&LProfitandLoss(Account)
PE Price–EarningsRatio
PPEProperty,Plant,andEquipment
PRIPrinciplesforResponsibleInvestment
PV Photovoltaic
R&DResearchandDevelopment
RCPRepresentativeConcentrationPathway
REDD+ReducingEmissionsfromDeforestationandforestDegradation
ROAReturnonAssets
ROEReturnonEquity
ROIReturnonInvestment
ROICReturnonInvestedCapital
S&PStandard&Poor’ s
SASBSustainabilityAccountingStandardsBoard
SDGsSustainableDevelopmentGoals
SEVSocialandEnvironmentalValue
SF SustainableFinance
SIBSocialImpactBond
SMESmall-andMedium-SizedEnterprise
SPOSeasonedPublicOffering
SPVSpecialPurposeVehicle
SRISociallyResponsibleInvesting
SV SocialValue
TCFDTaskForceonClimate-relatedFinancialDisclosures
TE TrackingError
TP TechnicalProvisions
TV TotalValueorTrueValue
UNUnitedNations
UNEPUnitedNationsEnvironmentProgramme
UNFCCCUnitedNationsFrameworkConventiononClimateChange
VaRValueatRisk
VBBsValues-BasedBanks
VDAValueDriverAdjustments
WACCWeightedAverageCostofCapital
WBCSDWorldBusinessCouncilforSustainableDevelopment
WEFWorldEconomicForum
WEOWorldEnergyOutlook
WTCWorldTradeCenter
WWFWorldWildlifeFund
YTMYieldtoMaturity
PartI Whatissustainabilityand whydoesitmatter?
1 Sustainabilityandthe transitionchallenge
Overview
Oureconomicmodelsweredevelopedintheageof resourcesabundance,when naturalresourceswereplentifulandcarbonemissionswerelimited.No environmentalconcernswerefactoredintothesemodels,onlylabourand capital.Likewise, financialtheorydoesnotaccountvaluetonaturalresources beyondtheirnear-termcash flows(CFs).Possiblyfataldepletionofresources isignored.Thesemodelsarestillwidelyused,butnolongertenable.Weare nowinatransitiontoalow-carbonandmorecirculareconomytoovercome environmentalchallenges.Whileanearlytransitionallowsforagradual adjustmentofourproductionandconsumptionpatterns,alatetransition willcausesuddenshocksandleadtostrandedassets,whichwillhavelost theirproductivevalue.Manynaturalresourcescompaniesarestillindenial, irrationallycountingonalateandgradualtransition.
Massproductioninacompetitiveeconomicsystemhasledtolongworking hours,underpayment,andchildlabour, firstinthedevelopedworldandlater relocatedtothedevelopingworld.Socialregulationshavebeenincreasingly introducedtocounterthesepracticesandtopromotedecentworkandaccess toeducationandhealthcare.Toguidethetransitiontowardsasustainableand inclusiveeconomy,theUnitedNations(UN)havedevelopedthe2030Agenda forSustainableDevelopment,whichwillrequirebehaviouralchange.
Sustainabledevelopmentisanintegratedconceptwiththreeaspects:economic,social,andenvironmental.Thischapterstartsbyexplainingthesustainabilitychallengesthatsocietyisfacing.Ontheenvironmentalfront, climatechange,land-usechange,biodiversityloss,anddepletionofnatural resourcesaredestabilizingtheEarthsystem.Next,poverty,hunger,andlackof healthcareshowthatmanypeoplelivebelowminimumsocialstandards. Sustainabledevelopment meansthatcurrentandfuturegenerationshavethe resourcesneeded,suchasfood,water,healthcare,andenergy,withoutstressingtheEarthsystemprocesses.
Whyshould financecontributetosustainabledevelopment?Themaintask ofthe financialsystemistoallocatefundingtoitsmostproductiveuse. Financecanplayaleadingroleinallocatinginvestmenttosustainablecorporatesandprojectsandthusacceleratethetransitiontoalow-carbonand
