The financial sector clearly has a major role to play in the global transition to net-zero greenhouse gas emissions yet, despite some progress, substantial barriers remain. Positive momentum has been building over the past decade and defining climate change as a real financial risk, which had to be included into fiduciary mandates, has been a big step forward - but change is not happening fast enough.1
The current ways of working of the finance industry are proving an obstacle to the transformational change required to combat climate change. Thorny questions still require answers about the purpose of the investment system and the changes required to achieve the redirection of capital that the climate crisis urgently requires.
Who’s responsible for holding financial institutions to account?
The current fragmented nature of the industry breeds misalignments of interests across the investment chain.2 Financial agents often have different interests which can create incentives to exploit information asymmetries and create obstructions for longer term capital allocation.3
Furthermore, since asset managers act as agents for their customers, often making investment decisions on their behalf, conflicts may arise between different customers or between firms and customers who have different views on social and environmental issues. As outlined in a 2013 CFA position paper, managing conflict of interests is key to encouraging more ethical and standards-aligned behaviours.4
Consumers, too, are often excluded from decision-making over their investments and have a limited role in keeping financial actors accountable. There is confusion over consumers’ options and protections with technical terms such as ‘asset allocation’ creating barriers to confident decision-making.56 This contributes to a system where individual savers are disempowered and decisions are often made on their behalf based on default and traditional assumptions.
More needs to be done to find ways to empower the consumer's voice and rely less on flawed assumptions that focus purely on financial return. Making financial education more accessible can allow more people to understand the range of financial products available and enable them to apply their values to their investment decisions.
How to evaluate success?
The current measures of success across the financial system often incentivize short-term financial returns over long-term sustainable value creation.7 Rethinking what good performance truly means could help to better establish incentives that drive the right behaviour.
Short-term benchmarked results are spotlighted as the measure of success for a fund often at the expense of pursuing long-term sustainable investment outcomes with typical pension funds chasing returns over three to five year horizons to the detriment of long-run wealth.8
The focus on benchmarking can restrict alternative investment strategies and cause product innovation to stagnate. Integrating environmental considerations into benchmarking strategies can improve long-term thinking and can allow for broader objectives, such as carbon reduction, to be better defined and measured.
In the current system, there is a strong focus on the continuous demonstration of growth and profitability. Yet to support the scaling-up of the new industries and business models that can deliver a sustainable economy, investors are needed who have no expectation of turning a quick profit. Investors who are willing to substantially increase their time-horizons for seeing impact, like those at British Patient Capital, could help to finance the changes needed to tackle the climate emergency.
How to measure risk and return?
If framings of risk and return are too narrow, they can prevent sustainable principles from being fully reflected in investment decisions. Risk measurement determines the asset allocation strategy, the objectives of the investment mandate and the freedom that fund managers have. Yet the way financial sector actors evaluate risk often excludes key elements such as environmental interactions and deeper societal uncertainties.9 This has a double negative impact of allowing continued investment in activities that drive systemic risks while blocking investment in those that generate long-term and sustainable financial returns alongside broader social values.
A short-term view of risk and return measurement also orientates the system away from long-term productive investment. In seeking to maximize short-term earnings, investors and corporates in fact increase system risk.10 But there remains no common approach for how to fully incorporate the broader risks of certain actions and inactions such as the risks of not investing in sustainable energy generation. Deeper uncertainties cannot always be translated into short-term risk metrics and so alternatives need to be found. Using scenarios to explore the range of plausible, and desired, outcomes could be helpful.1112
Siloed accounting frameworks can also prevent participants in the financial value chain really understanding the impact of capital flows. Without broader accounting metrics –which include a full understanding of different types of capital, for example, human, natural and social – actors lack the information they need to inform their decisions on important issues and support long-term value creation.13
Indeed, the development of impact-weighted financial accounts will be a cornerstone for the large-scale deployment of capital to meet sustainability goals.14 Promisingly, there are some accounting reforms underway. For example, the IFRS Foundation, the body that oversees the work of the International Accounting Standards Board, is designing a new board for setting sustainability reporting standards.15
What solutions does technology offer?
Technology development offers opportunities to disrupt the investment industry and reconnect end beneficiaries with the impact of their investments. Investment platforms that cut out a lot of the middlemen, for example, reduce the fee-driven incentives that contribute to conflicts of interest within the investment chain. Organization, such as OpenInvest, allow clients to hand-pick equity portfolios that meet their return objectives while screening against environmental, social and governance indicators.
Technology can also help in delivering greater clarity and empowering consumers to engage more with their funds. Automated management and advice platforms, such as FutureAdvisor, can give consumers access to information on emerging trends and data-based recommendations for their own investment goals.
More non-financial data should help in overcoming risk-avoiding behaviours and evaluating real impact too. A challenge for many investors, both retail and institutional, is a lack of data and disclosure by companies. Where data is made available, there tends to be a high level of sustainable investments1617 while disclosure also helps to keep financial institutions more accountable. To meet the rising demand in the market and channel significant capital towards more sustainable options, data on real-world impacts should be a fundamental decision-making element rather than an optional add-on.
Should investors’ duties be redefined?
It is generally accepted that re-orienting the fiduciary duty discipline is vital to pivot investments towards the long-term and support sustainable activities – and moves in this direction are already underway. Over the past few years, The Principles for Responsible Investment, the UN Environment Programme Finance Initiative and The Generation Foundation have done pioneering work to clarify investors’ obligations and duties to incorporate environmental issues into their decisions.18 Signatories to the Principles for Responsible Investment continue to grow, reaching $103.4 trillion signatory assets under management in 202019, a sign that environmental and social considerations are becoming more important for investors.
Incentivizing innovation and creating space for experimentation with more radical, yet sustainable and long-term, investment decisions could speed up system change. Innovative accounting frameworks could enable all participants in the value chain to really understand how capital is being used.20 Institutional asset owners, including pension funds and universities, could also drive transformation, setting new types of benchmarks for asset managers and enabling more tested innovation into the system.
There is a role for regulation too. Regulators, together with policymakers, have the capacity to create a regulatory environment that supports experimental financial approaches, provides a clearer direction in line with sustainability goals and fosters shared beliefs about our common future. There are positive signs, not just in the UK and the EU, but also in Japan, Korea and Malaysia. For example, the World Bank and the Malaysian Securities Commission are developing principles to guide the Malaysian green taxonomy and help Malaysia’s financial sector to classify green assets more transparently.21
Rebalancing financial and social values
Ultimately, a proper discussion about value is needed and on the investment system's goals. Only by challenging this, can it become possible to enlarge the current definition of ‘returns’ to incorporate the essential non-financial factors that will enable a sustainable future for the whole society.
With so much potential for transforming the sector and embedding sustainable practices, diversity and inclusion are needed in the sector to bring a wide range of views and to integrate principles of equity and justice in the future. A constellation of people, policymakers and businesses from both within and outside the finance sector can create a diversified environment where fairer decisions and collaboration may take place.2223
2021 is the time to accelerate the journey towards a financial system that supports and enables a net-zero economy. Rethinking what prosperity means in a world of environmental, social and economic limits is an urgent task. Without redefining the purpose of finance and rebalancing finance with broader values, it will not be possible to shift the financial system towards one that delivers financial security in a world worth living in.
This event summary was informed by a webinar and workshop hosted by the Chatham House Sustainability Accelerator and Financial Systems Thinking Innovation Centre (FinSTIC) which brought together the climate and finance community to discuss key challenges and opportunities to understand how financial systems could meet the needs of the society, the economy and the environment.