How to Create a Financial System Where People and Planet Flourish?
The financial system could generate positive social and environmental impacts by driving the transition to sustainability while creating a fairer world. But, right now, it’s not doing enough.
Research Topics Finance With Purpose
A man rides a bicycle along a street at the Raffles Place financial business district in Singapore in 2021. Image: Roslan RAHMAN via Getty Images.
Does the investment industry have a very positive impact on society and the environment? Only 11 per cent of investment leaders thought so.1 But it could be harnessed to support the technologies that will bring about a fair and prosperous society while respecting planetary boundaries. But, in order for this to happen, a thorough reshaping of the system is needed.
The investment status quo is increasingly at odds with the growing societal shift towards climate awareness and demands for sustainable long-term investments. Changes in demographics, the political economy, regulations and maturing markets are playing out in preferences for sustainable investment options.23
Actors within the financial system are beginning to expand their approach to sustainability in ways that were niche even a decade ago such as by adopting principles of generating positive impact beyond just financial return.4
Yet these positive steps will remain incremental unless structural and systemic barriers are addressed and the world rethinks the purpose of finance. The interconnected challenges facing communities across the globe, from the COVID-19 pandemic and the increasing impacts of climate change to the mounting debt crisis, are all pushing sustainability concerns to the forefront. While societies reassess the resilience of their economies, there’s a clear window of opportunity to question how the finance system will serve us in the long term.
Change needs to happen faster
The ways in which financial institutions are addressing climate change have evolved at pace over the past decade spurred by the recent focus on climate as a material financial risk, for example, through the work of the Task Force on Climate-related Financial Disclosures.
The sector’s understanding of the importance of considering environmental, social and governance (ESG) factors in investment decisions is increasing dramatically evidenced by the doubling in value of assets applying ESG data to drive decisions over four years to reach $40.5 trillion in 2020.56
The wave of net zero greenhouse gas emission commitments being made by businesses, governments and financial institutions is adding to the momentum. As of December 2020, an estimated 61 per cent of emissions, 68 per cent of GDP and 56 per cent of the global population were covered by national net zero commitments.7
But there remains a lack of capital for the business models and activities needed for the transition to sustainability.8 The increasing use of ESG criteria in investment evaluations is positive but it remains focused on a risk-centred negative screening approach9 which will not provide the scale of investment needed to create an environmentally-secure and equitable world.
Acceleration pathways
Impact investment – investing with the intention to generate positive social and environmental impacts as well as a financial return – is growing. Dedicated impact investment funds more than doubled from 2018 to reach $715 billion in 2020 but still remain a fraction of total assets under management which totalled $104.4 trillion at the end of 2019.10,11
A growing number of more conventional institutions are also beginning to step into the impact space, for example, many major financial players have dedicated products specifically to ‘impact’ including Bain, Citi Group, Goldman Sachs and Credit Suisse.12
But there’s a risk that unless the move towards impact investment happens in tandem with the development of standards and accountability, financial companies will 'impact-wash' and overstate the benefits of their product or service, and attempt to pass them off as more impactful than they are.13
Impact should therefore not be treated as a separate type of asset class or ring-fenced pot of money. Rather it should be an approach that is transparent and embedded in all investment decisions across the whole institution.
Clear and common standards are needed so that investors and others can hold companies to account and ensure that impact funds deliver what they promise.
But, for this to happen, several structural barriers need to be removed on the supply-side of financial capital, if not, efforts to channel more finance to companies with purpose will remain restricted.
Misalignment of interests across the investment chain can also mean that those making investment decisions can be remote from individual savers and, ultimately, from the needs of society.
Indeed, the business models and measures of success of financial institutions drive harmful short-termism which is compounded by too narrow definitions of risk.14
In light of this, financial actors need to find new ways of doing things that step beyond the incremental fixes currently being relied on, moving beyond ESG to a new paradigm with sustainability at its core. In order to accelerate this change, three things can help:
- Re-aligning institutional governance and incentives with societal value.
- Developing fit-for-purpose tools and metrics.
- Cultivating a paradigm shift.
Torre Unicredit and solar tree in the business center of Milan. Image: Giovanni Mereghetti/Education Images/Universal Images Group via Getty Images.
Aligning with society’s values
Decision-making in the investment sector can be opaque even for those within the industry. The large number of actors across the investment value chain means there can be a disconnect between the consumer and where their money is ultimately invested. Indeed, long and complex chains of financial intermediaries, all with different incentives, are prevalent, especially when investing for the long-term.15,16
Understanding what motivates actors within mainstream investment chains, therefore, is key if we are to drive a shift to more sustainable investing. But a wide range of incentives will be required to achieve change across diverse institutional and individual governance structures.
Shifting beyond a focus on benchmarks will also be crucial to overcoming harmful short-termism. Indeed, research finds that typical pension funds chase returns over multi-year horizons to the detriment of long-run wealth.17
Short-term financial performance benchmarks have become a pervasive proxy for success with strategies, recruitment and business models all based on them. Finding new indicators that capture the wider impact of financial activities could help re-orient investment strategies towards deliberate and tangible positive impact in the longer-term.18
In the current system, many individual savers have become disempowered, uninformed and unable to invest according to their own objectives. In fact, individuals often cannot access investment markets directly and so rely on financial advisors and asset managers to do so on their behalf. But these actors may prioritize other objectives.19
Fit-for-purpose tools are needed
In addition, financial tools in use today don’t adequately address the growing systemic risks of climate change and the uncertainty this brings.20 Financial models used across the insurance and pension chains, for example, are often designed to deal more with volatility rather than deep uncertainty. But a system dominated by short-term criteria cannot evaluate the long-term changes, uncertainties and investments that are needed to tackle climate change.
Establishing and mainstreaming a new suite of financial tools and models that can incorporate systemic risks is therefore a high priority. But quantifying the possible interactions of investment choices that either create systemic risk, or mitigate it, has proven challenging.
Importantly, the necessity of valuing natural capital is climbing the agenda, with the publication in February 2021 of The Dasgupta Review – commissioned by the UK Treasury – was a landmark. It called for governments to embrace a new measure of ‘inclusive wealth’, measuring how the well-being of current and future generations is being protected by combining the accounting value of produced capital, human capital and natural capital.21
A volunteer cleanses the mangrove seedlings that start to grow on the Mertasari coastline. Planting mangroves protects coastal ecosystems in the region. Image: Basri Marzuki/NurPhoto via Getty Images.
New shared language
Ultimately, the biggest question is what the goal of the investment system should be. Is it just about generating financial returns for investors or should it be more than that?
A shared global language is needed to foster agreement on common goals among financial institutions. Galvanizing leaders around a common vision of creating positive impact as a central tenet of investment could help to unify actors and embed additional motives beyond maximizing returns. This will also help to overcome the fragmented and varied structures both within, and between, financial institutions.
To have a hope of creating a world in which people and planet flourish, the norms on which the rules of financial activity are based need to change. There are promising signals that this is beginning to happen at scales beyond financial institutions themselves, with consumer behaviour and political choices reflecting a more climate-conscious society.
Moving ahead
A new roster of ideas for how to shape an investment system that delivers for society is needed. Applying systems thinking to the world of investment can help to make sense of the complexity and bring fresh insights into what needs to be done to make capital support an equitable and carbon-neutral world. Innovation will be key and needs to be incentivized across all parts of the finance system and the system needs to be overseen and supported by a regulator that understands that innovation takes risks, that pioneers need the space to innovate and that diversity means better decision-making.
Increasing the pace of learning in the system will be crucial. This challenge is still open and there is a role to play for every actor along the investment chain.