An important role of finance is to allocate funding to its most productive use and to stimulate value creation. Finance can steer investments to sustainable companies and projects without sacrificing financial return and speed up dramatically the transition to a sustainable economy. In this way, finance can be a powerful force for positive change.
Yet, some may ask, “how is that possible as finance is thought of as always looking for the highest financial return in the short term, while sustainable development is all about creating value in the long term”? This is definitely a legitimate question. Companies Indeed play an important role in achieving sustainable development goals through long-term value creation, so how can companies steer their business towards sustainable practices is actually a fundamental question of corporate finance.
Let’s go one step back and ask “what is the objective of the corporation”? For decades, maximizing profits has been the leading objective in corporate finance, which boils down to maximizing shareholder value. But often, the shareholder model is holding companies back from sustainable business practices. An alternative approach is to broaden the objective of the company to optimize the total or integrated value. This approach combines optimizing financial, social, and environmental value. In that way, the interests of stakeholders are ranked equally important. This shift, from the old shareholder model to the new stakeholder model, requires new rules for corporate governance and decision-making on corporate investments to deal with the different interests. It basically means incorporating social and environmental dimensions.
Now we get to the million-dollar question. The old view is that taking social and environmental concerns into account will cost investors money. The financial return will thus be lower. A new emerging view is that there is no need to sacrifice return when investing in solutions for sustainable development. To put it even stronger, investors should invest in the future to preserve the value of their investments, and companies need to adopt technological solutions (this is also an investment) that will enable the casting of sustainable infrastructure for long term value creation.
Let me give you an example. Coal will not be used anymore when carbon taxes are introduced over time. Another example. Underpayment in developing countries will disappear, as these countries tighten their social legislation in the future. Finance is about anticipating such changes. From a risk perspective, financial institutions have already started to avoid financing companies with unsustainable business models, built for example, on fossil fuels or cheap labor, because these are expected to be unprofitable investments in the future. Fossil fuel companies are thought of as becoming stranded assets when future carbon taxes or improved technology moves the business case to renewable energy. The reduced cost of solar energy and wind parks is already shifting the playing field of investments in the energy sector.
It gets more exciting when we switched from the risk perspective to the opportunity perspective. Some advanced investors look for companies that provide solutions for water, healthcare, or renewable energy. These investors tend to look beyond financial markets, which only convey financial information. They conduct a fundamental analysis of a company’s business models to uncover the social and environmental value next to the financial value.
By doing a broad analysis, covering the financial, social, and environmental dimensions, investors aim to select companies of the future. Companies that do well in the future will also provide an appropriate financial return. The financial sector can do well by doing good. Finance plays thus an important role in achieving sustainable development goals. Sustainable finance can, for example, speed up the availability of clean water and sanitation for all.
Let’s have another example. Phoebus Energy is a leading CleanTech company specializing in water heating and cooling in medium to large commercial facilities such as Hotels, Hospitals, Sports Clubs, etc’. The company has developed a patented energy-saving system that efficiently utilizes the temperature differential between incoming and outgoing water used in existing boilers and chillers — boosting overall operational performance while reducing energy expenses and carbon footprint. The unprecedented value of using this technology is that it saves 50% to 70% of the money spent by hotels (as a typical user of this technology) when heating water. It saves about 90% of the pollution in the site since it reduces by 90% the use of fossil fuels used to heat water by a boiler, and it saves an overall of 50% of the energy (on a global basis). Without getting into Phoebus’s business model details, it yields multi-million dollars in operational savings. For many companies, achieving such numbers is a matter of being or ceasing to be.
The beauty of this example, in my opinion, is that the unprecedented contribution to the financial bottom line is the least significant achievement of the application of such technology by a hotel. Think about its contribution to the environment, and its potential to serve as a catalyst for local government in providing tax benefits to hotels that apply such technology, and more. For financial investors, this is not just a safe investment, it is a long-term investment that can pay off exponential returns.
Phoebus’s case may also serve as an explanation for the following financial behavior. PGGM is a not-for-profit cooperative pension fund service provider. PGGM manages the pensions of various pension funds, the affiliated employers, and their employees. On 30 June 2020, they managed pension assets worth 246 billion euros for 4.4 million participants. In 2015, their main client, Pension Fund for the Healthcare and Social Sectors, or PFZW, added another objective, which is to have a positive impact on four specific themes. These themes are related to five of the Sustainable Development Goals: food — SGD 2, health — SDG 3, water — SDG 6, and climate and pollution — SDG 7 and SDG 13. PFZW had tasked to find €20 billion in impact investments that deliver: First, a market-rate financial return and second, a measurable positive contribution to one or more of the before-mentioned SDGs. By doing so, PFZW aims to have a positive impact on the world in which participants can truly enjoy their pensions. This is supported by other stakeholders such as the regulator, government, and civil society who are encouraging PFZW bonus to put pension savings to good use.
PGGM strives to be an excellent provider of pensions with a purpose, drawing on its strengths in responsible investment and private markets, among others. This ambitious target to invest €20 billion in solutions by 2020 means that PGGM must fire on all cylinders, pursuing opportunities in private markets such as private equity, infrastructure, real estate, as well in public markets such as listed equities and bonds on all the defined themes, including water.
Water-related investments — SDG 6 is an interesting theme for pension funds and for visionary investors in general because it is of fundamental importance to all economic activity in life. There’s no substitute and yet this increasingly scarce resource is both underpriced and under-invested. Estimates vary, but to realize water secured to everyone, the world needs $500 billion in investments per year. Only one-third of this enormous amount of capital requirement is currently covered since government budgets and concessional financing by development banks are insufficient. Achieving PGGM’s goal of investing €20 billion on impact investments, including water will be dependent on market availability and PGGM’s ability to source the right investments. Worsening availability and increasing competition for freshwater will inevitably lead to more direct or indirect investment opportunities for them. For example, in wastewater treatment, industrial water supply, water network repair, and maintenance, water savings, groundwater management, energy, and resource recovery, or in the hydrogen economy.
In conclusion, if anyone has the slightest doubt about what to invest in tomorrow, I am absolutely certain that these should be investments in resources and infrastructure that form the foundations on which our lives are founded. In this way, investors can achieve returns far above industry standard and also contribute to a much better future for all of us.
Originally published at https://www.mikulitski.com on December 19, 2020.