How investing works
There are multiple investment products a private individual can opt to (sustainably) invest in. The most important investment products are shares or stocks, bonds, and investment funds, and will be further explained below.
If you would like to purchase an investment product, then you will need an investment account to do so. A financial service provider such as a bank or a broker, can help you set up your account. More information can be found under the corresponding heading ‘How do I start with sustainable investing [link]’
Shares or stocks
A share or stock is in essence, a small part of a company. By investing in stocks or shares you will receive partial ownership of the company. For instance, a company owns a hundred shares in total. Purchasing five shares will give you five per cent ownership of the company.
There are two different options for making a return on stocks or shares:
- An increase (or decrease) in the value of the share. Predominantly, the value of the share is determined by the value of the company. Secondly, the expected (future) performance of the organisation plays a role in value determination. Yet, the final rate of a share is determined by market supply and demand;
- Dividend payments. The profits made by a company can be fully, or partially distributed to its investors. This periodical payment is called a dividend
The section above is on financial returns. Determining to what extent a share or stock is sustainable [link], can be done in various ways.
Bonds are loans where the bondholder lends money to a government or company for a set period of time. In the case of green bonds, the activities or projects that are being funded through the loan must contribute to the improvement of society.
Profit from a bond can be earned in two different manners:
- Through an increase (or decrease) in the value of the bond. The value of the bond is predominantly determined by the amount of the loan taken out, as well as by the agreed-upon interest and the (remaining) term. When a third party wants to take over the loan, the price is determined by market supply and demand.
- Through payment of interest by the company or government to the bondholder.
Funds can be viewed as ‘baskets’ that contain a collection of investment products. There are many different types of funds available, such as equity funds, bond funds and mixed funds (a combination of shares and bonds within the same fund).
Some equity funds are directed by a particular index. For instance, an S&P500 fund is composed of the 500 largest American companies. Funds that solely comprise shares or bonds from a specific country or industry are another example of an index-guided fund.
In general, funds are composed and managed by professional investors and analysts. Contrastingly, ETFs (Exchange-Traded Funds) are funds that are managed by an algorithm. This algorithm automatically purchases and vends investment products for, and from the fund, based on predetermined criteria.
What is sustainable investing?
The alternative to traditional investing
Investing money is a great way to improve the return on your own capital or equity. Currently, many are still investing in projects that can have negative consequences for society, the environment, and the climate. These consequences include child labour, deforestation and corruption, among others.
Sustainable, or green investments, are therefore a good alternative to the traditional or classic (often dubbed ‘grey’) way of investing. A way that is predominantly focused on receiving financial returns on investments. Contrastingly, sustainable investing is centred around the principle that invested capital should not only be focused on financial return but more so that the investment contributes to a better world. Or at least that the investment brings no harm to society or the planet.
Take society and the environment into account
During the investment process, the investor consciously takes particular social, environmental and governance factors into account within the selected companies. The VBDO, The Dutch Association of Investors for Sustainable Development, wields the official definition of the UN PRI: “Responsible investment involves considering environmental, social and governance (ESG) issues when making investment decisions and influencing companies or assets (known as active ownership or stewardship)”. In addition, it involves creating a positive impact where possible.
The term sustainable investing is often used interchangeably with the terms responsible investing and impact investing. Yet, it is good to note there are some differences. Responsible investing, in particular, involves looking at companies that you don’t want to invest in. This usually involves excluding certain companies, industries or countries from your investment portfolio. In addition, and similar to classic or traditional investing, there is a relatively high emphasis on financial return.
Sustainable investing involves focusing on investments which pose the lowest risk or are the least harmful to society and the environment. For example, the extent to which a new factory is built out of sustainable materials, if it makes use of green energy or if it is located in a risk area regarding forest fires or floodings.
Impact investing takes sustainability another step further. Impact investing involves creating a positive impact on society or the environment. The main difference with philanthropy is that successful impact enterprises also have a financially healthy business model, in addition to making a positive contribution to their environment. Companies that are dedicated to tackling food waste issues, improving social cohesion or removing CO2 from the atmosphere, are good examples of impact enterprises.
But how does sustainable investing work exactly, and how does one begin? On this web page you can find the steps you have to undertake to start investing sustainably as a private individual, and which benefits you may enjoy.
Sustainable shares or stocks
To what extent a company and its shares are sustainable, is initially up to you. Sustainability is a subjective term. What seems sustainable for one person, does not necessarily mean the same for another. For instance, some people would classify investing in nuclear energy as sustainable, whereas other people would exclude such investments on purpose. However, there are some methods that can help you make your decision.
The easiest method involves exclusion. You can opt to exclude companies from investments when you view them as being unsustainable or controversial. Many banks and brokers already make this choice for you. Therefore, the shares of these companies will not be included in their standard selection of investment products. Companies in the tobacco, weapon, or gambling industry are often excluded in this way. Companies can also be excluded based on their behaviour or sustainability scandals, such as child labour, animal testing or oil leakages.
Positive selection of shares, also often dubbed the ‘best-in-class approach’, involves only investing in companies that are leading in their sector in terms of set sustainability criteria.
Another method for selecting responsible investment products involves integrating ESG criteria (Environment, Social and Governance) into the selection procedure. These criteria give direction, in a number of ways, to your personal investment preferences with regard to the environment, society and governance.
The ranking of an ESG score is dependent on the criteria that are set up by the assessor. Therefore, ESG scores can differ across multiple assessors and may be higher or lower depending on the set criteria.
It is important to note that an ESG score does not tell us anything about the sustainability of a company. An ESG score simply demonstrates the company’s risk to be (financially) harmed by societal or environmental issues. A factory in a flooding area will therefore in general, have a lower E score than a company in a different location.
In a similar manner, a company will score higher on Social, respectively Governance, when it adheres to all guidelines for international labour law, and anti-corruption, compared to an organisation that does not. The latter will be more at risk to be convicted or fined by a local or international court.
The European Union has, with the establishment of the Green Deal and corresponding EU Taxonomy, set up a classification system which makes it easier for investors to determine which economic activities can be viewed as environmentally friendly and/or sustainable. Besides, multiple certifications such as the B-corporation exist, which indicate that people, the environment and society at large are being taken into account by the certified company.
Laws and regulations
The Sustainable Finance Disclosure Regulation (SFDR) was initiated in 2021. Fund providers are, under these European regulations, obliged to provide information on the sustainability level of their products.
The EU regulation MiFID II, for instance, dictates that banks and brokers must inquire about the sustainability preferences of their clients and subsequently take these into account when investing.
Some people prefer others to make their sustainability choices for them. Therefore, some parties preselect companies for you, so you don’t have to worry about making the wrong choice. If you invest through a sustainable financial institution such as Triodos Bank or ASN Bank, they will only offer you investment products which comply with the set sustainability criteria.