SUSTAINABLE FINANCE

Overview

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 1

Oxford University Press
 Overview of the course

1. Sustainability and the transition • CVCs vs VCs

challenge
• ESG and manipulation
2. Externalities - internalisation
3. Governance and behaviour
• Financing of new ventures
4. Coalitions for sustainable finance • Exercises
5. Strategy and intangibles – changing
business models
6. Integrated reporting - metrics and data
7. Investing for long-term value creation
8. Equity – investing with an ownership
stake
9. Bonds – investing without voting power
10. Banks – new forms of lending
11. Insurance – managing long-term risk

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 2

Oxford University Press
Principles of Sustainable Finance © Schoenmaker and Schramade 2019 Oxford University Press
3
 Systems approach

} Tempting to address challenges at each level

Ø Need for a holistic system perspective
Ø Adaptive capacity of system (e.g. eco-system or production process)

} But cross-system interactions and uncertain thresholds

Ø Example: global warming -> extreme weather events affecting
vulnerable countries -> economic downturn and poverty upturn

} We need a guide for trade-offs between economic, social and ecological

goals

} Finance can help in decision-making on trade-offs

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 4

Oxford University Press
 Functions of the financial system

Levine (2015):

Allocate capital to its Exert influence over

Price risk for trading
most productive use corporates (corporate
and valuation governance)
• can assist in making • risk management • controlling and
strategic decisions can help dealing directing corporate
on the trade-offs with uncertainties in boards
future (eg. scenario (engagement)
analysis) towards sustainable
business practices
(see Chapter 3)

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 5

Oxford University Press
 Framework for sustainable finance

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 6

Oxford University Press
 Comparing the stages

} Discussion
Ø Pros and cons of approaches (SF 1.0, 2.0, 3.0)
Ø Where are we now?

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 7

Oxford University Press
Principles of Sustainable Finance © Schoenmaker and Schramade 2019 Oxford University Press
8
 Internalising externalities

Government:
regulation or
taxation

Problem:
externalities not Consumers:
buy
Civil society:
NGOs can raise
sustainable
awareness
reflected in products and
services
(advocacy)

market prices Internalisation

Corporates: Financials:
incorporate incorporate
costs of ESG factors in
externalities in investment +
production lending

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 9

Oxford University Press
 How to deal with externalities?

What can business do with remaining externalities?

• Measuring and monetisation is possible through technology (IT,

data) and science (life cycle analyses, environmental economics)

• Pricing is possible by optimising across F, S and E dimension

10
 Scenario analysis
} Scenario analysis to get insight in development of externalities over time

} Strategic approach to making scenarios

1. Determine most important uncertainties for the future
2. Elaborate the scenarios with trends, uncertainties and possible actions
3. Re-present scenarios as appealing stories about (paths to) the future

} Analyst reports are the fortune tellers of investor community

• From DCF analysis of main scenario (often ‘business as usual’)
• Towards DCF analysis of 3 or 4 scenarios including disruptions and
internalising externalities

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 11

Oxford University Press
 Stress testing

} Central banks and supervisors conduct (climate) stress tests of financial

sector using extreme scenarios

} Goal is to
1. Raise awareness of major environmental exposures at financials
2. Monitor major concentrations at financials in supervision

} Possible instruments
• Large exposure rules for high carbon concentrations
• Brown capital charge for high carbon assets

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 12

Oxford University Press
 Role of finance

How can financial firms steer business towards

sustainable business practices?

• Corporate governance: stewardship and engagement

• Need to include social and environmental dimensions

• From short-term to long-term

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 13

Oxford University Press
 Governance models
} Executive contracts and compensation: incorporate sustainability as
KPI (key performance indicator)

} Type of shareholders: long-term investors (e.g. pension funds; Ch 4)

} Reporting: integrated reporting (Chapter 6)

} Non-executive monitoring:
Ø widen remit of audit committee towards integrated reports, or
Ø create sustainability committee: to monitor creation of social and
environmental value by management

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 14

Oxford University Press
 Discussion: barriers

What is the most important barrier to sustainable finance?

1. Value: shareholder value versus stakeholder value

2. Horizon: short term versus long term

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 15

Oxford University Press
Principles of Sustainable Finance © Schoenmaker and Schramade 2019 Oxford University Press
16
 Business models
Business model canvas (Osterwalder & Pigneur, 2010):

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 17

Oxford University Press
 Circular business models
The value hill in a circular economy (Circle Economy, 2016):
Repair/maintain
Add value Retain value
User

Retail Reuse/redistribute

Assembly Refurbish

Remanufacture
Manufacturing

Recycle
Extraction

Pre-use Use Post-use

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 18

Oxford University Press
 Reporting

kee try
g

nd ting
pin
n
bo ble e

s
ard
n
co u
u
ok
Do

Ac
sta
• Challenges
• Legitimacy?

pan r e
pan ck

pan y
f
l m th o

com olog
ets
ies

ies

ies
com lthca
com t sto

ark
w

chn
Gro
n

a
He
Joi

Te
ita
cap

Tangible Intangible
assets assets

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 19

Oxford University Press
 Pricing: from EMH to AMH

EMH AMH
Instantaneous incorporation of all Degree of market efficiency depends on
relevant information market ecology

Pricing of ESG information depends on

All ESG information is either irrelevant
the number and quality of market
or already priced

s ti c participants that take ESG seriously

a li i b le
U nre a u s
Pl

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 20

Oxford University Press
 Conditions for LTVC

1. Long
investment
horizons

6. Keep the 2. Active

investment management in
concentrated
chain short portfolio

Long-term
value
creation
5. Long-term
alignment of
3. Effective
mandate engagement
asset owner
and manager
4.
Performance
analysis of
value-added
in the real
economy

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 21

Oxford University Press
 Why does sustainability matter to
equity investing?

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 22

Oxford University Press
 Why does sustainability matter to
bond investing?

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 23

Oxford University Press
 Relevance of sustainability to bonds

Factors
Environmental, social influencing Credit risk
and governance factors indicators
creditworthiness

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 24

Oxford University Press
 Green bonds
The Green Bond Principles (GBP, 2017) give four criteria:

Use of proceeds Process for Management of Reporting

• are exclusively for project evaluation proceeds • mandatory on the
green projects, which and selection • the net proceeds of use of the proceeds
should be • the issuer should the green bond
appropriately clearly communicate should be credited to
described in the legal to investors: a sub-account, and
documentation for • 1) what the subsequently be
the security environmental tracked and verified
objectives are;
• 2) the process to
determine how the
project fits the
eligible green
projects categories;
• 3) the eligibility
criteria

25
Principles of Sustainable Finance © Schoenmaker and Schramade 2019 Oxford University Press
26
 Microfinance / microcredit

} Microfinance: banking service to low-income or unemployed and micro-

enterprises
Ø Pioneers in Bangladesh (different from traditional banking)
Ø Social control, group lending, etc.

} Challenges + opportunities
Ø Unserviceable and unreachable part of population
Ø Small loans at affordable cost
Ø New approaches: satellite linked with mobile vans/boats
Ø Use mobile telephones

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 27

Oxford University Press
Principles of Sustainable Finance © Schoenmaker and Schramade 2019 Oxford University Press
28
} Can VCs outbid CVCs in the market for ideas/start-ups?
◦ Provide an explanation about the growth of CVCs and why competition authorities
do not challenge such investment practices.

} Fund managers may just use ESG to attract fund flows.

◦ What is the main consideration of ESG funds?
◦ Do ESG funds behave more ethically than non-ESG funds?

Ø Why are new ventures hard to finance?

• What are the main sources of financing?
• Explain the main IPO puzzles.

29
 Exercises

} External financing: Zynga

• Zynga, a provider of social game services (FarmVille, launched on

Facebook in 2009), was founded in July 2007,

• The company was initially funded by Reid Hoffman (venture capitalist at

Greylock Partners and co-founder of LinkedIn) with an investment of
approximately $166,000,

• As of January 2008, Hoffman’s $166,000 initial investment in Zynga

represented 2,939,488 shares of Series A preferred stock à $0.056438
per share.

30
 § Zynga needed additional capital and thus management decided to raise this
money by selling equity in the form of convertible preferred stock:

§ Zynga sold 38,767,312 shares of Series A-1 preferred stock at

$0.125 per share in February 2008. After this funding round the
distribution of ownership was:

Round Number of shares Price per share ($) Total value ($ million) Percentage ownership
Series A 2,939,488 0.056438 0.37 7.0%
Series A-1 38,767,312 0.125 4.84 93.0%
41,706,800 5.21 100.0%

§ At the price the new shares were sold for, Hoffman’s shares were worth
$0.37 million (up from $0.166 million) and represented 7.0% of the
outstanding shares.

31
§ Pre-money valuation:
§ At the issuance of new equity, the value of the firm’s prior shares
outstanding at the price in the funding round:
§ $0.37 million in the Zynga example.

§ Post-money valuation:
§ At the issue of new equity, the value of the whole firm (old plus new
shares) at the price that the new equity is sold at:
§ $5.21 million in the Zynga example.

§ Post-money valuation = Pre-money valuation + Amount invested = Total

number of shares outstanding × Price per share (in the last financing
round).

32
 § Over the next years, Zynga raised three more rounds of outside equity
(Series B, B-1, and C):

Round Date Number of Price per Capital raised Total value Percentage
shares share ($) ($ million) ($ million) ownership
Series A Jan 2008 2,939,488 0.056438 0.166 41.24 2.85%
Series A-1 Feb 2008 38,767,312 0.125 4.85 543.87 37.61%
Series B Jul 2008 59,391,296 0.420938 25.00 833.21 57.61%
Series B-1 Nov 2009 210,700 4.746075 1.00 2.96 0.20%

Series C Feb 2011 1,782,010 14.02912 25.00 25.00 1.73%

109,090,806 1,446.27 100%

§ Note that Hoffman’s shares are now worth $41.24 million, but represent
only 2.85% of the outstanding shares,

§ External financing is costly in terms of control (100% à 2.85%).

[Link]
[Link]
[Link]
Margoles Publishing recently completed its IPO. The stock was
offered at a price of $14 per share. On the first day of trading, the
stock closed at $19 per share.

a) What was the initial return on Margoles?

b) Who benefited from this underpricing? Who lost, and why?

[Link]
a) The initial return on Margoles Publishing stock is:

($19.00 – $14.00) / ($14.00) = 35.7%.

b) Who gains from the price increase? Who loses from the price increase?

Investors who were able to buy at the IPO price of $14/share see an
immediate return of 35.7% on their investment. Owners of the other
shares outstanding that were not sold as part of the IPO see the value of
their shares increase. To the extent that the investors who were able to
obtain shares in the IPO have other relationships with the investment
banks, the investment banks may benefit indirectly from the deal through
their future business with these customers.

The original shareholders lose, because they sold the stock for $14.00 per
share when the market was willing to pay $19.00 per share.

[Link]
Your firm has 10 million shares outstanding, and you are about to issue 5
million new shares in an IPO. The IPO price has been set at $20 per share,
and the underwriting spread is 7%. The IPO is a big success with investors,
and the share price rises to $50 on the first day of trading.

a) How much did your firm raise from the IPO?

b) What is the market value of the firm after the IPO?
c) Assume that the post-IPO value of your firm is its fair market value.
Suppose your firm could have issued shares directly to investors at the fair
market value, in a perfect market with no underwriting spread and no
underpricing. What would the share price have been in this case, if you
would raise the same amount as in part (a)?
d) Comparing part (b) and part (c), what is the total cost to the firm’s original
investors due to market imperfections from the IPO?

[Link]
a) 5m × (20 – 7% x 20) = $93 million (Note that the investment bank takes a 7%
fee).

b) 15m × 50 = $750 million (total number of shares x most recent share price).

c) Market value of firm assets absent new cash raised = 750 – 93 = $657 million,
$657m / (10m original shares) = $65.70 per share.

d) (65.7 – 50) x 10m = $157 million.

[Link]
You have an arrangement with your broker to request 1000 shares of all
available IPOs. Suppose that 10% of the time, the IPO is “very successful” and
appreciates by 100% on the first day, 80% of the time it is “successful” and
appreciates by 10%, and 10% of the time it “fails” and falls by 15%.

a) By what amount does the average IPO appreciate the first day; that is,
what is the average IPO underpricing?

b) Suppose you expect to receive 50 shares when the IPO is very successful,
200 shares when it is successful, and 1000 shares when it fails. Assume the
average IPO price is $15. What is your expected one-day return on your IPO
investments?

c) If you decide to buy shares in every IPO, will you necessarily make money
from the underpricing?

[Link]
a) 0.10 × (100%) + 0.80 × (10%) + 0.10 × (–15%) = 16.5%.

b) Average investment = 0.10 × (50 × 15) + 0.80 × (200 × 15) + 0.10 × (1,000 × 15)
= $3,975
Average gain = 0.10 × (50 × 15 × 100%) + 0.80 × (200 × 15 × 10%) + 0.10
x (1,000 × 15 x [– 15%])
= $90
Return = 90 / 3975 = 2.3%.

c) If you followed a strategy of placing an order for a fixed number of shares on every IPO,
your order will be completely filled when the stock price goes down, but you will be
rationed when it goes up. In effect you only get substantial amounts of stock when you do
not want it. The winners’ curse is substantial enough so that the strategy of investing in
every IPO does not yield above market returns.

[Link]