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How to make finance a force for sustainability

Traditional finance focuses on financial return, considering the financial sector separate from both society and the environment. In contrast, sustainable finance considers financial, social and environmental returns in combination. In a new essay, Dirk Schoenmaker provides a framework for sustainable finance highlighting the move from the narrow shareholder model to a broader stakeholder model. Here he presents the key arguments.

By: Date: July 12, 2017 Topic: Energy & Climate

This blog summarises the arguments of a recent essay by the author:

Investing for the common good: a sustainable finance framework

Sustainable development is a holistic concept with three aspects: economic, social and environmental. Humanity is facing numerous sustainability challenges. Looking at the environment, we see climate change, land-use change, biodiversity loss and depletion of natural resources all destabilising the earth. And on the social front, poverty, hunger and a lack of health care reveal that many people live below basic social standards.

Sustainable development means that current and future generations should have the resources they need, such as food, water, health care and energy, without overwhelming the earth’s natural processes. To guide the transformation towards a sustainable and inclusive economy, the United Nations has developed the 2030 Agenda for Sustainable Development, which will require behavioural change.

Why should finance contribute to sustainable development? The main task of the financial system is to allocate funding to its most productive use, but a shift to sustainability means changing our ideas about what is “productive”. Finance can play a role in allocating investment to sustainable companies and projects and thus accelerate the transition to a low-carbon, circular economy. So sustainable finance considers how finance (investing and lending) interacts with economic, social and environmental issues.

In this allocation role, finance can assist in strategic decisions on the trade-offs between sustainable goals. Moreover, investors can exert influence over the companies they invest in, so long-term investors can steer companies towards sustainable business practices. Finally, finance is good at pricing risk for valuation purposes, and can thus help to deal with the inherent uncertainty about environmental issues, such as the impact of carbon emissions on climate change. At their core both finance and sustainability look to the future, so there is scope for a new alignment

A new framework

Thinking about sustainable finance has gone through different stages over the last few decades (see Table 1). The focus is gradually shifting from short-term profit towards long-term value creation. In a new essay, I analyse these stages and provide a new framework for sustainable finance.

Financial and non-financial firms traditionally adopt the shareholder model, with profit maximisation as the main goal. A first step in sustainable finance (1.0 in Table 1) would be for financial institutions to avoid investing in companies with very negative impacts, such as tobacco, cluster bombs or whale hunting. Indeed, some firms are starting to include social and environmental considerations in the stakeholder model (Sustainable Finance 2.0).

But to move ahead, we need to adopt a stakeholder approach to finance, with benefits accruing to the wider community rather than just shareholders. In the essay, I highlight the tension between the shareholder and stakeholder models. Should policymakers allow a shareholder-oriented firm to take over a stakeholder-oriented firm? Or do we need to protect firms that are more advanced in terms of sustainability? Another key development is the move from risk to opportunity. While financial firms have started to avoid (very) unsustainable companies from a risk perspective (Sustainable Finance 1.0 and 2.0), the frontrunners are now increasingly investing in sustainable companies and projects to create long-term value for the wider community (Sustainable Finance 3.0).

Mobilising investment funds for the long term

One major obstacle to the adoption of sustainable finance is short-termism. The costs of action are borne now, while the benefits are in the future. The impact of economic activity on society, and even more so on the environment, is typically felt in the long term. So how can financial institutions commit their investment for the long term and steer business towards sustainable practices?

In the essay, I make two concrete proposals. On the institutional front, I propose to introduce “loyalty shares” as an additional reward to shareholders if they have held on to their shares for a so-called loyalty period (for example three, five or ten years). This is an incentive for institutional investors to pursue a buy-and-hold strategy. It is also a reward for investors’ efforts on engagement with the companies in which they invest. This engagement on environmental, social and governance (ESG) issues is a powerful force to steer companies towards sustainable business practices. Social and environmental externalities take place in the corporate sector, but the financial sector can pressure corporates to address these externalities effectively.

On the investment side, I propose the creation of sustainable retail investment funds. Currently, the main vehicles for retail investors are Undertakings for Collective Investments in Transferable Securities (UCITS). UCITS are collective investment funds operating freely throughout the European Union on the basis of a single authorisation. The UCITS concept includes a transferability requirement, which assumes securities are listed on liquid markets. However, this discourages long-term commitment by investors. While liquidity is useful for retail investors, I suggest that this strict transferability requirement be revised into a concept of ‘liquidity that ensures a balanced control of in- and outflow of cash by fund managers’. This could be combined with a withdrawal limit on fund shares.

As part of their sustainability agenda, the European Commission should prepare legislation setting up liquid, sustainable retail investment funds or undertakings with an EU-passport. These new ‘Undertakings for Collective Investments in Sustainable Securities’ (UCISS) would replace the requirements on listing and transferability with the concept of sound liquidity management. UCISS would also incorporate a definition of eligible investments meeting enforceable sustainability criteria. The UN Sustainable Development Goals could underpin these criteria.

 


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