We're entering a new era for sustainable investment. Here's why

The year 2023 will be remembered as the start of a new era for investment policy, facilitation and promotion. Three developments are coinciding to transform the global investment climate and are set to take centre stage during the World Economic Forum’s Annual Meeting of the New Champions in Tianjin, China.

First of all, a set of global sustainability and climate reporting standards has been established – a game changer for firms to disclosure risks and opportunities – and thus enable investors and societies to better allocate capital and support.

Secondly, new global corporate income tax rules will affect how countries can use fiscal investment incentives, leading to changes in the volume and distribution of global investment flows and stocks.

And third, a landmark World Trade Organization (WTO) investment agreement will create a common taxonomy, baseline, framework and resources to facilitate cross-border investment flows.

For these three reasons 2023 looks set to be an annus mirabilis for investment policy, facilitation and promotion. This article aims to help governments and firms position themselves for investment success by explaining what has changed and suggesting what may come next.

After one-and-a-half years, the International Sustainability Standards Board (ISSB) has formulated two sets of global financial market standards that will be released on 26 June, with implementation to begin on 1 January 2024 – one for general sustainability reporting (IFRS Standard 1), and one for climate-related financial reporting (IFRS Standard 2).

These two sets of global standards were built on existing standards and benchmarks, moving sustainability regulation from an era of fragmentation to one of standardization. This process was launched by the IFRS Foundation, which has helped set global standards for financial reporting since being created in 2000.

At COP26, the IFRS Foundation launched the ISSB. The IFRS’s sustainability standards setting has been backed by the G7, the G20, the International Organization of Securities Commissions (IOSCO), the Financial Stability Board (FSB), African finance ministers and finance ministers and central bank governors from more than 40 jurisdictions.

The ISSB’s work builds on several market-led investor-focused reporting initiatives, including the World Economic Forum’s Stakeholder Metrics.

Both governments and firms need to get ready, including through efforts to build capacity to respond to the new requirements, and through supportive training, regulations and institutions.

The ability to address sustainability issues by firms will become a competitive advantage vis-à-vis their competitors, especially for businesses that adapt quickly and benefit from a ‘first-mover effect’, while the ability to address sustainability issues by governments will enhance an economy’s attractiveness and become a location determinant for foreign direct investment (FDI).

As a result, the new sets of sustainability standards will drive a reconfiguration of global value chains (GVCs). Host markets that fail to apply the standards will become less attractive to firms that become more and more sensitive to sustainability risks and opportunities for their international business, as well as accountability to their shareholders and stakeholders, and thus lose competitiveness as an investment destination.

Firms that do not report on the standards will find themselves less attractive for financing and receiving both host and home-country investment support measures. The impact will be felt not only by multinational enterprises (MNEs) but also by small and medium-sized enterprises (SMEs) to secure financing, as well as to gain or maintain access to contracts as part of regional and GVCs.

Investors will be better able to allocate capital according to sustainability and climate-related performance of firms, and therefore further incentivize firms to shift to operate in a more sustainable and climate-friendly manner, in what has been called a ‘virtuous sustainable investment cycle’.

Investors’ allocation of capital to sustainable operations is bolstered by the growing evidence that these kinds of investments perform better. Meta studies of thousands of individual studies find a positive relationship between environmental, social and governance (ESG) operations and performance in 57% to 59% of firms, and only a negative relationship in 6% to 14% of firms, with a recent study of more than 3,000 firms finding ESG operations led to 1.4% to 2.7% higher stock returns.

After eight years, so far 138 jurisdictions have agreed, through the Organisation for Economic Co-operation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) initiative, to a minimum corporate income tax of 15% percent. While global average statutory rates of corporate income tax are around 25%, effective tax rates are much lower due to fiscal incentives provided by host states.

Furthermore, MNEs often pay even less than the effective tax rate in a jurisdiction as they can shift part of their profits to lower-tax jurisdictions. Under the new tax reform, if host states levy less than the 15% minimum tax on firm profits, home states can charge a ‘top-up’ tax and pocket this amount.

This incentivizes host states to meet the 15% threshold or lose fiscal revenue without gaining investment attractiveness. United Nations Conference on Trade and Development (UNCTAD) estimates conservatively that taxes will rise by 2% on average globally, increasing tax revenues for host states by 15%.

Even though the new tax rules only apply to firms with revenues over €750 million, given that most FDI takes place by large firms with global revenues well beyond this threshold, over the past five years around 70% of new investment projects would have been affected.

The new rules, scheduled to be effective at the beginning of 2024, are expected to have both a volume and distribution effect on FDI.

On the one hand, firms may have less of an interest to carry out cross-border investment once the fiscal incentives are removed from the set of measures to attract such investment. Estimates place the downward effect on global FDI at around -2%. At the same time, the cut in tax rate differentials will result in the diversion of investment from traditionally lower- to higher-tax jurisdictions.

The new tax rules will therefore fundamentally affect how countries compete for international investment. On the one hand, it may put an end to the global race in wasteful fiscal incentives, but on the other, it may pose a new challenge for channelling investment into those Sustainable Development Goal sectors that are often less attractive in terms of risk-return.

Fiscal incentives will lose their effectiveness, and countries will need to use different tools, including other incentives (e.g., infrastructure provision, loans, grants) as well as core investment climate reforms (e.g., rule of law, regulatory predictability, institutional quality and administrative streamlining).

All this calls for a new investment promotion strategy and framework, including a ‘double shift’: shifting from location-based to performance-based incentive schemes, as well as shifting from profit-based to expenditure-based incentive schemes.

After five years, 118 governments have concluded text-based negotiations for a draft WTO Agreement on Investment Facilitation for Development. This new agreement, the first of its kind, aims to create new rules on parties to adopt investment facilitation measures that will strengthen their investment climate, and in so doing should increase investment flows and their development benefits.

According to an academic study, global welfare could increase by up to 1.1 trillion dollars or in percentage terms by between 0.56% and 1.74%. Examples of commitments in the new agreement include transparency on rules, streamlining of regulations, coordination between and within economies, and innovative instruments such as supplier development programmes and supplier databases to increase capacity and help match capital with firms.

The significance of this new agreement is that it creates a common roadmap to strengthen investment climates through adopting new measures, and a framework for cooperation to grow investment, both government to government and government to investor.

Having a pro-multilateral framework – rather than the existing set of bilateral and regional agreements – can result in greater impact through creating a common baseline of good regulatory practice across more than two-thirds of WTO members.

Any agreement is only as useful as it is put into practice, and so now comes the implementation phase. The first step will be to determine the needs of developing countries in terms of the delta between current practice in terms of investment facilitation measures and provisions in the agreement.

The launch of the World Investment for Development Alliance in Davos in May 2022 has created a mechanism for leading investment-concerned organizations to collaborate and synergize technical assistance and capacity building efforts in developing countries on implementing the new agreement.

This will require public-private, multistakeholder projects to understand what the real bottlenecks and pain points are to growing investment flows, and how provisions of the agreement can help address them.

In short, three big developments will make the year 2023 a big milestone for investment policy and practice. Governments and companies have an opportunity in Tianjin to work together to get ready for, and make the most of, these transformative changes.