financing mechanisms used to address financing gaps, which might be through an Initial Public Offering (IPO) or project finance loans from banks. The term “Valley of Death” is often used during the phase discussed above to describe the difficulties of accessing commercial finance between the initial VC investment and the demonstration, or from demonstration to commercial rollout with secondary VC investment.
The diagrams show where public grants or specific subsidies are essential. One can conclude that the private sector is capable of providing finance in more mature stages of commercial development, but is less reliable for early-stage finance where VC/PE operates. It demonstrates the need for a potential sharing of risk at the initial stages between private and public investors, for example, by providing incentives for private investment in the early deployment of new technologies or by improving the capacity of the insurance market.
Box 6: The universal owner theory explained
The universal owner theory (UOT) concerns a solution to an important contradiction in the investment system: short-term rewards for some are potentially available where externalities, such as climate change, ecosystems destruction or ignoring the rule of law) are not adequately accounted for. However, in the longer term these externalities may undermine the value of investments for all. Emerging work around the UOT is deepening our understanding and starting to quantify the economic, financial and investment implications of externalities along the investment chain.
A joint UNEP FI/PRI report on the subject estimated that the equivalent of US$ 6.6 trillion of damage was externalised in 2008, or 11 per cent of the value of the US$ 60 trillion global economy (UNEP FI and PRI 2010). Without action, the cost of environmental and social externalities relative to the value of the global economy is projected to increase by 62 per cent from 2008 to 2050. If environmental externalities are not addressed, the damage incurred annually continues over time and accumulates. The study also found that companies in the MSCI All Country Index are associated with over US$ 1 trillion in environmental externality costs annually. This equates to 5.6 per cent of the market capitalisation of companies in the Index, and 56 per cent of their earnings. Environmental externalities could present a financial risk to universal owners invested in equity markets. Source: UNEP FI/PRI (2010)
4.3 Integrating ESG risks into financial and investment decision making
To date, the degree to which ESG risks are factored explicitly into banking considerations is limited, largely due to the difficulties in establishing the financial materiality of such risks. Although public policy shifts have set processes in motion to strengthen the financial materiality of a range of these risks (see Box 7), there is a significant lag between a clear reflection of such risks in public policy at global, regional and national levels and its integration into the inner workings of the financial system. For the banking sector, this particularly relates to understanding and quantifying the credit risk, for example, linked to the likelihood of new regulation, and default implications of these emerging risks as well as the negative impact on collateral.
Also, the speed with which financial institutions are able to transfer risk into the system by removing the liability from their own balance sheet is an important factor in the assessment of how these emerging risks impact banking operations and the degree to which they are financially material for individual institutions. A 2006 report (UNEP FI and EcoSecurities 2006) concludes that in many cases for North American banks there was no link between bank lending and climate change risks because of the short average maturity of such loans and the speed with which banks transferred loans off their own balance sheet.
If the information that investors receive is shallow and short-term then their investment decisions can show similar characteristics, which is why the finance and investment community is demanding more data on ESG issues such as carbon emissions from the entities in which they invest. This type of sustainability/ESG reporting (hereafter “sustainability reporting”) has grown exponentially in recent years, for example, the GRI Financial Services Sector Supplement and Equator Principles. However, methodologies and international norms can still be improved. There are now significant moves towards more integrated reporting. To that end, in July 2010 the International Integrated Reporting Committee (IIRC) was formed to try and create a globally accepted framework for accounting for sustainability – a framework that brings together financial and ESG information in a clear, concise, consistent and comparable format. This issue is also being discussed by global stock exchanges.
However, the link between improved accounting and reporting and actual business practices is somewhat weak. Some 1,100 financial institutions (UNEP FI and PRI) now support United Nations -backed principles and statements that advocate firm steps towards a sustainable financial system and a responsible approach to investment, but progress in putting these statements into practice can be inconsistent and, in many cases,