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Mainstreaming sustainable finance part 2: reasons for optimism?

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My last article attempted to clarify what we mean by ‘mainstreaming’ sustainable finance and lamented how an echo chamber prevents an objective assessment of the progress we are making to align the financial system with sustainability. The implication is that there is much more hype than progress and we still have a lot more to do.

Here I identify three shifts among financial institutions that are real and meaningful, as well as highlight how the financial system has the capacity of changing remarkably quickly. These provide some reasons for optimism and suggest pathways to successfully mainstream sustainable finance at the scale and pace required given the environmental challenges we face.

First, by showing sustained interest in stranded assets caused by climate-related risks, the Bank of England and other regulators have forced functions within financial institutions that were not previously engaged on anything to do with stranded assets to now become engaged. For example, Solvency II requires every insurance and reinsurance firm operating in the UK to conduct their own risk and solvency assessment (ORSA) and to submit this to the regulator for approval to be licensed to operate. With the Bank of England’s thought leadership on climate change it is likely to be the view of insurers and reinsurers that their ORSAs should include some reference to climate-related risks to avoid the possibility of their ORSAs being rejected or further interrogated. This is because it is reasonable to assume that there would now be efforts to integrate climate-related risks into Bank of England supervisory practice. This moves assessment of stranded asset exposure from the category of being entirely optional into something that is now potentially fundamental to securing regulatory approval to operate.

Second, the involvement of central banks and regulators has also helped to shift the terms of the dialogue within financial institutions. It has been the norm in many institutions for ESG specialists, or those with a direct interest in sustainable finance topics, to ‘sell upwards’ to their senior management. This means they identify topics or ideas that are likely to be approved by their superiors – which inevitably means that some topics or ideas are rejected and that the ambition of what is sold up is lower than they might want to secure internal support. In most organisations this inevitably places a premium on low cost, uncontroversial, and non-disruptive proposals. These may also be the least effective proposals for the integration of environment-related risk and opportunity into investment decision-making.

This situation could now be changing. One thing that I have noticed, particularly in the run up to the Paris climate change negotiations and in the period after it, has been CEO- and CIO-level engagement from many more financial institutions than has previously been the case. They can then instruct downwards and get their teams to implement what they have committed to voluntarily with their peers.

This is a new dynamic for many firms. 

Third, developments in the practice of managing environment-related risk and opportunity in investment portfolios are starting to catch up with the theory. There are significant new analytical possibilities. Existing data can be analysed using techniques involving artificial intelligence and machine learning, while new asset-level data can be made accessible from sources previously unavailable such as remote sensing and ‘big data’. These new frontiers are complemented with extant international efforts to enhance and improve the consistency of disclosures that can support the management of stranded assets (for example, the Task Force on Climate-Related Financial Disclosures and the Sustainability Accounting Standards Board).

These three shifts – the integration (real or anticipated) of climate-related risk into supervisory theory and practice; sustainable finance being driven by the c-suite not ‘sold up’ to senior management; and a period of rapid technical innovation driven by asset-level data and advanced analytics – are significant and could, with luck and further success, augur the rapid change urgently needed.

There are many instances of rapid change in the financial system. Many of the ‘permanent’ features of capital markets in terms of norms, practices, asset classes, and architecture are in fact quite new and became ‘standard’ very quickly. Here are a few examples that quickly became standard practice within one to two decades of being theorised or invented:

  • Modern Portfolio Theory (MPT) – 1950s
  • Capital Asset Pricing Model (CAPM) – 1960s
  • Asset-backed Securities (ABSs) – 1970s
  • Black–Scholes model for options pricing – 1970s
  • The Bloomberg Terminal – 1980s
  • Black–Litterman model for asset allocation – 1990s
  • Passive investment and Exchange Traded Funds – 1990s

There are, of course, many other examples. But these are sufficient to highlight that rapid innovation and then the dissemination and mainstreaming of such innovation is a feature of capital markets. Low barriers to replication, large incentives for replication, and highly connected clusters where information and knowledge are shared quickly in common languages (accounting, mathematics, and English) all make this possible.

The precedents are there for finance to change and to change in a big way. Mainstreaming substantive changes in investment practice at the speed needed is therefore possible. But we need to create virtuous cycles where shifts in the right direction are magnified and built upon. We also need to ride the drivers of mainstreaming in finance – creating things that can be readily and profitably replicated and focusing on key financial centres that drive widespread adoption.

This is part of a series of blogs on sustainable finance and investment by Ben Caldecott, Director of the Sustainable Finance Programme at the University of Oxford Smith School of Enterprise and the Environment and a Senior Associate at E3G.

This blog was first published in Responsible Investor.