The Financial System We Need
From Momentum to
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  • 1.
    The global financial system needs reshaping to finance an inclusive, prosperous and environmentally sound future – in other words: to achieve sustainable development.

The Inquiry’s 1st edition of ‘The Financial System We Need’ published in 2015 identified:

  • The need for reforms within the financial system that can correct market and policy failures and deliver sufficient financing for sustainable development, while complementing both real economy actions and public finance measures.
  • A ‘quiet revolution’ in how such actions across the financial system were starting to respond to this challenge, with notable leadership from developing, as well as some developed, nations.

The Inquiry’s first generation of findings have been widely welcomed and reaffirmed through subsequent developments.

  • 2.
    This momentum has dramatically increased over the past year.

One year on, these efforts have accelerated through:

  • Market Leadership: Leading financial institutions are recognizing that sustainable development is key to their future success, as exemplified by the green bond market, with US$118 billion now outstanding.
  • National Action: Financial policy makers and regulators are acting to drive the reallocation of capital, improve risk management and enhance transparency.
  • International Cooperation: In 2016, for the first time, the G20 and the Financial Stability Board are exploring how to develop the financial system to take greater account of environmental factors.
  • 3.
    Policy, market and broader international drivers are underpinning this momentum.
  • Adoption of the Sustainable Development Goals and the Paris Agreement on climate change.
  • Evolving national development priorities, particularly of developing countries.
  • Continuing efforts to correct market and policy failures across the financial system.
  • Growing technological disruption to the financial system.
  • Rising social expectations of financial system performance.
  • Increasing regard for green finance as a competiveness factor for businesses and financial centres.
  • 4.
    Today’s momentum remains inadequate to deliver the transformation needed to finance sustainable development.
  • Natural capital continues to decline precipitously, alongside growing social inequality and unrest.
  • Sustainable financial flows and stocks remain marginal to the deployment of capital, world wide.
  • Financial system remains disconnected from the long-term needs of the real economy.
  • Tomorrow’s financial stability is increasingly threatened by the effects of today’s unsustainable economy.
  • 5.
    Key steps can align the purpose and impact of the financial system to serve the real economy in the transition to sustainable development.
  • Anchor sustainability in national strategies for financial reform and development.
  • Channel technological innovation to finance sustainable development.
  • Realize the triple leverage potential of public finance.
  • Raise awareness and build capabilities across the system.
  • Embed sustainability into common methods, tools and standards across the financial system.

From Momentum to Transformation

Revisiting the Quiet Revolution

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:

  • Increasing efforts are being made to integrate aspects of sustainable development into financial system reform, development and practice, in nations as diverse as China and the UK, Bangladesh and France, and Brazil and Kenya, with notable policy and regulatory leadership coming from some developing, as well as developed countries.
  • Experience points to an emerging toolbox of measures that can support capital reallocation, better risk pricing and market governance, and practices aligned to sustainable development, across a range of priorities from air pollution, clean energy and climate change to financial inclusion, rural development and water.
  • There is potential to scale and systematize these early innovations, both nationally and internationally, to effect a major redeployment of capital to finance sustainable development.

The Inquiry’s findings came at an historic moment rich in potential for major change, underpinned by three interlocking developments:

  • The landmark adoption of the 2030 Agenda for Sustainable Development and the Paris Agreement on climate change, both of which recognized that financing is essential for realizing their goals and remains – on current trends – inadequate.
  • Policy action following the financial crisis of 2008, which sought to improve the efficiency, effectiveness and resilience of the financial system in serving the long-term needs of the global economy.
  • Rapid evolution of the financial system itself, resulting from the combined effects of post-crisis macroeconomic environment and reforms, the increasing influence of emerging and developing countries, new social expectations and the disruptive forces of technology across the financial system.

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:

  • National action: national compacts and action plans to build sustainable financial systems provide a foundation for making strategic progress. Such roadmaps would most effectively be designed and overseen by coalitions of key institutions, and driven by national circumstances and priorities, including a diagnostic of practice and needs, an assessment of opportunities, a pathway for action and implementation with strong feedback mechanisms to enable learning and improvement.
  • International cooperation: ten priorities for international cooperation were identified, including: developing principles for a sustainable financial system; reaching convergence on disclosure standards; developing sustainability stress testing methods; optimizing fiscal measures in the financial system; incorporating environmental risks in global banking standards; developing a code on investor duties; establishing a green capital markets coalition; introducing guidance for insurance regulators; and, developing a performance framework for a sustainable financial system.

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

The Growing Momentum

The last year has seen an acceleration in the quiet revolution’s momentum across the financial system. Historic circumstances, innovation and leadership have combined to incorporate aspects of sustainable development into financial system design and practice. Progress is being made in different places, at multiple levels and involving diverse actors across three, inter-locking pathways of change: market leadership; national action; and international cooperation.

“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

How the ‘Quiet Revolution’ Got Louder

As this momentum has developed, so new dimensions have emerged:

  • Public debate has advanced. Central bank governors, finance ministers and regulators, and finance sector executives are increasingly being asked to explain their contribution to advancing sustainable development. Public interest institutions are playing an increasingly important role in shaping public debate, for example about the risks of ‘stranded assets’. Citizens are taking up the opportunities to redeploy their own capital aligned to their values and longer-term interests.
  • Sustainability is becoming a factor in the competitive development of the world’s financial centres, with global and regional centres including Hong Kong, Nairobi, London, Paris and Switzerland exploring how best to develop rules, fiscal measures and market leadership to take advantage of new opportunities.
  • Collaborative networks are multiplying and deepening, with a growing trend evident across various jurisdictions to create and institutionalize partnerships, associations and fora for the sharing of best practices, information and experiences. The Inquiry is involved in several of these new initiatives, including the Sustainable Insurance Forum, made up of insurance supervisors and associated with the private sector-focused Principles for Sustainable Insurance, and the Green Infrastructure Investment Coalition.
“Green finance is burgeoning, it has reached a point of spontaneous combustion. But it needs to be aligned. It needs to go beyond the leadership of a few champions.”
Nuru Mugambi, Director of Communications and Public Affairs, Kenya Bankers Association

The Challenge Is Scale and Speed

Mapping The Momentum

2016 – The Year of Green Finance

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.

Green Bonds: Co-Evolution of Markets and Policy

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.

Green finance also brings specific concerns and opportunities for developing countries beyond the G20. UN Environment has specifically engaged with practitioners and regulators from Bangladesh, Colombia, Egypt, Honduras, Jordan, Kenya, Mauritius, Mongolia, Morocco, Nigeria, the Philippines, Thailand and Vietnam. From this experience, it is clear that green finance has to be advanced in conjunction with wider finance sector development priorities, such as capital market deepening and extending access to finance for SMEs and households. In addition, international approaches to green finance should reflect the needs of developing countries. Equally, there is a potential for ‘leapfrogging’ in green finance, learning from the lessons of other innovations such as mobile banking. Indeed, green finance could be a catalyst for wider sector development and the attraction of foreign capital.

“Leadership must come from the private sector, business community and NGOs, not only from the officials. We need a comprehensive and coherent framework supported by political will that enables market forces to move businesses from the traditional to the green economy.”
Mohammed Omran, Chairman, Egyptian Stock Exchange (EGX)

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.

Harnessing Financial Technology for
Sustainable Development

  • Finance is a system in constant flux – and financial technology (fintech) is now emerging as a powerful driver of disruption with profound implications for sustainable development.
  • The use of technology in finance is of course not new – but a step change is now expected with the novel application of a number of technologies in combination, notably involving blockchain, the ‘internet of things’ and artificial intelligence.
  • UN Environment commissioned an initial landscape review of the potential for fintech to advance sustainable development.
  • Technological innovation is already offering sustainability solutions across the five core functions of the financial system: moving value; storing value; exchanging value; funding value creation; and managing value at risk.
  • Fintech offers the prospect of accelerating the integration of the financial and real economy, enhancing opportunities for shaping greater decentralization in the transition to sustainable development.
  • There is a range of both transitional and more structural unintended consequences, however, with potential downside risks for sustainable development.
  • Policy interventions can be active on both the fintech supply-side and on the manner in which financial system development is aligned to sustainable development. Some key steps in the fintech for sustainable development innovation journey could include:
  • Ensure that fintech is an integral part of financial system development plans and roadmaps focused on financing sustainable development, particularly at the national level, and especially for developing countries.
  • Establish a platform of leading fintech companies, working with others to influence the right enabling businesses, policies and standards to effectively connect fintech and sustainable development.
  • Incentivize fintech aligned with sustainable development, for example by:
  • Supporting venture capital and social impact funds to fund start-ups with specific sustainable development ambitions.
  • Creating a challenge fund, similar in nature to the Longitude and X-Prizes, which would seek to create a global community of purpose that can pilot and create replicable solutions over time.

Aligning Tomorrow’s Financial System – Not Today’s

The financial system is in a constant state of flux. The financial system is woven into almost every human habitat,from the rural village trader to the global investment banker. Its global architecture, diversity of institutions and billions of daily transactions impact those both with and without access to modern financial services. The financial system’s share of global income has grown rapidly in recent decades, nearly doubling between 1988 and 2005 to peak at 3.3% of global GDP – before trillions in losses originating in the global financial crisis.

The financial system is unusually dynamic and adaptive. Due to their intangible nature, financial products are more numerous, more diverse and more rapidly created or destroyed than those in the real economy, even in most service sectors. Leveraging global communications infrastructure has allowed the financial system to compress space and time, creating the possibility for nearly immediate capital flows across jurisdictions – but also leading to many problematic issues such as tax avoidance, illicit financial flows, or regulatory arbitrage.

Disruptions to incumbent business models represent an ongoing, endemic risk to all. The sector is mature with massive market actors, but many factors are driving the sector towards major disruption and transformation. Policy and regulatory changes, for example, in the wake of the financial crisis, have diminished the profits of traditional banking after several decades of extraordinary financial success. Unprecedented low interest rates resulting in part from policy-directed financial stimulus programmes including quantitative easing have put the long-term investment revenues of some pension funds and insurance companies at risk.

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.

Technology Is a Driver of One of the UNEP Inquiry’s Four Scenarios

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.

  • Some base their positive expectations on extrapolations of today’s growing armada of value-led, small-scale, early stage innovations.
  • Others base their pessimism on concerns about the negative impacts of accelerated commoditization of markets driven by fintech-powered efficiencies.

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:

  • Game-changer: that fintech could significantly change the ways in which the financial system could embrace sustainable development.
  • Contingent: that the technology itself does not imply a fixed answer to the core question, but it will unleash a new generation of impactful, patterned norms.
  • Shaping: that the nexus between fintech and sustainable development can be shaped by market innovation, collaboration and public-interest measures.

Fintech Landscapes

Fintech offers the prospect of a more efficient, accessible and less vulnerable financial system, but brings with it known risks and many unknowns. Fintech covers everything from mobile payment platforms to high-frequency trading, and from crowdfunding and virtual currencies to blockchain. At its core, fintech reduces market friction by cutting out incumbent intermediaries and often replacing them with lower cost variants, from robo-investors to high-frequency traders, and so ultimately by increasing the speed and lowering the costs of transactions. In combination, fintech innovations are likely to threaten the viability of many of today’s financial sector business models. Furthermore, they may undermine the effectiveness of some of the financial policies, regulations and market norms that have shaped modern finance, offering in their stead technology-driven rules embedded through a new generation of code, financial systems and institutions.

Fintech is part of a broader, technology-driven revolution in progress. The world is undergoing a transformation at high speed, driven by the fusion of advanced digital, material and biological innovations. The accelerating confluence of emerging technology breakthroughs covers wide-ranging fields such as artificial intelligence (AI), robotics, the internet of things (IoT), autonomous vehicles, 3D printing, nanotechnology, synthetic biology, DNA editing, biomimicry, advanced materials science, energy storage and distributed computing, to name but a few. This changing technological ecology is likely to rewire every aspect of our global economy and the design and functioning of many core societal functions, from the role and functioning of labour markets to the state.

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:

  • Payments are the most immediate ‘low-hanging fruit’, particularly in developing countries. M-PESA, the iconic P2P mobile money service that was launched in Kenya almost a decade ago, currently has about 25 million customers in 11 countries. ANT Financial Services currently has 450 million users in China, and a further 170 million in India through a joint venture.
  • Borrowers and lenders have been ‘matched’ through online P2P platforms for around a decade already, but the total amount lent remains small, less than 1% of total loans according to the CITI GPS.
  • Fintech has entered the investment industry to date through the growth of ‘robo-advisors’, which according to CITI GPS are already managing US$2.6 trillion of the total US$30.4 trillion of the Exchange Traded Fund (ETF) and mutual fund market.

Measuring Performance

The Need to Measure Performance

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:

  • Providing a map of the financial system dynamics that we need.
  • Enabling country, and financial centre, progress to be measured.
  • Highlighting areas for market and policy, and regulatory action to improve performance.
  • Identifying steps needed to broaden and deepen the performance framework itself.

This section summarizes the emerging framework and presents the initial findings and recommended steps moving forward.

Taking Stock of Current Practice

The Inquiry in its first phase provided early signals of what might be considered in measuring the alignment of the financial system with sustainable development (see Figure 18). This highlighted the need to measure the workings of the system as a whole, alongside but not restricted to measures of financial flows and stocks, the latter being essentially the outputs of the system. From this perspective, it was proposed to frame any performance measurement with three core system characteristics: efficiency, effectiveness and resilience.

To date, there have been no consistent attempts to capture and analyse data across these key outputs and system characteristics. Some elements are available, including estimates of requirements and information on current flows, such as UNCTAD’s widely used estimate that US$5-7 trillion is needed in investments to deliver the Sustainable Development Goals, and some country data such as China’s estimate of its green financing needs as US$600 billion annually. Some flow data also exists, such as estimates of global investment in renewables – rising to US$286 billion in 2015. Similarly, some stock data exists, such as China’s estimate that about 10% of bank lending in China is classified as ‘green’, and the estimate of the Brazilian Federation of Banks, FEBRABAN, that 8.8% of corporate lending was allocated to green investment. Data availability is, however, limited to such leadership cases, and even in these cases is based on differing definitions.

“There is an opportunity for the G20 to create practical green financing models for the developed and the developing world. The good news is there is an abundance of capital globally, but governments need to create the proper conditions to attract this capital. They have an important role to play in setting the policies, regulations, incentives, and in ensuring that they are enforced - (...) Global capital markets are powerful forces. Directed properly, they can alleviate the burden on governments and unlock a sustainable economic future.”
Henry (Hank) M. Paulson, Jr., Chair, Paulson Institute

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.

Developing the Performance Framework

Understanding the performance features of a highly dynamic system is challenging, but possible. Financial system performance cannot be assessed like a plane or football team. Its complex, adaptive nature makes for uncertain relationships between context, interventions, actors and outcomes, all the more so given its massive scale, volume of activities, and transboundary features. The multi-dimensional nature of sustainable development makes this task even harder. In spite of this, well-established frameworks do capture the traditional aspects of system performance, notably the Financial Sector Assessment Program and the World Bank’s Global Financial Development Index. We have also drawn on earlier work supported by the OECD in building scenarios for sustainable financial systems, the ‘FAIR’ framework set out by the Bank of England’s Governor, Mark Carney, and the Citizens’ Finance Dashboard developed by a coalition of civil society organizations convened by FinanceWatch. In addition, consideration has been given to specialized analytic perspectives, such as ongoing work on the dynamic relation between financial inclusion and financial system development.

The scope of the performance framework is limited to developments within the financial system itself. Many factors influence the alignment of finance with sustainable development. This includes economic policy, notably the degree to which environmental outcomes are internalized into market prices and value creation, and the deployment of public capital, both through fiscal measures and the use of development finance to leverage private capital. This framework focuses exclusively on action and results within the financial system, while recognizing in practice the existence of important dynamics between these areas.

The proposed framework is grounded in core performance characteristics, which in turn cascade into proxy indicators. The framework is rooted in the three performance characteristics of efficiency, effectiveness and resilience:

  • Effectiveness – the degree to which the market prices sustainability factors into financial asset values (sometimes called ‘allocative efficiency’).
  • Efficiency – the costs of running the financial system that delivers financial flows aligned with sustainable development.
  • Resilience – the susceptibility of the financial system to disruptions related to unsustainable development, such as water scarcity, air pollution or climate change, including transition risks.

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.

Steps towards Transformation

Amplifying the Momentum

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

Recognizing the urgent need to move from momentum to transformation is not a matter of optimism or pessimism. The Inquiry highlights the need for, and progress made, in advancing financing for sustainable development. Public finance is essential for realizing the Sustainable Development Goals, and has multiple roles to play – in direct financing, crowding-in private finance, and otherwise shaping financing flows, such as through public procurement and influencing standard-setting. Yet public finance is insufficient. Many of the market and policy innovations intended to drive financing for sustainable development are at an early stage, and despite rapid growth, such changes are starting from a low base. Few countries have made comprehensive progress across their financial systems – and most countries have yet to start. Most actions have yet to be fully implemented or institutionalized, and little is known as to which, often in combination, are most effective.

Failing to amplify the current momentum delays the reallocation of capital away from, and so perpetuates, unsustainable economic development. The continuation of these trends generates powerful feedback loops, undermining human progress and also building up systemic risks that the financial system is, at present, ill-prepared to manage. Such systemic feedback creates more volatility and further undermines the prospects of long-term, sustainable prosperity. In spite of encouraging momentum, then, we risk slipping backwards if the bulk of financing flows continue to be channelled towards unsustainable production and consumption patterns.

Momentum is Not Enough

Moving to the Next Phase

Moving from today’s momentum to tomorrow’s transformation is not just about doing more of the same. Strategies need to evolve as we move from early stage innovation to broader structural change. As we have sought to illustrate with our initial performance framework, a system-wide approach to transforming finance is needed – one that encompasses the architecture of rules, the practice of market behaviour, and the quantitative stocks and flows of finance towards sustainable assets and away from those that degrade natural capital.

Thomas Kuhn described a paradigm shift as being when evidence can be effectively described and dealt with only by affirming the explanations and worldviews that are new or were previously controversial and unacceptable. Paradigm shifts lead to the emergence of new norms, orthodoxies and worldviews. Peter Hall, drawing on Kuhn’s work, distinguishes three orders of change:

  • First-order changes are ‘paradigm maintaining’ and involve processes that adjust policy without challenging their existing, underlying assumptions about the way things are.
  • Second-order changes are more significant, where the instrument of a policy is adjusted but not the overarching policy. Both first- and second-order changes are characterized by incrementalism.
  • Third-order changes reflect deeper changes to the underlying terms of the discourse and indicate that a paradigm shift is occurring. Third-order change is the paradigm shift described by Kuhn, involving reappraisal of what have previously been considered certainly true.
“Green finance is burgeoning, it has reached a point of spontaneous combustion. But it needs to be aligned. It needs to go beyond the leadership of a few champions.”
Nuru Mugambi, Director of Communications and Public Affairs, Kenya Bankers Association

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.

Transformational Financing in Times of Turmoil

Today’s economic uncertainty and volatility are often cited as key reasons why more transformational approaches to finance are not possible. Since the global financial crisis, key aspects of the financial system have been in a state of rapid change. Many of these changes are positive – such as the introduction of post-crisis regulation to restore integrity and stability to core financial markets. Others are problematic – such as the apparent break in the long-term trend to increasing cross-border capital flows. Weak underlying growth in key industrialized markets continues to deliver historically low interest rates, challenging some of the traditional fundamentals of financial practice, and placing many business models and long-term savers at risk. Technology itself, over recent decades a source of significant value added to incumbents, is now also a source of disruption and change. Fintech is challenging not only today’s business models in key financial sectors, but also the very foundations of our modern monetary system, and the basis on which the financial system can be governed in the future.

Moving from momentum to transformation needs to be achieved at a time of turmoil. The direct causes of turmoil may change over time, but turmoil itself looks set to remain a core feature of our global landscape. It is unlikely that we will move into a period of relative calm, allowing for a more deliberative approach to addressing longer-term considerations. So either turmoil has to be circumnavigated to address the Sustainable Development Goals and the ambitions underlying the Paris Agreement, or else this period of recalibration of core features of the financial system needs to be seen as an opportunity for advancing these long-term agendas.

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.