Sustainable Finance Glossary
Active ownership refers to the diligent use of shareholder rights to inluence and adress business strategy and decisions, including ESG-related issues and policies. Active shareholders can either engage with current or potential investee companies’ management and boards of directors, or vote at shareholder meetings. Active ownership can be used by responsible investors to reduce investment risk and improve long-term shareholdder value, or both.
The Appui au Développement Autonome (ADA) is a Luxembourg-based non-governmental organisation that has been supporting inclusive finance organisations, such as microfinance institutions (MFIs), in Central America, Africa and South-East Asia since 1994. ADA provides those MFIs with technical support and assists local governments and regulators to improve their microfinance sector. ADA also acts as an advisor to the Luxembourg Microfinance Development Fund (LMDF) in its MFI investment decisions.
Blue bonds are debt securities issued to finance the preservation, protection and sustainable use of marine resources. The Republic of Seychelles issued the first blue bond in 2018 to fund the transition towards sustainable management of its fishing industry, including measures to rebuild fish stocks and expand protected marine areas.
Unlike green bonds, blue bonds are not governed by internationally accepted standards or principles. Nevertheless, the current blue bonds markets exists within already sustainable bond frameworks, such as ICMA’s Green Bond Principles (GBP). UN Global Compact identifies three steps for the issuance of blue bonds:
- Aligning with existing standards (such as the frameworks developed by ICMA)
- Develop a “blue” framework including:
- Setting a blue baseline, i.e., ensuring consistency with SDGs or various “blue finance” frameworks such as the Sustainable Blue Economy Finance Principles
- Developing clear and measurable KPIs
- Disclose relevant sustainability performance metrics on a regular basis
- Secure a Second Party Opinion
Similarly to Positive screening, the best-in-class investing approach uses ESG ratings to select companies that are frontrunners in ESG practices within their sectors, without necessarily excluding any particular sector or industry. Asset managers may apply a threshold and retain companies that rank above it, or reweight their holdings against an index or a benchmark, that is, overweight companies with high ESG scores and underweight the worst performing ones.
CSR is defined as the responsibility of organisations for the positive and negative impacts that they may have on social and environmental issues and on society. That definition captures the impact that an organisation may have across three areas of responsibility:
- Internal or management responsibility, relating to the positive and negative impacts of the organisation's management systems and models, by reference not only to its transversal support functions (HR, purchasing, IT, communications, compliance/risk functions, etc.) but also to its governance and its code of ethics;
- Responsibility for its activities as regards the impacts of the products and services that it offers and the operational approaches applied in that connection. Responsibility for products and services entails the integration of ESG (environmental, social and governance) criteria in the business models used;
- Civic and territorial responsibility as regards the contribution made by the activities in question, and by the management of the business, to the creation of value for all stakeholders and for local communities, but also for the planet.
CSR is commonly composed of the following three pillars:
17. The economic pillar: the economic pillar integrates various themes, including the economic sustainability of the business and its governance, but also the direct and indirect economic impacts of its investments, its purchases, its financing operations and its fiscal policy (see GRI Standard 207), etc.
18. The environmental pillar: this pillar encompasses energy efficiency, respect for biodiversity, waste management, water, emissions and consumption.
19. The social pillar: the social pillar is made up of two sub-groups of principal CSR themes, namely those linked to the responsible management of human resources, having regard to such matters as diversity, training, employability, health and safety in the workplace, and those linked to citizenship issues and social impacts on local communities. These themes are also known as "societal" themes. They include such things as respect for human rights, education and awareness-raising programmes, and health initiatives for the benefit of local communities.
In the field of finance, these three pillars also have concrete implications arising from the consideration of "ESG" criteria:
- "E": the pillar relating to environmental issues
- "S": the pillar relating to social and societal issues
- "G": the pillar relating to governance issues
The development of a CSR strategy does not exclude the economic dimension of the product or service in question, which must support a viable and lasting economic model over the long term, both for the organisation itself and for its stakeholders.
Click here to access the ABBL CSR practical guide for the banking sector.
Click here to access the INDR CSR Guide.
Corporate governance covers all of the institutions and rules that manage and control a company, and which allocate powers and obligations among shareholders and the Management. The functioning of governance and agility of interactions among parties involved impacts on the effectiveness of the decision-making process and implementation of strategy.
One of the first definitions of CSR is Carroll's Pyramid. Carroll's basic premise is that society has expectations of companies, and that those expectations in turn generate responsibilities for companies with regard to society. This conceptual model stipulates 4 main expectations and responsibilities that are organised into a hierarchy, starting with the most fundamental:
- Economic: operating in the long term (avoid the risk of bankruptcy)
- Legal: knowing the rules of the game and observing them (compliance with laws, regulations, etc.)
- Ethics: differentiating between what is good and what is not (avoiding negative impacts for its stakeholders and for society)
- Philanthropic: offering its own resources (donations, patronage, etc.) to do good in society (generating positive impacts for its stakeholders and for society)
Ethical responsibility requires the company not to destroy value in society, and philanthropic responsibility requires it to create value.
The Climate Disclosure Standards Board (CDSB) is a not-for-profit consortium of business and environmental NGOs created in 2007 during the World Economic Forum in Davos. The CDSB works as forum of collaboration on how existing standards and practices can link financial and climate-related information. As such, the CDSB has developed a reporting framework for environmental information, natural capital and the associated capital impacts, linking and building on already existing standards instead of creating a set of new ones, inluding the TCFD recommendations, IFRS, GRI and SASB.
The Carbon Disclosure Project (CDP), is an independent international not-for-profit organisation that supports companies, investors, municipalities and states in reporting on their GHG emissions, and provides extensive databases on environmental data.
Carbon pricing refers to the legislative or regulatory actions and practices of enforcing a cost on carbon emissions in order to incentivise emission reduction and drive investment into alternative energy sources and transit options. Carbon pricing comes in two forms:
- Carbon tax: A carbon tax sets a mandatory charge on each ton of emitted greenhouse gases in order to incentivise economic actors to reduce their emission levels.
- Emissions trading schemes: With emissions trading schemes (often referred to as “cap-and-trade systems”), lawmakers set a maximum carbon emission level per annum for certain sectors or the whole economy and distribute allowance certificates matching the emissions cap. Large emitters are then able to purchase certificates from low-emitting companies. Since the number of certificates is limited, their price will fluctuate as a function of the demand for allowances, which will in turn incentivise companies to cut their carbon emissions. From there on, lawmakers are able to adjust the emissions cap in conformity with their CO2 emission reduction goals.
Climate risks (also referred to as “Environmental risks”) refers to the risk assessment based on the probabilities and consequences of the impacts of climate change. A discussion paper published by the EBA identified three main transmission channels for environmental risks:
- Physical transmission channels (physical risks), which refer to potential financial losses caused by climate-related hazards. This type of risk may be further decomposed into acute risks arising from extreme, but sporadic, climate events such as droughts or storms, and chronic risks occurring from progressive change such as increasing temperatures, sea-level rise or biodiversity loss.
- Transition transmission channels (transition risks), which refer to risks of financial losses directly or indirectly linked to the adjustment towards a low-carbon economy, possibly triggered by sudden changes in policies, technology or market preferences.
- Liability transmission channels (liability risks), which refers to risks stemming from people or businesses seeking compensation for losses they may have incurred due to ESG factors, e.g. when institutions’ counterparties are held accountable for the negative impact through their activities on the environment,the society and theirgovernance factors.
The Corporate Sustainability Reporting Directive (CSRD) was introduced as a proposal by the EU Commission in April 2021 to extend the scope of the Non-Financial Reporting Directive (NFRD), which had previously introduced obligations for certain large companies to report on sustainability-related information.
The CSRD’s new requirements encompass all large companies (both listed and private), as well as listed SMEs. Not only does the CSRD introduce more specific disclosure obligations, it also lays out plans to establish EU Sustainability Reporting Standards to be developped by the European Financial Reporting Advisory Group (EFRAG). The disclosed sustainability-related information will also need to be audited and attain a similar level of assurance as traditional financial reporting. Furthermore, businesses that fall under the CSRD’s scope will be required to digitally “tag” their sustainability disclosures, as to make them machine readable and thus able to be directly fed into the European Single Access Point, an upcoming digital platform which will centralise both financial and sustainability-related corporate disclosures.
Carbon offsetting is a way to reduce emissions and to pursue carbon neutrality when emissions released in a sector are offset by negating or reducing them somewhere else. This can be done through investment in renewable energy, energy efficiency or other clean, low-carbon technologies. The EU’s emissions trading system (ETS) is an example of a carbon offsetting system.
Carbon capture and storage (CCS) refers to techniques allowing to capture CO2 and storing them in geological locations, most often underground rock formations including oil and gas reservoirs. Carbon capture technology has existed in power plants for years, allowing to directly capture CO2 pre- or post-combustion. The trapped carbon dioxide must then be compressed and transported to its sequestration location. While CCS is no be-all, end-all solution by itself, it might still play an important role in tackling climate change.
A carbon footprint is the total amount of greenhouse gas emissions produced either directly or indirectly by an individual, an event, an organisation or a product. Since greenhouse gases (GHG) comprise of several different gases, carbon footprint is expressed as carbon dioxide equivalent, which is the amount of other gases converted to their equivalent amount CO2 with the same global warming potential (GWP).
See Greenhouse Gases for more information on emission scopes.
Carbon neutrality refers to achieving zero net carbon emissions. For a company, this is done by reducing its total CO2 emissions as much as possible and offsetting its remaining CO2 emissions by purchasing CO2-certificates. These CO2-certificates allow to compensate for emissions by contributing to carbon offset projects that invest in renewable energies or reforestation projects.
The circular economy is an alternative to the current linear economy, which a follows a traditional process of harvesting materials to be transformed into products, which are then disposed of after usage.
Instead, circular economies work as closed-looped system and rely on processes such as recycling, refurbishing, remanufacturing, repairing and reusing to extend the life cycle of products and materials to form a sustainable cycle of production of consumption that generates minimal waste.
As part of the European Green Deal, the European Commission adopted the Circular Economy Action Plan in March 2020. This action plan includes legislation proposals on sustainable product designs, reducing waste and empowering consumers (e.g. right to repair), with a particular focus on resource-intensive sectors such as electronics, packaging, textiles or construction.
Due diligence is a basic duty of care that the company must exercise before engaging in a business transaction. It consists of identifying risks of human rights violations (pertaining to freedom of association, collective bargaining, forced labour, child labour, discrimination, vulnerable groups, etc.) and taking action to prevent or mitigate negative impacts.
The concept of “double materiality” was introduced in the European Commission’s Guidelines on Reporting Climate-related Information in 2019. It is composed of two elements: the “traditional” financial materiality, and a new “environmental and social materiality”. The latter refers to “the impact of the company’s activities” and should be reported if it is “necessary for an understanding of the external impacts of the company”.
While such information would mostly interest stakeholders such as consumers, employees and communities, it would also be of interest to investors, who are mainly concerned about the effects of sustainability-related issues on a company’s financial performance.
Source: European Commission
A divestment is the opposite of an investment, as it refers to the process of withdrawing capital from companies for financial, ethical or political reasons. In the context of sustainable finance, investors may decide to divest companies that do not meet certain ESG criteria or that are active in certain industries.
Decarbonisation refers to the processes of reducing or eliminating carbon dioxide emissions from energy generation and usage, generally by reducing the use of fossil fuels, increasing energy efficiency, installing carbon capture and storage solutions or switching to carbon-free energy sources.
In the context of sustainable finance, investment portfolios can also be decarbonized. Investors may choose to simply divest carbon-intensive companies. Alternatively, they may decide to actively engage with the high-emitting companies of their portfolios, so as to influence their corporate actions and policies. Large capital re-allocations and investor engagement incentivise companies to adapt their business models in the transition towards a low carbon economy.
EuroSIF is a European association of national Sustainable Investment Forums (SIFs), working to raise awareness on socially responsible investing and promote the adoption of its principles across european financial markets.
The European Commission’s proposal for an European Climate Law intends to formally enact the climate-neutrality goal of the EU Green Deal. As such, the purpose of the upcoming regulation is to set legally binding targets for GHG reductions, as well as the roadmap towards climate neutrality, including provisions for regular progress assessments and adjustment mechanisms in the case of lack thereof.
The EU reached a political agreement on April 21st on a GHG emission reduction target of “at least 55%” by 2030, compared to 1990 levels and climate neutrality by 2050.
ESG integration is an investing approach which explicitly includes financially relevant sustainability-related information in investment decision-making in order to assess long-term material impact of ESG factors on a company’s financial performance and, in turn, reduce portfolio risk.
As part of the European Green Deal, EU Regulation 2020/852, the so-called “EU Taxonomy Regulation”, was adopted in June 2020. The regulation lays out a classification system intended to provide investors, businesses and policymakers guidance on identifying activities that can be considered environmentally sustainable. By providing transparent and clear definitions on sustainable activities, the Taxonomy regulation aims to re-orient investment flows towards sustainable businesses and protect investors from greenwashing. While the current state of the taxonomy only deals with environmental sustainability, the framework might be expanded over time to include other sustainability matters.
To qualify as environmentally sustainable, an economic activity must
- substantially contribute to one of the following six environmental objectives:
- Climate change adaptation
- Climate change adaptation
- Sustainable use of water and marine resources
- Transition to a circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
- do no significant harm (DNHS) to any of the other environmental objectives
- avoid violation of minimum safeguards
- comply with Technical Screening Criteria developed by the Technical Expert Group, which will be published later on.
The taxonomy will come into effect in two phases:
- as from January 1, 2022 regarding the climate-related objectives (a) and (b), and
- as from January 1, 2023 regarding the other objectives (c), (d), (e) and (f).
Also referred to as the 'Action plan for sustainable growth', the Action Plan on financing sustainable growth is the European Commission’s long term strategy to enable the transition to a carbon neutral and more sustainable economy, launched in March 2018. It sets 10 key actions within 3 main axes:
Reorient capital flows towards sustainable investments
- 7. EU taxonomy
- 8. Labels for green financial products
- 9. Foster investment in sustainable projects
- 10. Incorporate sustainability in financial advice
- 11. Develop sustainability benchmarks
Mainstream sustainability in risk management
- 12. Integrate sustainability in credit ratings and market research
- 13. Clarify asset managers’ and investors’ duties regarding sustainability
- 14. Integrate sustainability in prudential regulation
Fost transparency and long-termism
- 15. Strengthen sustainability disclosure and accounting rule-making
- 16. Foster sustainable corporate governance and attenuate short-termism in capital markets
Source: European Commission
The European Green Deal is the European Union’s roadmap to meet the goals of the Paris Agreement and to reach carbon neutrality by 2050.
Described by the European Commission’s President Ursula von der Leyen as Europe’s “man on the moon” moment, the Green Deal’s main target is to achieve a 55% reduction in Greenhouse Gas emissions by 2030. To achieve this, the Green Deal sets out to review current laws and to introduce new legislation and policies on clean energy, circular economy, building and renovation, biodiversity, farming and sustainable mobility.
These policies will be financed through InvestEU, an investment plan with a forecasted €1 trillion mobilised by the Member states over the next decade.
When it comes to sustainable investing, ESG criteria are often used by investors to evaluate a company’s performance in three broad categories. Standing for Environmental, Social and Governance, these criteria provide non-financial information on companies and form the foundation for most sustainable investing strategies. Analysing ESG factors is becoming an ever-popular method to assess a company’s present and future performance for investors. To do so, investors may look into a broad range of criteria.
Environmental factors provide insight into the company’s ecological footprint. These commonly include, but are not limited to, GHG emissions, hazardous waste disposal, energy consumption and water consumption.
Social factors look at the company’s relationships with its employees, surrounding communities and stakeholders. Investors may gauge how a business behaves as a corporate citizen or how it adapts to the pressures of ongoing social trends. Such factors may include, without being limited to, employee rights, diversity, training and turnover, supply chain standards, human rights, consumer protection or product safety ratings.
Governance factors cover topics closely linked with the policies and practices of a company’s management. These topics include, but are not limited to, Board structure, diversity and independence, executive compensation, shareholder rights and engagement, or business ethics.
The Global Reporting Initiative (GRI) is an international independent standards organisation established in 1997 to develop a reporting framework for economic, social and environmental performance using a multi-stakeholder approach involving multiple governance bodies made up of businesses, investors, policymakers and civil society.
The GRI standards were developed by the Global Sustainability Standards Board, GRI’s committee dedicated to the creation of reporting standards. These standards work as a modular set of universal standards and “topic” standards, the latter being based on an organisation’s material topics.
Click here to access the GRI standards download page.
Based on Article 8 of the Taxonomy on Sustainable Activities and its response to the European Comission’s call for advice on disclosure requirements, the European Banking Authority (EBA) published in March 2021 a recommendation on a set of KPIs which included most notably a “Green asset ratio” (GAR). The GAR would serve to disclose the proportion of a credit institution’s banking book that is associated with economic activities that are taxonomy-aligned, including without being limited to, all exposures to financial and non-financial corporates, SMEs, loans and advances, debt securities and equity instruments.
Greenwashing is the practice of conveying misleading information on the sustainability or environmental benefits of a company’s products, services or corporate practices.
A well known recent example of greenwashing involved major car manufacturers making fraudulent claims on the CO2 emissions of their diesel-fueled vehicles. Smaller examples can be found far and wide in commercial products. Some items might be labeled as containing “50% more recyclable materials than before”, whereas the product’s recyclable content increased from 2% to 3%. While technically true, the claim remains misleading as it makes the product appear more ecological than it actually is.
In the context of sustainable finance, greenwashing may occur when companies make ambiguous or inaccurate claims on their corporate sustainability practices to influence investors’ perception of the company. Genuinely environmentally friendly and/or sustainable products and corporate practices are backed up by verifiable and comparable data and information. The EU is currently developing new regulatory frameworks to protect investors from greenwashing with more robust, science- and data-based reporting standards and enforcement.
Greenhouse Gases (GHG) are compound gases that accumulate in the planet’s atmosphere, trapping heat as a result. Shortwave radiation (i.e., sunlight) from the Sun passes through the atmosphere and gets absorbed by the Earth’s surface before being released back as longwave radiation (i.e., heat). While gases such as nitrogen (N2) and Oxygen (O2) make up most of the gases comprising the atmosphere, those cannot absorb the longwave radiation emitted back by the Earth. However, other gases like methane (CH4), carbon dioxide (CO2) are also present in the atmosphere. Those gases are able to absorb the longwave radiation and release some of the heat back to the surface. This process of heat trapping is known as the “greenhouse effect”.
Burning fossil fuels, such as coal, natural gas or oil, produces GHG emissions, which in turn prevent some of the longwave radiation to leave the atmosphere, increasing surface temperatures in the process. As GHG continue to accumulate in our atmosphere, more and more heat will become effectively trapped, driving climate change as a consequence.
The Greenhouse Gas Protocol, a standardised framework to measure and manage GHG emissions, categorises emissions into three categories:
- Scope 1: Direct emissions resulting from an organisation’s activities
- Scope 2: Indirect emissions from the purchase of electricity
- Scope 3: All other indirect emissions from downstream and upstream activities and operations
Green bonds are bonds issued to finance projects aiming to bring positive environmental or climate impacts. Such projects include, but are not limited to, the transition to renewable energy, energy efficiency renovations, pollution prevention measures, or sustainable water and wastewater projects.
In the same manner as for social bonds, the International Capital Markets Association (ICMA) provides a set of voluntary guidelines and principles to guide the process of issuing green bonds. Furthermore, as part of the European Green Deal, the European Commission is working on establishing a voluntary EU Green Bond Standard aligned with the principles of the EU Taxonomy. In Luxembourg, eligible bonds may apply to LuxFLAG’s Green Bond Label to assure their alignment on internationally recognised standards.
The International Climate Finance Accelerator (ICFA) was jointly created by the Luxembourg Government and 10 private entities of the financial sector in 2018. Its mission is to provide support for fund managers during the launch phase of new funds aiming to invest into climate change mitigation, climate change adaptation and REDD+ projects. Selected funds will benefit from financial leverage, enhanced visibility and credibility, as well as access to a community of fund managers specialised in climate finance.
The International Integrated Reporting Council (IIRC) was created in 2010 as an international coalition of investors, businesses, regulators and NGOs. Its mission is to develop the International Integrated Reporting () Framework to support businesses in adopting the principles of integrated reporting worldwide. Integrated reporting is a reporting process based on integrated thinking, which focuses on understanding how value is created over time in order to improve management decision-making.
Integrated reporting combines and links sustainability and financial data in a single report. As a result, this form of reporting gives a holistic view of the impacts of a company’s strategy and governance on the creation of value.
Impact investing is a targeted approach that seeks to generate positive, measurable social and environmental impact alongside a financial return. The core characteristics of impact investing are:
- Financial return
- Return expectations / asset classes ranging from below-market to market-rate
- Impact measurement and reporting Source: Global Impact Investing Network
Source: Global Impact Investing Network
The Inclusive Finance Network Luxembourg (InFiNE) is a not-for-profit association created in 2014. InFiNE acts as a platform to connect stakeholders from the public, private and civil society sectors involved in inclusive finance to promote and encourage financial inclusion as a tool to combat poverty and empower low income groups.
The National Institute for Sustainable Development and Corporate Social Responsibility (INDR) was founded by the Union des Entreprises Luxembourgeoises (UEL) in 2007. Its mission is to promote corporate social responsibility (CSR) and support businesses in Luxembourg in the adoption of CSR, so as to bolsten their competitiveness and corporate image, and ultimately to contribute to sustainable development.
Businesses may apply for the INDR Label ESR – Entreprise Responsable, provided the company demonstrates a clear CSR strategy, throughout a diligent application process.
The Luxembourg Microfinance and Development Fund (LMDF) is a social investment fund created in 2009. It was established to contribute to reducing poverty globally by investing in emerging microfinance instituations (MFIs) in underdeveloped markets. For that, the LMDF has partnered with ADA which is responsible for investment proposals, due diligence and oversight of the MFIs. The fund itself is accessible to public, retail and institutional investors.
The Luxembourg Finance Labelling Agency (LuxFLAG) is an independent not-for-profit association created in July 2006 by the Luxembourg Government, ALFI, ABBL, ADA, the European Investment Bank, Luxembourg for Finance and the Luxembourg Stock Exchange. The agency aims to promote Responsible Investment by granting recognisable labels to eligible investment vehicles and fixed income securities. Currently, LuxFLAG offers 5 different labels:
|Thematic fund labels with impact and ESG considerations:||Microfinance Label|
|Climate finance Label|
|Cross-sectoral fund label with affirmation on ESG/Sustainability orientations:||ESG Label|
|Fixed income instruments label:||Green Bond Label|
The Luxembourg Sustainable Finance Initiative (LSFI) is a not-for-profit association created in January 2020 by the Luxembourg Government, Luxembourg for Finance and the High Council on Sustainable Development. The LSFI’s purpose is to promote current and upcoming sustainable finance initiatives, and monitor the financial sector’s progress in integrating sustainability.
The Luxembourg Green Exchange (LGX) was created in 2016 and is the first platform entirely dedicated to the display of green, social and sustainability securities. Those securities must comply with certain eligibility criteria to benefit from a higher visibility on LGX, while investors gain easy access to sustainable securities with better transparency and documentation.
A label is a seal that acknowledges the quality, or the standards (including ecological criteria) met by a given product. In the context of sustainable finance, labels provide insight to and assure the market on a financial product’s dedicated responsible investment strategy. In Luxembourg, such labels are awarded by the Luxembourg Finance Labelling Agency (LuxFLAG) to eligible investment vehicles and debt instruments. Companies that have integrated Corporate Social Responsibility (CSR) into their business models may also also be eligible to the INDR Label.
Microfinance mostly refers to micro-credit, that is, the activity of providing small loans to low income or incomeless clients that do not have access to traditional banking services. Microfinance to provide financial services to the poorer population segments, often in emerging or developing countries. While the size of the loans may vary, micro-credit are designed to offer funding for activities that generate income (like small startup companies), with reasonable interest and repayment plans. As such, the purpose of microfinance is to promote economic development and employment by supporting entrepreneurship and small businesses in developing countries. Often, Microfinance institutions (MFI) also provide other services such micro-insurance, financial or business education and training (e.g. bookkeeping, basics of investing) or legal counsel. This is sometimes referred to as Inclusive Finance. In Luxembourg, the ADA, the LMFD and InFiNE are some of the major actors active in the field of microfinance.
Norm-based screening is the investing approach of excluding companies, sectors or issuers from a portfolio, based on the alignment of their corporate practices with internationally accepted norms and standards including but not limited to, the OECD’s Guidelines for Multinational Enterprises, UN Global Compact or the International Labour Organisation Declaration on Fundamental Principles and Rights at Work.
Negative screening (also referred to as “exclusionary screening”) is one of the oldest methods of socially responsible investing. Using this strategy requires applying a set of filters to systematically exclude companies, sectors or issuers engaged in activities that are deemed unacceptable, from a portfolio. Examples of exclusion include, but are not limited to, product categories such as tobacco or weapons, GHG emissions thresholds or corporate practices such as human rights violations.
The Paris Agreement is the international treaty signed at the 21st Conference of the Parties (COP21) of the United Nations Framework Convention on Climate Change (UNFCCC). The Paris Agreement is the first legally binding accord to bring all countries into the common cause of fighting climate change.
The treaty set the long-term goal to keep the increase in global average temperature to well below 2°C above pre-industrial levels, with efforts to limit the increase to 1.5°C. The accord requires all signatories to determine their own objectives and planned action by submitting their Nationally Determined Contributions (NDCs).
As of March 2021, 191 of UNFCCC are parties to the agreement. The European Union (EU) formally ratified the agreement on October 5th, 2016. The EU recently updated its NDC to raise its emissions reduction target from 40% to at least 55% by 2030, compared to 1990 emission levels.
The Principles for Responsible Banking (PRB) were adopted during the United Nations General Assembly in New York in 2019 and provide a single framework for the development of a sustainable banking industry. The PRBs were conceived by a group of 30 financial institutions on behalf of and in consultation with the UNEP FI’s framework of banks. The 6 principles are:
- Alignment with the objectives of the SDGs and the Paris Agreement
- Commit to improving positive impacts while reducing negative impacts, set and publish targets on the bank’s most significant impacts
- Engage with clients and customers to encourage sustainable practices and enable economic activities that foster shared prosperity for current and future generations
- Proactively and responsibly consult, engage and partner with relevant stakeholders to achieve society’s goals
- Commit to these principles and objectives through effective governance and a culture of responsible banking
- Review the implementation of the principles periodically, commit to transparency and assume full responbility for positive and negative impacts
In the context of sustainable finance, philanthropy (often referred to as “Venture Philanthropy”) can be regarded as a long-term, impact-only investment approach, whereby investors support one or several clusters of social or environmental concerns, without any explicit profit intention.
For companies, philanthropy means voluntarily using financial or material resources to carry out altruistic action and thereby contribute to sustainable development. Strategic philanthropy seeks to find a balance between the company's core business and its priority CSR topics
Positive screening refers to the strategy of identifying and investing in the better performing companies in terms of environmental and social corporate practices and products, labor policies, human rights or other ESG-related criteria.
Source: Principles of Responsible Investing
By acknowledging that ESG factors do affect the financial performance of investment portfolios, six voluntary principles were developed by international institutional investors:
- Incorporate ESG issues in investment analysis and decision-making
- Act as active owners and incorporate ESG issues in ownership policies and practices
- Push for appropriate disclosure on ESG issues by owned entities
- Promote the PRIs within the investment industry
- Work on improving effectiveness in the integration of the PRIs
- Report on the progress and activities towards implementing the PRIs
The Paris Agreement Capital Transition Assessment (PACTA) is an open-source software launched in 2018 by the 2° Investment Initiative (2DII), an international not-for-profit think tank working to align financial markets and regulations with the Paris Agreement’s objectives.
Using aggregated forward-looking asset-level and parent company level data from various industry data providers, PACTA produces a customised report which users can use to evaluate their portfolio’s alignment with different climate scenarios and compare their results to portfolios held by other investors in the market.
Additionally, PACTA for Banks was developed in 2020 to help banks measure the climate alignment of their corporate lending portfolios across climate-relevant sectors, by analysing various climate scenarios based on their clients’ capital stock and expenditure plans.
Standing for “Reducing emissions from deforestation and forest degradation and the role of conservation, sustainable management of forests and enhancement of forest carbon stocks in developing countries”, REDD+ is a mechanism created by the United Nations Framework Convention on Climate Change (UNFCCC). It incentivises developing countries to reduce their emissions stemming from deforestation and forest degradation with results-based payments based on the actions and measures taken towards those objectives.
Social bonds are bonds issued to finance projects aiming to achieve a positive social outcome, or to tackle a specific social issue. Such projects include, but are not limited to, affordable housing, access to essential services (e.g. health care, education, etc.), access to basic infrastructure (e.g. clean drinking water, transportation, etc.) or socioeconomic advancement. The target populations may include people living under the poverty line, the unemployed, aging populations, the elderly or vulnerable youths.
Alongside its Green Bond Principles, the International Capital Markets Association (ICMA) has developed a similar voluntary, non-binding framework for the issuance of social bonds in its Social Bond Principles.
As part of its response to the COVID-19 crisis, the European Commission created the SURE instrument (short for “Support to mitigate Unemployment Risks in an Emergency”), a new type of social bond specifically designed to mitigate the concurring economic crisis, aligned with the ICMA’s Social Bond Principles.
Stakeholders, or interested parties, are individuals or groups of people (e.g. employees, customers, suppliers) that may be influenced or impacted by the company's decisions or activities. Since stakeholders can in turn affect company operations, their rights and interests should be taken into consideration.
The main internal stakeholders are: shareholders, owners, representatives and members of decision-making bodies, general management, executives, various categories of staff (exposed to different risks or with different interests according to their tasks), temporary staff, trainees, staff representatives, etc.
The main external stakeholders are: customers (prospects, buyers, consumers), suppliers, subcontractors, intermediaries, creditors, banks, investors, fund managers, insurance companies, institutions (government, ministries, municipalities, tax administration, Trade & Companies Register, etc.), academic institutions (schools, universities, research centres), interest groups (non-governmental organisations, professional bodies, professional chambers, trade unions, cultural associations, religious communities), local communities (neighbours, local residents), employees' families, candidates (potential, applicants), alumni, competitors, analysts, media, general public (public opinion), future generations, etc.
As part of its CSR strategy and its risk management, the company needs to identify and understand its stakeholders' interests in order to manage their specific expectations. Stakeholder management is fundamentally based on engaging with internal and external stakeholders.
Sustainability rating (also referred to as ESG rating or ESG scoring) refers to third party ratings or scores that attempt to provide insight into a company’s or a fund’s performance relative to ESG factors or their exposure to risks related to ESG issues.
The Sustainable Development Goals (SDGs) were adopted by the United Nations General Assembly in 2015 with a view to “achieve a better and more sustainable future for all”, as part the 2030 Agenda for Sustainable Development. The 17 Goals are accompanied by 169 metrics, each having a number of indicators to measure progress towards achieving the targets.
Various tools have been developped to measure progress towards the SDGs, such as the SDG-tracker, an open-access resource developped by Our World in Data.
European Regulation 2019/2088, the so-called Sustainable Finance Disclosure Regulation (SFDR), was published in December 2019 as part of the EU’s broader Sustainable Finance Action Plan with the objective of redirecting capital flows towards sustainable investments. The SFDR imposes transparency requirements on the integration of sustainability risks into investment decision and advice, and the consideration of of investments’ adverse impacts, for financial market participants (FMP) and financial advisers (FA), both at entity level and product level, even if they do not offer any ESG-related products. The regulation establishes two sustainability-integrating financial products categories, both of which having specific transparency requirements:
- Products that promote environmental and/or social characteristics (Article 8)
- Products that have sustainable investment as an objective (Article 9)
- The SFDR’s main provisions (Level 1) entered into force on March 21st, 2021. The EU Commission has yet to publish its more detailed disclosure requirements (Level 2) which are stated to apply from January 1st, 2022.
Socially Responsible Investing (SRI) is an umbrella term covering all investment strategies that aim to bring a positive social and/or environmental impact alongside financial return. SRI often goes by many other names, including “green investing”, “social investing”, “ethical investing”, “responsible investing”, “sustainable investing” or “values-based investing”.
On top of traditional financial performance metrics, SRI strategies consider additional metrics regarding corporate practices and policies which are often gauged through environmental, social and governance criteria. Responsible investors may choose among a number of different investment strategies with varying impact intentions, ranging from negative screen to impact investing.
Stranded assets are physical assets recorded on a company’s balance sheet that must be written off before the expected end of their economic life, and that are therefore no longer able to generate an economic return. These write-offs may be due to changing trends, regulation or technology that renders these assets redundant or obsolete.
In the context of the transition towards renewables and emissionless alternative fuels, the term “stranded assets” is often used for fossil fuel reserves that become unusable due to adherence to the Paris Agreement, which aims to limit the raise of global average temperatures to well below 2°C.
The Sustainability Accounting Standards Board (SASB) is an American independent, not-for-profit organisation founded in 2011 to develop sustainability accounting standards.
SASB’s standards were specifically designed to allow companies to provide reliable, comparable and decision-useful information on material sustainability topics to investors in their corporate filings to the U.S. Securities and Exchange Commission.
The standards set by the SASB focus on pinpointing environmental, social and governance issues that are most relevant to the financial performance of companies as a function of the industries they operate in. As such, the SASB has identified material sustainability topics for 77 industries across 11 sectors. For each topic, the SASB provides a set of quantitative metrics that allow companies to precisely and objectively describe their performance in each given sustainability topic.
Sustainability-linked bonds (SLB) are any type of bond that embed environmental, social and governance (ESG) or sustainability targets which the issuers explicitly commit to achieve. In contrast with Green, Social and Sustainability Bonds, the use of proceeds from SLBs is intended for general purposes. An SLB’s structural and/or financial characteristics (e.g. coupon rate) may vary depending on whether the issuers reach the pre-defined ESG or sustainability objectives.
The International Capital Markets Association (ICMA) has developed non-binding guiding principles for the issuance of this type of bonds in their Sustainability-linked Bonds Principles (SLBP) with structuring features and reporting recommendations. The SLBP have five core components, namely:
- Selection of Key Performance Indicators (KPIs)
- Calibration of Sustainability Performance Targets (SPTs)
- Bond characteristics
As such, issuers should clearly define KPIs and SPTs, i.e. targeted measurable improvements in the chosen KPIs, as well as the rationale, motivation and methodologies behind the selected indicators and targets. Issuers should regularly publish up-to-date data on the selected KPIs and performance against chosen SPTs.
Sustainability bonds are bonds issued to finance or re-finance combinations of green and social projects. Since certain social projects may also bring positive environmental benefits and vice-versa, the International Capital Market Association’s (ICMA) Green Bond Principles and Social Bond Principles also apply to Sustainability bonds.
Social impact bonds are a type of financial securities that focus on allocating funds to social programs with a view to create positive social outcomes and generate savings. They differ from traditional debt instruments by the number of actors involved in the process and the lack of a fixed rate of return.
Generally, social impact bonds are issued after a solution is found to an identified problem within the public sector (health, safety, social equality, etc.). Funds are raised from private investors through the social impact bonds to finance the execution of the solution. A project manager uses those funds to set the project in motion and service provider will execute the programme. The project’s results are assessed by an independent evaluator at the end of the fixed term, based on a number of quantitative metrics that were predetermined at issuance. If the project’s results meet the required criteria, the investors are repaid by the government, with financial return depending on the level of success. If however the project is deemed a failure, investors receive not repayment at all.
Source: Corporate Finance Institute
The Triple Bottom Line is a holistic accounting framework coined by John Elkington in 1997. It builds upon the traditional definition of “bottom line” (i.e., a company’s net income) by adding an environmental and a social dimensions to it. The three dimensions are also known as the “three Ps” for “People, Planet, Profit”.
In 2018, the European Commission created a Technical Expert Group (TEG) on Sustainable Finance comprised of 35 members from civil society, academia, business and the financial sector, to support the conception and implementation of the measures laid down by the Commission’s legislative proposals of May 2018, namely:
- An EU-wide classification system (Taxonomy)
- An EU Green Bond Standard
- Methodologies for EU climate benchmarks
- Guidance to improve corporate disclosure of climate-related information
In the context of sustainable finance, thematic investing (also referred to as “Sustainability-themed investing”) is the approach of capitalising on ESG-related long-term issues and themes by investing in companies and industries that are best positioned to offer solutions to those problems. Such themes might include environmental topics such as climate change adaptation and mitigation (e.g. financing the transition to renewable energy sources), sustainable infrastructure or water treatment.
The Task Force on Climate-related Financial Disclosure (TCFD) was created in 2015 by the Financial Stability Board (FSB) with the goal of developing recommendations for climate-related disclosures in mainstream corporate filings. The TCFD’s recommendations are voluntary and provide guidance on identifying and reporting risks and opportunities related to climate change faced by companies.
The recommendations are structured around four core elements, namely governance, strategy, risk management, metrics and targets, each associated with specific recommended disclosures to provide information on the undertaking approaches climate-related risks and opportunities.
The TCFD’s recommendations are accessible via this link.
The UN Global Compact is a strategic initiative launched by the United Nations in 2000 that aims to encourage companies to align their strategies and operations with 10 universal fundamental principles on human rights, labor, environment and anti-corruption.
Click here to consult the UN Global Compact’s Ten Principles.
The United Nations Environment Programme Finance Initiative (UNEP FI) is a partnership between the global financial sector and the UN’s Environment Programme, the management body in charge of coordinating responses environmental issues within the UN. UNEP FI works with actors of the banking, insurance and investment sectors to bring systemic change and improvement across the global financial industry and encourage the implementation of sustainable practices at all levels of operations in financial institutions.