Ben Caldecott showcases a ‘sustainable finance framework’ that could help regulators, bankers and consumers measure the impact of financial services and finance products on greening the real economy.
According to the Global Sustainable Investment Alliance, assets managed under sustainable investment strategies reached $30.7trn globally in 2018 – a 34% increase from 2016.
This is probably a good indicator of the rapid growth and increasing interest in sustainable finance. But the numbers also highlight the yawning gap between embellishment and greenwashing on the one hand, and realising the genuine integration of the environment into financial decision-making on the other.
This gap is a big problem.
It is a problem for central banks and supervisors seeking to ensure that environment-related risks are being properly managed by financial institutions.
It is a problem for policymakers wanting to see capital reallocated to activities that will help them deliver the Paris Agreement and the Sustainable Development Goals.
And it’s a big problem for consumers who care about the environment.
Retail investors increasingly want their investments to have smaller environmental footprints – and for these to become aligned with environmental thresholds as quickly as possible.
Growing societal concern extends to environmental challenges including:
- climate change
- habitat destruction
- biodiversity loss
- overfishing
- and plastic pollution.
Reducing exposure
Can we be sure that the financial products and services on offer reduce exposure to environmental impacts and/or environmental risks?
The answer is yes, though claims of reduced environment impact and/or risk are often misleading or inaccurate.
Much more needs to be done to improve the data, analysis, and transparency required to track changes in environmental risk and impact exposures.
Impact on the real economy
And can we be sure whether a ‘green’ or ‘sustainable’ labelled financial product will help the real economy transition to environmental sustainability?
Yes, we can. But there has been much less interest and urgency in clarifying this. I suspect this is in part because of how little impact many of the products and services that are currently promoted actually have.
So what can we do to improve this?
Sustainable finance framework
There are only a few ways sustainable finance products and services can impact the real economy. These are set out broadly in the framework below:
- cost of capital – reduce, or increase, the cost of capital for ‘green’ or ‘brown’ projects
- liquidity – increase, or reduce, liquidity for ‘green’ or ‘brown’ projects
- provide or enable risk management of environment-related physical and transition risks
- encourage or enable companies to adopt more sustainable practices
- support systemic change through spill over effects
Testing the framework
Quite simply, if a green or sustainable labelled financial product or service doesn’t do at least one of the first four things listed – and can’t evidence that it is making a difference – we have a problem. Products and services that claim to be greening the economy need to have a very clear theory of change.
Let’s look at a few examples.
Green bonds
I would argue that there is very little evidence to support the claim that standard ‘recourse-to-the-issuer’ green bonds – where the repayment obligations reside with the legal entity issuing the bonds – contribute to 1, 2, or 3.
And a lot hinges on the claims their proponents make for 4 and 5. In contrast, non-recourse green project or infrastructure bonds could additionally provide 3 to investors.
Sustainability improvement loans
I think they can certainly support 1, 3, and 4, and there is an argument to made in favour of 2 and 5.
Sustainable listed equities funds benchmarked to the S&P500 or FTSE100
They won’t contribute to 1 or 2, might potentially contribute to 3 depending on the fund and the investor’s other holdings. They could contribute to 4 if the fund has an effective investor engagement strategy. They may possibly contribute to 5, but it’s very debatable.
Regulating green finance
It’s clear that consumers need more choice. And the products and services on offer need to make a real difference. Financial regulators have an important role here.
Progress is being made, particularly by the UK’s Financial Conduct Authority (FCA).
In a report published in October 2019 they said:
“The ‘sustainable’ label is applied to a very wide range of products. On the face of it, some of these do not appear to have materially different exposures to products that do not have such a label…
“[As such we will] challenge firms where we see potential greenwashing, clarify our expectations and take appropriate action to prevent consumers being misled.”
We should all demand much more progress. If a product is claiming it will do something, it should be clear how it will do it and there should be an accountable and transparent way of measuring the claimed contribution over time.
Financial supervisors should be much stricter at authorising and monitoring product and fund claims. The above framework can help them and others make this a reality.
Dr Ben Caldecott is founding Director of the Oxford Sustainable Finance Programme and an Associate Professor at the University of Oxford, as well as Co-Chair of the Global Research Alliance for Sustainable Finance and Investment and a Senior Adviser to the Chair and CEO of the Green Finance Institute.
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The Centre for Sustainable Finance considers issues relating to markets, regulation, risk management and government policy from an international perspective.