The six trends transforming finance for a sustainable economy
28 May 2020 – Alice Chapple, Course Convenor on the new Sustainable Finance online short course from the University of Cambridge Institute for Sustainability Leadership (CISL), explores the trends that are emerging in the world of finance, from the need to manage climate change risk, to responsible investment and harnessing big data.
The world of finance is changing. Since the financial crash in 2008, there has been a slow but steady move away from traditional finance models, as the value of embedding deeper approaches to social and environmental issues has become increasingly clear. Now, the world has taken a shocking blow from the Covid-19 pandemic. The tragic deaths, lost livelihoods, and curtailed freedoms are unprecedented, and no-one can tell how or when the global economy will recover from a downturn of this speed and scale. As we tackle one of the biggest global crises of our time, and look to rebuild in a way that ensures we emerge from this stronger and more resilient, sustainable finance – in other words, finance that takes account of positive and negative social and environmental factors, particularly the factors that tend to play out over the medium to long-term – will be more critical than ever.
Driven by global sustainability challenges, organisations have the opportunity to transform business towards a sustainable economy, creating better value for both society and business. Demand for leaders who can guide their teams through the pressures facing the current financial system is rising, as trends in sustainable finance continue to emerge and develop.
What are the trends driving sustainable finance now, and how are they likely to evolve?
1 Climate change and biodiversity risks
In late 2019, the World Economic Forum concluded that the two greatest global risks arise from extreme weather and the risk of climate action failure. Climate action failure was also rated the greatest risk in terms of impact, with biodiversity loss close behind. (Pandemics had featured in the high-risk categories in recent years, and many scientists have been consistently highlighting the clear and present danger, but few anticipated the devastation caused by the combination of healthcare implications and economic fallout.)
Over the last few years, bankers, insurers, and investors have begun to realise that climate change is much more than an environmental issue, and that it has deep implications for all sectors of the economy. Insurers have been hit hard by extreme weather events; the valuation of coal companies has plummeted as the transition to renewable energy sources picks up pace; and extreme weather events are affecting supply chains in all sectors.
The current Covid-19 crisis has made it clear that no-one is insulated from disasters. They can wipe out years of financial gains on investment in a matter of days, and they can have effects on the wider economic system that can last for years.
The impacts of extreme weather events caused by climate change or of biodiversity loss could be even more devastating. These environmental megatrends require an accelerated and scaled-up response across the finance sector.
2 ESG and resilience
Changing the direction of investments now towards low-carbon and sustainable options will help to prevent some of the worst outcomes of these risks. In-depth assessment of the social and environmental factors that affect investments will help investors to make better decisions. ESG investing (that is, investment where environmental, social and governance aspects are identified, mitigated, and managed) has been growing strongly over the last decade. This development is largely because effective management of high-impact risks such as climate change, biodiversity loss, growing inequality, and poor governance is recognised as an increasingly important part of a high-performing and resilient portfolio.
The shock waves created by the Covid-19 crisis have further emphasised the vulnerability of the global economy, and how important it is that companies and investment portfolios increase their resilience. It’s too soon to be definitive, but early indications are that investors with a focus on ESG have fared better through the Covid-19 crisis than those without. Their investee companies have tended to be more resilient in the downturn because their products and processes are designed to take economic, social, and environmental factors into account.
Increasingly asset managers, who have a fiduciary duty to manage funds for asset owners in a way that delivers the best outcome for the asset owners, will be accused of failing in their duty if they don’t take ESG factors into account.
3 Impact
Managing the environmental, social, and governance aspects of investments reduces the financial risk as well as the risk to people or the environment, and evidence shows that strong ESG analysis underpins resilient financial performance. However, it’s important to note that investors, increasingly aware of the importance of social and environmental issues, want to be confident that their investments are doing no harm, and they would be prepared to take a lower return if necessary to ensure that is the case.
Some investors are looking not just to manage risk but also to have a positive impact. They want to know how and whether their investments help to deliver the UN Sustainable Development Goals.
The trend towards greater impact investment (where an investment is deliberately designed to create a positive impact) is therefore likely to play out in different ways for different types of investors. Some, who are keen to find new ways to deliver impact for society and are prepared to take some risks, may explore new and pioneering ways to invest for impact. Other investors may look for investments where impact and return can be combined.
In all cases, investors will demand more information on the positive and negative impact of their investments. Financial institutions will need to be in a position to respond.
4 Big data and AI
Both the awareness of risk and the desire for impact is leading to a demand for social and environmental data that can be used to inform financial decisions, as well as report on impact. Financial organisations that can gather, analyse, and use big data to understand the most important social and environmental trends and company performance will be able to outperform their peers.
Blockchain provides a way to ensure that the data is robust and verifiable. Artificial intelligence will also have an important role to play, but the pressure will be on for financial institutions to ensure and demonstrate that AI is deployed in a way that will drive improved or fairer outcomes for society and the environment. Where financial institutions use AI simply for algorithmic trading or for biased selection of customers for credit or insurance, it’s likely that their reputation will suffer.
5 Digital inclusion
Digital solutions will have an important part to play in making finance more inclusive. Although access to finance is not an end in itself, it can be an enabler of opportunity and a determinant of resilience for the most vulnerable people in the world. The growth in digital finance, if accompanied by other appropriate forms of support, to create jobs, increase incomes, and provide access to energy and other infrastructure, could kick-start a virtuous circle of increased growth in the poorest countries.
Covid-19 has highlighted the existing gap between those who can access education, consumer goods, markets, workplaces, healthcare, and finance through digital means and those who cannot. Digital inequality, both within nations and between them, needs to be addressed.
6 Financial innovation
The financial crisis in 2008 revealed some parts of the financial system to be self-serving, with innovations providing no benefits to society. Since then, however, new and innovative financial instruments that can be deployed to address social and environmental challenges have been on the rise. A recent report from CISL’s Banking Environment Initiative examined how banks can transform how they do business in order to help accelerate the transition to a low-carbon economy, not only with new products, but also with new models for working with their clients.
Sustainability bonds and green bonds raise funds for specific social and environmental uses, and are a valuable part of the sustainable finance portfolio. Social impact bonds and development impact bonds can ensure that governments and other donors encourage private sector investment into activities with a high social return. Forms of blended finance are also on the rise, where the public and private sectors invest together with a suitable combination of financial risk and social or environmental return.
Portfolio construction by pension funds will increasingly include an allocation to impact investing. This will help to diversify the current portfolio while also providing a way of supporting activities that are likely to deliver a better society and environment for pensioners to retire into in the future.
The new Sustainable Finance online short course from CISL provides insight into the ways that bankers, insurers, investors, and others in the financial system are rethinking how they provide finance for the economy, to reduce risks, and improve the value of their portfolios. The course explores the approaches that are needed to assess and value companies in a way that takes deeper account of social and environmental factors.
Building on CISL’s commitment to developing leadership and solutions for a sustainable economy, and its experience in driving change across the finance sector through the Centre for Sustainable Finance, this new online course explores sustainable finance strategies, as well as practical examples for how individuals and organisations can deliver meaningful change through sustainable approaches.