What is driving the growth of green and social finance?
By Shu Tian, Donghyun Park, Mai Lin C. Villaruel
There is evidence of a positive link between sustainable behavior and financial return which will likely drive the continued growth of green and social finance.
Over the past decade, sustainable finance has become a prominent feature of global finance around the world. Green and social finance which target investments with specific and measurable environmental or social objectives witnessed fast expansion in recent years.
According to Bloomberg, more than $30 trillion assets under management globally in 2018—about one-third of the total and a 34.3% increase from 2016—are now subject to some form of ESG (environment, social and governance) framework. The rapid growth of green and social finance, particularly from the private sector, can be sustained since it is increasingly driven by financial considerations, besides the desire to achieve sustainable development goals.
Three major factors are driving the development of green and social finance.
First, in recent years, the preferences of investors, managers, shareholders, clients, and society at large, shifted markedly toward the United Nations’ Sustainable Development Goals. Since COVID-19 had a disproportionate impact on the poor and vulnerable, it may have a long-term impact on the preference of investors and stakeholders for assets which take into consideration environment, social and governance issues.
A survey of financial advisors conducted by Broadridge in 2020 shows that around a quarter saw increased client interest in environment, social and governance assets during the pandemic, and predicted that this share of clients and assets will double in the next two years.
A study on environment, social and governance investor sentiment by Allianz Life in 2019 shows that nearly two-thirds of surveyed millennials, who are expected to inherit $68 trillion of wealth over the next decades, and around half of older generations such as Gen Xers and baby boomers consider environment, social and governance a key factor in making investment decisions.
Meeting the Sustainable Development Goal preferences of investors and clients helps attract less return-sensitive and more patient capital to green and social investment. There is some evidence showing that investors are more patient when investing in sustainable assets.
Mutual fund flows become more persistent and less sensitive to fund performance when funds invest in more responsible assets, driven by clients’ nonfinancial considerations. Evidence also shows that companies that issue green bonds tend to see an increase in long-horizon and domestic institutional investors.
Social capital pays big dividends during market shocks when overall confidence is low and the value of trust increases.
Second, tapping green and social finance helps companies and investors hedge and mitigate risks associated with sustainability issues such as climate-related risks. Evidence shows that climate-related risks have already been priced in across various asset classes such as equities, bonds, real estate, and mortgages. Higher sustainability risk affects firms’ operations as well as investors’ recognition of it, thus has financial implications.
Our research for Asian Development Outlook 2021 shows that the ratification of the Kyoto Protocol in Australia significantly increased the cost of capital of high Australian emitters. Relative to non-emitters, high emitters experience a 5.4% higher increase in cost of debt and a 2.5% higher increase in cost of equity. Meanwhile, since financial institutions perceive high emitters to be more risky, high emitters experience a 13.2% decline in institutional investors’ ownership and a 27.2% drop in loan credit from major banks, relative to no-emitters.
Third, tapping green and social finance offers insurance-like benefits against both market shocks such as a pandemic, and against firm-specific shocks such as big environmental lawsuits. Practicing social responsibility helps firms to build social capital or trust. A high level of social capital strengthens the perception of trustworthiness among investors, clients, managers, and employees.
Social capital pays big dividends during market shocks when overall confidence is low and the value of trust increases. Responsible firms can be supported by stakeholders’ commitment through, for instance, credit lines and sales. In the event of negative corporate incidents, a high level of social capital mitigates negative judgment and sanctions, thereby reducing the reputational cost. Evidence shows that during both market and firm-specific shocks, socially responsible firms show superior profitability and stock performance, and less reduction of firm value.
Furthermore, firms tap green and social finance to signal their awareness of and commitment to Sustainable Development Goals. Such signals lead to positive investor recognition. According to Asian Development Outlook 2021, Asian stock markets respond positively to the issuance of corporate green bonds.
Issuers’ common stocks post an average of 0.5% cumulative abnormal return during a 16-day period around the announcement of a green bond issuance. This translates into an annualized return of about 8%. Such positive reaction implies that investors see green and social finance as creating value through green and social investments.
The fact that economic and financial motives are coming to the forebodes well for the future of green and social finance, both globally and regionally. While financial market stakeholders now care more about green and social impact than ever before, ultimately what they care about most is financial return.
Therefore, evidence of a positive link between sustainable behavior and financial return implies that the growth of green and social finance can be sustained in the future.
This blog post is based on research conducted for the Asian Development Outlook (ADO) 2021: Financing a Green and Inclusive Recovery.