We are facing a crucial tipping point in sustainable finance.
With the macro-forces of regulation, growing evidence of untold damage of traditional industry on the environment and greater consumer awareness and frustration, the financial services industry in its current form is arguably acting as a barrier to change.
It stands in the way of enabling and accelerating the reality of a circular economy and flow of capital to worthy businesses and investable projects.
The main issue is a lack of global standards in evaluating and applying the importance of ESG (Environmental, Social and Governance) criteria to businesses. Applying a score – either with self-verification or via an agency – is subjective. There are many elements within an average ESG scoring methodology which are not quantitative but qualitative.
Just look at the evolution of the myriad green bond issuers over the last five years via the Climate Bonds Initiative.
The challenges for private markets
Investors are ill-equipped and conflicted
In a recent study undertaken by non profit, InfluenceMap evaluated how the largest 15 financial services companies including Goldman Sachs, Morgan Stanley and Blackrock, are at odds with the rapid transition needed by institutional investors to a low carbon economy.
Additionally, ESG has evolved into an expansive topic and is sadly being used and abused in many ways. Most investment portfolios focus on the risk management elements of ESG scoring given that impact (social or environmental) can only be assessed in the field/observing the operation of a business. Many fund managers are far removed from this reality.
Then there is the concern of ‘stranded assets’ – the cost of reforming/reconstructing portfolios away from low scoring ESG players and what that would do to fund performance.
Efforts are underway to shift this. The UN’s Principles for Responsible Banking and Responsible Investment are gaining in participation momentum. But there is a long way to go in terms of the investment industry’s transparency and the speed of how this impacts much needed capital to worthy projects.
ESG is not a panacea or the norm in private markets
The drive to ESG disclosure is mostly a listed company phenomenon. But this is a dwindling pool in capital markets. Private capital markets have been growing for the last decade and the move from public to private continues where companies feel the benefit of being listed is outstripped by the costs and responsibility. While there is no direct correlation between being a private company and less sustainability scrutiny, there is concern that controversial companies will go private. Private equity has far more flexibility in how it operates in financing companies.
The bigger issue for many is the ability to source emerging, viable and investible growth companies that are viable candidates for green finance. How does the private capital market mobilise to source and serve these companies?
These smaller opportunities are, therefore, overlooked in favour of larger projects that are oversubscribed against sustainability metrics. They, therefore, need to lower as much ESG risk as possible through access to accurate data.
Green capital: grass is not ‘greener’ on the other side
The scale of investment needed to finance the transition to a sustainable, low-carbon world ($6 trillion per year) will exceed both the capabilities of the post-financial crisis banking sector and the constrained balance sheets of utility companies.
This is why debt capital markets will be significant in facilitating the continued operation of existing projects via refinancing, and the development and construction of a wide range of new projects supporting climate change mitigation and adaptation.
The emergence of green bonds has been one of the key developments in recent years. The aim is to improve the ability of debt capital markets to raise capital to finance solutions to environmental and climate challenges, while also offering investors an opportunity to share in financial returns available from the transition to a sustainable, low-carbon world.
For the most part, the green debt market is not discounted – so there is the cost of capital benefit for the issuer and consequently no economic advantage. The cost of capital is the same as if they just borrowed normally in the debt capital markets. In fact, as they must pay for the bond to be verified there is an extra cost of issuance. That in effect increases the cost of capital, albeit by a small amount. At best, there is no cost of capital benefit for the issuer and at worst it is more expensive.
Additionally, given the evolving nature of capital markets from public to private, a lack of consistency in evaluating green investments and ESG scoring at institutional level, there is a grave risk that capital is being held back from where it is most needed.
Project and investee ‘proximity’: the key to unlocking green and sustainable investment capital and the role of Green Fintech
I have spent the last two years involved in private environmental and social impact businesses learning first-hand how costly access to capital can be for these businesses.
I have also seen how ill-equipped funders are to understand their business models and apply coherent mechanisms to value businesses, release costs efficient capital and commit to support onward capital injection.
In at least half the cases, I have seen promising young businesses strangled and suffocated by the time and resources needed to fund raise versus the time needed to build their business. And I have witnessed how a lack of funding has forced some businesses to close their doors.
Fintech has a huge role to play in supporting access to capital in a far more efficient way. Leveraging business models used effectively for crowd-funding and peer-to-peer lending means there remains a real opportunity to provide competitive capital to work and spread the return potential for retail investors/lenders in projects they believe in.
The Internet Of Things
‘Deep’ technology capability such as IOT, analytics, drone technology and mobile can all be applied onsite monitoring and verification of supply chains and operations.
Artificial Intelligence can be used to collate and scout for investable projects using unstructured public data, while simultaneously providing agile mechanisms to blend ESG scoring tools with actual operational data.
Blockchain technology offers significant potential to support institutional trade finance efficiencies. It also provides new retail investment opportunities in capital intensive projects such as real estate by offering fractional ownership via tokenisation of the underlying real-world assets.
The role of finance as an enabler to a sustainable world is unquestionable. Green finance has a way to go and its ability to serve the greater good at scale and at pace rests with innovative technology business models.
The time for green fintech is now.
Read part one in Redsand’s Nicole Anderson’s blog series on Green Fintech and how it helps unlock sustainable finance.