Blog Post

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.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Opinion

The EU and the US: a relationship in motion

Europe’s post-crisis recovery has been disappointing in comparison with the USA. But lower rates of inequality are staving off populism and bolstering support for globalisation. With the USA an increasingly unpredictable partner, the EU must address internal imbalances and build alliances to defend the multilateral order.

By: Maria Demertzis Topic: Global Economics & Governance Date: July 28, 2017
Read article More on this topic More by this author

Opinion

ASEAN Against the World: Strength in the Numbers

Corporate debt in emerging markets has long been perceived as a relevant risk for the global economy. In reality, this perception might be true for some large emerging economies, especially China, but not for its neighboring countries, namely those in the Association of Southeast Asian Nations (ASEAN) region.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: July 19, 2017
Read article More on this topic

Blog Post

Building positive incentives: the potential of coalitions for sustainable finance

We need to move towards more sustainable, long-term thinking in the corporate and financial worlds. Coalitions of willing actors could play a role in driving this process. But what makes for an effective coalition, and how can this be measured? The authors assess existing coalitions for sustainable finance and business, and argue that well-functioning coalitions can positively reinforce social and government action.

By: Enrico Nano and Dirk Schoenmaker Topic: Finance & Financial Regulation Date: July 18, 2017
Read about event

Upcoming Event

Sep
7-8
09:00

Bruegel Annual Meetings 2017

The Annual Meetings are Bruegel’s flagship event. They offer a mixture of large public debates and small private sessions about key issues in European and global economics. In a series of high-level discussions, Bruegel’s scholars, members and stakeholders will address the economic policy challenges facing Europe.

Speakers: José Antonio Álvarez Álvarez, Agnès Bénassy-Quéré, Pervenche Béres, Jean Luc Demarty, Anna Ekström, Lowri Evans, Sandro Gozi, Peter Grünenfelder, Patrick Graichen, Reiner Hoffman, Levin Holle, Kate Kalutkiewicz, Steffen Kampeter, Peter Kažimír, Robin Kenselaar, Emmanuel Lagarrigue, Matti Maasikas, Steven Maijoor, Nathalie Moll, James Murray, Julia Reinaud, Carlos Sallé Alonso, André Sapir, Dirk Schoenmaker, Mateusz Szczurek, Marianne Thyssen, Liviu Voinea, Johan Van Overtveldt, James Waterworth, Ida Wolden Bache and Guntram B. Wolff Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Square - Brussels Meeting Centre
Read about event More on this topic

Upcoming Event

Sep
13
09:00

EU-China Economic Relations: Looking to 2025

This event will see the launch of a report on EU-China relations and discuss issues such as trade and investment, indusstrial cooperation and innovation and global governance

Topic: Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF More by this author

Essay / Lecture

Investing for the common good: a sustainable finance framework

Traditional finance focuses solely on financial return and risk. By contrast, sustainable finance considers financial, social and environmental returns in combination. This essay provides a new framework for sustainable finance highlighting the move from the narrow shareholder model to the broader stakeholder model, aimed at long-term value creation for the wider community. Major obstacles to sustainable finance are short-termism and insufficient private efforts. To overcome these obstacles, this essay develops guidelines for governing sustainable finance.

By: Dirk Schoenmaker Topic: Energy & Climate, Finance & Financial Regulation Date: July 11, 2017
Read about event

Upcoming Event

Sep
25
12:30

How can sustainable finance contribute to the Paris climate goals?

What is the role of sustainable finance in reaching the Paris Climate goals? What are the specific proposals towards this goal and which are the challenges facing the implementation of green finance?

Speakers: Peter Blom, Viktoria Dendrinou, Olivier Guersent, Catherine Howarth, Stewart James and Dirk Schoenmaker Topic: Energy & Climate, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Oct
20
09:00

EU-Turkey energy and climate dialogues

This event is part of the joint Bruegel-IPC initiative European Neighbourhood Energy and Climate Dialogues.

Topic: Energy & Climate Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

The US 100% renewables dispute

What’s at stake: Two years ago, a debate started on whether it would be feasible for the US to achieve 100% renewable energy power. The arguments on both sides have been fierce, and more has been written recently. We review the debate.

By: Silvia Merler Topic: Energy & Climate Date: June 26, 2017
Read about event More on this topic

Past Event

Past Event

Renewing the 2050 Roadmap

The objective of this brainstorm session is to explore how we can improve the quality and the impact of the revisited 2050 Roadmap, set the agenda for revising it, increase ownership of it and analyze the methodological basis of the 2050 Roadmap.

Speakers: Georg Zachmann Topic: Energy & Climate Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 22, 2017
Read article Download PDF More by this author

Parliamentary Testimony

European Parliament

Combating inequalities as a lever to boost job creation and growth

This presentation was delivered in Brussels at the Employment and Social Affairs Committee (EMPL) of the European Parliament on 29 May 2017.

By: Zsolt Darvas Topic: European Parliament, Testimonies Date: June 20, 2017
Read article Download PDF

Policy Contribution

How to handle state-owned enterprises in EU-China investment talks

Chinese state-owned enterprises (SOEs) are one of the main obstacles preventing China and the European Union from agreeing a bilateral investment agreement. Creating barriers to prevent Chinese companies acquiring European assets will not solve the problem, but bringing Chinese corporate governance closer to global market principles will be essential to ensure European and Chinese corporates operate on an equal footing in their cross-border investment decisions.

By: Alicia García-Herrero and Jianwei Xu Topic: Global Economics & Governance Date: June 19, 2017
Load more posts