The Complex Terrain of Sustainable Investments: A Legal and Financial Discourse

Josef Bergt
2023

Introduction

In an era where the exigencies of environmental conservation and social responsibility are increasingly integrated into investment paradigms, the concept of sustainable investment has emerged as a focal point of both legal and financial discourse. This article aims to furnish a comprehensive understanding of what constitutes a sustainable investment, the risks involved, and the prospective changes in the regulatory landscape. The objective is to equip investors, legal practitioners, and financial advisors with a nuanced understanding of the complexities surrounding sustainable investments, thereby enabling them to make informed decisions that align with their ethical, social, and financial goals.

Defining Sustainable Investment: A Multifaceted Construct

Traditionally, investments have been evaluated based on three core criteria: yield or return on investment, associated risk, and liquidity. However, the criterion of sustainability introduces an additional layer of complexity to this evaluation. Numerous investment vehicles now explicitly exclude sectors such as coal-based energy production, while others aim to actively support social or environmental projects, such as the construction of schools or solar parks. Thus, sustainability in investment is not merely an ancillary consideration but has evolved into a critical factor that shapes investment decisions.

The Ambiguity of Sustainability Criteria

Despite the burgeoning interest in sustainable investments, there is a conspicuous absence of uniform minimum standards or independent consumer labels. Terms like "ecological," "social," "ethical," "green," or "climate-friendly" are often used interchangeably, and their interpretation varies among providers. Consequently, investors must exercise due diligence to ascertain whether a particular investment aligns with their understanding of sustainability.

The Fluidity of the Concept of Sustainability

The term "sustainability" itself is subject to various interpretations depending on the context in which it is used. In environmental policy, it refers to the long-term ecological viability of economic activities. However, from an economic perspective, sustainability implies the enduring financial success of a business model. Increasingly, the concept of sustainability incorporates both environmental and, to some extent, social aspects, which can contribute to the long-term economic success of a business. However, it is crucial to note that sustainable investments are not inherently safer or more profitable than conventional investments.

Risks Associated with Sustainable Investments

The notion that an investment is inherently secure because it adheres to ecological or social criteria is a fallacy. Risks vary depending on the type of investment vehicle. For instance, a savings account is generally less risky than an investment in a fund. Within the realm of funds, sector-specific funds are usually riskier than diversified funds. Moreover, the risk of total loss is relatively high in closed funds or direct investments in projects like solar parks or forests.

Regulatory Oversight and the Grey Capital Market

Investment products can be legally structured in various ways, such as open and closed public funds, which are subject to regulatory oversight by financial authorities. However, there are also numerous providers in the so-called "grey capital market" that are not subject to stringent regulatory requirements. The absence of a regulatory permit does not necessarily imply the endorsement of the financial authority regarding the accuracy of the information provided or the reliability of the issuer.

The Phenomenon of Greenwashing

Another risk inherent in sustainable investments is "greenwashing," where financial products are misleadingly labeled as sustainable despite containing or financing environmentally harmful elements.

Regulatory Changes on the Horizon

Currently, investment advisors are required to inquire about an investor's experience, financial situation, risk tolerance, and investment objectives. However, future regulations may mandate advisors to also inquire about an investor's sustainability preferences. This change will also apply to insurance-based investment products.

EU Regulations and Taxonomy

Two new EU regulations will gradually require providers to disclose specific sustainability-related information from March 2021. Additionally, the EU is working on an Ecolabel for financial products. The EU Taxonomy aims to establish a common language within the European Union to define what constitutes a sustainable investment.

ESG: A Concrete Framework

The acronym ESG (Environmental, Social, and Governance) provides a concrete framework for sustainability, encompassing climate protection, adaptation to climate change, sustainable use of water resources, transition to a circular economy, pollution prevention, and ecosystem protection.

Costs and Fees

It is essential to scrutinize the costs and fees associated with both sustainable and conventional funds as they may significantly impact investment returns. While higher costs may be justified for a fund that is rigorously certified as sustainable, it is crucial to consider all costs, including those that may be incurred at a later stage.

Diversification and Risk

A well-diversified portfolio across various companies, sectors, countries, and currencies is crucial for mitigating risks. Concentrating investments in a single sector, such as renewable energy, exposes the investor to a "cluster risk," which increases the potential for losses.

Grey Capital Market and High-Risk Investments

Investors interested in sustainable investments often encounter offers for subordinated loans, particularly in "green real estate," wind and solar parks, hydroelectric plants, or biogas facilities. These are high-risk investment forms, and if the project fails or the issuer becomes insolvent, a total loss of the investment is likely.

Conclusion

The landscape of sustainable investments is fraught with complexities, ambiguities, and risks that necessitate a nuanced understanding and meticulous due diligence. Regulatory changes are imminent, and the EU Taxonomy and ESG frameworks provide some clarity, albeit not without their limitations. Costs and fees are a critical consideration, and diversification remains a cornerstone for risk mitigation.

Source: BaFin on Sustainable investments.

Executive Summary:

• Sustainable investment is an evolving concept that incorporates environmental, social, and financial criteria.
• The absence of uniform standards and the risk of "greenwashing" necessitate rigorous due diligence.
• Regulatory oversight varies, and the grey capital market poses additional risks.
• Costs and fees are a significant factor in investment returns, and diversification is essential for risk mitigation.
• Imminent regulatory changes will further integrate sustainability criteria into investment advisory services.