Universität Stuttgart University of Stuttgart

Fakultät Wirtschafts- Faculty of Business

und Sozialwissenschaften and Social Science
Betriebswirtschaftliches Institut Institute of Business Administration
Abteilung III (Finanzwirtschaft) Department III (Corporate Finance)
Prof. Dr. Henry Schäfer Prof. Dr. Henry Schäfer

Sustainable Finance
-
A conceptual outline

Working Paper Series

Nr. 03/2012

Univ.-Prof. Dr. Henry Schäfer

Stuttgart, August 2012

ISSN 1864-0125

Institute of Business Administration (BWI)

at the University of Stuttgart

Chair of Corporate Finance

Keplerstraße 17
70174 Stuttgart
T: +49 (0)711-685-86001
F: +49 (0)711-685-86009
E: h.schäfer@bwi.uni-stuttgart.de

Electronic copy available at: http://ssrn.com/abstract=2147590

 II

Table of Contents

Table of Contents ........................................................................................................... II

List of Illustrations ........................................................................................................ III

1 Abstract ............................................................................................................. 1

2 Introduction ....................................................................................................... 2

3 The ethical dimensions of finance and gateways for sustainability ......... 4

3.1 An outline of ethics in economics and finance ............................................ 5
3.2 The concept of sustainable development and links to finance ................. 8
3.3 Corporate sustainability and responsibility – a twin challenge to finance
.......................................................................................................................... 10

4 A framework for sustainable finance .......................................................... 12

4.1 Ethical investment.......................................................................................... 13
4.2 Socially Responsible Investment and related terms ................................ 14

5 Concepts and styles of SRI .......................................................................... 15

6 SRI markets: Labour divisions and agents’ functions .............................. 19

6.1 SRI investors .................................................................................................. 21
6.2 SRI intermediaries ......................................................................................... 24
6.3 SRI and firms .................................................................................................. 26
6.3.1 SRI and the link to equity.............................................................................. 26
6.3.2 SRI and the link to debt ................................................................................ 29
6.4 ESG and the link between corporate, financial and social performance
.......................................................................................................................... 32
6.5 SRI and the performance of investments .................................................. 33

7 Selected areas of sustainable finance........................................................ 35

7.1 Socially responsible property investments (SRPI) ................................... 36
7.2 Microfinance ................................................................................................... 38
7.3 Areas with an intersection with sustainable finance................................. 39
7.3.1 Valuation of the sustainable firm ................................................................. 39
7.3.2 Carbon finance ............................................................................................... 42

8 Discussion and conclusions ......................................................................... 43

Literature ....................................................................................................................... IV

Electronic copy available at: http://ssrn.com/abstract=2147590

 III

List of Illustrations

Exhibit 1: The transmission of financial and sustainability objectives and agents’

interactions ................................................................................ 21
 1

1 Abstract

The concept of sustainable development affects every part of economic life. The
provision of liquidity and capital should contribute to a habitable ecological and
social environment. This paper surveys the role of finance in the concept of sus-
tainability. It starts with a discussion of finance and ethics, as sustainability, in
principle, is an ethical concept. In the following sections, the focus is on socially
responsible investments (SRIs) as the most prominent representatives of sus-
tainable finance. Various techniques to construct such investment products and
their different types are explained. We demonstrate the labour division between
and the tasks of the different agents in the network of SRI. Special reference is
made to empirical results concerning the performance of an asset allocation
process restricted by sustainability criteria. As SRI intends to promote a firm’s
contributions to social, environmental and governance issues, the question that
is discussed is if and how investors can enforce such a real impact. Sustainable
finance goes beyond financial investment contracts. With socially responsible
property investments, research on an asset class is presented, which repre-
sents real investments with sustainability criteria. Sustainable finance with a
strong focus on very direct impacts on the borrower side and partial links to phi-
lanthropy is discussed by introducing microfinance. The paper ends with a look
at the valuation of a firm conducted under ecological and social criteria and with
a brief discussion on carbon finance. 1

Keywords: Sustainable development, socially responsible investments, corpo-

rate social responsibility, ethics, financial markets

JEL Classification: G20, G30, L21, M14, Z13

1
I am grateful to Olaf Weber, Associate Professor in Environmental Finance, University of
Waterloo (Canada) and Wim Vandekerckhove, Senior University Lecturer in Human Re-
sources and Organisational Behaviour at the University of Greenwich, London for their val-
uable comments to a previous version of this research paper. I am also very grateful to the
research team at my department that supported me by literature research and helpful ide-
as.
For any suggestions or remarks please contact the author directly via following e-mail ad-
dress: h.schaefer@bwi.uni-stuttgart.de.
 2

2 Introduction

Current state-of-the-art finance and capital market theory found in text books
and academic thinking is implicitly grounded on the assumption of a monetary
market economy. Although financial processes such as savings and lendings
can be exercised in purely barter economies, the use of money eases economic
transactions and reduces transaction costs (Clower 1977). Arrow/Debreu (1954)
demonstrated in their neoclassical total equilibrium model that the role of money
is reduced to a “numéraire”. In a complete and perfect market system of the Ar-
row/Debreu type, money is like a veil and “traded” on a residual (money) mar-
ket, which is required to make the mathematical equations solvable. Financial
assets can be understood from money-derived contracts. The notion of neutral-
ity is inherent in corporate finance and capital market theory as documented in
the separation and the value additive theorems in different models (Fisher 1930,
Modigliani/Miller 1958, Markowitz 1952, etc.).

The model of Black/Scholes (1973) and further developments delivered an im-

portant ingredient of the contingent claim idea of the neoclassical total equilib-
rium paradigm and was a crowning of capital market theory. It created a boom
of sophisticated models in research and of new financial instruments, transac-
tion types and profit opportunities in the capital markets. The dynamics of con-
tinuously improving valuation models enabled innovations in financial instru-
ments. It motivated agents to exploit perpetually new opportunities to gain short-
term profits. This carrousel of profit generation for the sake of profits led to dy-
namics in the capital markets that constituted a very special kind of separation
theorem – between the monetary and the real sector but with non-neutral
money, as the subprime crisis demonstrated drastically. Doubts have risen
about the sustainability of such a monetary divide for the functioning of the allo-
cation processes, unbiased price formations and the rationality of economic de-
cision-making in the real sphere and moral indisposition seems to occur: “It is
time to reinstate moral reflection in financial thinking, as is done in other sensi-
tive areas (biology, medicine and others). Finance is not an abstract mathe-
matical theory but truly a social structure with a deep impact on the system and
the individuals in the system.” (Cossin 2009, p. 19).
 3

Common people, politicians, mass media and non-governmental organizations

(NGO) are increasingly convinced that finance, capital markets and banking
represent an immoral business. An increasing number of institutional investors,
private households and government organisations are leaving the ways of
common banking. They deposit their savings in social banks, do not invest in
what some call “sin shares” and demand more transparency about where their
money goes. A growing body of financial intermediaries understands that not
only economic but, more dramatically; ecological and social systems are in
transition (Giuseppi 2001). Climate change and energy shortage became the
top challenges for a sustainable development in the past few years. But, they
also offer new and enduring business opportunities for the financial industry.
Meanwhile, nearly every financial intermediary offers socially responsible in-
vestment (SRI) products or finances energy-efficient buildings. Some of them
invest their own money in portfolios that have been screened by environmental,
social and/or governance criteria. Since the millennium SRI markets are grow-
ing in double digits in most industrialised countries and even emerging countries
have raised interest.

Sustainability issues in the fields of corporate finance and capital markets the-
ory lead a shadowy existence despite a growing body of academic research,
awareness in practice and some wishful thinking on the part of politicians to
overcome most of today’s problems in banking, finance and the financial mar-
kets with sustainable finance. This paper gives an overview of the variety of re-
search in what is called sustainable finance, although such a term is not yet fully
settled in academics and in practice. It serves as a functional umbrella under
which very different approaches in research and business practices can be
subsumed and explained.

The structure of the remainder of this article is as follows. In the next section a
brief introduction is given on the relationship between finance and ethics as the
concept of sustainability is, in principle, an ethical one. The section presents the
main streams of the concept of sustainable development and is linked to fi-
 4

nance. In the third section, socially responsible investments as the cornerstone

of sustainable finance are discussed and the different approaches are pre-
sented. Over the past years, specific styles and techniques of SRI have evolved
and they are introduced in section four. In section five the division of labour be-
tween the different groups of involved agents in the SRI markets is elaborated.
A special focus has been given to empirical research as sustainable finance is
not only a matter of capital markets and the asset classes traded there. Section
six demonstrates extensions of the concept of sustainable development to real
estate. It also demonstrates how the concept particularly impacts investments in
the form of microfinance. The section ends with a look into peripheral areas of
sustainable finance, focusing on firm valuation and carbon finance. A discussion
and some conclusions will complete the article.

3 The ethical dimensions of finance and gate-

ways for sustainability

Modern finance and capital market theories reduce the complexity of finance
and investment processes, the interactions of agents, the setting of rules and at
least the entire financial value creation process to mathematical and statistical
operations. Human behaviour is simplified to follow the assumptions and axi-
oms for an optimal allocation in capital markets. As strictly rational agents who
exploit all available information, they are on a daily track to optimise their indi-
vidual wealth positions. According to the neoclassical paradigm of finance and
capital market theory, a human being (an agent) actually has no role to play as
a personality. Economic agents are part of a well-defined system of complete
and perfect capital markets and are assumed to all behave in the same manner
(from rational and homogenous expectations, maximise their wealth or income,
etc.). Each agent is part of an exogenous market-driven allocation process un-
der uncertainty, comparable to a lottery or roulette game (Stulz 2000, p. 7).
Price formation processes of assets and investments are randomly expressed
by martingales and exogenous probability functions. The outcome of the game
 5

is based on an arbitrage and (ethically) value-free equilibrium process (Horrigan

1987, p. 105). Under these circumstances, it seems obvious that modern fi-
nance and capital market theory is free of ethical or moral values and agents
are operating according to quasi-laws (Raines/Leathers 1994).

3.1 An outline of ethics in economics and finance

Ethics is generally understood as the study of principles or standards of human
conduct, while morals mean socially accepted standards and fairness (Soppe,
2000, p. 15). According to an oft-used philosophical framework in business eth-
ics, we adhere in the following to the classical triad of teleological, virtue and
deontological ethics (Donaldson/Werhane 1996). Although it is not common in
finance to elaborate on ethics, it is implicitly part of it as many basic pillars of fi-
nance and capital market theories are based on the neoclassical paradigm (Sen
1987). Here the assumption of the rationality of a human being is a core ele-
ment, embodied in the metaphor of the homo oeconomicus. His ethical ground-
ing is based on the notion of utilitarianism as Jeremy Bentham (1789) and later
John Stuart Mill (1863) have formulated. Their approaches belong to the cate-
gory of teleological ethics and can be understood as “rational goodness”. It fo-
cuses on the link between actions and consequences related to specific goals.
Actions are judged primarily with regard to the consequences instead of the ba-
sis of the actions themselves. In this sense, human behaviour is assumed to be
rational (Baron et al. 1997, p. 151). According to Bentham (1789), the principle
of utility is the core, as actions are ethically and morally right if their conse-
quences create the greatest happiness for the greatest number of people. This
imagination of happiness fits very well with the notion of Irving Fisher that the
“hunger for experience” ultimately drives agents when investing in ventures. Fu-
ture cash flows from a venture generate monetary income, which enables an
agent to consume goods and to satisfy his hunger for experience (Fisher 1930,
pp. 10-12). If a mathematical calculation of such an economic concept of happi-
ness and pain is possible, then a teleologist can state what is right and what is
wrong. John Stuart Mill (1863) extended Bentham’s concept in his work Utilitari-
 6

anism to the idea that people may differ in the quality of their pleasure
(Boatright, 1999, p. 36). The question would then arise as to how individually
different utilities should be expressed and calculated. The solution was a uni-
versal substitution of individual utility by general monetary and market-
determined economic values.

Teleological ethics is quite different from virtue ethics. It encompasses all ethi-
cal attitudes that are not based on moral laws, rules or principles. The focus of
virtue ethicists is on individual inner traits, dispositions and motives. Represen-
tatives are ancient Greeks, mainly Aristotle and Plato. The third school of ethics
is represented by deontological ethics. Here, duty rather than virtue is the fun-
damental category, and it is often associated with the Kantian categorical im-
perative. Sen (1987) and partly Rawls (1971) are modern representatives. Al-
though the dominant role of teleological ethics for the neoclassical paradigm
and capital market theories is obvious, Baron et al. (1997, p. 151) argued that
there is enough possibility for the integration of the remaining two categories.

It is worth noting that the normative science to which ethics belongs has existed
much longer than economic science. The separation of economics and ethics
as we perceive it today is historically seen as very young. 2,400 years ago, it
was Aristotle who distinguished between economics, ethics and politics in his
pragmatic philosophy but did not separate them. In his famous distinction be-
tween oikonomia and chrematistics he indirectly underlined that the use of
money as a medium of exchange allows people to buy goods that permit them a
sufficient and good life. By doing so, individuals also do well to the society as a
whole. Aristotle criticised the use of money as a mean to create a maximum of
profit for the sake of profit-making and without any real sector linkage (chrema-
tistics), as we would say today. Aristotle’s reference system was the supply of
goods for the average need of a private and public household. He also con-
 7

Demned interest-taking as being unnatural, and his implicit attitude was that of
neutral money (Bartlett/Collins 2011). This notion is very similar to the neoclas-
sical conception of money in the Arrow/Debreu model and its relatives.

The ideal of oikonomia implicitly determined economic life in Europe for centu-
ries. It was associated with notions like interest-taking is usury (as it was com-
mon in the late Middle Ages) and should be restricted or even prohibited. The
emergence of the modern market economy is regularly based on Adam Smith’s
path-breaking work The Wealth of Nations (1776). It is common to stress his
concept of a decentralised economy with an “invisible hand” as a metaphor of a
privately organised, non-regulated economic allocation process. Rational indi-
viduals who solely maximise their own utility ensure the optimal allocation of re-
sources and goods. What is often left out is Smith’s strong ethical background
as he was very much adhered to premises of the ancient Greek Stoics, of whom
Aristotle was one. In their imagination, human life should be in accordance with
Nature. In his The Theory of Moral Sentiments, Smith emphasised the impor-
tance of ethics for the functioning of a market economy and that the “invisible
hand” needs the “invisible morality” just like a twin (Soppe 2000, p. 7). Contrary
to many prevailing interpretations, Smith’s concept does not exclusively require
a utility-maximising, selfish and rational individual. Bassiry/Jones (1993) under-
lined that Smith also states that an individual can gain utility if he is striving for
altruistic behaviour and is not only seeking a maximising of goods.

Despite the long tradition of ethical philosophers and ethically “infected” classi-
cal economists, mainstream economic paradigms have been developed in the
post-Smithsonian, i.e. neoclassical era, more or less without an explicit reflec-
tion of ethical positions. Amartya Sen (1987), in his study of economics and eth-
ics since the 17th century, picked up the hidden bits of ethics in economics. He
distinguished between the ethics-related view of motivation for economic activity
(represented by Smith, Mill, Marx and others) and the more technically oriented
 8

economists like Walras, Quesnay, Ricardo, among others, who focused on find-
ing solutions for concrete economic tasks. For the equilibrium of economic sci-
ence, both groups of economists need to be in balance, as Sen argued. In his
1993 lecture on ethics and economics of finance, he classified the ethical
framework of finance into duties and consequences (Sen 1993, pp. 204-207).
He pinpoints the responsibility of a firm’s management for all stakeholders. In
his normative approach, he discussed constraints for firms which are needed to
foster them to deliver positive contributions to the society and the environment
(the “Nature”). His ideas lead to the question of how private agents should as-
sume responsibility in finance.

3.2 The concept of sustainable development and links

to finance
With the transformation of most of the former socialist-communist countries in
the 1990s, the thought on the significance and the role of ethics and morals in
economic life saw a renaissance. The recapitulation of morality and ethics in
capital markets and finance started rather late. It was dominated by discussions
about the capital markets’ roles in a natural environment that comes close to the
end of its carrying capacity (e.g. concerning waste) and near-exhausted re-
sources, as detected by several empirical analyses starting from the 1970s, like
the “Limits to Growth” of the Club of Rome (Meadows et al. 1973) and academic
research on exhaustible natural resource and economic growth (e.g. Baumol
1968). On the eve of globalisation, the development of new, emerging markets
and erratic technological innovations, the United Nations installed the World
Commission of Environment and Development (WCED) in 1987, chaired by the
former Norwegian Prime Minister Brundtland. The so-called Brundtland Com-
mission formulated the concept of sustainable development with a clear-cut an-
thropogenic impetus, which displaced the former eco-centric concept (World
Commission of Environment and Development 1987, p. 24). Together with the
 9

following United Nations Conference on Environment and Development

(UNCED) in Rio de Janeiro in the year 1992 sustainability was reformulated to a
concept of justice – between existing generations (intra-generation justice, e.g.
the distribution of wealth and income between developed and emerging nations)
and between present and future generations (inter-generation justice) (Atkinson
2000). Since then the term „Sustainable Development“ is introduced as an in-
ternational acknowledged normative guiding principle in politics and manifested
in the Declaration of Rio. Since then, sustainability has a double ethical impera-
tive with a strong link to Aristotle’s oikonomia – the resiliency of the natural capi-
tal and the sufficiency of the social capital (Daly 1991, p. 29). Although the find-
ings of the Brundtland Commission remained vague in many parts and led to a
profusion of definitions and interpretations of the term sustainability
(Pearce/Atkinson 1998), the imagination of sustainability spreads to politicians,
managements and societies.

The most important development in the field of sustainability was in 1997 the
Kyoto Protocol at the United Nations framework convention on climate change
(United Nations Framework Convention on Climate Change 1998). The public
and academic discussion of the concept of sustainable development was nar-
rowed down to the question of how to cope with the worldwide greenhouse ef-
fects and the man-made climate change. The increase in global warming, caus-
ing extreme weather, desertification, water shortages, etc. has become a top is-
sue in many political and economic agendas currently. Studies of the Intergov-
ernmental Panel on Climate Change (IPCC 2007) warn of the disastrous con-
sequences of the greenhouse gas effect. The Stern Report made it clear that
the economic challenge will be immense and that capital markets have to carry
the biggest burden of financing the conversion of economies to greater climate-
friendliness (Stern 2007). Financing sustainability not only appears as a neces-
sity to impede climate change but also as an opportunity to participate in a
Kondratieff cycle of new technologies and innovative products to cover long-
lasting needs (Schmidheiny/Zorraquin 1998). The path-breaking link to the con-
cept of sustainable development in the financial markets was succeeded by the
 10

former UN secretary Kofi Annan. In spring 2006, he announced the United Na-
tions Principles for Responsible Investments (briefly PRI) following the already
developed concept of the UN Environmental Program for the Finance Initiative
(UNEP FI). Currently, more than 900 asset managers, financial intermediaries
etc. have signed the PRI, representing about assets worth US$30 trillion under
their management worldwide (PRI 2011). Signees of the PRI draw upon the ca-
pacity of investors and capital markets in general to make prominent contribu-
tions to sustainable development by setting progressive environmental, social
and governance goals for the management of firms and public authorities.

3.3 Corporate sustainability and responsibility – a twin

challenge to finance
Capital market theory commonly envisages shareholders as the dominating
stakeholders due to their property rights and their liability in the case of a de-
fault. Next to debt holders, they both provide the necessary liquidity for the func-
tioning of value-creating processes in firms. Both groups of stakeholders base
their investment decisions on the strict quantitative trade-off between expected
return and risk, outlined in models of standard capital market theory. As these
models are commonly judged as (ethical) value-free, shareholders and debt
holders are assumed to solely maximise their utility in the Fisherian sense, i.e.
they maximise the income streams out of the firm to satisfy their impatience to
consume. Moreover, such a notion of the firm as an ethical value-free cash flow
generation system fits well with the ignorance of external negative effects
caused by the production processes of a firm and its output. Managers are ex-
pected to act as agents of shareholders and debt holders to satisfy their income
demands, disregarding the interests of third parties. In this sense, managers do
not have to worry about the social or environmental costs of their work. Such a
conception of management in terms of agency theory implicitly adheres to teleo-
logical ethics, especially utilitarianism, and is often accentuated by a famous ci-
tation of the Nobel laureate Milton Friedman (1962, p. 132): “(…) few trends
 11

could so thoroughly undermine the very foundations of our free society as the
acceptance by corporate officials of a social responsibility other than to make as
much money for their stockholders as possible.” Friedman refers to manager-
led firms listed on the stock markets. He was not only worried about possible
agency costs but also afraid of a disturbed social freedom if socially responsible
managers would interfere in the labour division between the public and private
sectors (Friedman 1970).

It was Freeman (1984) who made the point about stakeholders as new target
groups beside shareholders. Until then, agency theory ignored stakeholders,
like employees, customers or non-government organisations (NGOs). But in the
1990ths convictions rose that stakeholders might affect business objectives,
can be critical for a firm’s financial success and contest the shareholders’ de-
mands on a firm’s free cash flows (Carroll/Buchholtz 2008, Donaldson/Preston
1995). The discussion about the role and the impact of stakeholders paved a
path to sustainability that is currently dominating the academic discussions and
efforts in practice – the responsibility of a firm, i.e. its management, to provide
and sustain a socially and ecologically habitable environment.

Comparable to the broad variety of interpretations of the term “sustainability”,

the definitions of corporate social responsibility (CSR) are also manifold (Carroll
1999). Dahlsrud (2008) proved in his meta-analysis that 37 definitions of CSR
include mostly the following dimensions: stakeholders, social issues, economic
issues, voluntariness, and (to a minor level) environmental issues. With the
concepts of CSR and sustainability at the firm level (corporate sustainability), a
twin emerged in the last twenty years which in principle is different but very
similar in the way they are materialised (Reed 2001). At the firm level, it encom-
passes policies to manage additional non-financial environmental, social and
governance objectives (abbreviated as ESG hereafter). To formulate ESG ob-
 12

jectives and strategies and to derive appropriate activities for a firm is in most
parts stakeholder-related and dynamic. A firm builds up social capital which can
be an important part of a firm’s strategic dynamic capabilities. In turn, it should
allow the exploitation of future competitive advantages and generate higher
cash flows (Fombrum et. al. 2000, Russo/Fouts 1997). Stakeholder theory then
addresses the question whether there exists a link between corporate social
performance (CSP) comprising the measured quality of stakeholder manage-
ment and corporate financial performance (CFP), gauging the financial success
of the overall business.

4 A framework for sustainable finance

As the preceding survey on finance, ethics and sustainability has demonstrated,

finance and capital market theory lack an explicit and integrated paradigm
which could justify a term “sustainable finance”. Finance, on the one hand, is
still predominantly operating in the traditional neoclassical understanding as an
ethical value-free discipline. On the other hand, academic, political and busi-
ness awareness of sustainability has emerged at the firm level. Beside the so-
called business case of sustainability (Wilson 2003, p. 2), a growing number of
investors, asset managers and financial intermediaries are willing to integrate
sustainability criteria into their asset management processes. The financial in-
dustry is viewed as one of the fundamental stimulators for firms to adopt re-
sponsible and sustainable policies referring to environmental, social and gov-
ernance goals (Haigh/Hazelton 2004, Mill 2006).

So far, the generally accepted term “sustainable finance” is just at the beginning
of its evolution. A mere semantic combination of sustainability and finance
would be misleading as there exists no general understanding of such a term. It
is also not yet introduced and well-defined in academics. Soppe (2004) talked of
“Sustainable Corporate Finance” when he discussed in his contribution the pos-
sible links between the concept of sustainability and traditional finance. In his
 13

paper, Scholtens (2006) focuses on the transmission mechanism between fi-

nance and sustainability, with a strong emphasis on financial intermediaries. He
avoids creating any term with respect to sustainable finance and instead refers
to socially responsible investments (SRIs). Indeed, this term seems to be the
one most often used in academics and practice. Weber/Remer (2011a) and
Weber/Scholz/Michalik (2009) used the term in connection with banking that is
related to ecological, social and governance criteria. Sustainable finance, there-
fore, is at first glance, best associated with the term SRI, which itself is inter-
preted and used variously. In the following section, the different approaches to
definitions of SRI will be discussed.

4.1 Ethical investment

The predecessor of SRI is the traditional term “ethical investment”, which “(…)
describes the process in which value-based organisations apply internal ethical
principles to an investment strategy” (Sparkes/Cowton 2004, p. 46). Originally,
in the 1920s, U.S. religious groups like the Methodists and the Quakers refused
to invest into firms which contradicted their moral principles. Such early at-
tempts to avoid investments into so-called “sin shares” are the benchmark for
ethical investments until present (Schueth 2003). Religious motivations and the
specific guidelines of the Protestant Church in the U.S. and the Anglican Church
in the UK were the initiators of ethical investments. They promoted such in-
vestments for their own asset management and demand until present a moral
behaviour of firms. Ethical investments reflect an early practice of a type of SRI,
which is nowadays called investment by the use of exclusionary criteria (Cow-
ton 1994). At present, the term ethical investment is still in use but of minor
relevance as financial market experts and researchers now see SRI maturing,
and a broader understanding of SRI has emerged (Sparkes/Cowton 2004, p.
45).
 14

4.2 Socially Responsible Investment and related terms

It is remarkable that the dominating contributions to the definition of SRI have
come from practitioners and NGOs with the national associations of SRI in the
forefront (Sparkes 2002, pp. 26–27). The umbrella organisation of the national
European Social Investment Forums, the European Social Investment Forum
(EURSIF), has delivered the most often-used term, pinpointing the generic
character of SRI: “Sustainable and Responsible Investment (SRI) combines in-
vestors' financial objectives with their concerns about social, environmental, eth-
ical (SEE) and corporate governance issues. SRI is an evolving movement and
even the terminology is still very much in the evolving phase. Some SRI inves-
tors refer only to the SEE risks while others refer to ESG issues (Environmental,
Social, Governance).” (EUROSIF 2011). A definition more related to the term
sustainable finance but referring to investments in the sense of rent seeking as-
set management was published in 2011 by the World Economic Forum (WEF).

WEF presented in its White Book the term “sustainable investments” (World
Economic Forum 2011, p. 10). The WEF’s definition is the first one that uses
the term “sustainable” in the context of finance and capital markets in a specific
manner. But like most of the modern definitions of SRI, it also emphasises the
environmental, social and governance (ESG) issues.

Now, there is a consensus that investors can practise SRI in different ways. A
very direct link to an ethical or moral impetus can be the reason for so-called
mission-related investing. In such a case, investors (for instance foundations or
Churches) define their ESG-related investment policies on behalf of the institu-
tion’s individual missions, values and goals. A somewhat different approach in
SRI is programme-related investing. In most of such cases, investors adapt in-
ternal or external guidelines and norms with references to goals of the concept
of sustainable development or corporate social responsibility (Cadman 2011). A
growing importance in programme-related investing has caused The European
Society of Financial Analysts Societies (EFFAS) to take an initiative. It deve-
 15

loped a set of non-financial key performance indicators that will mainstream and
coordinate the divergent principles and guidelines of numerous ESG-standard
setting institutions with the needs of the financial community (Gartz/Volk 2007).
Contrary to those external programmes, internal investor programmes can be
based on investor-specific ESG preferences and may be embedded in internal
investment guidelines.

That SRI has become more focused in the last ten years in the active contribu-
tion towards solving social and environmental problems, motivates a growing
number of investors. The term “impact investing” describes an investor’s inten-
tion to influence the investment policy of a capital seeker by the investor’s spe-
cific and binding conditions. Impact investing in this sense intends “(…) a mean-
ingful change in economic, social, cultural, environmental and/or political condi-
tions due to specific actions and behavioural changes by individuals, communi-
ties and/or society as a whole” (Godeke et al. 2009, p. 10). Examples of such
investment targets are microfinance institutions, community credit unions, etc..
There is also a very strong link to “social finance” (Vandemeulebroucke et al.
2010). Impact investing is often associated with philanthropy and social busi-
ness, as investors strive to gain a social return, sometimes accepted below a
comparable return on the capital markets (Mulgan 2010, Weber/Remer, 2011b).
The common element in those approaches is that their time value of money dif-
fers from the interest rates in the capital markets (where the Fisherian type of
agent dominates). They follow the notion of a social time value of money, a term
and concept intensively discussed in the 1960s (e.g. Marglin 1963).

5 Concepts and styles of SRI

Currently, SRI is represented by investments into shares and to a minor degree

into bonds of companies listed on securities exchanges (Novethic/Caisse des-
 16

Dépôts Group 2011). Hirshman’s (1970) fundamentally distinction of economic

behaviour (voice, exit, loyalty) can be transferred to cluster a SRI investor’s
choice: Voice stands for an active interference into a firm’s strategy and policy,
e.g. by rising a shareholder’s voting right at the annual shareholders’ meeting
(ASM). The exit option represents the policy of punishing an inefficient man-
agement by selling the firm’s shares. Loyalty means that the investor has in-
vested into an operation that fits very well with his moral or ethical aspiration
(e.g. investing into a renewable energy venture). Exit, loyalty and voice strate-
gies in the context of SRI refer to a scope of actions with which shareholders
and debt holders can organise their asset management to move a firm towards
sustainable policies.

According to a widespread and generally accepted EUROSIF categorisation of

different types of detailed ESG-related asset management concepts, a principal
distinction can be made between pre- and post-investment strategies. As many
investors design their SRI portfolios out of a share or bond index-related uni-
verse, the pre-investment strategy encompasses the modes to select “sustain-
able securities” out of a basic sample. Such screening processes are distin-
guished into three concepts:

− The technique to screen by means of exclusionary criteria refers to the ap-

proach of negative screening. In its basic version, the investor sets specific
criteria concerning business practices (like child labour, violations of human
rights, etc.) and business areas (e.g. gambling or alcohol industry), which he
intends to exclude from his investment universe completely or only partly at
a firm level (e.g. no investment in firms with a stake of above five percent in
alcohol-producing firms). Negative screening can be done on the basis of a
single criterion or by a set of multiple criteria.
 17

− By means of positive screening, the investor’s objective is to focus on those

securities which promise an above-average contribution to social, environ-
mental or governance issues. Most often, this approach is used to identify
pioneering and leading firms in sustainability. In the past few years, this was
dominated by the attractiveness of small capitalized firms, operating in the
renewable energy sector. Positive screening is mostly used for the creation
of portfolios with specific sustainability themes (theme or focus investing).
− Variations of positive screening are the best-in-class (referring to a single
firm) and the best-of-class approaches (meaning an outstanding sector in
terms of sustainability). They are very ambitious as they require a sophisti-
cated technology for the screening and monitoring of securities, i.e. their is-
suing entities. In its basic version, the best-in-class approach (BIC) does not
exclude any security in advance. By operating with a scoring model, each
security, i.e. its issuing entity, passes through an investor-specific sustain-
ability filter with sometimes up to 200 single items and different weights. The
operations are mainly conducted by ESG-rating agencies, specialised in-
house research departments or securities index providers. Further details
are explained in section 5.2, where the interactions of the different market
players are presented. The outcome of such a screening process is a uni-
verse of securities with individual scores which allow the investor to rank se-
curities from the most sustainable to the worst. It depends then on the asset
manager’s policy to decide where the threshold to invest according to the in-
vestor’s sustainability approach is set (first quintile, the best average, etc.).

The described concepts allow combinations. In financial markets, mutual funds

based on BIC approaches and enriched with specific exclusionary criteria are
widespread. Pre-investment strategies give the instructions on building an SRI
portfolio either based on an inclusion strategy (operating with a positive screen-
ings) or on an exclusion strategy (based on negative screening) (McLach-
lan/Gardner 2004, p. 13). The post-investment strategy encompasses actions to
monitor a firm’s management. The main tools used commonly are the right to
vote at the ASM, dialogue with a firm’s management, external communication,
 18

shareholder resolutions, communication of shareholders with regulators and the

filing of a lawsuit (EUROSIF 2006, p. 33). Such processes are titled “engage-
ment” or “advocacy” policies. They are practiced in individual investor mandates
and to a smaller extent, in mutual funds.

SRI markets exist in different countries. EUROSIF (2010, p. 59) publishes

worldwide statistics based on the distinction between a broad and a core cate-
gory of SRI.

− Core SRI encompasses assets based on more than two exclusionary criteria
or funds that have undergone a positive screening, including BIC and SRI
theme funds. Also, combinations of the aforementioned strategies are part of
that category.
− Broad SRI is composed of funds based on simple screening (a single exclu-
sionary criterion), include norms-based screening (up to two negative crite-
ria), engagement and integration (inclusion of ESG risks into traditional fi-
nancial analysis).

EUROSIF’s current worldwide statistics on SRI is dated 2010. It collected as-

sets under management in the USA, Canada, Australia/New Zealand, Japan
and Europe. The total SRI was calculated to nearly Euro 7.6 trillion, having
been invested into the different types of SRI (as explained above). With an
amount of Euro 4.3 trillion, the bulk of assets under management were invested
into the broad category of SRIs. Nearly Euro 2 trillion may be found in US-
based portfolios. With Euro 4 billion, the Japanese market was the smallest. In
Europe, regarding Core SRI, Norway was the leading SRI investing country with
assets under management of about Euro 378.1 billion. About Euro 216.6 billion
were invested each in Sweden and Euro 143.9 billion in Denmark. The German
SRI market followed at a significant distance. Euro 12.9 billion was invested in
2009, with Euro 12.2 billion invested in Core SRI. The quota of SRI to the total
of assets under management is traditionally low in Germany and below 1%. In
 19

many other European countries, with a significant lower total amount of accu-
mulated assets under management on the macroeconomic level, the quota is
about 10%. Nevertheless, in recent years, annual growth rates in all national
SRI markets have been double digit figures.

6 SRI markets: Labour divisions and agents’

functions

The concepts of SRI determine specific techniques for the management of indi-
vidual investor mandates or to create marketable investment products, mostly in
the form of mutual funds. As the bulk of SRI investments are made in firm-
issued shares and bonds, in the following section, the focus will be on these as-
set classes. The financial service industry offers a wide range of differently
styled SRI funds stretching from ethical funds (with solely exclusionary criteria),
theme funds (in most cases concerning the renewable energy industry) to sus-
tainability funds (based on BIC concepts). All these different styles offer inves-
tors a self-selection mechanism. By the SRI technique and integrated ESG cri-
teria, the selected fund reveals the hidden ethical position of the investor. For
the financial industry, it is a marketing challenge to construct SRI funds that
match the ESG preferences of a critical mass of investors to generate the calcu-
lated turnover and profit of such an investment product.

SRI products, especially mutual funds, have a natural tendency to represent in-
complete or implicit contracts as the understanding of sustainability differs be-
tween investors (and financial service providers). The materialising of sustain-
ability, even by referring to specific ESG criteria, is complex, open-ended and
changing over time. The concept of sustainable development itself underlies a
permanent discourse that changes the meaning of sustainability in general. The
different understandings of investors in sustainability, the different ways of ma-
terialising ESG criteria and the complexity of interactions between such non-
 20

financial aspects and financial risk and return relationships can lead to extraor-
dinary quality uncertainty about SRI products and be a deterrent or moral haz-
ard on the producer’s side. SRI products and, to a degree, investor mandates
are, therefore, in many cases comparable to experience and credence goods in
the sense of Nelson (1970, p. 312). SRI products represent special bundles with
different attributes which satisfy the investor’s utility in two dimensions: a mone-
tary one represented by the cash flow earnings of the investment and the non-
financial one covering the investor’s ESG impact on the firm. The valuation of
an SRI product as a bundle with financial and different non-financial, i.e. ESG,
attributes is in principle difficult to handle in standard valuation models like
CAPM or APT. SRI products very often have different ESG criteria and share
many similarities with the idea of hedonistic pricing (Lancaster 1966). It could be
promising for future research to plumb the capacity of such an approach for the
evaluation of SRI products.

The most striking information asymmetry in the SRI markets is in the fields of
firm-related ESG data. Bridging the information gap is the most important pre-
requisite to construct SRI products and to exercise the investors’ intentions to
influence a management’s ESG policies. A special type of non-monetary finan-
cial intermediary, a kind of a rating institution, evolved in SRI markets to solve
such specific agency problems. This group of capital market participants is the
nucleus in the SRI markets. The participants are embedded in a network of dif-
ferent agents, exhibited in chart 1. The chart has to be read from left to right and
demonstrates that each national SRI market is part of a surrounding ecological
system, where the social and economic systems have to be understood as sub-
systems. They are complemented by the relevant national legal and financial
frameworks. Exhibit 1 draws a causal line from the ultimate investor over inter-
mediaries and markets (securities exchanges) to the issuer of equity and debt
contracts and the financial, but also sustainability, performance. In the following
section, the different stages and players will be explained in more details.
 21

Screening,
Optimizing
Monitoring, Investments into Economic outcome
risk adjusted
Enforcement, economic activities in financial terms
financial returns

Environmental system, social and economic (sub-)systems

Asset Management

Stock
Rational Monetary exchange
Investors Financial quoted, Financial
Intermediaries non-quoted Performance
(Banks, trusts,

Legal & financial system

mutual funds etc.) firms
Consumption
Investors
Non-monetary Environmental
Financial Performance
Intermediaries Govern-
Investment (Rating ments, Social
Investors Agencies,
NGOs, Index Supranational Performance
provider etc.) Institutions,
Non profit Governance
Impact Securities organizations Performance
Investors Exchanges etc.

Sustainability
Optimizing Liquidity, Investments into outcome in
social returns trading, valuation social activities non-financial
terms

Exhibit 1: The transmission of financial and sustainability objectives and agents’

interactions

6.1 SRI investors

Whether a non-financial or a purely financial dimension dominates in an asset
management process depends on the investor’s objectives. Beal et al. (2005,
pp. 66-76) offer a promising categorisation in defining rational, consumption and
investment investors.

A rational investor has attributes and preferences of the Fisherian type. The
non-financial part of an investment is of no relevance. Therefore, this investor
 22

will be marked as neutral with regard to ESG criteria and ethical or moral values
(Statman 2005, p. 31). Some neutral investors might partly look beyond their
own noses and are willing to give ESG criteria some attention in their invest-
ment analysis, if an abnormal return or additional risk reduction can be ex-
pected. Beal et al. (2005, pp. 66-76) distinguished a second category which
they called consumption investors. They integrate ESG criteria in their invest-
ments according to behavioural reasons, like fashions, social infections and so-
cial imitations. The utility function of consumption investors is heterogeneous
and open to external influences (Statman 2005, p. 35; Cullis et al. 1992, p. 9).

According to Beal et al. (2005, pp. 75-77), those investors who understand SRI
as a means to change an issuing entity’s behaviour with respect to the inves-
tors’ ESG issues and objectives are “investment investors”. It is assumed that
they firstly gain a direct, monetary utility from the SRI investment measured in
risk return relationships. Secondly, they are looking for an indirect, non-
monetary benefit from the impact on a firm’s ESG performance (McLach-
lan/Gardner 2004, pp. 12-21). In the extreme version, investment investors mu-
tate to impact investors who are prioritising social returns and are sometimes
willing to engage in investments with a financial performance below comparable
opportunities in the capital markets (Mulgan 2010, p. 40).

Research on the relationship between investor types and their willingness to in-
vest has to distinguish between private households and institutional investors.
For the first group rare scientific research is available and many of them lack
updates (see e.g. Lewis/Cullis 1990, Cullis et al. 1992, Williams
1989McLahan/Gardner 2004). The inclusion of non-financial arguments into the
utility function is a challenging one. The tremendous work on behavioural fi-
nance seems to offer promising approaches for tackling research topics on SRI-
specific investor behaviour, expectation formation, decision-making processes
and related subjects. Hens/Bachmann (2008) and Pompian (2006) took steps in
such a direction when they analysed how investment preferences of high net
 23

worth individuals, which often tend towards SRI (Capgemini/Merrill Lynch 2011),
can be explained by selected behavioural finance approaches. More research
seems necessary for a deeper insight into the preference formations and deci-
sion-making processes of private households in general (EUROSIF 2010).

By far the most important SRI investor group in terms of assets under manage-
ment are institutional investors. EUROSIF (2010) has provided statistical evi-
dence for this for several years. In Europe, institutional investors hold 92% of
assets managed with SRI principles. Pension funds are the leading SRI inves-
tors. In many European countries, they are forced by national law to declare
how and to which extent they have invested funds according to ESG criteria.
Other SRI-minded investors in Europe are foundations and other non-profit or-
ganisations. Churches and religious institutions traditionally have a high quota
(Cunningham 2001) in this. For institutional investors, as fiduciaries, the ques-
tion is of high importance whether SRI is consistent with the prudent person’s
rule and does not violate fiduciary obligations. In two path-breaking legal opin-
ions ordered by the UNEP FI, the international law firm Freshfields, Bruck-
hauser, Derringer gave proof that fiduciaries have a duty to consider ESG ap-
proaches in their investment strategies (UNEP FI 2009). Beyond such legal re-
quirements, the motivations of institutional investors for SRI policies encompass
very different causes. They stretch from a purely alpha-enhancing or beta-
securing motivation according to the rational investor classification to mission-
related investing, especially in the case of foundations (Allianz Global Investors
2010, EUROSIF 2010).
 24

6.2 SRI intermediaries

In general, SRI investment products are manufactured and distributed by banks,
mutual funds and other asset managers. The critical resources for a successful
creation of, e.g. SRI mutual funds are adequate research capacities. Financial
intermediaries are often challenged by the nature of ESG data that differs tre-
mendously from financial data. The data is non-financial, lies outside the
sources of financial data and require specific knowledge to be understood, in-
terpreted and exploited (Schäfer 2005, p. 109). For these reasons, over the last
15 years, a specific kind of labour division between financial data provider and
ESG data provider has established in SRI markets. The latter are represented
by specialised ESG-rating agencies. The semantic analogy to credit rating
agencies is misleading. The important differences are that ESG ratings are un-
solicited and do not evaluate a financial shortfall risk. ESG ratings, therefore,
are much closer to sell and buy side analysts’ researches. Although we will stick
to the term “ESG rating” in the following section as it is the most common term
in use among practitioners and academics, the term “ESG rating” has to be
handled carefully (Schäfer 2009, p. 451).

The basic source of ESG ratings is data from the so-called “triple bottom line”
(TBL) accounting. It means that beyond a firm’s financial performance, the
management reports on the firm’s environmental and social performance
(Elkington 1997). The information satisfies the needs of a broad scope of differ-
ent stakeholders and not only of capital-providing entities as is the case in fi-
nancial reports. The constitution and management of an ESG database often
causes high transaction costs for a firm. And for stakeholders, the collection and
assessment of such data induces high transaction costs too. It not only con-
cerns the time and resources for collecting the ESG data but also for assessing
the reliability and creditworthiness of the data. In most countries, firms are not
obliged by law to report on their ESG performance and ESG reporting relys on a
voluntary basis. Many firms operate with the reporting framework of the Global
Reporting Initiative (GRI 2006). Over the last 10 years, in a consensus-seeking
 25

process, this network-based organisation developed a framework which is used

in most of the globally published sustainability reports. Currently, standard-
setting forces are under way as the International Integrated Reporting Commit-
tee (IIRC), a multi-stakeholder network, intends to establish guidelines for an in-
tegrated “triple bottom line reporting” (IIRC 2011).

As the ESG performance of a firm is mainly published in sustainability reports,

they are the main database for ESG ratings. Currently, about 60 ESG-rating en-
tities all over the world (Schäfer 2009) work with different approaches to materi-
alise a firm’s sustainability or responsibility. They use individual micro-criteria
and weights in their scoring models and differ in the organisation of their data
processing. The majority of those ESG-rating entities materialise ESG subjects
with the help of externally available guidelines, standards or norms. They were
developed by NGOs which have very specific access to special ESG subjects
(Waygood/Wehrmeyer 2003). One example for such a guideline is the often
used International Labour Standards of the International Labour Organization
(ILO 2011).

However, the individual ESG ratings operate in many similar ways. They focus
on exchange-listed firms as rating targets and offer their rating reports to finan-
cial market participants, which are the dominating customers. ESG ratings are
working with a cardinal scale and a finite set of rating scores. The processes ini-
tially start with a (first) screening followed by a regular monitoring. A rating that
signals an ESG investment grade of a share or a bond helps investors to build
their SRI portfolios supports a firm’s management’s efforts to proceed in ESG
issues and signals to stakeholders, in general, the contribution a firm makes to
sustainable development (SustainAbility/Mistra 2004).

In principle, the same forces are at work when securities index providers issue
an ESG index. Starting with the first ESG stock market index in 1990 (the U.S.-
based Domini 400 Social Index), currently, each of the world’s leading securities
 26

index providers offers a family of ESG indices (Schäfer 2005). The worldwide
leading ESG related indices are styled in the BIC manner. Beyond them, many
special ESG-related indices are offered. Some focus on environmental themes
like water, mobility, renewable energy (e.g. DAXglobal Alternative Energy In-
dex), others stress social selection criteria like microfinance (Symbiotics Micro-
finance Index, SMX) and a minor share of ESG-related indices emphasise reli-
gious criteria (e.g. DJ-Islamic-Market-Titans100, Stoxx-Europe-Christian-Index).
ESG-rating agencies and index providers do not only seek to bridge the infor-
mation gap between capital-providing investors and capital-seeking firms or
other institutions (like government organisations, supranational organisations).
They also play an increasingly important role in the enforcement of ESG strate-
gies and policies for the management of firms and organisations in which an in-
vestment could be made.

6.3 SRI and firms

As we saw in the preceding section, SRI is best understood as a vehicle to ad-
dress ESG issues according to individual investor preferences or pre-defined
preferences as it is common in the mutual funds industry. In the following sec-
tions, we will concentrate on publicly listed firms as the most important invest-
ment targets in SRI. Corporate finance offers, in principle, several channels to
affect real investment processes by the decisions of SRI investors. An analysis
can adhere to the transmission effects discussed in the corporate finance re-
search literature – the provision of equity (and the execution of ownership
rights) and the fuelling of a firm with debt capital be it bonds or bank loans.

6.3.1 SRI and the link to equity

As SRI investments are dominated by shares of (big capitalised) listed firms, it

is obvious to focus on the equity side when the impact of SRI investors on a
firm’s ESG behaviour has to be assessed. Private equity and venture capital
has statistically seen nearly no significance in SRI markets although such asset
 27

classes offer important access to ESG related policies of a firm as a very direct
control of investments is possible for investors (Scholtens 2006, p. 26). Theo-
retical and empirical studies provide evidence that the mere act of selling
shares can have disciplinary effects on a firm’s management (Admati/Pfleiderer
2005). Referring to the case of sustainability, studies like the one of Heinkel et
al. (2001) and von Arx (2007) exhibit a picture of disillusionment concerning the
ESG impact of SRI equity investments. They highlighted in their studies that
transmission channels are very complex and the interactions between ESG-
minded investors and the management are manifold. A mere empirical research
is often misleading as the theoretical causalities under those circumstances
need in-depth analysis of causalities. The most important plea against a well-
defined and direct transmission seems to be the necessary size of shares in the
hands of ESG investors. Heinkel et al. (2001) find in their study that a minimum
of 25% of a firm’s total shares must be held by ESG-motivated shareholders to
prompt the management of a polluting firm to switch to a cleaner production.
The ideal model assumes that a poor ESG-performing management would in-
duce the selling of the firm’s shares by the ESG investors. If the quota of such
investors is high enough, then the selling of shares would lead to a decrease in
the share price. In turn, this would put on the management the burden of higher
costs of equity and lower personal income in share price-linked compensation
plans. In their analysis, Haigh/Hazelton (2004) and Johnsen (2003) came to the
conclusion that the impact of shareholders to push a firm’s management to-
wards sustainability is rather limited. Nevertheless, they see potential for future
research as the transmission channels need more explicit attention in theoreti-
cal research.

Much hope of ESG-minded investors lies in the “voice” option. As stated in

agency theory, a management consists of agents who are responsible for exe-
cuting the directives of the principals, represented by a firm’s shareholders. As
Shleifer/Vishny (1997, p. 740) argued, incentive-compatible and complete con-
tracts between management and shareholders are often not possible according
to prohibitive transaction costs. Accompanying corporate governance policies
 28

are appropriate for mitigating such agency costs. Shareholder activism is part of
such governance policies and consists of strategies like “active ownership”, “ac-
tivist blockholders” and “active ownership” (Gillan/Starks 1998). In the context of
SRI, investors seek to promote ESG policies of a firm or to reduce unsustain-
able behaviour, i.e. negative external effects. Recent research studies suggest
that both financial and “moral legitimacy” of firms are now being challenged by
shareholder activism (den Hond/Bakker 2007).

The impact of shareholder activism has been empirically researched in the past
for a few years with a focus on corporate governance (for an overview, see
Renneboog/Szilagyi 2010). In their meta-studies, Karpoff (2001) and Gil-
lan/Starks (2000) came to very mixed results concerning the success of ESG-
related topics. Relevant subjects of engagement have not been ESG-related but
were mostly addressed to special corporate governance topics. Some of the
surveyed studies confirmed a positive trade-off between activities in engage-
ment and shareholder value, mainly for financially underperforming companies
(e.g. Judge et al. 2009). But as Karpoff (2001, p. 2) summed up in his survey:
“(…) shareholder activism can prompt small changes in target firms’ govern-
ance structures, but has negligible impacts on share values and earnings.”
Some event studies were able to provide evidence for a small short-term in-
crease in the stock price after the announcement of engagement actions
(Charkham 1999, Renneboog/Szilagyi 2010, Renneboog et al. 2008).

The empirical analysis of effects of engagement on ESG topics exists mainly for
the U.S. and partly for the UK. A change in the ESG policy of a firm could be
empirically proved as a response for the engagement of some U.S. pension
funds (so-called “CalPERS effect”, Nelson 2006, p. 188). ESG-related engage-
ment seems to influence a management’s actions, if well-defined single sub-
jects are addressed to it. Caton et al. (2001, p. 21) stressed the point that an
improvement in management’s policy according to shareholder engagement re
 29

quires “(…) the ability to respond to the challenge to improve performance”. For
UK, the UKSIF (2011) revealed in three surveys among fiduciaries that those
investors believe engagement will improve sustainable behaviour of firms. The
biggest effect will be achieved by pension funds exercising their voting rights.

Negative side effects of engagements in general and with reference to sustain-

ability have also been identified. David et al. (2001) complain a short-term na-
ture of many engagement actions hampering long-term investment decisions in
a firm and which might conflict with a long-term understanding of corporate sus-
tainability. One can confess that research on shareholder activism with refer-
ences to ESG topics is in an infant stage and has in some countries just started
(see, e.g. for Germany, Schäfer/Hertrich 2011). Overall, significant methodo-
logical problems were stated by Karpoff and Gillan/Starks as the measurement
of engagement raises many methodological and empirical challenges (Gil-
lan/Starks 1998, p. 19, Karpoff 2001, p. 2). Short/Keasey (2005, S. 87ff.) stated
for the UK a “(...) complex web of interrelationships (…) between the various
ownership interests.“

6.3.2 SRI and the link to debt

Besides equity capital, debt financing serves as another channel to transmit

ESG objectives to a firm’s management. Scholtens (2006, pp. 24-25) confesses
that the credit contracts and the financing institutions like banks, leasing firms,
etc. have been underestimated as drivers of a firm’s ESG strategy and policy. It
is commonly assumed that unsystematic firm-specific risk can be eliminated by
an optimal diversification. Amato/Remolona (2003) demonstrated that a com-
plete diversification in bond portfolios is often limited and can imply a pricing of
credit spreads. Increasing environmental, social or governance risks are typi-
cally firm-specific and, therefore, could lead to higher credit spreads and in-
crease the cost of debt financing (Goss 2009).
 30

Empirical studies in most cases either operate with causalities between aggre-
gated ESG ratings and selected financial parameters or correlate such parame-
ters with single ESG items. Ashbaugh et al. (2006) and Bradley et al. (2007)
analyse in their corporate governance-related studies the structure of impact
and influence of shareholders on credit ratings. Other studies focus on envi-
ronmental risks and the effect on a firm’s credit rating (e.g. Graham et al. 2001).
Current empirical studies operate with data basis of ESG research and rating
entities. Most of those studies were able to provide evidence for causality be-
tween the ESG performance of a firm, expressed in its ESG rating and the de-
fault risks expressed in its credit spread. In their studies, Bassen et al. (2006),
Di Giulio et al. (2007) and Bauer/Hann (2010) came to the conclusion that an
above-average sustainability performance of a firm might imply a lower credit
spread. By their empirical study, Goss/Roberts (2007) could calculate that firms
with an ESG performance below average have to pay a 16 basis points higher
credit spread compared to the ESG leaders in the relevant sector. On the other
hand, some empirical studies could hardly find any valid link between sustain-
ability ratings and credit spreads (Menz/Nelles 2009 for a bond analysis).

Other research fields of previous empirical studies consider the ways in which
ESG risks can be integrated into the processing of loan application and granting
of the loan (Weber et al. 2010) and the technique to determine and calculate
ESG risks in the credit rating process (Weber et al. 2008 and Weber at al.
2010). The studies of Thompson/Cowton (2004) and Weber et al. (2008) could
provide evidence that banks increasingly integrate environmental criteria into
their credit business. In an empirical study, BankTrack (2010) identified that the
loan-granting processes of banks lack quality, transparency and do not comply
with guidelines that underlie an ESG-related loan granting. Guidelines are for-
mulated in a too general manner and have no sound and clear-cut criteria or re-
quirements concerning the assessment of ESG risks.
 31

The current state of research concerning the link between debt financing and
ESG performance at the firm level has made only minor contributions to theo-
retical causalities. Research also lacks empirical studies that draw a line be-
tween single ESG-related non-financial key performance indicators and default
risks. A disaggregation of ESG ratings seems promising for analysing the link
with default risk as single ESG criteria might differ in their importance for sec-
tors and for firms as well as for investors (Griffin/Mahon, 1997). Risks and op-
portunities might also differ between single ESG parameters (Mattingly/Berman
2006).

Scholtens (2006, p. 27) made the point that project finance compared to corpo-
rate finance could offer a more direct impact on ESG issues on the capital
seeker’s side by the specific contractual arrangements. In setting up project fi-
nancing arrangements, organisational elements become more important than
they are in corporate finance. In the view of the separate and legally independ-
ent nature of the project entity, which is financed in the ideal case without rights
of recourse to the sponsors, the main task in setting up project financing ar-
rangements is implementing organisational and contractual arrangements that
result in stable and predictable cash flows (Esty 2004). It is typical for project fi-
nance to focus on large capitalised infrastructural ventures like energy plants,
highways or embankment dams. Those projects typically cause external effects,
which can put a heavy burden on the environment and the social welfare of
people in the neighbourhoods. With the emergence of the so-called Equator
Principles (EP), leading international banks have committed themselves to put
each project in the phase of credit appraisal through a careful ESG due dili-
gence. Depending on the level of the EP a bank has agreed upon in the signing,
a bank is more or less reticent to finance projects (Esty et al. 2005).
 32

6.4 ESG and the link between corporate, financial and

social performance
In exhibit 1 it is stated that ESG-related dispositions and activities of investors
and the enforcement of ESG rating intermediaries can have two effects on the
firm’s side: influencing the firm’s corporate financial performance (CFP) and af-
fecting the corporate social performance (CSP). As they are interrelated, the re-
lationship between CFP and CSP is of relevance. ESG policies might be the re-
sult of, but also might have a capability for, a firm’s financial success (Wood
1991, Waddock/Graves 1997). The empirical literature on CSP can be distin-
guished into two categories. The first group measures the effect of ESG criteria
with selected indicators on a firm’s financial market value. Event studies are of-
ten used to analyse whether abnormal returns as a result of market reactions to
ESG-relevant public information can be detected (see e.g. Teoh et al. 1999).
The second group of empirical studies used accounting data like return on as-
sets, return on sales, etc. to measure the influence of ESG-related policies on
CFP (e.g. Waddock/Graves 1997). In a recent study, Eccles et al. (2011) com-
bine both approaches and found that, in their samples, firms with a high CSP
(materialised by corporate culture proxies) had higher accounting-related per-
formance indicators as well as higher financial market returns.

Margolis/Walsh (2001) examined 95 single studies which were analysing the re-
lationship between financial performance and corporate social responsibility be-
tween 1972 and 2000. Two-thirds of the studies showed a positive correlation,
the remaining saw no relationship and only very few studies observed that sus-
tainable companies are less financially successful. The results were criticised
by Orlitzky et al. (2003) in their follow-up meta-study for methodological short-
comings (e.g. sample and measurement errors). After a re-evaluation of the
Margolis/Walsh study by using a meta-analysis technique, Orlitzky et al. (2003),
however, came to nearly the same results. They concluded that most of the
studies proved that firms with a high CSP tend to have a higher CFP.
 33

6.5 SRI and the performance of investments

As the studies referring to the relationship between CSP and CFP indicate, in
principle a positive trade-off, one would also expect that investor portfolios
structured by one of the SRI techniques presented in section 4 might also ex-
hibit positive effects on the financial performance of mutual funds, mandates
and other SRI portfolios. Starting in 1972 with the first empirical work on such
an issue by Moskowitz (1972), a tremendous empirical work has been done in
the last 40 years. The differences in empirical methods, selected data, time ho-
rizons, asset classes, etc. allow drawing a differentiated empirical picture.

Obviously, most of the SRI techniques would lead to portfolios that contradict
the recommendations of the portfolio selection models in the Markowitz tradi-
tion. To reduce the investment universe, i.e. to reject the market portfolio, not
only contradicts the basics of today’s textbooks but must reduce an investor’s
utility by sub-optimal risk return relationships as one is below the efficiency line.
Inefficiencies with structure and composition effects like sector, country and size
tilts would accompany. As the rigid assumptions of modern portfolio selection
theory are repeatedly violated in practice and are often contested by empirical
studies (e.g. Cochrane 1999), alternative asset allocation strategies as style in-
vesting have established and have tried to exploit abnormal returns (Bernstein
1995). Despite the skepticism of modern portfolio selection theory, SRI grew
over the preceding decades, as the statistics in section 4 have illustrated. The
accompanied question initially posed by asset managers and investors and later
on by academics was whether an SRI investor would face a suboptimal risk re-
turn relationship, i.e. an underperformance compared to the alternative conven-
tional asset management strategy in line with the Markowitz world. The referring
empirical works could be distinguished into two generations:

− The mark I models operated in their empirical analysis with a simple market
model. The exogenous factor was either the rate of return of a stock market
index, the return of a conventional share portfolio or a conventional mutual
fund. Those parameters were regressed on an endogenous factor compris-
ing the return of an SRI portfolio (mutual SRI funds, synthetic SRI portfolios,
 34

SRI stock indices). Performance was, in most cases, measured with Sharpe
or Treynor ratios or with Jensen’s alpha. Some studies integrated additional
explanation parameters like small cap factors (e.g. Luther/Matatko 1994).
The main findings of the bulk of empirical studies were that they could, in
most cases, detect no difference in risk-adjusted returns of an SRI portfolio
compared to a conventional one (e.g. Moskowitz, 1972, White, 1995,
Grossmann/Sharpe 1986).
− The next generation of financial performance measurement models also op-
erated in the manner of using matching, synthetic portfolio or index portfolios
as reference framework for the empirical analysis. The basic empirical con-
struction of such mark II models was more sophisticated and in the
Fama/French (1992) tradition. In most cases, a Carhart (1997) related model
was adapted, with an explicit integration of size effects, relationship between
book and market values, and a momentum parameter. Summing up the
main findings of the numerous studies, one can conclude that, despite the
very different analytical methods in econometrics, different time horizons
and data sources, most of the empirical studies could not detect an under-
performance of SRI portfolios compared to different kinds of conventional
portfolios (e.g. Climent/Soriano 2011, Humphrey/Lee 2011, Bauer et al.
2005, Schröder 2004, Derwall et al. 2005, Galema et al. 2008).

Besides these performance-oriented models, others were operating on more

specific questions such as alpha biases originated by SRI experts in asset
management (Gil-Bazo et al. 2010), performance of portfolios comprising sov-
ereign bonds (Drut 2010) or corporate bonds (Derwall/Koedijk 2009), specific
asset allocation strategies (Kempf/Osthoff 2007) or event studies (e.g. Conso-
landi et al. 2009). Chegut et al. (2011) analysed 41 empirical studies in a
method-oriented meta-study on SRI performance. They provide an actual and
detailed research on the current state of the art in methods of performance
measurement of SRI portfolios. According to their findings, the robustness of
empirical studies depends on the use of independent verified SRI funds’ inte-
 35

gration of multiple benchmarks, among others. Finally, one can conclude that
although some facets like specific asset allocation strategies, e.g. core satellite
concepts in SRI, are missing, the empirical work on performance-related SRI
studies seems to be exploited.

7 Selected areas of sustainable finance

The survey of section 5 concentrated on SRI and this section focuses on firm-
issued shares, bonds and related assets like indices. With respect to the capital
markets, at present, nearly each asset class can serve as a vehicle to carry
ESG criteria and to enforce impact. Capital markets offer SRI embodied in ex-
change traded funds, hedge funds, index linked bonds, life insurance contracts,
sovereign bonds, private equity, venture capital, money market funds and bank
deposits. Besides these financial market-related assets, in the following sec-
tions, an overview will be given about areas, which play a special role in sus-
tainable finance. One category belongs to emerging (non-quoted) asset classes
in SRI markets that are related to real investments like forestry, timber or real
estate. The other category focuses on microfinance, besides investments in so-
cial business a representative of a combination of philanthropy and investing
that intends a very direct and social impact. The residual part is devoted to an
outline of further areas which have an intersection with sustainable finance but
either have established an own research programme (like carbon finance) or
belong to established research fields (like valuation of the firm). Given this me-
dium positive correlation, interesting questions could be how to find those firms
that show the win-win effect in order to invest in them. The challenge in the fu-
ture will be to find those firms that guarantee both, high financial and social re-
turns.
 36

7.1 Socially responsible property investments (SRPI)

While ESG issues are increasingly integrated into corporate strategies and the
value creation processes of firms, the transformation of buildings and real es-
tate into sustainability is just at its beginning. In general, buildings are absorbing
lots of non-renewable resources. Currently, the focus is on how buildings should
cope with energy shortages and climate change. As the Intergovernmental
Panel on Climate Change (IPCC) has stated in its assessment report (IPCC
2007), the contribution of buildings to green house gas emissions and climate
change is significant. The latest report of the United Nations Environment Pro-
gramme Finance Initiative’s Property Group stresses that buildings bear a high
potential to contribute to a reduction in green house gas (McNamara 2009, p.
18). With numerous initiatives, multilateral organisations like the World Business
Council on Sustainable Development Property Working Group, UNEP SBCI
(Sustainable Buildings and Construction Initiative) and UNEP FI RPI (Finance
Initiative Responsible Property Investing) foster the awareness of landlords,
commercial real estate enterprises, investors and others to cope with the chal-
lenges of “greener buildings” (Schäfer et al., 2011, p. 7).

Corresponding to the term SRI in capital markets, in real estate markets, the
term socially responsible property investments (SRPI) has emerged and is de-
fined as “maximizing the positive effects of property ownership, management
and development on society and the natural environment in a way that is con-
sistent with investor goals and fiduciary responsibilities” (Pivo/McNamara 2005,
p. 128). It includes the pursuit of sustainability and durability as necessary in-
gredients (Roberts et al. 2007). Comparable to the screening and monitoring of
the ESG performance of firms necessary to construct SRI products, SRPI re-
quires a preceding assessment of the ESG attributes of an individual property.
The design of ESG evaluation schemes for properties, to collect relevant data
and to examine the extent of sustainability is done by specialised certification
entities (Lützkendorf et al. 2008). Similar to ESG ratings at the firm level, ESG
property certification entities exist in many developed countries all over the
 37

world, have individual and specific techniques for assessing properties sustain-
ability and, in most cases, operate on a for-profit basis (Pivo/McNamara 2005).

Besides direct property investments, the main focus of SRPI is on indirect prop-
erty investments. Closed-end funds, mutual funds and Sustainable Real Estate
Investment Trusts are the financial investments which allow an investment into
green properties in many countries. However, to date, SRPI represents a still
neglected asset class within the SRI sector (Ernst & Young 2008). At the mo-
ment, only a very limited number of property investment firms or funds make
sustainability an explicit objective. Furthermore, SRPI funds in the U.S. as well
as across Europe are still at the beginning. Current empirical research, e.g. for
Germany, indicate that not only ESG-minded property investors, but also “main-
stream” investors are becoming aware of the potentials of SRPI and are look-
ing for investment opportunities (Schäfer et al. 2011, p. 15).

Like SRI, SRPI is also challenged by the question as to whether an investor

would suffer losses from such an investment. Empirical studies could not detect
an underperformance in most cases (see e.g. Fuerst/McAllister 2008). Some
important reasons might be the lower energy costs of green buildings and
higher rent as tenants are willing to pay a higher price if sustainable buildings
offer an additional superior living comfort (Kats 2003). Worzala/Sirmans (2003)
ascertained that green properties have the potential to improve the risk return
ratio of a mixed-asset portfolio. But research on such portfolio effects is still
rare. A variety of models to evaluate green properties have been developed in
the past years (see Lorenz/Lützkendorf 2011 for a survey). The highly regulated
national property valuation schemes are a specific challenge for such research
and need a careful integration into the development of ESG-related property
valuation schemes.
 38

7.2 Microfinance
The origins of microfinance lie in the philanthropic impetus to provide credit aid
to economically active but poor people (World Bank 2007). Such micro-
entrepreneurs have a need for small business loans and other financial services
to become economically independent. A business loan ranging from US$50 to
US$5,000 is called a microcredit and it is the most common form made avail-
able by microfinance. Microcredits are granted and monitored by microfinance
institutions (MFIs), which have specialised in this type of credit extension and
operate very locally. The specific contractual designs to monitor borrowers and
to enforce interest and redemption payments are made special by microcredits.
The very low default rates characterising microcredits in the past were mainly
the result of a group-based credit lending mechanism. In such a case, the fi-
nancing for an individual borrower has to be guaranteed by group members
(e.g. village people). The credit prolongation, an increase in the credit amount
or additional credit for other group members depend on previous credit repay-
ments and the complete fulfilment of the credit contract’s obligations (Sen-
gupta/Aubuchon 2008, pp. 11-12). Complementary or alternative ways to en-
sure a low default rate are direct monitoring, non-refinancing threats and regular
frequent payment schedules. Women predominate as borrowers mainly due to
their high reliability and low risk tolerance (Robinson 2001). Close links exist be-
tween microfinance and community investing in the U.S., where special loans
for disadvantaged urban people and infrastructure projects are granted (Smith
2005).

In recent years, institutional investors as well as private investors are showing

an increased interest in microfinance. At the end of 2009, over 73 so-called Mi-
crofinance Investment Vehicles (MIVs) were identified worldwide with an in-
vestment volume of about US$6.2 billion (CGAP 2010 pp. 6-15). Microfinance
Investment Funds (MFIFs) represent just a small part of MIVs but are very
popular in retail banking (Goodman 2005). In general, MIVs are directly in-
vested in MFIs, most of them as debt capital (Reille et al. 2009). Owing to the
 39

novelty of MFIFs, the annual return and risk characteristics as well as the bene-
fits in a diversified portfolio are not yet sufficiently understood.

Schäfer/Oehri (2011) demonstrated in their empirical study that microfinance in-

vestments fulfil the requirements of an own asset class and are able to improve
the risk return structure of a mixed asset portfolio. Furthermore, studies indicate
a low correlation of microfinance investments with the performance of the formal
bank sector in the country where the funds are investing (Robinson 2001). To
some extent, experts also see indications that microfinance investments enjoy a
certain degree of independence from overall macroeconomic shocks
(Krauss/Walter 2006). Research on microfinance with respect to capital market
theory is still at an initial stage. Special areas of interest are the interaction of
macroeconomic risks like country risk and currency risk with the default risk of
borrowers (Gonzalez 2007) and a deeper insight into the risk return relation-
ships in MFIFs.

7.3 Areas with an intersection with sustainable finance

In the following, an overview of two research areas is given, which stem from
environmental economics and do not appear to be part of the core of sustain-
able finance but are noteworthy as they have remarkable intersections. The first
area encompasses models of the valuation of the firm.

7.3.1 Valuation of the sustainable firm

As stated in section 5.4, the meta-studies of Margolis/Walsh (2001) and Orlitzky

et al. (2003) have documented the average positive effects of social and envi-
ronmental policies on a firm’s financial performance. A firm’s social or sustain-
able performance is understood as delivering contributions according to the
 40

demand of its stakeholders and constituting social capital (Pearce/Atkinson

1998) to gain steady and lasting profits Rappaport (2006). Serving stakeholders’
needs in an environment-friendly manner and, simultaneously, increasing
shareholder value is the theoretical core of such models (Reed 2001, p. 3). Four
groups of approaches to implement sustainability strategies into a firm’s value-
creation process and to determine a firm’s financial value can be distinguished:

− Models of the environmental shareholder value type integrate the eco-

efficiency concept (Epstein/Young 1998, p. 4) into Rappaport’s basic con-
cept of environmental issues in a strategic manner. Integrated environmental
technologies streamline production processes and make a firm more versa-
tile. It is assumed that it can better cope with future resource shortages and
is more rigid against sudden changes in environmental laws. From a strate-
gic view, a firm can extend such an approach to a cost leadership strategy
(Hart 1995, pp. 999-1005). Another strand of the environmental shareholder
value approach is the assumption that a firm is operating according to an
eco-induced differentiation strategy. Producing environment-friendly prod-
ucts as well as creating a high reputation as an eco-leading firm attracts
consumers and builds up a competitive advantage (Reinhardt 1998). A fur-
ther shareholder value-increasing effect can stem from reduced costs of
debt financing if a firm with low negative external effects or with low envi-
ronmental risk exposures can gain lower credit spreads, as argued in sec-
tion 5.3.2.

A modification of the environmental shareholder value model operates with

the integration of the real options valuation (ROV) approach. The first gen-
eration of such models focused on the potential of a firm to cope in a flexible
manner with future eco-regulations or to be able to react faster than a com-
petitor to technology switches (see e.g. Cortazar et al. 1998 and Reed
2001). A second strand of the ROV approach envisages the creation of firm-
specific dynamic capabilities with respect to ESG issues. On one hand, this
 41

could be understood as a hedge against a future threat of disappointed

stakeholders. Accusing a firm for unsustainable behaviour might erode a
firm’s profits by NGO activism or consumer boycotts. Past investments in
reputation and other trust-building intangible assets of a sustainable leading
firm are comparable to an option premium. The legitimating of a firm’s future
economic environmental and social activities by the acceptance of critical
groups of stakeholders is the option value (Hall/Vredenburg 2003, p. 62).
Beyond these insurance-related real options, investments in sustainability-
relevant dynamic capabilities can have the structure of growth options. In-
vestments in tacit eco-relevant knowledge of the staff, the eco-brand of the
products, the development of eco-friendly propulsion techniques, etc. often
have the character of options as their real economic value lies in the future
and is conditioned, e.g. if consumer preferences or market prices (e.g. of
exhaustible energy) have allowed the option to come in the money (Fom-
brum et al. 2000, p. 90).

− A third group is the stakeholder valuation model. They stick to the economic
role of stakeholders mentioned in section 3.2. The stakeholder value ap-
proach allows an extension of the value creation process with a focus on a
firm’s investment in specific stakeholder groups being critical for the firm and
its expected payoffs (Cornell/Shapiro 1987).
− Figge/Hahn (2008, 2005) and Hahn et al. (2007) developed several types of
a sustainable value model and applied these to empirical studies. Their con-
cept transforms the opportunity cost approach for all forms of capital (includ-
ing natural capital) employed in the value creation process of a firm. The ob-
jective is to determine a firm’s cost of ‘sustainability capital’ analogously to
the way the cost of capital is determined in the capital markets. With the
methodology of the sustainable value approach, it seems possible to calcu-
late a firm’s and its subsidies’ contribution to the firm specific sustainability
capital from a value-based perspective, which is contrary to the often domi-
nating burden-based logic of a firm’s environmental and social policy.
 42

7.3.2 Carbon finance

The term carbon finance has been evolving since the Kyoto protocol was rati-
fied in many countries after its proclamation in 1997. The core of the Kyoto pro-
tocol is the so-called flexible mechanism with three types which enabled the es-
tablishment of special carbon markets especially in Europe. Two of the flexible
mechanisms are project-related. With the Clean Development Mechanism
(CDM), Certified Emission Reductions (CER) can be created with projects
which reduce green house gas (GHG) in developing countries. The Joint Im-
plementation Mechanism (JI) allows the generation of Emission Reduction Units
(ERU) with GHG-reducing projects in industrialised countries. Both reductions
can be traded as Assigned Amount Units (AAU) of emission certificates at ex-
changes according to the EU-Emission Trading Scheme (EU-ETS) which was
installed in 2005. The EU-ETS belongs to the third type of flexible mechanism of
the Kyoto protocol, the International Emissions Trading (IET) (United Nations
Framework Convention on Climate Change 1998).

For firms especially in the carbon-intensive sectors, the emergence of GHG-

induced climate change, new regulations to reduce GHG emissions and the ac-
tivities of NGOs towards climate-friendly policies have transmitted carbon sub-
jects into the strategic and operational focus. New financial risks and opportuni-
ties occurred, with an increasing impact on balance sheets. New market-based
instruments have been made available to cope with the new generation of car-
bon risks and to achieve environmental objectives. Carbon finance also encom-
passes investment opportunities in GHG emission reduction projects and the
creation of financial contracts tradeable on the carbon markets. The privately
initiated Carbon Disclosure Project (CDP), since its establishment in 2000, has
bundled a volume of US$ 64 trillion assets under management with globally 534
institutional investors who address to firms the demand to make their climate
risks transparent and to reduce their GHG emissions (CDP 2012).

Another strand of carbon finance is the valuation of projects in the fields of re-
newable energy, their interaction in energy parks and the valuation of energy
 43

power in general. Sun et al. (2006) give an overview of the different methods to
evaluate investments in power plants with special respect to regulation and the
specific risks especially on the demand side. In the last decade, research in the
valuation of single power plants, energy projects and energy firms has evolved
continuously. It is remarkable that the ROV approach is integrated in nearly
every study. Menegaki (2007) identifies the ROV approach as the predominat-
ing method for deriving a financial value of the flexibility in the fields of renewa-
ble energy. Especially growth, liquidation, capacity and production processes in
the fields of energy-producing firms or projects are modelled with ROV ap-
proaches for instance in Correia et al. (2008). The research in this strand of
carbon finance is very vivid and dominated in most parts by researches from
engineers.

8 Discussion and conclusions

Sustainable finance is primarily evolving from the motivation of an increasing

number of investors who aims to achieve with their investments, not only a risk-
adjusted return but simultaneously an impact on a firm’s ESG strategy and pol-
icy. To take such non-financial key performance indicators into account in the
daily business means to acknowledge the concept of sustainable development.
As it refers to justice, it bears an ethical core. The study of history reveals per-
manent discourses between ethics, economics and finance. In some parts, the
current discussions and controversies about investment banking, the welfare
role of financial markets and the role of finance in a monetary economy remind
one of the intensive struggles between different philosophical schools, religious
fundamentalists and even classical economists. But modern finance and capital
market theory still seems spellbound by mathematical equations, excel spread
sheets and normal distribution functions in an ethical free space.
 44

The strong assumptions for rational behaviour and frictionless capital markets
reduce financial transactions and allocations on capital markets to a quasi-
automatism. Investing with additional, non-monetary objectives is in its very
fundamental nature motivated by an investor’s intention to overcome the sepa-
ration principle between finance and investment. Investors related to ESG crite-
ria are not strictly ruled by the Fisherian assumption that individuals are solely
investing for the sake of a monetary income. By looking where their money
goes and attempting to change a capital seeker’s behaviour e.g. towards inter-
nalisation of negative external effects, building up social capital, investing into
reputation, etc. the separation between finance and investment is implicitly
bridged. In a few cases, such investors are willing to accept a time value of
money which lies below the current level of the capital markets. Such a prefer-
ence of a social time value of money at the expense of a (higher) private time
value of money is not new and was intensively discussed in finance in the
1960s.

Socially responsible investments are the nucleus of sustainable investments. It

is surprising how much research on related subjects has been carried out. This
fits well with the expansion of SRI-related products and assets under manage-
ment in capital markets of industrialised countries. One of the most controver-
sial research topics is the performance question of ESG-structured portfolios.
The contradictions to the text books in the Markowitz tradition are obvious. But,
on the other hand, it is well known that numerous empirical papers doubt the
validity of standard capital market models and have left the door open for style
investing and other deviations (like SRI) from the main street of capital market
theory in asset allocation processes. If the most important motivation for the in-
tegration of ESG into asset allocation is to aim for impact on the capital-seeking
side then the question arises about the outcome. Many empirical researches
confirm that firms leading in sustainability (e.g. expressed by a prime in ESG
rating) often reveal a proper financial performance. But detailed investigations
 45

into the transformation channels of ESG-related equity and debt transactions

uncover very complex structures, which still need further research. It is also in-
spired by empirical results that cause disillusionment as they question a clear-
cut impact effect of ESG-minded shareholders and debt holders on the ESG
behaviour of a firm’s management.

The breadth and frequency of studies in fields related to sustainable finance re-
flect that sustainability issues affect many parts of economics and even finance.
It is remarkable that in some of those fields, like in real estate and energy, re-
searchers in finance could rarely be found. Engineers dominate here as they
are, from a very practical point of view, confronted with physical attributes of
properties, real investment objects, etc., which have very close links to sustain-
ability issues like energy conservation, GHG reduction or efficiency of buildings.
There seem to be backlogs but there are still interesting opportunities in many
fields of sustainability for scientists in finance. If the scientific community in fi-
nance would not be inspired by such chances, politicians will do it as the trans-
formation from exhaustible energy, the management of energy efficiency, the
coping with climate change and many other topics on the agendas of interna-
tional summits, national legislations and NGOs demonstrate nearly every day.
 IV

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