Sustainable finance requires a change in incentives

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Hurricane Harvey's trail of destruction is just one example of a fierce weather event whose financial burden will outweigh the cost of preventing climate change in the first place. [AMFPhotography / Shutterstock]

Hurricane Harvey’s trail of carnage through Houston, the oil capital of the US, was a stark reminder of the effect that climate change can have on our economy, writes Peter Blom.

Peter Blom is the co-chair at Sustainable Finance Lab and CEO of Triodos Bank.

Detached as parts of the financial sector may feel from society, the impact of uncontrollable climate change threatens to severely impact and destabilise the whole of finance, which is ultimately and inextricably linked to the economy it is meant to serve.

The costs of limiting climate change to the globally agreed goal of well below 2 degrees are much lower than the damage done by a further increase in global temperatures. The extra €180 billion needed, annually, for the next twenty years, to make the European economy sustainable is unquestionably a lot of money.

It is however much less than the costs of doing ‘too little too late’. The cost of Hurricane Harvey’s damage alone is estimated at $180 billion.

So what needs to be done? The High-Level Expert Group on Sustainable Finance (HLEG), installed by the European Commission, in its interim report made the right analysis. It pointed to two crucial misalignments in the financial sector: a time horizon that is too short; and an inappropriate conception of risk, generally turning a blind eye towards ecological risks.

Unfortunately, the early recommendations almost exclusively focus on increasing transparency. Here the report falls dangerously short. Because more transparency by itself will not bring the Union the €180 billion a year of sustainable investments it so urgently needs.

For that, we need game changers that go to the heart of finance. We need to change the incentives that drive behaviour in banking and investment: by tackling capital requirements and investment mandates.  These ideas, already discussed by the HLEG, should become part of the recommendations to be delivered to the European Commission in December.

Nothing drives the behaviour of bankers as much as the regulatory capital requirements. Requirements which currently almost totally neglect risks related to ecological stress.

Whether the risk of floods like with Harvey, or the risk of companies that have gambled on a fossil future, investing in gas guzzling cars instead of electric models. These sustainability risks should be reflected in the capital regulation if this is to reflect the true riskiness of assets.

This can be done through either supervisors using their discretion to increase capital requirements when they detect increased risk due to large exposures and portfolio concentration on ‘brown assets’, or with a general capital charge for ‘brown’ activities and if applicable a discharge for ‘green’.

To change the incentives in the investment chain the key lever to pull is that of the contractual agreement between asset owners and asset managers. Many asset owners, like pension funds, have in recent years adjusted their investment beliefs, declaring they want to be long-term investors and that they believe that environmental, social and governance drive risk and return.

However, so far the changes in the mandates, the contracts that steer behaviour in asset management, have been rather limited. Who dares to be the first? To set the new norm in asset management?

Sustainable model mandates can help individual asset owners to overcome the fear of what should become the new normal in asset management.

These model mandates contain the requirement of full integration of environmental, social and governance factors in investment decisions, active engagement and voting on these issues, the choice of sustainable benchmarks, less frequent but more meaningful reporting by asset managers and a long-term oriented fee and pay structure.

This is financially sound as sustainability issues will increasingly drive financial risk and return. But it is also what the asset owners, like pension beneficiaries, want. A liveable world for their children and grandchildren. That is not a ‘soft wish’ but increasingly a ‘hard reality’.

In its mid-term review of the Capital Markets Union, the European Commission rightly noted that ‘a deep re-engineering of the financial system is necessary for investments to become more sustainable’.

The experts have put on the table the right analysis underpinning the need for such a deep re-engineering. If they now also provide the recommendation that will make this a reality the Union will be able to play its part in preventing a disastrous global climate change.

That’s where the interests of society, the real economy and finance meet. For this, the HLEG recommendations need to go beyond increasing transparency, we need to change incentives as well.