SUSTAINABILITY| 17.12.2021

What is sustainable finance, and what are ESG criteria?

Javier Caamaño Malagon

Sustainability is a concern that is being increasingly expressed by society, and many companies have begun to listen. They are now starting to dedicate specific efforts to addressing these concerns, to the point where in many cases this has become a central focus of their activities.

In the world of finance, this has translated into what is known as sustainable finance or Socially Responsible Investing (SRI). This is a trend that is on the rise, and it is one that essentially consists of taking into account factors of sustainability, rather than just profitability, when making investment decisions.

The sustainability of an investment is analyzed based upon environmental, social, and corporate governance criteria, often abbreviated as ESG. Each of these can be described as follows:

Environmental criteria

Investors will evaluate how a company’s activities are affecting our planet, including aspects such as its greenhouse gas emissions, which have the effect of accelerating climate change, its generation of pollution and wastes, and its use of natural resources. A good ESG analysis will consider both the direct and indirect impact of a company’s activities.

Social criteria

Sustainability is considered to be a concept that must go far beyond respect for the environment. Socially committed investment puts the focus on issues such as human rights, working conditions for employees, equal opportunity, inclusion of women, a company’s mission and social actions, and data protection. In the same way that environmental criteria refer to the effects on the planet, these factors revolve around an organization’s impact on society, including the way it treats its employees and customers, the communities in which it operates, and other stakeholders.

Good governance criteria

A company’s sustainability is fundamentally affected by good directorship and management practices, and these are seen as an important factor when assessing its responsibility and commitments. Some of the issues typically taken into account include transparency, accountability, accounting standards, policies on executive compensation, and independence of the Board of Directors. This means more than just applying the concepts of ethics to the world of business, because there are financial repercussions as well: companies with good governance have demonstrated better long-term performance, and because of this, they tend to develop a better reputation among investors.

ESG criteria are increasingly being applied when decisions are made about investment. And because of the enormous amounts that are channeled through financial institutions, applying these criteria can be a very powerful tool for achieving a more sustainable economy.

These are criteria that are becoming more widely institutionalized, and although this is a trend that began decades ago as voluntary in nature, it is becoming one that, in practice, is now almost inescapable. Numerous international bodies have published guidelines for investment firms, and some governments are already producing mandatory laws and regulations on the subject. Beginning in August 2022, all financial advising and management firms working in the European Union will be required to ask their clients about their “sustainability preferences” before giving them investment recommendations. It has now become apparent to those working in the finance sector that options with this focus are better accepted by all types of clients.

Because of this, sustainable finance and ESG criteria are now being materialized in the form of investment options such as specific funds, green bonds and loans, and social venture capital. However, they are also being increasingly used as a filter when the time comes to decide upon investments of all types. This is also the case with MAPFRE, which is now offering modalities such as its Capital Responsible fund, which invests in companies that are notable for their ESG strategies, and its Inclusión Responsable fund, which invests in firms that support people with disabilities. In addition, a global decision has been made to avoid investing in companies with 30% or more of their revenue derived from coal, and to refuse to insure any projects involving construction of new coal-fired power plants or operation of new coal mines.

In practice, this expansion of a sustainability focus into the world of finance means that a company may have difficulty surviving unless it demonstrates its good environmental, social, and governance values. This is because it will be gradually excluded from investment sources, especially in countries where commitment to these principles is the strongest. In this way, ESG criteria are becoming a driver of change for industries with the most room for improvement on these subjects, and as an example of this, it is sufficient just to think of the efforts that energy companies are now making to publicize their environmental commitments.

How is compliance with ESG principles analyzed?

Establishing some principles to guide the focus of investment can have an undeniable positive effect on the economy as a whole. However, it also brings up a major challenge: How should a company be analyzed on the basis of those principles? How do we know that those principles are really being applied?

Experts say that ESG indicators are not always reliable, and there are many differences among the ones being used. A good analysis must avoid being influenced by deceptive practices such as “greenwashing”, where companies implement certain measures just so they can be labeled as “green”, without actually being very sustainable. This type of analysis also needs to take in a broad perspective. For example, companies in the technology field tend to obtain good scores, far above the typical rating for a mining company, but the materials that the mining company extracts will end up being used to produce the cell phones or computers being sold by those same technology companies. Also, if these principles are applied without sufficient flexibility, they can translate into divestment of funds from the places where they are really needed. An example of this would be the case of an energy company that is taking significant steps towards renewables, but which is still in a transition phase that it cannot successfully complete without external assistance.

In view of these difficulties, the rating systems and methodologies used for responsible investing, and the professionals who specialize in this area, have become a very valuable asset for entities that want to continue along this path. MAPFRE has relied upon creation of its own ESG database, and for this purpose, in 2017 it acquired a 25% stake in the French management firm La Financière Responsable, which is dedicated to responsible investment. With this operation, it gained access to a team with decades of experience in this area, and to a high-quality working system that has been tested over time, in a field that has now become a very important discipline within the finance sector.

“At MAPFRE, we think it is important to emphasize not just financial returns, but societal returns as well. In fact, the two can go perfectly hand-in-hand, and this is being demonstrated by the solid returns being recorded for these options”, explains José Luis Jiménez, group chief investment officer at MAPFRE. This is because far from being contradictory, these two concepts can work in alignment, which is the ultimate objective of sustainable finance.