Principles of Sustainable Finance

Dirk Schoenmaker
Willem Schramade

January 2019

Abstract
Finance is widely seen as an obstacle to a better world. Principles of Sustainable Finance
explains how the financial sector can be mobilized to counter this and provides many
examples and tools. Using finance as a means to achieve social goals we can divert the
planet and its economy from its current path to a world that is sustainable for all.
Written for undergraduate, graduate, and executive students of finance, economics,
business, and sustainability, this textbook combines theory, empirical data, and policy to
explain the sustainability challenges for corporate investment. It shows how investors and
bankers can steer funding to sustainable companies and projects without sacrificing return
and thus speed up the transition to a sustainable economy.
Tailored for students, Principles of Sustainable Finance starts each chapter with an overview
and learning objectives to support study. It includes suggestions for further reading,
definitions of key concepts, and extensive use is made of figures, boxes, and tables to
enhance educational goals and clarify concepts.

Published by Oxford University Press

Dirk Schoenmaker is Professor of Banking and Finance at the Rotterdam School of

Management, Erasmus University, and Research Fellow at the Centre for European Policy
Research.

Willem Schramade is Guest Lecturer at the Rotterdam School of Management, Erasmus

University, and Senior Portfolio Manager Impact Investing and Sustainable Equities at NN
Investment Partners.

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Contents

Part I: What is sustainability & why does it matter?

Chapter 1 Sustainability and the transition challenge
1.1. Why does sustainability matter?
1.2. Sustainability challenges
1.3. The role of the financial system
1.4. Three stages of sustainable finance
1.5. Challenges to integration of sustainability into finance

Part II: Sustainability’s challenges to corporates

Chapter 2 Externalities - internalisation
2.1. Why externalities matter
2.2. Government intervention
2.3. Measuring and pricing externalities
2.4. Scenario analysis
Chapter 3 Governance and behaviour
3.1. Behavioural biases against sustainable development
3.2. What is the objective of the corporation?
3.3. Corporate governance mechanisms
3.4. Horizon – moving from short-term to long-term thinking
3.5. Guidelines governing sustainable finance
Chapter 4 Coalitions for Sustainable Finance
4.1. Increasing role of institutional investors
4.2. A system approach towards sustainability
4.3. Coalitions for sustainable finance
Chapter 5 Strategy and intangibles - changing business models
5.1. Preparing for transformational change
5.2. Theories of competitive position, business models, intangibles and strategy
5.3. Typical material sustainability issues
5.4. Circular business models
5.5. Long-term value creation and the purpose of the firm
Chapter 6 Integrated reporting - metrics and data
6.1. Financial reporting: merits and limitations
6.2. Nonfinancial metrics, data and value drivers
6.3. The emergence of integrated reporting
6.4. Sustainability data providers
6.5. Future outlook

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Part III: Financing sustainability
Chapter 7 Investing for long-term value creation
7.1. (Over)reliance on market metrics
7.2. Limitations of current approaches to include ESG factors
7.3. Solving it with an active investment approach
7.4. Conditions for long-term value creation
Chapter 8 Equity - investing with an ownership stake
8.1. Basics of equities
8.2. Why does sustainability matter to equities?
8.3. Integrating sustainability into equity investing
8.4. Impact investing
Appendix: Case study - how you can do ESG integration
Chapter 9 Bonds - investing without voting power
9.1. Basics of bonds
9.2. Why does sustainability matter to bonds?
9.3. Integrating sustainability into bond investing
9.4. Green bonds and social bonds
Chapter 10 Banking – new forms of lending
10.1 Basics of banking
10.2. Sustainability of banks
10.3. Why does sustainability matter to lending?
10.4. Risk-based approach towards sustainable lending
10.5. Values-based banking
Chapter 11 Insurance – managing long-term risk
11.1. Basics of insurance
11.2. Why does sustainability matter to insurance?
11.3. Managing long-term catastrophe risk
11.4. Microinsurance

Part IV: How to get there?

Chapter 12 Transition management and integrated thinking
12.1. Transition governance
12.2. Transition management
12.3. A change of mindset: towards integrated thinking

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 Chapter 1

Sustainability and the transition challenge

Overview
Our economic models were developed in the age of resources abundance, when natural
resources were plenty and carbon emissions were limited. No environmental concerns were
factored into these models; only labour and capital. Likewise, financial theory does not
account value to natural resources beyond their near term cash flows. Possibly fatal
depletion of resources is ignored. These models are still widely used, but no longer tenable.
We are now in a transition to a low carbon and more circular economy to overcome
environmental challenges. While an early transition allows for a gradual adjustment of our
production and consumption patterns, a late transition will cause sudden shocks and lead to
stranded assets, which have lost their productive value. Many natural resources companies
are still in denial, irrationally counting on a late and gradual transition.
Mass production in a competitive economic system has led to long working hours,
underpayment and child labour, first in the developed world and later relocated to the
developing world. Social regulations have been increasingly introduced to counter these
practices and to promote decent work and access to education and healthcare. To guide the
transition towards a sustainable and inclusive economy, the United Nations has developed
the 2030 Agenda for Sustainable Development, which will require behavioural change.
Sustainable development is an integrated concept with three aspects: economic,
social and environmental. This chapter starts by explaining the sustainability challenges that
society is facing. On the environmental front, climate change, land-use change, biodiversity
loss and depletion of natural resources are destabilising the Earth system. Next, poverty,
hunger and lack of healthcare show that many people live below minimum social standards.
Sustainable development means that current and future generations have the resources
needed, such as food, water, healthcare and energy, without stressing the Earth system
processes.
Why should finance contribute to sustainable development? The main task of the
financial system is to allocate funding to its most productive use. Finance can play a leading
role in allocating investment to sustainable corporates and projects and thus accelerate the
transition to a low carbon and more circular economy. Sustainable finance looks at how
finance (investing and lending) interacts with economic, social, and environmental issues. In
the allocation role finance can assist in making strategic decisions on the trade-offs between
sustainable goals. Moreover, investors can exert influence on the corporates in which they
invest. In this way, long-term investors can steer corporates towards sustainable business
practices. Finally, finance is good at pricing risk for valuation purposes and can thus help

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dealing with the inherent uncertainty about environmental issues, such as the impact of
carbon emissions on climate change. Finance and sustainability both look at the future.
The thinking about sustainable finance has gone through different stages over the
last decades, whereby the focus is gradually shifting from short-term profit towards long-
term value creation. This chapter analyses these stages and provides a framework for
sustainable finance. In addressing social and environmental challenges, a key development is
the move from risk to opportunity. While financial firms started to avoid unsustainable
companies from a risk perspective, the front-runners are now increasingly investing in
sustainable companies and projects.

Learning objectives
After you have studied this chapter, you should be able to:
• explain the planet’s social and environmental challenges
• list and understand the United Nations Sustainable Development Goals
• understand the transition of the economic system
• explain the main functions of the financial system and how to apply them to
sustainability
• explain the various stages of sustainable finance

1.1. Why does sustainability matter?

Our economic models were developed in an empty world with an abundance of goods and
services produced by nature (Daly and Farley, 2011). That was at the onset of the Industrial
Revolution in the 19th century. Labour and capital were the scarce production factors to
optimise in economic production, while nature and its services were freely available. But the
Industrial Revolution had profound impacts on the economy, society and the global
ecosystem. Human society became largely dependent on fossil fuels and other non-
renewable resources, partly in response to the depletion of forests as fuel. This increased
energy use provided access to other raw materials. Technological advances, dependent on
fossil fuel (starting with the steam engine), allowed unprecedented production of consumer
goods, spurring economic and population growth. Urbanisation led to a reduction of arable
land, driving further deforestation.
Back in the early 1970s, the Club of Rome was the first to highlight that the Earth
system cannot support these rates of economic and population growth much beyond the
year 2100, even with advanced technology. In their aptly titled report Limits to Growth, the
Club of Rome examines five basic factors that determine and, in their interactions, limit
growth on this planet: i) population increase, ii) food production, iii) non-renewable resource
depletion, iv) industrial output, and v) pollution generation. They also suggest that
humankind can create a society in which it can live indefinitely on earth if it imposes limits
on itself and its production of material goods to achieve a state of global equilibrium with
population and production in carefully selected balance (Meadows et al., 1972).

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 To illustrate the limits to growth, the Club of Rome developed a world model that
analyses the carrying capacity of the planet and population growth. Population growing in a
limited environment can approach the ultimate carrying capacity of that environment in
several possible ways. It can adjust smoothly to an equilibrium below the environmental
limit by means of a gradual decrease in growth rate, as shown in the left panel of Figure 1.1.
It can also overshoot capacity by consuming some necessary non-renewable resource or
causing pollution, as shown in the right panel. This behaviour has occurred in many natural
systems. A major purpose in constructing the world model has been to determine which, if
any, of the behaviour modes will be most characteristic of the world system as it reaches the
limits to growth.

Figure 1.1: The world model

Source: Limits to Growth (Meadows et al., 1972).

While the Club of Rome was a private initiative, the United Nations (UN) installed the
Brundtland Commission, formally known as the World Commission on Environment and
Development, to unite countries to pursue sustainable development together. Gro Harlem
Brundtland, former Prime Minister of Norway, was chosen as chair due to her strong
background in the sciences and public health. The Brundtland Report (1987) argues that
"...the "environment" is where we live; and "development" is what we all do in attempting
to improve our lot within that environment. The two are inseparable." The report defines
sustainable development as “development that meets the needs of the present without
compromising the ability of future generations to meet their own needs”. The Brundtland
report thus reinforces the fact that sustainability is about the future.
Climate change is one the largest environmental risks affecting society. Starting at
the Earth Summit in Rio de Janeiro in 1992, the United Nations Framework Convention on
Climate Change (UNFCCC) is an international environmental treaty to ‘stabilise greenhouse
gas concentrations in the atmosphere at a level that would prevent dangerous
anthropogenic interference with the climate system’. The parties to the convention have
met annually from 1995 in Conferences of the Parties (COP) to assess progress in dealing
with climate change. In the 2015 Paris Agreement on climate change (COP21), countries
reconfirmed the target of limiting the rise in global average temperatures relative to those in
the pre-industrial world to 2°C (two degrees Celsius), and to pursue efforts to limit the

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temperature increase to 1.5°C (UNFCCC, 2015). Doing this would ensure that the stock of
carbon dioxide and other greenhouse gases in the atmosphere does not exceed a certain
limit. The Intergovernmental Panel on Climate Change (2014) estimates that the remaining
carbon budget amounts to 900 gigatonnes of CO2 from 2015 onwards. The speed with which
the limit is reached depends on the emissions pathway. If current global carbon emissions at
about 40 gigatonnes a year are not drastically cut, the 2°C limit would be reached in two
decades.
Section 1.2 discusses that climate risk, land system change, biodiversity loss, nitrogen
and phosphorus flows, poverty, food, fresh water and health form the most pressing
environmental and social challenges. Our economic system, organised through business
firms, creates these environmental and social impacts on society; these externalities are thus
not separable from production decisions. To highlight the tension between unbridled
economic growth and sustainable development, we provide two examples. Box 1.1 describes
the Deepwater Horizon oil spill in the Gulf of Mexico. Box 1.2 shows the impact of the
collapse of a factory building in Bangladesh. These examples have in common an
underinvestment in safety to increase short-term profits.

Box 1.1: The Deepwater Horizon oil spill

Oil began to spill from the Deepwater Horizon drilling platform on 20 April 2010, in the
British Petroleum-operated Macondo Prospect in the Gulf of Mexico. An explosion on the
drilling rig killed 11 workers and led to the largest accidental marine oil spill in the history
of the petroleum industry. The US Government estimated the total discharge at 4.9 million
barrels. After several failed efforts to contain the flow, the well was declared sealed on 19
September 2010.
A massive response ensued to protect beaches, wetlands and estuaries from the
spreading oil using skimmer ships, floating booms, controlled burns and oil dispersant. Oil
clean-up crews worked on 55 miles of the Louisiana shoreline until 2013. Oil was found as
far from the Deepwater Horizon site as the waters off the Florida Panhandle and Tampa
Bay, where the oil and dispersant mixture was embedded in the sand. The months-long
spill, along with adverse effects from the response and clean-up activities, caused
extensive damage to marine and wildlife habitats and the fishing and tourism industries.
Numerous investigations explored the causes of the explosion and record-breaking
spill. Notably, the US government's September 2011 report pointed to defective cement
on the well, laying the fault mostly with BP, but also rig operator Transocean and
contractor Halliburton. Earlier in 2011, a National Commission (2011) likewise blamed BP
and its partners for a series of cost-cutting decisions and an inadequate safety system, but
also concluded that the spill resulted from "systemic" root causes and that without
"significant reform in both industry practices and government policies, might well recur".

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Box 1.2: Rana Plaza factory collapse

The Rana Plaza collapse was a disastrous structural failure of an eight-storey commercial
building on 24 April 2013 in Bangladesh. The collapse of the building caused 1,129 deaths,
while approximately 2,500 injured people were rescued alive from the building. It is
considered the deadliest garment factory accident in history and the deadliest accidental
structural failure in modern human history.
The building contained clothing factories, a bank, apartments, and several shops.
The shops and the bank on the lower floors were immediately closed after cracks were
discovered in the building. The building's owners ignored warnings to evacuate the
building after cracks in the structure appeared the day before the collapse. Garment
workers, earning €38 a month, were ordered to return the following day, and the building
collapsed during the morning rush-hour.
The factories manufactured clothing for brands including Benetton, Bonmarché,
the Children's Place, El Corte Inglés, Joe Fresh, Monsoon Accessorize, Mango, Matalan,
Primark and Walmart.

1.2. Sustainability challenges

“There can be no Plan B, because there is no Planet B.”
Former United Nations Secretary-General, Ban Ki-moon

Environmental challenges
The aim is to keep the planet liveable for current and future generations. There is increasing
evidence that human activities are affecting the Earth system, threatening the planet’s
future liveability. The planetary boundaries framework of Steffen et al. (2015) defines a safe
operating space for humanity within the boundaries of nine productive ecological capacities
of the planet. The framework is based on the intrinsic biophysical processes that regulate
the stability of the Earth system on a planetary scale. The green zone in Figure 1.2 is the safe
operating space, yellow represents the zone of uncertainty (increasing risk) and red indicates
the zone of high risk. Table 1.1 specifies the control variables and quantifies the ecological
ceilings.
Applying the precautionary principle, the planetary boundary itself lies at the
intersection of the green and yellow zones. To illustrate how the framework works, we look
at the control variable for climate change, the atmospheric concentration of greenhouse
gases. The zone of uncertainty ranges from 350 to 450 parts per million (ppm) of carbon
dioxide. We crossed the planetary boundary of 350 ppm in 1995, with a level of 399 ppm in
2015 and adding at a rate of around 3 ppm every year. The upper limit of 450 ppm is
consistent with the goal (at a fair chance of 66 per cent) to limit global warming to 2° Celsius
above the pre-industrial level and lies at the intersection of the yellow and red zones.
Another example in the yellow zone of increasing risk is land-system change. The
control variable is the area of forested land as a proportion of forest-covered land prior to

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human alteration. The planetary boundary is at 75 per cent, while we are currently at 62 per
cent and the percentage is falling.

Figure 1.2: The planetary boundaries

Source: Steffen et al. (2015).

The current linear production and consumption system is based on extraction of raw
materials (take), processing into products (make), consumption (use) and disposal (waste).
Traditional business models centred on a linear system assume the ongoing availability of
unlimited and cheap natural resources. This is increasingly risky because non-renewable
resources, such as fossil fuels, minerals and metals, are increasingly under pressure, while
potentially renewable resources, such as forests, rivers and prairies, are declining in their
extent and regenerative capacity.
Moreover, the use of fossil fuels in the linear production and consumption system
overburdens the Earth system as natural sink (absorbing pollution). Baseline scenarios (i.e.
those without mitigation) for climate change result in global warming in 2100 from 3.7° to
4.8° Celsius compared to the pre-industrial level (Intergovernmental Panel on Climate
Change, 2014). Figure 11.6 in Chapter 11 depicts this high emission scenario.
With this linear economic system, we are crossing planetary boundaries beyond
which human activities might destabilise the Earth system. In particular, the planetary
boundaries of climate change, land-system change (deforestation and land erosion),
biodiversity loss (terrestrial and marine) and biochemical flows (nitrogen and phosphorus,
mainly because of intensive agricultural practices) have been crossed (see Figure 1.2). A
timely transition towards an economy based on sustainable production and consumption,

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including use of renewable energy, reuse of materials and land restoration, can mitigate
these risks to the stability of the Earth system.

Table 1.1: The ecological ceiling and its indicators of overshoot

Earth system Planetary

Control variable Current value and trend
pressure boundary

Atmospheric carbon dioxide At most 399 ppm and rising

Climate change
concentration; parts per million (ppm) 350 ppm (worsening)

Genetic diversity: rate of species At most 10 Around 100-1,000 and

extinction per million species per year rising (worsening)
Biosphere loss
Functional diversity: biodiversity Maintain 84% applied to southern
intactness index (BII) BII at 90% Africa only

Area of forested land as a proportion of At least 62% and falling

Land-system
forest-covered land prior to human 75% (worsening)
change
alteration

Blue water consumption; cubic At most Around 2,600 km3 and

Freshwater use
kilometres per year 4,000 km3 rising (intensifying)

Phosphorus applied to land as fertiliser; At most 6.2 Around 14 million tons

millions of tons per year million tons and rising (worsening)
Biochemical
flows
Reactive nitrogen applied to land as At most 62 Around 150 million tons
fertiliser; millions of tons per year million tons and rising (worsening)

Average saturation of aragonite (calcium At least Around 84% and falling

Ocean
carbonate) at the ocean surface, as a 80% (intensifying)
acidification
percentage of pre-industrial levels

Aerosol optical depth (AOD); much _ _

Air pollution regional variation, no global level yet
defined

Ozon layer Concentration of ozon in the At least 283 DU and rising

depletion stratosphere; in Dobson Units (DU) 275 DU (improving)

Novel entities No global control variable yet defined _ _

(e.g. chemical
pollution)

Source: Steffen et al. (2015).

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Social foundations
Mass production in a competitive economic system has led to long working hours,
underpayment and child labour, first in the developed world and later relocated to the
developing world. Human rights provide the essential social foundation for all people to lead
lives of dignity and opportunity. Human rights norms assert the fundamental moral claim
each person has to life’s essentials, such as food, water, healthcare, education, freedom of
expression, political participation and personal security. Raworth (2017) defines the social
foundations as the twelve top social priorities, grouped into three clusters, focused on
enabling people to be: 1) well: through food security, adequate income, improved water and
sanitation, housing and healthcare; 2) productive: through education, decent work and
modern energy services; and 3) empowered: through networks, gender equality, social
equity, having political voice and peace and justice.
While these social foundations only set out the minimum of every human’s claims,
sustainable development envisions people and communities prospering beyond this, leading
lives of creativity and fulfilment. Sustainable development combines the concept of
planetary boundaries with the complementary concept of social foundations or boundaries.
Sustainable development means that current and future generations have the resources
needed, such as food, water, healthcare and energy, without stressing processes within the
Earth system (Raworth, 2017).
But many people are still living below the social foundations of no hunger, no poverty
(a minimum income of $3.10 a day), access to education and access to clean cooking
facilities (see Table 1.2). More broadly, political participation, which is the right of people to
be involved in decisions that affect them, is a basic value of society. The UN’s Universal
Declaration of Human Rights states that “recognition of the inherent dignity and of the equal
and inalienable rights of all members of the human family is the foundation of freedom,
justice and peace in the world”. Human rights are an important social foundation. Next,
decent work can lift communities out of poverty and underpins human security and social
peace. The 2030 Agenda for Sustainable Development (see at sustainable development
below) places decent work for all people at the heart of policies for sustainable and inclusive
growth and development. Decent work has several dimensions: a basic living wage (which
depends on a country’s basic living basket), no discrimination (e.g. on gender, race or
religion), no child labour, health and safety, and freedom of association.
From a societal perspective, it is important for business to respect these social
foundations and to ban underpayment, child labour and human right violations. Social
regulations have been introduced in developed countries, but these practices are still
happening in developing countries. A case in point is the use of child labour in factories in
developing countries producing consumer goods, like clothes and shoes, to be sold by
multinational companies in developed countries. These factories often lack basic worker
safety features (Box 1.2). Another example is the violations of the human rights of
indigenous people, often in combination with land degradation and pollution, by extractive
companies in the exploration and exploitation of fossil fuels, minerals and other raw
materials.
Kate Raworth (2017) has summarised the social foundations and planetary
boundaries in the Doughnut, which shows how the safe and just space for humanity lies

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between the social foundation of human well-being and the ecological ceiling of planetary
pressure (see Figure 1.3). Table 1.1 specifies the ecological ceiling and Table 1.2 the social
foundation.

Figure 1.3: The Doughnut: the safe and just space for humanity

Source: Raworth (2017).

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Table 1.2: The social foundation and its indicators of shortfall

Illustrative indicator
Dimension % Year
(percent of global population unless otherwise stated)

Food Population undernourished 11% 2014-16

Population living in countries with under-five mortality rate 46% 2015
exceeding 25 per 1,000 live births
Health
Population living in countries with life expectancy at birth of 39% 2013
less than 70 years
Adult population (aged 15+) who are illiterate 15% 2013
Education
Children aged 12-15 out of school 17% 2013
Population living on less than the international poverty limit 29% 2012
Income and of $3.10 a day
work Proportion of young people (aged 15-24) seeking but not able 13% 2014
to find work

Water and Population without access to improved drinking water 9% 2015

sanitation Population without access to improved sanitation 32% 2015
Population lacking access to electricity 17% 2013
Energy
Population lacking access to clean cooking facilities 38% 2013
Population stating that they are without someone to count on 24% 2015
Networks for help in times of trouble
Population without access to the Internet 57% 2015
Global urban population living in slum housing in developing 24% 2012
Housing
countries
Representation gap between women and men in national 56% 2014
Gender parliaments
equality
Worldwide earnings gap between women and men 23% 2009
Population living in countries with a Palma ratio of 2 or more 39% 1995-
Social equity (the ratio of the income share of the top 10% of people to that 2012
of the bottom 40%)
Population living in countries scoring 0.5 or less out of the 1.0 52% 2013
Political voice
in the Voice and Accountability Index
Population living in countries scoring 50 or less out of 100 in 85% 2014
Peace and the Corruption Perceptions Index
justice Population living in countries with a homicide rate of 10 or 13% 2008-13
more per 10,000
Source: Raworth (2017).

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Sustainable development
To guide the transition towards a sustainable and inclusive economy, the United Nations has
developed the 2030 Agenda for Sustainable Development (UN, 2015). The 17 UN Sustainable
Development Goals stimulate action over the 2015-2030 period in areas of critical
importance for humanity and the planet. To facilitate implementation, the 17 high level
goals are specified in 169 targets (see
https://sustainabledevelopment.un.org/topics/sustainabledevelopmentgoals).
Following Rockström and Sukhdev (2015), we classify the Sustainable Development
Goals (SDGs) according to the levels of the economy, the society and the environment.
Nevertheless, we stress that the SDGs are interrelated. A case in point is the move to
sustainable consumption and production (economic goal 12) and sustainable cities (societal
goal 11), which are instrumental to combat climate change (environmental goal 13). Another
example is an appropriate income and decent work for all (economic goal 8), which is
instrumental in attaining the societal goals 1 to 4. Through a living wage, households can
afford food, healthcare and education for their family.

The 17 UN Sustainable Development Goals are the following (UN, 2015):

Economic goals
• Goal 8. Promote sustained, inclusive and sustainable economic growth, full and
productive employment and decent work for all
• Goal 9. Build resilient infrastructure, promote inclusive and sustainable industrialisation
and foster innovation
• Goal 10. Reduce inequality within and among countries
• Goal 12. Ensure sustainable consumption and production patterns

Societal goals
• Goal 1. End poverty in all its forms everywhere
• Goal 2. End hunger, achieve food security and improved nutrition and promote
sustainable agriculture
• Goal 3. Ensure healthy lives and promote well-being for all at all ages
• Goal 4. Ensure inclusive and equitable quality education and promote lifelong learning
opportunities for all
• Goal 5. Achieve gender equality and empower all women and girls
• Goal 7. Ensure access to affordable, reliable, sustainable and modern energy for all
• Goal 11. Make cities and human settlements inclusive, safe, resilient and sustainable
• Goal 16. Promote peaceful and inclusive societies for sustainable development, provide
access to justice for all and build effective, accountable and inclusive institutions at all
levels

Environmental goals
• Goal 6. Ensure availability and sustainable management of water and sanitation for all
• Goal 13. Take urgent action to combat climate change and its impacts
• Goal 14. Conserve and sustainably use the oceans, seas and marine resources for
sustainable development

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• Goal 15. Protect, restore and promote sustainable use of terrestrial ecosystems,
sustainably manage forests, combat desertification, halt and reverse land degradation
and halt biodiversity loss

Overall goal
• Goal 17. Strengthen the means of implementation and revitalise the Global Partnership
for Sustainable Development

Global strategy
The UN SDGs is the global strategy of the governments under the auspices of the United
Nations and provides direction towards (future) government polices, like regulation and
taxation of environmental and social challenges. The global strategy is boosted by
technological change (e.g. the development of solar and wind energy and electric cars at
decreasing cost), which supplements government policies (e.g. carbon pricing). Some
companies are preparing for this transition (future makers) and are part of the solution
(Mercer, 2015). Other companies are waiting for the transition to unfold before acting
(future takers). A final category of companies is unaware of this transition and continues
business as usual. They are part of the problem.
We, as authors, attach a positive probability to the scenario that the SDGs are largely
met. Our observation is based on the success of the earlier Millennium Development Goals
in reducing poverty, hunger and child death rates in Southeast Asia and Latin America, but
less so in Africa. Of course, opinions can, and do, differ about the probability that the
transition towards a sustainable economy will largely succeed. But the status quo scenario,
which assumes no transition, is highly implausible. While the pathway and the speed of the
transition are uncertain and may even be erratic with failures along the way, the sustainable
development agenda gives direction to thinking about the future. This book is about the role
finance (investors and lenders) can play in shaping this future and making production and
consumption more sustainable.
The UN SDGs address challenges at the level of the economy, society and the
environment (or biosphere). Figure 1.4 illustrates the three levels and the ranking between
them. A liveable planet is a precondition or foundation for humankind to thrive. Next, we
need a cohesive and inclusive society to organise production and consumption in order to
ensure enduring prosperity for all. In their seminal book Why nations fail, Acemoglu and
Robinson (2012) show that political institutions that promote inclusiveness generate
prosperity. Inclusiveness allows everyone to participate in economic opportunities. Reducing
social inequalities is thus an important goal (goal 10 above). Next, there can be resource
conflicts: unequal communities may disagree over how to share and finance public goods.
These conflicts, in turn, break social ties and undermine the formation of trust and social
cohesion (Barone and Mocetti, 2016).

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Figure 1.4: Sustainable development challenges at different levels

Source: Adapted from Rockström and Sukhdev (2015).

Gladwin, Kennelly and Krause (1995) define five principles of sustainable development:
1. Comprehensiveness: the concept of sustainable development is holistic or all-
embracing in terms of space, time and component parts. Sustainability embraces
both environmental and human systems, both nearby and far-away, in both the
present and the future;
2. Connectivity: sustainability demands an understanding of the world’s challenges
as systemically interconnected and interdependent;
3. Equity: a fair distribution of resources and property rights, both within and
between current and future generations;
4. Prudence: keeping life-supporting ecosystems and interrelated socio-economic
systems resilient, avoiding irreversible actions, and keeping the scale and impact
of human activities within regenerative and carrying capacities;
5. Security: sustainable development aims at ensuring a safe, healthy, high quality
of life for current and future generations.

Although sustainable development is a holistic concept, Norström et al. (2014) argue to

address trade-offs between the ambition of economic, social and environmental goals and
the feasibility of reaching them, recognising biophysical, social and political constraints.

System perspective
While it is tempting to start working on partial solutions at each level, the environmental,
societal and economic challenges are interlinked. It is important to embrace an integrated
social-ecological system perspective (Norström et al., 2014). Such an integrated system
perspective highlights the dynamics that such systems entail, including the role of
ecosystems in sustaining human wellbeing, cross-system interactions, and uncertain
thresholds.

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 Holling (2001) describes the process of sustainable development as embedded cycles
with adaptive capacity. A key element of adaptive capacity is the resilience of the system to
deal with unpredictable shocks (which is the opposite of the vulnerability of the system). An
adaptive cycle that aggregates resources and periodically restructures to create
opportunities for innovation is a fundamental unit for understanding complex systems, from
cells to ecosystems. But some systems are maladaptive and trigger, for example, a poverty
trap or land degradation (i.e. the undermining of the quality of soil as a result of human
behaviour or severe weather conditions). Holling (2001) concludes that ecosystem
management via incremental increases in efficiency does not work. For transformation,
ecosystem system management must build and maintain ecological resilience as well as
social flexibility to cope, innovate and adapt.

Examples of cross-system interactions and uncertain thresholds

As we have argued, the economic, social and environmental systems interact. A well-known
example of cross-system interaction is the linear production of consumption goods at the
lowest cost contributing to ‘economic growth’, while depleting natural resources, using child
labour and producing carbon emissions and other waste. In this book, we use carbon
emissions as shorthand for all greenhouse gas emissions, which include carbon dioxide CO2 ,
methane CH4 and nitrous oxide N2O.
Another example of cross-system interaction is climate change leading to more and
more intense weather-related disasters, such as storms, flooding and droughts. The low- and
middle-income countries around the equator are especially vulnerable to these extreme
weather events, which could damage a large part of their production capacity. The
temporary loss of tax revenues, and increase in expenditure to reconstruct factories and
infrastructure, might put vulnerable countries into a downward fiscal and macro-economic
spiral with an analogous increase in poverty. Social and environmental issues are thus
interconnected, whereby the poor in society are more dependent on ecological services and
are less well protected against ecological hazards.
A related example is land degradation in the form of soil erosion, salinisation
(exacerbation of natural soil salinity level), peatland and wetland drainage and forest
degradation. The resulting damage is estimated at $6.3 trillion a year (8.3 per cent of global
GDP) in lost ecosystem service value, which includes agricultural products, clean air, fresh
water, climate regulation, recreational opportunities and fertile soils (Sutton, Anderson,
Costanza and Kubiszewski, 2016). Land degradation also exacerbates losses in biodiversity
and jeopardises the livelihoods of half a billion mostly poor people who depend on forests
and agricultural land. Declining land productivity undermines sustainable development,
threatens food and water security, and leads to involuntary human migration and even civil
conflict.
An example of an uncertain threshold combined with feedback dynamics is the
melting threshold for the Greenland ice sheet. New research has found that it is more
vulnerable to global warming than previously thought. Robinson, Calov and Ganopolski
(2012) calculate that a 0.9°C of global temperature rise from today’s levels could lead the
Greenland ice sheet to melt completely. Such melting would create further climate feedback
in the Earth’s ecosystem, because melting the polar icecaps could increase the pace of global

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warming (by reducing the refraction of solar radiation, which is 80% from ice, compared with
30% from bare earth and 7% from the sea) as well as rising sea levels. These feedback
mechanisms are examples of tipping points and shocks, which might happen.
An important conclusion from this section is that we cannot understand sustainability
of organisations in isolation from the socio-ecological system in which they are embedded:
what are the thresholds, sustainability priorities, and feedback loops? Moreover, we should
not only consider the socio-environmental impact of individual organisations, but also the
aggregate impact of organisations at the system level. The latter is relevant for sustainable
development.

1.3. The role of the financial system

How can the financial system facilitate decision-making on the trade-offs between
economic, social and environmental goals? Levine (2005) lists the following functions of the
financial system:
• Produce information ex ante about possible investments and allocate capital;
• Monitor investments and exert corporate governance after providing finance;
• Facilitate the trading, diversification, and management of risk;
• Mobilise and pool savings;
• Ease the exchange of goods and services.

The first three functions are particularly relevant for sustainable finance. The allocation of
funding to its most productive use is a key role of finance. Finance is therefore well
positioned to assist in making strategic decisions on the trade-offs between sustainable
goals. While broader considerations are guiding an organisation’s strategy on sustainability,
funding is a requirement for reaching sustainable goals.
Finance plays this role at different levels. In the financial sector, banks, for example,
define their lending strategy regarding which sectors and projects are eligible for lending and
which not. Similarly, investment funds set their investment strategy, which directs in which
assets the fund invests and in which assets not. The financial sector can thus play a leading
role in the transition to a low-carbon and more circular economy. If the financial sector
chooses to finance sustainable companies and projects, they can accelerate the transition.
In terms of monitoring their investments, investors can also influence the companies
in which they invest. Investors thus have a powerful role in controlling and directing
corporate boards. The governance role also involves balancing the many interests of a
corporation’s stakeholders. In Section 1.4, we review the progressive thinking about how
interests should be balanced, including the interests of the environment and society. A rising
trend in sustainable investment is engagement with companies in the hope of reducing the
risk of adverse events occurring in those companies.
Finance is good at pricing the risk of future cash flows for valuation purposes. As
there is inherent uncertainty about environmental issues (e.g. exactly how rising carbon
emissions will affect the climate, and the timing and shape of climate mitigation policies),
risk management can help to deal with these uncertainties. Scenario analysis is increasingly
used to assess the risk and valuation under different scenarios (e.g. climate scenarios; see

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Chapter 2). When the potential price of carbon emissions in the future becomes clearer,
investors and companies have an incentive to reduce these emissions. The key challenge is
to take a sufficiently long horizon, because sustainability is about the future. Chapter 3
discusses the appropriate horizon for sustainable finance and ways to overcome the bias
towards short-termism.

1.4. Three stages of sustainable finance

How can finance support sustainable development? Figure 1.5 shows our framework for
managing sustainable development. At the level of the economy, the financial return and
risk trade-off is optimised. This financial orientation supports the idea of profit maximisation
by organisations and economic growth of countries. Next, at the level of society, the impact
of business and financial decisions on the society is optimised. And finally at the level of the
environment, the environmental impact is optimised. As we have argued, there are
interactions between the levels. It is thus important to choose an appropriate combination
of the financial, social and environmental aspects.

Figure 1.5: Managing sustainable development

Source: Schoenmaker (2017).

The concept of sustainable finance has evolved as part of the broader notion of business
sustainability over the last decades (see Chapter 5). Table 1.3 shows the typology for
sustainable finance on four aspects: i) the value created; ii) the ranking of the three factors;
iii) the optimisation method; and iv) the horizon. The evolution highlights the broadening
from shareholder value to stakeholder value or triple bottom line: people, planet, profit. The
final stage looks at the creation of common good value (see also Tirole, 2017). To avoid the

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dichotomy of private versus public goods, we use the term common good referring to what
is shared and beneficial for all or most members of a given community. Next, the ranking
indicates a shift from economic goals first to societal and environmental challenges (the
common good) first. Importantly, the horizon is broadened from short term to long term
along the stages.
In traditional finance, shareholder value is maximised by looking for the optimal
financial return and risk combination. Table 1.3 labels this the finance-as-usual approach.
Although shareholder value should also look at the medium to long term, there are built-in
incentives for short-termism, such as quarterly financial reporting and monthly/quarterly
benchmarking of investment performance (see Chapter 3). Finance-as-usual is consistent
with the argument of Friedman (1970) that ‘the business of business is business’. The only
social responsibility of business is to use its resources and engage in activities designed to
increase its profits so long as it stays within the rules of the game. Friedman (1970) argues
that it is the task of the government to take care of social and environmental goals and set
the rules of the game for sustainability. However, product demand ultimately derives from
societal needs. Moreover, externalities are not perfectly separable from production
decisions (Hart and Zingales, 2017). While there is a good case against corporate
philanthropy, there is not a case against integration of sustainability into strategy and
finance.
The three stages of our Sustainable Finance (SF) typology in Table 1.3 are discussed
one after another below. The stages moves from finance first, to all aspects equal, and
finally to social-environmental impact first (the ranking of factors in the third column of
Table 1.3).

Table 1.3: Framework for Sustainable Finance

Sustainable
Ranking of
Finance Value created Optimisation Horizon
factors
Typology

Finance-as-usual Shareholder value F Max F Short term

Refined Max F
Sustainable Finance 1.0 F >> S and E Short term
shareholder value subject to S and E

Stakeholder value
Sustainable Finance 2.0 I=F+S+E Optimise I Medium term
(triple bottom line)

Common good Optimise S and E

Sustainable Finance 3.0 S and E > F Long term
value subject to F
Note: F = financial value; S = social impact; E = environmental impact; I = integrated value. At
Sustainable Finance 1.0, the maximisation of F is subject to minor S and E constraints.
Source: Schoenmaker (2017).

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SF 1.0 Profit maximisation, while avoiding ‘sin’ stocks
A first step in sustainable finance is that financial institutions avoid investing in, or lending
to, so-called ‘sin’ companies. These are companies with very negative impacts. In the social
domain, they include, for example, companies that sell tobacco, anti-personnel mines and
cluster bombs or that exploit child labour. In the environmental field, classic examples of
very negative impacts are waste dumping and whale hunting. More recently, some financial
institutions have started to put coal and even the broader category of fossil fuels on the
exclusion list because of carbon emissions. These exclusion lists are often triggered under
pressure from non-governmental organisations, which use traditional and social media for
their messages (Dyllick and Muff, 2016).
But the initial effects of exclusion and divestment are limited (Skancke, 2016). From a
general equilibrium perspective, fewer investors hold the excluded companies leading to
lower stock prices and a higher cost of capital. In an empirically calibrated model, Heinkel,
Kraus and Zechner (2001) indicate that more than 20 per cent of green investors are
required to induce any polluting companies to reform. Existing empirical evidence indicates
that at most 10 per cent of funds is invested by green investors. Divestment by a growing
number of investors might turn the balance. Another effect is that divestment may
stigmatise a sector or companies to the point where they lose their social license to operate
(see at SF 3.0 below). This might lead to less investment in that sector. An exclusion criterion
targeted at a sector or the worst performers within a sector could have an effect by setting a
norm for acceptable standards.
A slightly more positive variant of the refined shareholder value approach is if
financial institutions and companies put systems in place for energy and emissions
management, sustainable purchasing, IT, building and infrastructure to enhanced
environmental standards, and all kinds of diversity in employment. The underlying objective
of these activities remains economic. Though introducing sustainability into business might
generate positive side-effects for some sustainability aspects, the main purpose is to reduce
costs and business risks, to improve reputation and attractiveness for new or existing human
talent, to respond to new customer demands and segments, and thereby to increase profits,
market positions, competitiveness and shareholder value in the short term. Business success
is still evaluated from a purely economic point of view and remains focused on serving the
business itself and its economic goals (Dyllick and Muff, 2016). Shareholder value or profit
maximisation is still the guiding principle for the organisation, though with some
refinements. Box 1.3 contains the formal objective function for the refined profit
maximisation approach of investors.

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Box 1.3: Refined profit maximisation

Investors optimise the financial value 𝐹𝑉 of their portfolio by increasing profits and
decreasing their risk (i.e. the variability of profits), while avoiding excessive negative
social and environmental impact by setting a minimum level 𝑆𝐸𝑉 !"# . The objective
function is given by:

! !
max 𝐹𝑉 = 𝐹( profits, risk ) 𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝐹profits > 0, 𝐹risk < 0, 𝑆𝐸𝑉 ≥ 𝑆𝐸𝑉 !"# (1.1)

Where 𝐹𝑉 = financial value = expected current and discounted future profits, and 𝑆𝐸𝑉 =
!
social and environmental value. 𝐹profits is the partial derivative of 𝐹 with respect to the
!
first term, and 𝐹risk with respect to the second term. This optimisation can be used by
investors in a mean-variance framework to optimise their portfolio and by banks and
corporates in a net present value framework to decide on financing new projects.

SF 2.0 Internalisation of externalities to avoid risk

In Sustainable Finance 2.0, financial institutions explicitly incorporate the negative social and
environmental externalities into their decision-making. Over the medium to long-term
horizon, these externalities might become priced (e.g. a carbon tax) and/or might impact
negatively on an institution’s reputation. Incorporating the externalities thus reduces the
risk that financial investments become unviable. This risk is related to the maturity of the
financial instrument, and is thus greater for equity (stocks) than for debt (bonds and loans).
On the positive side, internalisation of externalities helps financial institutions and
companies to restore trust, which is the mirror image of reputation risk.
Attaching a financial value to social and environmental impacts facilitates the
optimisation process among the different aspects (F, S, E). Innovations in technology
(measurement, information technology, data management) and science (life-cycle analyses,
social life-cycle analyses, environmentally extended input-output analysis, environmental
economics) make the monetisation of social and environmental impacts possible (True Price,
2014). In this way, the integrated value I can be established by summing the financial, social
and environmental values in an integrated way. Financial institutions and companies use a
private discount rate (which is higher than the public discount rate because of uncertainties)
to discount future cash flows. As social and, in particular, environmental impacts become
manifest over a longer horizon and are also more uncertain than financial impacts, private
discounting leads to a lower weighting of social and environmental value than financial
value. Chapter 2 sets out the methodology for calculating and optimising the integrated
value (which is also labelled total or true value).
However, integrated value optimisation can lead to perverse outcomes: the negative
environmental impact of deforestation, for example, can be offset by large economic gains;
in other words legitimising destruction. To avoid these outcomes, we incorporate in

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equation 1.2 the constraint that the social-environmental value cannot be worsened
compared to its initial value. Another caveat is the inherent uncertainty (e.g. underlying
climate scenarios) that makes pricing difficult. A final issue is participation (Coulson, 2016).
Producers could involve stakeholders in the application of the integrated value methodology
to form a more inclusive and pluralist conception of risk and values for social and
environmental impacts. Box 1.4 provides the formal objective function of investors for
optimising the integrated value of their portfolio.
Sustainable Finance 2.0 comes in different shapes. Examples are triple bottom line
(people, planet, profit) and integrated profit and loss accounting. Within corporate
governance, we can speak of an extended stakeholder approach, whereby not only direct
stakeholders, such as shareholders, suppliers, employees and customers, but also society
and environment, as indirect stakeholders, are included. Nevertheless, Dyllick and Muff
(2016) claim that corporates still adopt an inside-out perspective by asking how they can
reduce their social and environmental impact. While this is helpful, it also restricts their
potential to address social and environmental challenges.

Box 1.4: Internalisation of externalities

To internalise the social and environmental externalities, investors optimise the
integrated value 𝐼𝑉 of their portfolio. The integrated value is the sum of the financial
value, the social value and the environmental value: 𝐼𝑉 = 𝐹𝑉 + 𝑆𝑉 ! + 𝐸𝑉 ! . The
superscript 𝑝 stands for the privately discounted value of the social and environmental
impacts.
Investors thus optimise the integrated value 𝐼𝑉 of their portfolio by increasing their
integrated profits, and decreasing their risk (i.e. the variability of integrated profits), while
not worsening their social and environmental impact 𝑆𝐸𝑉 ! . The objective function is
given by:
! !
max 𝐼𝑉 = 𝐹( integrated profits, integrated risk ) 𝑠. 𝑡. 𝐹integr. profits > 0, 𝐹integr. risk < 0,

!
𝑆𝐸𝑉!!! ≥ 𝑆𝐸𝑉!! (1.2)
!
See Box 1.3 for the explanation of the variables. 𝑆𝐸𝑉!!! = next period social and
environmental impact. In line with the integrated value methodology, not only profits but
also risk is assessed in an integrated way (i.e. integrated across the three values), which
includes the covariance between the profits.

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SF 3.0 Contributing to sustainable development, while observing financial viability
Sustainable Finance 3.0 moves from risk to opportunity. Rather than avoiding unsustainable
companies from a risk perspective, financial institutions invest only in sustainable companies
and projects. In this approach, finance is a means to foster sustainable development, for
example by funding healthcare, green buildings, wind farms, electric car manufacturers and
land-reuse projects. The starting point of SF 3.0 is a positive selection of investment projects
on their potential to generate social and environmental impact; creating an inclusion list
instead of an exclusion list as in SF 1.0. In this way, the financial system serves the
sustainable development agenda in the medium to long term.
The question that then arises is how the financial part of the decision is taken. An
important component of sustainable development is economic and financial viability.
Financial viability, in the form of a fair financial return (which at the minimum preserves
capital), is a condition for sustainable investment and lending; otherwise projects might
need to be aborted prematurely because of financial shortfalls. Box 1.5 derives the formal
objective function for this approach. The key change is that the role of finance turns from
primacy (profit maximisation) to serving (a means to optimise sustainable development). It
moves from the front row in equation 1.1 to the back row in equation 1.3.
What is a fair financial return? Of the respondents to the Annual Impact Investment
Survey (GIIN, 2016), 59 per cent primarily target risk-adjusted, market-rate returns. Of the
remainder, 25 per cent primarily target returns below market-rate that are closer to market-
rate returns, and 16 per cent target returns that are closer to capital preservation. So the
great majority pursues returns at market rate or close to it, while a small group accepts
lower returns for sustainability reasons.
More broadly, the question is whether investors including the ultimate beneficiaries,
such as current and future pensioners are prepared to potentially forego some financial
return in exchange for social and environmental returns (e.g. enjoying their pension in a
liveable world). Social preferences play an important role for investors in socially responsible
investment (SRI) funds, while financial motives appear to be of limited importance (Riedl and
Smeets, 2017). SRI investors expect to earn lower returns from SRI funds than from
conventional funds, suggesting that they are willing to forego financial performance in order
to invest according to their social preferences. However, ex ante it is not clear what the
ultimate effect of impact investing is on financial return. If investor coalitions, for example,
could accelerate the transition towards sustainable development, there would be less
chance of negative financial returns because of extreme weather events or stranded assets.
This argument depends on sufficiently large amounts of investment moving to sustainable
finance (see Chapter 4).
On investment performance, there is a mixed picture on the relationship between
corporate social-environmental performance and financial performance. Reviewing several
studies, Busch, Bauer and Orlitzky (2016) conclude that, at the very least, there is no clear
indication of a negative relationship, or trade-off, between corporate social-environmental
performance and corporate financial performance.

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Box 1.5: Contributing to sustainable development
To foster sustainable development, investors optimise the social-environmental impact or
value 𝑆𝐸𝑉 of their portfolio, which is the sum of the social and environmental value
𝑆𝐸𝑉 = 𝑆𝑉 + 𝐸𝑉, by increasing their impact, and decreasing their risk (i.e. the variability
of impact), subject to a minimum financial value 𝐹𝑉 !"# . The objective function is given
by:
! ! !"#
max 𝑆𝐸𝑉 = 𝐹( impact, risk ) 𝑠. 𝑡. 𝐹impact > 0, 𝐹risk < 0, 𝐹𝑉!!! ≥ 𝐹𝑉!!! (1.3)

See Box 1.3 and 1.4 for the explanation of the variables. The financial viability or
!"#
minimum financial value can be presented as follows: 𝐹𝑉!!! = !1 + 𝑟 !"#$ ! 𝐹𝑉!!"# ,
where 𝑟 !"#$ ≥ 0 is a fair financial return for one period.

In banking, the Global Alliance for Banking on Values (2016) compares a group of 25
sustainable banks with the group of 30 global systemically important banks (selected and
published by the Financial Stability Board). The sustainable banks maintained their financial
return through the global financial crisis with a return on equity fluctuating between 4 and
10 per cent over the 2006-2015 period. At the same time, the median return on equity for
the global banks fluctuated between 0 and 15 per cent over the same period (see ECB (2015)
for a similar result for the euro-area banks). While the average return on equity for the
group of sustainable banks is slightly lower at 8.3 per cent compared to 8.7 per cent for the
global banks over the 2006-2015 period, the variance of the return on equity is lower for the
sustainable banks at a standard deviation of 4.9 per cent compared to 7.7 per cent for the
global banks. This smaller variance can be explained by two factors: stable return on assets
(around 0.5 to 0.7 per cent for sustainable banks versus 0.2 to 0.8 per cent for the global
banks over the 2006-2015 period) and a higher capital ratio1 (1 to 1.5 per cent higher for
sustainable banks). High leverage with more debt and less equity - which is equivalent to a
lower capital ratio - contributes to variability in banks’ return on equity and thus increases
bank risk, as found in the case of the global banks.
Ortiz-de-Mandojana and Bansal (2016) investigate the short and long-term benefits
of organisational resilience through sustainable business practices. In the long run, a higher
survival rate of sustainable organisations is expected, as resilience helps companies to avoid
crises and bounce back from shocks. They show that companies that adopt responsible
social and environmental practices, relative to a carefully matched control group, have lower
financial volatility, higher sales growth and higher chances of survival over a 15-year period.
Yet, they do not find any differences in short-term profits. This suggests that there is no
short-term cost to adopting sustainability practices.

1
We refer here to the unweighted capital ratio, also known as the Basel leverage ratio, which is
defined as Tier 1 equity divided by total assets.

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 However, the evidence on socially responsible investing (SRI), which incorporates
environmental, social and governance issues in investment decisions, is mixed. In a meta-
study on the performance of SRI funds, Renneboog, Ter Horst and Zhang (2008) report that
existing studies at the portfolio level hint but do not univocally demonstrate that SRI
investment funds perform worse than conventional funds. But Bauer, Koedijk and Otten
(2005) find little evidence that the average performance of SRI in the United States and the
United Kingdom is different from that of conventional funds. More recently, Ferrell, Liang
and Renneboog (2016) find a positive relation between corporate social responsibility and
value (measured by Tobin’s Q, which stands for the market value divided by the book value).
Corporate social responsibility can thus generate more returns for investors through
enhanced firm value. Although results have been mixed, the majority of the research
suggests a positive relationship between corporate environmental performance and
corporate financial performance (Dixon-Fowler et al., 2013).
Moving to corporate governance, legitimacy theory underpins Sustainable Finance
3.0, which targets long-term value creation for the common good. Legitimacy theory
indicates that companies aim to legitimise their corporate actions in order to obtain
approval from society and thus, to ensure their continuing existence (Omran and Ramdhony,
2015). This social licence to operate represents a myriad of expectations that society has
about how an organisation should conduct its operations. The corporation thus acts within
the bounds and norms of what society identifies as socially responsible behaviour, including
meeting social and environmental standards.
Finally, Dyllick and Muff (2016) argue that corporates need to develop an outside-in
perspective by asking how they can contribute effectively to solving social and
environmental challenges (instead of looking inside-out by asking how they can reduce their
social and environmental impact). This outside-in perspective allows corporates to take a
system approach towards sustainability at the macro level. As indicated in Section 1.2, an
integrated social-ecological system perspective is needed to address the discrepancy
between the emerging practices in sustainable investments and business at the micro level
and the outcomes or impacts at the macro level. On the environmental aspect, this system
approach starts with the planetary boundaries or ecological limits. So, natural resources are
not depleted, waste is reused and carbon emissions stay within the available carbon budget
to limit global warming. In short, the available or sustainable ‘budgets’ respect the closed
cycles of the natural environment and thus point to a circular or closed-loop economy
(Busch, Bauer and Orlitzky, 2016). Chapter 4 discusses ways to achieve a system approach.

Comparing the stages: where are we?

The three stages of sustainable finance lead to different levels of realised social-
environmental value. Sustainable Finance 1.0 introduces a minimum level, 𝑆𝐸𝑉 !"# , below
which investors cannot go. Corporates or investment projects that do not meet this
minimum level are on an exclusion list. The next stage, Sustainable Finance 2.0, balances the
privately discounted financial, social and environmental value in an overall approach
optimising the integrated value. We label this 𝑆𝐸𝑉 !"#$%&' . For illustration purposes we
incorporate this privately discounted social-environmental value halfway between the
minimum and optimal level on our social-environmental value scale in Figure 1.6. Finally,

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Sustainable Finance 3.0 optimises the social-environmental value, 𝑆𝐸𝑉 !"#$%&' . Companies
and projects that deliver this this optimised social-environmental value are eligible for
investment or lending and are on an inclusion list.

Figure 1.6: Levels of social-environmental value (SEV)

min private optimal

SEV SEV SEV
SEV
0% 100%

Note: 𝑆𝐸𝑉 !"# = minimum level of social and environmental value; 𝑆𝐸𝑉 !"#$%&' = optimised
integrated value (= privately discounted financial, social and environmental value); and 𝑆𝐸𝑉 !"#$%&' =
optimised social and environmental value.
Source: Schoenmaker (2017)

The first two stages aim to avoid reputation risk, because the public demands a minimum
level of corporate social responsibility and externalities are expected to be priced-in at some
stage. The third stage aims to grasp the opportunities of realising social-environmental
impact through investment and lending.
Where are we currently on the social-environmental axis? The majority of firms are
at the Sustainable Finance 1.0 level, putting financial value first. About 30 to 40 per cent of
financial institutions and 20 to 30 per cent of corporates adopt sustainable principles in their
investment and business practices (see Table 4.3 in Chapter 4). But these firms are only
partly (fraction 𝛼) maximising integrated value. They are somewhere between Sustainable
Finance 1.0 and 2.0, which can be expressed as max 𝑉 = 1 − 𝛼 𝐹𝑉 + 𝛼 𝐼𝑉 = 𝐹𝑉 +
𝛼 (𝑆𝑉 + 𝐸𝑉), in which V stands for the overall value maximised by the firm, FV for financial
value, IV for integrated value (IV = FV + SV + EV), SV for social value and EV for
environmental value.
A fair approximation is that financial value is dominant and social-environmental
value is incorporated for about 10 per cent (α = 0.1). This implies that we are just above, but
still quite close to, 𝑆𝐸𝑉 !"# . To increase the social-environmental value, the real challenge is
to switch from Sustainable Finance 1.0 to Sustainable Finance 2.0. This is similar to the
dichotomy of Hart and Zingales (2017), who distinguish between shareholder value (SF 1.0)
and shareholder welfare (SF 2.0). Box 3.2 in Chapter 3 reports on a recent battle between
the shareholder model (SF 1.0) and the stakeholder model (SF 2.0). Finally, the group of
financial institutions adopting Sustainable Finance 3.0 is tiny at less than 1 per cent (Table
4.3).
The framework is dynamic. Non-governmental organisations (NGOs) put pressure on
investors to raise the minimum level by expanding the number of exclusions. The
introduction of government regulation or taxation on social and environmental externalities
can cause an upward shift of the social-environmental component in the integrated value
calculation.

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1.5. Challenges to integration of sustainability into finance
The obvious answer to deal with social and environmental issues is to put them simply in our
economic models. However, these models are still confined to capital and labour, without
the services and goods of nature. The famous Cobb-Douglas production function, using
labour input (the total number of person-hours working in a year) and capital input (the
value of machinery, equipment and buildings) for the production of goods (Cobb and
Douglas, 1928), is still being taught to first-year economy and business students. The
problem is that many of the social and environmental issues are externalities or external
effects, which affect other parties without these effects being reflected in market prices.
Neo-classical models employ market prices as relevant signals for decision-making (e.g.
investment, production or consumption decisions) and thus do not incorporate social and
environmental externalities. Governments can use regulation or taxation to price or
internalise externalities. Moreover, there are societal forces at work, which put pressure on
investors and business, to internalise social and environmental externalities. Chapter 2
discusses the concept of externalities and the rate of internalisation.
Figure 1.7 illustrates the inputs (in the form of capitals) and players in the economy
(governments, corporates and households) for value creation. Panel A shows the traditional
finance regime that is aimed at financial value creation and builds on linear production and
consumption processes and locked-in government budgets for incumbent sectors (e.g.
agricultural production and fossil fuel based energy infrastructure). Panel B illustrates the
sustainable finance regime aimed at long-term value creation. This chapter stresses the need
to take an integrated view on the use of the services of natural, social and financial capital in
production and consumption. As this book focuses on the role of the financial system, Figure
1.7 draws the financing lines (investment and lending) to the main players. The endpoint –
long-term value creation consistent with achieving the Sustainable Development Goals by
2030 – is the relevant perspective for all players (financial sector, corporates, government
and households) in the system. The feedback loop highlights that long-term value creation
preserves natural, social and financial capital in the long term.
Corporates play a key role in the transition to a sustainable economy. It is therefore
important to broaden their objective from shareholder value to stakeholder value, which
integrates financial, social and environmental value. Another challenge is a behavioural bias
towards the short term. Market practices, like monthly or quarterly performance
benchmarking and variable pay, reinforce this short-term bias. A possible cost of financial
markets is thus short-termism, with agents in the financial intermediation chain weighing
near-term outcomes too heavily at the expense of longer-term opportunities. But
sustainability is about the long term. Chapters 3 and 4 explore governance approaches that
focus on long-term value creation.
Some corporates will survive that transition, others will not, because their
competitive positions are eroded. Sustainability is therefore also about corporate survival. It
is a critical issue to competitive positions, business models and, ultimately, strategy. The
fields of strategy and finance overlap in the areas of valuation and strategic value
management. The latter is the practice of ensuring that investment decisions create long-
term value. This involves the analysis of a company’s value drivers, which in turn are

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affected by material sustainability issues. Chapter 5 discusses how successful companies can
anticipate sustainability issues in their valuation and strategy.

Figure 1.7: Value creation

Panel A: Financial value creation in traditional finance

Panel B: Long-term value creation in sustainable finance

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Metrics and data to assess and manage social and environmental issues are not only needed
for ex ante decision-making, but also for ex post accountability to facilitate governance. An
emerging trend is integrated reporting, whereby companies report on financial,
human/social and natural capitals in an integrated way rather than publishing separate
reports: one financial report and one sustainability report. Investors have typically been
interested only in the first type of reports. The lack of reliable metrics and data is to date a
major hurdle in the acceptance of integrated reports. Chapter 6 highlights the need for
developing appropriate metrics, collecting relevant data and assuring the quality of
published data in integrated reports.
Sustainability needs to be incorporated in mainstream finance. Table 1.4 presents
how our sustainable finance typology developed in this chapter can be applied to various
financial instruments and sectors. At the basic level (SF 1.0), exclusion of companies or
projects with very negative social or environmental impact is incorporated in the
investment, lending or insurance strategy. The next level (SF 2.0) incorporates ESG factors
and risks in the decision-making and manages the integrated value. The advanced level (SF
3.0) starts with an analysis of the social and environmental impact before considering
financial returns. While Chapter 7 analyses new investment approaches for long-term value
creation, Chapters 8 to 11 discuss the integration of sustainability in financial instruments
and sectors.
Finally, the transition to a sustainable economy requires changing our ways of
working (Chapter 12). While technical discussions of externalities and policy development
dominate the sustainability debate, the real transition challenge is developing integrated
thinking and implementing effective transition management. Integrated thinking combines
the financial, social and environmental dimensions: integrated value becomes then the new
norm for business and investment decision-making. Organisations are often hierarchical and
locked into traditional ways of working; building capacity for sustainable development may
be difficult in such structures. Doppelt (2017) outlines a guide for change, which starts with
challenging and shifting the dominant business-as-useful mindset across the organisation.

Table 1.4: Integration of sustainability in financial instruments and sectors

Sustainable Equity Bonds Banking Insurance

Finance
Typology (Chapter 8) (Chapter 9) (Chapter 10) (Chapter 11)

Sustainable Finance 1.0 Exclusion

Sustainable Finance 2.0 ESG integration

Green bonds Impact lending

Sustainable Finance 3.0 Impact investing Microinsurance
Social bonds Microfinance

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1.6. Conclusions
Coming from an ‘empty’ world with abundant natural resources, the Industrial Revolution
has brought prosperity in the form of economic and population growth. At the same time,
this growth -based on production processes dependent on fossil fuels and other natural
resources- has created social and environmental challenges. Mass production in a
competitive economic system has led to long working hours, underpayment and child
labour, first in the developed world and later relocated to the developing world. Social
regulations are increasingly introduced to counter these practices and promote decent work
and access to education and healthcare. Next, mass production and consumption is stressing
the Earth system through pollution and depletion of natural resources. Climate change is
now the most pressing ecological constraint or planetary boundary. To address these social
and environmental challenges in our economic system, the United Nations has developed
the Sustainable Development Goals for 2030. Sustainable development means that current
and future generations have the resources needed, such as food, water, healthcare and
energy, without stressing the Earth system processes.
Sustainable finance looks at how finance (investing and lending) interacts with
economic, social, and environmental issues. This chapter shows how sustainable finance has
the potential to move from finance as a goal (profit maximisation) to finance as a means. In
his book Finance and the Good Society, Shiller (2012) provides some stimulating examples of
how finance can serve the society and its citizens. The same could be done to address the
environmental challenges.
We are in the transition to a low-carbon and more circular economy. The
externalities of the current carbon-intensive economy are becoming increasingly clear to the
wider public. Examples are more catastrophic weather events, droughts and flooding in
countries close to the equator, and air pollution. A case in point is California, where air
pollution from heavy traffic in the 1990s prompted environmental regulations and
stimulated innovations, such as electric cars of Tesla and solar technology. China, India and
Mexico, for example, face similar, or even worse, air pollution today, which may prompt at
some point environmental regulations in these countries. Finance is about anticipating such
events and incorporating expectations in today’s valuations for investment decisions.
Finance can thus contribute to a swift transition to a low-carbon economy.

Key concepts used in this Chapter

Common good refers to what is shared and beneficial for all or most members of a given
community
Environmental issues or ecological issues are issues, abiotic or biotic, that influence living
organisms; see planetary boundaries for the most critical environmental issues
Externalities refer to consequences of activities, which affect other (or third) parties without
this being reflected in market prices
Fair financial return preserves at the minimum the (real) value of capital

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Inside-out perspective asks how business can reduce their social and environmental impact;
this perspective contrasts with the outside-in perspective
Integrated thinking combines the financial, social and environmental dimensions
Integrated value is obtained by combining the financial, social and environmental values in
an integrated way (with regard for the interconnections)
Legitimacy theory indicates that corporates aim to legitimise their corporate actions to get
the approval from society and thus to ensure their continuing existence
Linear production and consumption system is based on extraction of raw materials (take),
processing into products (make), consumption (use) and disposal (waste)
Living wage is a wage for a full-time worker sufficient to provide his or her family’s basic
needs for an acceptable standard of living; a living wage varies with the local cost of living
Outside-in perspective asks how business can contribute effectively to solving social and
environmental challenges

Planetary boundaries framework consist of nine planetary boundaries within which

humanity can continue to develop and thrive for generations to come; these boundaries
include climate change, biosphere integrity, land-system change, freshwater use,
biochemical flows, ocean acidification, atmospheric aerosol loading, stratospheric ozone
depletion and novel entities
Precautionary principle states that an action should not be taken (or a boundary should not
be crossed) if the consequences are uncertain and potentially dangerous
Resilience of a system (e.g. an eco-system or organisation) is the adaptive capacity of a
system to deal with unpredictable shocks
Resources abundances refers to the plentiful availability of natural resources like minerals,
metal ores, fossil fuels, land and freshwater
Shareholder value approach means that the ultimate measure of a corporate's success is the
extent to which it enriches its shareholders
Social foundations consist of the twelve top social priorities, grouped into three clusters,
focused on enabling people to be: 1) well: through food security, adequate income,
improved water and sanitation, housing and healthcare; 2) productive: through education,
decent work and modern energy services; and 3) empowered: through networks, gender
equality, social equity, having political voice and peace and justice
Stakeholder value approach means that a corporate should balance or optimise the interests
of all its stakeholders: customers, employees, suppliers, shareholders and the community
Sustainable development means that current and future generations have the resources
needed, such as food, water, healthcare and energy, without stressing processes within the
Earth system

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Sustainable finance looks at how finance (investing and lending) interacts with economic,
social, and environmental issues

Suggested reading
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Levine, R. (2005), ‘Finance and Growth: Theory, Mechanisms and Evidence’, in: P. Aghion
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Raworth, K. (2017), Doughnut Economics: Seven Ways to Think Like a 21st-Century
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Steffen, W., et al. (2015), ‘Planetary boundaries: Guiding human development on a changing
planet’, Science 347(6223): 736-47.
Tirole, J. (2017), Economics for the Common Good, Princeton University Press, Princeton.
United Nations (2015), ‘UN Sustainable Development Goals (UN SDGs) - Transforming our
world: the 2030 Agenda for Sustainable Development’, A/RES/70/1, New York.

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