We’re back with more Sustainable Finance content, this time to write about the elephant in the room – measuring sustainability. As this theme continues to go mainstream, more and more people are asking the same question: How do we actually measure impact?
Similar to financial accounting standards, GAAP or IFRS, where a set of information is selected to generate an understanding of the current state of a business, measuring sustainability is no different. A set of metrics are collected, synthesized, and interpreted regularly to keep track of, hopefully, some level of “sustainability” progress.
The challenge with tracking progress in sustainability is that most operators have no clue how to actually do that. It’s not like pulling down a Quickbooks file to track your P&L. Most companies haven’t a clue how to track their Greenhouse gas emissions, the incidence of high-risk diseases within their workforce, or the general social impact of a business within their community. There simply aren’t Quickbooks type solutions for these sorts of assessments.
Larger firms will typically deploy headcount to these tasks – the so-called sustainability teams, or corporate social responsibility teams – to make it at least look like they know what they’re doing. These teams’ job is to basically ‘create’ these metrics to support their glossy annual report (usually filled with people smiling). Check the box and move on kind of thing.
As good capitalism would have it, in the last couple of years we’ve seen many start-ups emerging to attempt to help traditional businesses ‘do better business’. Founders understand how challenging it is to measure and report sustainability, and many efforts are being done to automate, standardize and simplify sustainability accounting (more on this in the ‘Further Reading’ section at the end).
Once a business gets a trace amount of data collected and a sustainability team stood up, the sustainability report is basically done (heavy sarcasm here). Thankfully, larger firms have engaged in a process to follow somewhat consistent reporting standards (similar to GAAP and IFRS) to ensure efficiency and hopefully effectiveness.
Standardized reporting is THE big next step for the industry.
The degree of complexity in assessing sustainability is directly linked to the size (generally in terms of supply chain complexity) of a given business. This is the case for an employee, investor, or a consumer, justifying in part the reason why most of the businesses we brand as being net positive often are small in scale and complexity – think of all the simple businesses behind the sustainable shampoos and organic beard glitter Tim has in his recycled nomad backpack (i.e. businesses with a small product catalog and supply chain complexity).
Financial markets intercept sustainable finance in:
Bonds and loans typically finance projects or operations. The banks’ sustainable finance desk at the debt capital markets teams originate bonds and loans which finance sustainable projects or sustainable operations. These are the so-called green / social / sustainability bonds / loans or the so-called sustainability-linked bonds / loans.
A key characteristic of these products is the requirement for a clearly defined project (e.g. a more sustainable factory, improvement of school infrastructure, a new train line to be developed, etc.), meaning these are project financing bonds, as opposed to capital structure financing bonds.
This is a key limitation that has prevented sustainability bonds from becoming a relevant piece of the $125+ trillion global bond market (currently accounts for less than 1%) as the proceeds of these bonds are tied up in specific projects, whereas non-project based bonds can be used for working capital requirements, stock buybacks (capital structure adjustments), or a myriad of other uses to run to the business.
The market solved this issue by creating sustainability KPIs and setting annual targets for the whole business rather than simply project specific. With that, sustainability bonds are used nowadays to not only fund sustainable projects, but also to fund regular operations as long as they comply with the sustainability KPIs linked to the bond themselves (with interest rates step up and down depending on the level of compliance of those KPIs).
The primary goal of these instruments is to lower the cost of capital of businesses as they comply with sustainable targets.
The FOMO of being part of the sustainable finance bandwagon, or the pressure to tick the ESG box felt by equity asset managers, led to a whole lot of nonsense.
As companies begin ‘measuring’ sustainability and pump out their glossy sustainability reports, asset managers have begun navigating those ‘data points’ so that they can claim their investment process takes into consideration ESG variables.
Whilst making these claims is not completely unreasonable, where it gets a bit excessive is when market participants use ESG as the fundamental thesis for their investment case (and consequently as a rationale for investment outperformance). Case in point – ESG Scores, which are typically the result of a simple and unsophisticated averaging mechanism.
The problem with this practice is that investors tend to outsource third-party agencies’ ESG scores rather than building them internally.
These scores are made through proprietary methodologies which we do not have visibility on, raising our skepticism around their accuracy. Paradoxically, this would be the equivalent of investing in equities and using sell side research to make investment decisions, with a caveat – you do not have visibility on how the research analyst is coming up with the price target. ($TSLA to $3,000!)
Ideally, asset managers would perform their own research as they do with their traditional investment methodologies. If this is asking too much, increased transparency on agencies scoring methodologies, to at least ensure the sustainability screen is, indeed, sustainable in the long term, would be a nice consolation prize.
As biased as a professional like myself (Manuel) within this space will be, it’s in the alternatives that the greatest level of confidence about a given impact statement can be found.
The close involvement between the investment managers and the companies’ management allows for a degree of value alignment not attainable elsewhere, at least for now. Within the mandates aiming at earlier stages (e.g. VC) and mandates targeting specific products (e.g. real estate, infrastructure), it’s a lot easier to quantify the net impact of a given business, hence a lot more comforting to engage with bold net positive impact statements.
Measurement of sustainability in these alternative assets follows the same methodologies as the ones mentioned above – that time-consuming accounting exercise – but the proximity between the capital allocator and the management teams of the businesses ensures a more fluid exchange of information, and a clearer path to action that can be put in place to ensure that targets are being respected.
Proximity is power, and that is certainly true in the world of sustainability. At least, for now.