Financing the Future
Nick Robins (British, born 1963) is a sustainable investor and business historian. He has worked on the policy, business, and financial dimensions o sustainable development for the past twenty years and is author of The Corporation That Changed the World: How the East India Company Shaped the Modern Multinational and coeditor of Sustainable Investing: The Art of Long-Term Performance.
The past forty years have become known as the era of financialization. During this time rising incomes, deregulation, and technological innovation delivered a massive growth in capital markets. But it also delivered widening inequality, increased market volatility, and facilitated the continued liquidation of natural assets.
The global financial crisis that started in 2007 has revealed that the world does not behave according to the stylized notions of conventional economics and finance. Individuals are not all-seeing, self-regarding “rational” automatons; fairness, for example, is a powerful motivator of human behavior, along with personal aggrandizement. Markets are also not the arena of efficiency and equilibrium that underpin modern financial practice and regulation. Income inequality—driven in part by the expansion of performance related pay (e.g., bonuses), led by the financial sector—has emerged as a major source of financial fragility.8 The spectacular growth in derivative markets is a case in point. Many had assumed that derivatives would bring greater market stability as complexity increased. In fact, derivatives acted as a risk magnifier in the crisis. Andrew Haldane, director of financial stability at the Bank of England, has said that finance has “shown itself to be neither self-regulating nor self-repairing. Like the rainforests, when faced with a big shock, the financial system has at times risked becoming non-renewable.”
This inherent instability of the financial system is clearly problematic. But more worrying from a sustainability perspective is the “missing planet problem”—the disappearance of what was traditionally known as “land” and now termed “natural capital.”
Modern financial theory assumes away the resource base—and therefore implies that an inexhaustible stream of ecosystem services will continue to underpin economic growth. Natural capital is missing from both corporate and national balance sheets, making conventional investor projections of output and growth acutely vulnerable to the shock of the real. In spite of the growing awareness of the threat of climate change, for example, it is just dawning on financial markets that only a fraction of what is currently considered valuable assets—oil, gas, and coal reserves—can be exploited. The continuing (mis)allocation of capital into fossil-based assets potentially dwarfs the subprime housing bubble, with the looming prospect of stranded assets and further contractions in the value of pension funds.
The net result is that financial markets are both a brake and an enabler on the road to sustainability. Financial short-termism is legendary.
As John Maynard Keynes observed in 1936, “It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism wherever investment funds are managed by committees or boards or banks.” As a consequence, Keynes advised that “it is better for [one’s] reputation to fail conventionally than to succeed unconventionally.” Powerful institutional and intellectual forces for inertia remain in place. This does not bode well for a change that would make financial markets become one of the main drivers of sustainable development long before 2052—as I believe they will.
So why am I so confident that a shift will occur? The first reason is that a growing minority of market practitioners recognize the limitations of twentieth-century conventional wisdom—and are implementing policies and systems to change how they operate. From almost nothing in 2006, over USD 25 trillion in assets now supports the UN Principles for Responsible Investment (UN PRI), a voluntary initiative that requires signatories to integrate environmental, social, and governance factors into their decision making. Real-world evidence already shows that sustainable investment is a better way of delivering risk-adjusted returns.
By nature, many institutional investors have to have a long-term outlook in order to deliver pensions and insurance far into the future.
But the prevailing focus on short-term profits has masked this strategic perspective. The surge in commitment that led to initiatives such as the UN PRI arose from the failure of financial markets to succeed on their own terms. It was supported by rising acceptance that conventional risk analyses were unable to deal with new, long-term, system externalities such as climate change. The UN PRI and similar investor-led initiatives provide a latent support for more structural solutions, including regulation to confront the continued mis-pricing of natural capital.
The second reason why I think we will see a shift in financial practice flows from the dawning realization that the major constraint to the green economy is financial—and poses no insuperable obstacle. For instance, renewable energy operations are generally capital-intensive, requiring large injections of up-front investment in technology, but then they are considerably cheaper to operate. Energy efficiency invariably involves up-front costs, paid back through energy savings in the future. Until recently, the investment community was a missing stakeholder in sustainability negotiations. But this is changing as investors seek long-term assets that match their liabilities, and as governments look for injections of capital into the green economy that can replace loans from the overstretched banking sector. By 2020, I believe that new packages of policy support, regulation, and financial innovation will have become routine. For example, large-scale building-retrofit programs will be operating in all major cities, with investors receiving returns linked to the energy savings, most likely in the form of fixed-income bonds.
A much more difficult process will be how public policy and capital markets address the reality of unburnable carbon—fossil fuel assets currently viewed as wealth. Financial crises occur when markets realize that what was previously regarded as a solid asset has dissolved. In the dot-com crash, the asset was overvalued technology stocks; in the credit crunch, the asset was overvalued property, particularly subprime housing. In the carbon transition, the asset will be overvalued fossil-based companies. The task for financial regulators charged with managing systemic risks to the markets will be to take away the punch bowl of fossil-fuel assets before the bubble bursts.
The third reason why change will occur is that governments and society will no longer be willing to give capital markets the benefit of the doubt. As with other fundamental sectors of the economy— such as agriculture and energy—the public now realizes that finance is heavily dependent on government regulation and subsidy for its continued existence. This subsidy includes not only the devastating cost of bailouts during crises, but also the routine underwriting of bank accounts and tax relief for individuals who save. At present, no sustainability requirements are attached to these transfers from the public purse. But that situation cannot and will not continue. In the UK, for example, the total government subsidy for pension savings is more than four times that for agriculture. By 2020, for example, I expect that pension subsidies will be provided only for funds that support the green economy. Other funds may well still exist but will no longer receive tax relief.
The vexing issue of remuneration and bonuses will also be resolved as a result of changing social expectations. The public is starting to realize that these are threat multipliers, increasing underlying financial volatility, and also perform a highly limited role in improved productivity and performance.
Foresight is not a particularly well-developed muscle in the human character. But apprehension about the future following from lived experience can overcome inertia. I believe that the convergence of the enlightened self-interest of long-term investors, the marriage of sustainability and financial policy via hard regulatory change, and the recasting of societal expectations will mean that capital markets will become a driving force for sustainable development long before 2052.