The Inquiry’s 1st edition of ‘The Financial System We Need’ published in 2015 identified:
The Inquiry’s first generation of findings have been widely welcomed and reaffirmed through subsequent developments.
A ‘quiet revolution’ is under way in how the financial system is becoming aligned to sustainable development. This was the key finding of the first, two-year phase of the UNEP Inquiry. The Inquiry set out to identify policy and market actions that could be taken within the financial system to complement reforms in the real economy and public finance. Launched at the IMF/World Bank Annual Meetings in Lima, Peru in October 2015, the first edition of the Inquiry’s global report, ‘The Financial System We Need’, focused particularly on country leadership in innovating the rules governing the financial system, highlighting that:
The Inquiry highlighted steps that could be taken to encourage and systematize this growing practice, noting that action within the financial system could most effectively be built: (a) through collaboration efforts between private and public sectors; (b) involving action at both the national and international levels; and (c) complementing classic sustainable development policies, such as public financing and policies directly impacting the real economy. Key options for making this happen included:
The UNEP Inquiry’s first generation of findings have been widely welcomed and reaffirmed through subsequent developments, with many of the proposed next steps reflected in work-in-progress at both multinational and international levels.
“India has a huge opportunity to discuss the policy intervention required to drive the flow of sustainable financing and to align the financial system towards a sustainable development agenda. Several goalposts including creating awareness of the financial sector, developing common definitions of green finance indicators, developing green products, measuring progress and framework for assessing financial risks are critical for achieving this.”
R. Gandhi, Deputy Governor, Reserve Bank of India
Efforts to build a sustainable financial system have shifted to a new stage over the past year. What were once considered ‘niche’ applications are now becoming recognized as important – not just for the delivery of sustainable development, but also for the overall health of the financial system. In addition, market practice, policy and regulatory initiatives and public expectations are starting to combine at the national and international levels. This section highlights some of the key developments over the past year, focusing not only on the ‘what’, but also on ‘how’ these actions are blending together to achieve better alignment between the financial system and sustainable development.
One expression of this dynamic is the increasing significance of green finance – robust financial practices that support the regeneration of the environment. Green bonds show how issuers in the real economy, financial institutions, policy makers and standard setters can create new markets (see Figure 3). Green bonds, taken alone, are a means of raising capital by quite conventional methods to use for financing or refinancing green projects, from railways to clean energy, and from green buildings to land remediation.
Yet, green bonds are also part of a broader ecology of change. For example, leading financial centres such as London, Paris and Hong Kong, incentivized by the immediate prospect of capturing a slice of the rapidly growing green bond market, have launched strategic initiatives to become hubs for the growing green finance market as part of their wider plans for growth and competitiveness. Announcing its recommendations in May 2016, Hong Kong’s Financial Services Development Council stated, “if it does not seize this opportunity, others will do so.” Financial policy makers and regulators have also explored their role in terms of introducing market guidelines, standards and incentives needed to secure a piece of the green bond market. Furthermore, green bonds were one of the topics discussed under China’s presidency of the G20 in the Green Finance Study Group (see Box 4).
The current surge of activity builds on many preceding initiatives and market activities. Ethical and social investing goes back many decades. Such innovations set the scene for multiple developments along seemingly unrelated pathways. Ethical screening inspired the Equator Principles, the voluntary guidelines for environmental and social risk analysis in project finance. These in turn triggered leadership in banking regulatory action at the national level, exemplified by the China Banking Regulatory Commission’s Green Credit Guidelines. Such leadership has catalysed international cooperation, through UNEP Finance Initiative’s work with the banking sector and the IFC-hosted Sustainable Banking Network made up of regulators and associations in developing countries.
Ensuring consistency between the functioning of the financial system and the response to climate change has been another focus area. The Paris climate agreement has catalysed the convergence of previously separated drivers, actors, and financing sources, including international public finance commitments, strategic climate targets, rising public expectations about financial sector performance, and voluntary commitments from the financial community. Connecting the dots, unusually, has been civil society action, notably the well-advocated technical arguments about the risks of stranded assets by the Carbon Tracker Initiative and others. Such connections – combined with climate change’s higher policy goals and broader public profile – has stimulated the engagement of national financial policymakers and regulators. These include the Bank of England’s prudential review of climate impacts on the insurance sector and France’s requirement that institutional investors must disclose their management of climate-related risks and alignment with the global, regional and national low-carbon transition perspectives. Once again, this mix of actions has stimulated international cooperation, notably through the FSB’s pivot towards the consideration of environmental challenges.
In this dynamic and disruptive context, efforts to align the financial system with sustainable development will require a forward-looking approach. Making predictions about the future path of the financial system is a risky business, given its many likely twists and turns. Failing to take into account possible changes runs the risk of misperceiving opportunities that are in reality on the wane, or missing potential because it is not yet manifest in the mainstream of the financial system. Many of today’s sources of momentum have emanated from yesterday’s marginal activities, and from hitherto marginal actors.
“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next 10. Don’t let yourself be lulled into inaction.”
Bill Gates, Co-Chairman of the Bill and Melinda Gates Foundation
Systemically important innovations can also be made in the governance of the financial system itself. How best to align the financial system with sustainable development depends in significant part on how the governance of the system evolves. In the first edition of the Inquiry’s report, ‘The Financial System We Need’, a number of future governance scenarios were developed with OECD support. These mapped the possible contexts under which finance and sustainability needed to be brought together. One of the scenarios, ‘Technology Edges’ (Figure 13), highlighted the potential for technology-based disruptions to impact the financial system in two related ways – in reshaping market actors and financial services, and in shifting the dynamics between the market and its governance.
Although it is hard to say when, financial technology, or ‘fintech’, in combination with other innovations, will likely change the face of finance and its alignment with sustainable development. The use of fintech is not new, but the novel application of a number of technologies in combination is likely to reconfigure both financial sector business models, as well as the financial policies, regulations and market norms that have shaped modern financial practice. The impact of fintech on sustainable development to date has been an under developed area of research and dialogue, largely framed by firmly held preconceptions.
In short, there has been little serious analysis to date of the core and most important question as to ‘the possible scaled effects of fintech on sustainable development. This section lays out the key aspects of the fintech landscape, some key interconnections with sustainable development, the major unintended consequences that need to be addressed, and possible next steps. At this initial early stage, the UNEP Inquiry’s initial landscape review of this topichas focused on three hypotheses:
Fintech is already disrupting the financial sector. Some technological disruption fundamentally erodes value across a whole industry. According to Citi, there has been a 44% loss of share from physical-to-digital business models over a 10-year period of digitalization in music sales, video rentals, travel booking, newspapers, taxis and hotels. Fintech has so far challenged financial incumbents in mobile and internet payments, unsecured P2P lending, and invoice finance, among others. Goldman Sachs has estimated that US$11 billion of annual profit are already at risk from digitalization. Fintech start-ups raised a total of US$19 billion in 2015, concentrated mainly in payments, capital markets, bank credit and personal financial management.
Fintech’s scope is potentially very broad. Many of the individual technologies involved are not new, but their combination is driving the overall disruptive potential. This spans at least five core financial sector activities: moving value; storing value; exchanging value; funding and investing in value creation; insuring value and managing risk. Current examples include:
There is growing recognition that progress towards aligning the financial system with sustainable development must be measured. The positive momentum means that there are now many initiatives under way. Making sense of the comparative and absolute value of these activities is rapidly becoming a priority. During 2016, several measurement-focused initiatives were launched, including private initiatives, country-level initiatives, and international work such as the G20’s Green Finance Study Group and other international organizations. Such initiatives are of critical importance, particularly those focused on building consistent, comprehensive data sets such as the G20-related work taken forward by the World Bank and others.
The UNEP Inquiry also advanced further work during 2016 in exploring how best to establish a consistent basis for specifically measuring progress in aligning the overall financial system with sustainable development outcomes, and to map out how this basis can be improved over time. The objective of this work has been to add value by:
This section summarizes the emerging framework and presents the initial findings and recommended steps moving forward.
Estimates of financial requirements, flows and stocks do not provide a full picture of the efficiency, effectiveness or resilience of the financial system, given the challenges of sustainable development. The connection between efficiency and sustainable development remains unexplored, although the work of Thomas Philippon has pointed to the value of deepening this analytic lens. Equally, there is little data or analysis to help us understand which parts of the financial system are most effective in pricing and managing sustainable development-related risk. Forward-looking information on the resilience to emerging environmental factors such as air pollution, climate change and water stress is equally sparse. For example, the prudential reviews undertaken to assess climate-related risks have been limited in time horizon and constrained by a lack of scenario-based risk modelling by financial enterprises.
As a contribution to filling this gap, UN Environment has developed an initial version of a performance framework based around these primary characteristics. Capturing the complex dynamics of sustainable finance will ultimately require extensive modelling of both the real and financial economies, including the public sector and covering nuanced interactions between domestic and international financing considerations and outcomes. Not only is such modelling beyond the scope of the UNEP Inquiry, but also any attempts at this stage would suffer from extreme data shortfalls, high costs and uncertain value.
This work has only been possible through a series of formed partnerships to enable data to be acquired, recast, analysed, interpreted and communicated. Key data sources and partners have included: Bloomberg New Energy Finance, CDP, Corporate Knights, FTSE Russell, the Principles for Responsible Investment, Thomson Reuters and the Sustainable Stock Exchanges Initiative. Support was also received from the Bank for International Settlements, Bloomberg, the Cleantech Group, the Climate Bonds Initiative, the IMF, SwissRe, UNCTAD, the United Nations Framework Convention on Climate Change and the World Bank.
Individual indicators may relate to one or more of these characteristics. Pricing in climate risk, for example, is clearly a matter of effectiveness, but also impacts on system resilience. Improved effectiveness, similarly, would tend to increase financial flows aligned with sustainable development (and reduce flows that are not), thereby increasing measures of efficiency and almost certainly resilience.
The framework rests on three analytical pillars – the architecture of rules, behaviour in markets and the flows of finance. Under architecture, we include all rules, regulations, policies, norms and standards in the financial system that might directly or indirectly enhance sustainable development outcomes. Here we measure whether the ‘rules of the game’ are aligned with sustainable development needs, drawing on the Inquiry’s global database of measures featured in Section 1, supplemented by specific indicators that seek to measure the quality of the governance architecture. Under markets, we identify the behaviours of market actors. Here, we measure how well market players, market makers, and financial services are aligned with sustainable development needs. And under flows we measure allocation of capital to sustainable (and unsustainable activities), both in terms of annual flows and overall stock of assets.
Ideal indicators would exactly capture these characteristics across all these pillars and market segments, but in practice rarely exist due to both conceptual problems and data availability. Proxy indicators have therefore been selected both on the basis of their ability to illuminate performance aspects, and on the practical matter of data availability. Even within a self-imposed ‘green finance’ limitation, almost 70 potential indicators were screened in depth, from which a total of 21 were selected for use in this cycle. Efforts were made to select proxies that would have relevance across as wide a possible range of countries, and to ensure that we had some measures for each of the selected financial system segments.
Today’s momentum is to be applauded and encouraged, but needs to be amplified to secure transformation. This is the central message of this year’s edition of ‘The Financial System We Need’. The 2030 Agenda for Sustainable Development and the Paris Agreement represent the most ambitious multilateral goals ever set. While moving in the right direction, current levels of financing for sustainable development remain inadequate. We should not allow celebration of the momentum achieved to cloud the challenges we now face.
“Meeting the Paris Agreement’s goals will require the full mobilization of all stake holders, including financial sector actors. I fully support efforts to make financial flows consistent with the needed limitation of greenhouse emissions and the financing of climate resilient development.”
Michel Sapin, Finance Minister, France
The transition to sustainable development will require profound changes to the financial system itself. Ambitious goals, and arguably most Sustainable Development Goals and associated targets, will require some degree of system change, often including the ‘creative destruction’ of existing markets and institutions, and the emergence of new configurations, rules and conventions. Finance is without doubt a case in point. It is not a coincidence that some developing countries have taken leadership in progressing alignment of their domestic financial systems with sustainable development. Such leadership is partly explained by the higher visibility and impact of unsustainable development. Beyond this, or perhaps in part because of this, developing country central banks and financial regulators understand their role as being to align finance with national development priorities, alongside the roles they share with their developed country counterparts of monetary and financial stability and market integrity. As Dr. Atiur Rahman, the previous Governor of the Bangladesh Bank, pointed out, developing countries appreciate more readily the profound connections between central and development banking.
“Once climate change becomes a defining issue for financial stability, it may already be too late.”
Mark Carney, Governor, Bank of England
Now is the need to move towards a deeper change in the financial system. Innovations such as green bonds reflect the extended application of existing market architecture – and in many ways that is their strength, enabling rapid market expansion. Today’s momentum is, however, signalling the need and potential to move beyond the current level of innovation to achieve greater scale by addressing the role of sustainable development in broader market norms such as credit ratings. As mainstream investors, insurers and banks increasingly embrace ‘responsible’, ‘sustainable’ or ‘low-carbon’ financing, we see for example the early signs of their convergence with metrics and norms until now only seen in work undertaken by specialist impact investors , and social banking pioneers. Notable shifts in the interpretation of, and regulations governing, pension funds’ fiduciary responsibilities are looking increasingly like more avant-garde innovations in corporate governance, such as the ‘B Corporation’ legal forms allowing for financial and non-financial corporate objectives. In highlighting the complex dynamic between climate change and financial stability, innovative central banks are deepening the quality of conventional practice and signalling the need for an alignment of their mandates with longer-term policy goals.
Today’s momentum, then, is already exhibiting some of Hall’s ‘second-level’ characteristics – the straddling of at least two different narratives, stretching inherited conventions and providing an early glimpse of an emerging new set of conventions.
Low interest rates provide a unique historical moment for advancing sustainable development-aligned investment, boosting short-term economic growth and providing greater security for long-term savers. Investment levels remain well below what is needed, and corporate cash-hoarding remains at an all-time high of more than US $5 trillion. Yet many leading experts have pointed out that historically low interest rates in developed countries could provide a rare moment in time for financing capital-intensive long-term investment for sustainable development. International action on this front could deliver a low-cost boost to short-term growth and advance much-needed, low-carbon, resilient and productive infrastructure. Such investments could, furthermore, if delivered through crowded-in private finance, help institutional investors overcome severe revenue and asset valuation shortfalls against future liabilities, and so help in protecting future income streams for ageing populations.
In the wake of the financial crisis, furthermore, central banks and financial regulators are giving greater consideration to broader policy objectives. As well as classical economic objectives such as the US Federal Reserve’s employment-related mandate, this increasingly includes related social and environmental goals. Indonesia’s financial regulator, for example, introduced a Sustainable Finance Roadmap in the wake of the global financial crisis to strengthen the competitiveness of its financial sector and align it to long-term development priorities. Peru’s Superintendency of Banking, Insurance and Private Pension Fund Administrators (Superintendencia de Banca y Seguros) has placed increasing emphasis on ensuring investor oversight over mining-related social and environmental risks, given their potential macroeconomic effects.