Capital providers, and those who regulate them, can jointly consider how to reflect social and environmental risk factors in the cost of capital.
The cost of capital is a key factor in business decisionmaking. It is influenced by multiple drivers that interact with one another, including the business strategies of individual capital providers and the requirements set by regulators. Ultimately, the assessment of risk and return that underpins cost of capital calculations dictates how capital is deployed and hence which business activities are able to flourish.
Today, the cost of capital rarely reflects the true costs of business activities across equity, debt and insurance. This means that one of the key drivers of business decisionmaking is at best sending unhelpful signals to companies, and at worst allowing important risks to society to accumulate in the longer term. This danger is already being recognised by some central banks and financial regulators, who, for example, are asking whether the by-products of unsustainable economic activity, such as climate change and income inequality, could threaten financial stability.
Some individual capital providers are identifying strategies that enable them, on a unilateral basis, to reflect more closely the true costs of business activities in their cost of capital. For example, some banks require customers to meet certain environmental, social and governance (ESG) standards as a condition of business, while some investors integrate these considerations into their asset choices. These efforts need to be brought front and centre of financial institutions' thinking, enabled as necessary by fiscal, monetary and regulatory interventions.
Though they are regarded by some to be simply good risk management, how consistently are they being applied, and how visible is this to business?