4 Opportunities and challenges in financing the green economy
Section 2 showed that current financial flows into a green economy need to be dramatically scaled up while Section 3 showed that innovative financial mechanisms have emerged for many environmental and natural resource areas and have begun to channel funds to them. This section identifies some of the key barriers to scaling up these flows throughout the typical life cycle of investments from pre-investment to final exit, and suggests ways to remove them.
4.1 Addressing the full cost of externalities
If the costs of environmental degradation and social harm remain external to the costs of business and investment activity, then the risk/reward equation that underpins so much of financial services and investment activity will continue to promote environmentally and socially unsustainable business practices and financial activity. For most of the period in which a formal investment industry has evolved over the past 200 years, ESG issues were not considered in the investment policy-making and decision-making processes of most mainstream financial institutions.
One of the primary reasons for this omission was that externalities – costs that are external to a company’s balance sheet such as pollution or destruction of ecosystem services – have simply not been assessed, priced or accounted for in traditional market activity and the associated investment processes that have supported that activity. Analysis in the recent TEEB business report (TEEB for Business 2010) confirmed that standard business valuation techniques for most part still fail to capture the values of basic ecosystem services. In addition, criteria employed in accounting to ensure relevant and reliable financial reporting are framed in a way that typically excludes intangible issues such as impacts and dependencies on ecosystems and biodiversity.
The failure to internalise the wide and diverse range of environmental and social externalities prevents larger amounts of capital flowing into a green economy. While governments, through their regulatory activities (direct regulation, environmental taxes, user charges, and tradable permit systems) and budgetary activities (payment for environmental services) will play a major
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role to address these externalities, voluntary initiatives within the financial and investment sectors can contribute also. While externalities remain unaccounted for in investment activity, the risk/reward equation that underpins most capital market activity makes the dramatic scaling up of financial flows to a green economy infeasible in the short-term. In recent years, however, some of the world’s largest investors have begun to focus on the questions of fiduciary responsibility and fiduciary legal issues in the context of ESG matters (see Box 5). In particular, it is in the interests of large, diversified institutional investors that own a fairly representative sample of the global economy – so called universal owners – to act to reduce negative externalities (see Box 6). While interest around the universal ownership theory continues to grow, it has yet to attain mainstream status and there are some dissenting views with respect to the overall thesis.
Most recently, there have been attempts to put a price on the damage caused by business to human health, the degradation of ecosystems, and the depletion of natural resources. Avoiding these costs represents one of the main benefits to society from greening the economy. For example, UN-backed research found that the human use of environmental goods and services in 2008 caused an estimated US$ 6.6 trillion in environmental costs, equal to 11 per cent of the global economy (UNEP FI and PRI 2010). As the economic perils of a broad range of the “slow failures” or “creeping risk” (WEF 2010b) become more apparent, there is an accelerating need for capital markets and financial institutions to understand how natural and social value at risk will impact their investments in both the short and long-term.
A strategic commitment to capture these values and incorporate their consideration in internal decision making can help pave the way for greater capital flows to a green economy. Focused public policy action will speed up this process. The need to understand natural and social value at risk and its implications for economies poses a series of complex questions for the financial services sector, as well as for the broader business community. These questions are crucial for those parts of the financial system, such as the pensions and investment sector, which need to protect and grow assets over the long term.