The world we live in is run by economics, be it at an individual level, corporate level or sovereign level; or be it within retail, energy, automotive, manufacturing or any other industry. It is all associated with one common factor that fuels its working, i.e. finance. Finance is a broad term that describes activities associated with banking, leverage or debt, credit, insurance, capital markets, money, and investments. Finance also encompasses the oversight, creation, and study of money, banking, credit, investments, assets, and liabilities that make up financial systems. Financial institutions (FIs) increasingly contribute to, either directly or indirectly, towards the deterioration of our environment and ecosystems we depend on for our survival.
And with the above prelude, we now get a sense of the indispensable role finance will play in our sustainability.
Sustainable Finance is nothing but taking environmental, social and governance (ESG) considerations into account when making investment decisions in the financial sector, leading to more long-term investments in sustainable economic activities and projects. For good reasons.
The uncertainty and drastic changes in climate conditions, environmental degradation of soil, air and water are defining global challenges of our time. Long-time chairman of the Intergovernmental Panel on Climate Change, the late Rajendra Pachauri, had said: “Warming of the climate system is unequivocal... most of the global average warming over the past 50 years is very likely due to anthropogenic greenhouse gas increases.” Now as the situation is almost at the point of no return, drastic and immediate measures are critical to ensure a sustainable future for all of us.
These are the areas to look out for in the financial services value chain to keep a check on the sustainability parameters:
Thus it becomes clear: It will be difficult for FIs to maintain a sustainable outlook without a real policy and governance in place. Sustainability cannot be relegated to being a mandatory chapter in the annual CSR report, where there is intent, but no clear action. It has embedded its root at the highest levels and gained a much broader purpose, of which The Paris Climate Agreement is an example.
This agreement, in particular, includes the commitment to align financial flows with a pathway towards low-carbon and climate-resilient development. Another way to consider this is by looking at two contrasting assessments done by the United Nations Environment Program Finance Initiative (UNEPFI):
FIs implement their sustainable goals and responsibilities both in their internal operations (in terms of how they manage their physical locations, human capital, costs, opportunities, risks exposures) and their activities relating to external interactions with their clients and the types of services they support and the funding/credit they provide.
The European Commission in July 2021 has outlined the strategy for financing the transition to a sustainable economy. It is based on four pillars:
a. Financing the transition of the real economy towards sustainability: This is a key step because it will not only boost the current business, but also provide financial support to those adopting measures to reduce greenhouse emissions. The recognition of in-transition activities will also be a part of the Taxonomy framework (via the Climate Taxonomy Delegated Act). This will help to phase out the non-sustainable activities in a controlled and timely manner.
b. Towards a more inclusive sustainable finance framework: The sustainable finance framework becomes more inclusive when financing opportunities are also offered to retail investors or consumers, and SMEs. Also, by increasing insurance coverage, the financial system can better protect the economy and society against certain climate-related and natural disaster risks. Risk-sharing between public and private investors can effectively address market failures that hinder the financing of sustainable infrastructure and innovation-driven transition.
c. Improving the financial sector’s resilience and contribution to sustainability: The double materiality perspective – improve financial reporting standards that adequately reflect sustainability risks and encourage natural capital accounting. This can happen when credit agencies factor in ESG risk; integrate sustainability risks in their risk management systems and prudential framework for insurers; adopt strategic science-based climate and sustainability targets and improve cooperation among authorities.
d. Fostering global ambition: Set a high level of ambition in the development of international sustainable finance initiatives and standards. High-income countries can support low- and middle-income countries in their transition efforts.