The Role of Financial Institutions in Creating a Sustainable Economy

Business and Finance

Photograph: John Lau

On January 27th, 2021, a number of leading financial figures participated in a digital discussion entitled ‘Financing the net-zero transition’. The discussion was organised by the World Economic Forum and the prestigious panel, which comprised of former US vice-president Al Gore and Allianz CEO Oliver Bäte, considered the roles of both the public and private sectors in financing a global progression towards sustainability. All members acknowledged that while progress has certainly been made, a stronger, multilateral effort is still necessary to further mobilise capital in an eco-friendly direction. Public sector commitments to sustainability are starting to filter across into the private sector; however, more needs to be done to de-risk and incentivise investment in eco-friendly projects and funds. This is the purpose of sustainable finance.

According to the European Commission, sustainable finance generally refers to ‘the process of taking due account of environmental, social and governance (ESG) considerations when making investment decisions in the financial sector, leading to increased longer-term investments into sustainable economic activities and projects.’ Financial institutions are in a unique position where they can incentivise environmentally friendly investment and this is something that has been acknowledged and acted upon in recent years. The emergence of financial instruments such as green bonds (typically asset-linked bonds that are specifically earmarked to raise money for climate and environmental projects) and sustainably linked loans (a loan instrument that demands the borrower’s achievement of ambitious, predetermined sustainability goals) stand testament to this recognition. Green bonds surged by over 50% to over $250 billion in 2019, exemplifying an increased market focus on sustainable investment. Furthermore, the application of environmental consideration in assessments of potential investments is now commonplace. Such considerations impact the long-term risk and reward of an investment, thus shaping the way banks evaluate capital flows. These recent changes clearly demonstrate that the finance industry is restructuring itself for the better.

However, the success and magnitude of these shifts are yet to be determined. A study from the Imperial College Business School and International Energy Agency showed that over the last 10 years renewable power generated 7 times the return of fossil fuels (423% against 59%). This is largely due to the superior risk and returns profile for renewable power portfolios, which can be attributed to an un-correlation with the wider market - renewable power is often less risky to invest in because it is not as well integrated into the economic system as fossil fuels are, therefore making it less vulnerable to the effects of market volatility. Consequently, as the greater returns on renewable power illustrate an increased awareness of the climate crisis, they illustrate a lingering global dependence on fossil fuels.

The Intergovernmental Panel on Climate Change recently published a report stating that $2.4 trillion, or roughly 2.5% of global GDP, needs to be invested annually in the energy system between 2016 and 2035 to limit global warming to 1.5°C. This is unlikely to be met at present levels of investment. It is therefore clear that more must be done to encourage sustainable investment, as highlighted by the participants of the ‘Financing Net Zero’ event. There are numerous measures currently being considered and implemented worldwide to do this. One such measure is the international standardisation of sustainability goals and legislation, which would enable sustainable capital to flow more seamlessly between economic systems and facilitate international cooperation. Another possible measure, one that has so far been met with formidable political opposition, is the idea of a carbon tax or emissions trading system, which would be aligned with the conceptual ‘carbon budget’ (the single figure which encapsulates our planet’s physical limits and humanity’s ability to reach Net Zero). This system, if actualised, would further integrate sustainability into the modern global economy and thus, allow economic development to consolidate with sustainability.

As we edge towards 2030, the year by which 192 nations have pledged to cumulatively reduce emissions by 87.6% under the Paris Agreement and other less superficial climate milestones, the importance of decisive action grows. It remains evident that an instantaneous divorce from fossil fuels is impossible; however, the transition needs to be hastened. The finance sector has an opportunity, and an obligation, to help achieve this.