Finance of Transition, Transition of Finance

This editorial by Frédéric Ducoulombier, Director of EDHEC-Risk Climate, was originally published in the July newsletter of the Institute. To subscribe to this complimentary newsletter, please contact: [email protected].

Transitioning to low emissions and resilient economies “to secure a liveable and sustainable future for all” [1] requires prompt action and considerable investment in climate change mitigation and adaptation. While substantial, the required investments are within the realm of global financial capabilities: their total amount pales relative to world GDP, government expenditures, and naturally, the accumulated wealth or the stock of financial assets.[2] However, private investments and public funds directed towards mitigation and adaptation projects need to increase many times over current levels.[3]

The Paris Agreement, now close to a decade old, aims to catalyse this shift, but the systemic alignment of financial resources—whether public or private, domestic or international—with the goals of climate change mitigation and adaptation is still far off. Various parties have laid the responsibility for this situation squarely at the feet of the financial industry: the industry prioritises short-term profits and rent-seeking[4] over long-term sustainability, continues to support projects that are inconsistent with the goals of the Paris Agreement, misleads stakeholders about the environmental performance of their products, services, or overall business practices, and lacks transparency and accountability.

All of this is true, but how specific is this to finance? Are not companies in all industries engaging in the very same behaviours, driven as they are by the imperative to maximise utility for their principals,[5] even when this harms the economy, the fabric of society, or even the preservation of the human race’s ecological niche? Should we hold finance to higher standards? Given the central position of the financial industry in the economy, it is imperative that we do.

Market economies rely on decentralised decision-making and price signals to allocate resources where they are most valued. The financial industry plays a critical role by facilitating the mobilisation and allocation of capital resources and the management of risk within and across all sectors. The funding of new ventures may contribute to innovation and long-term economic development. Risk diversification, hedging, and transfer facilitated by the financial industry may support activity and contribute to stability. When capital is directed to its most productive uses, overall economic efficiency is enhanced. [6] 

However, when market failures occur, such as those caused by environmental and social externalities,[7] the financial industry will perpetuate and exacerbate these issues. Financial institutions will fund projects that may be profitable over their investment horizon but will reduce long-term collective welfare. And the financialisation of the economic system will contribute to speeding up the pace of destruction by spreading the influence of the wrong incentives and accelerating growth. These financing activities also put the industry at risk if it accumulates claims on projects negatively affected by these harmful influences.

In the context of climate change, this can translate into losses from both physical and transition risks. Physical risks arise from direct or indirect damages due to climate hazards, physical changes such as productivity losses caused by increased temperatures or changes in humidity, and additional expenses incurred to adjust to the actual or expected physical effects of climate change (i.e., adaptation costs). Transition risks, on the other hand, stem from changes in social norms, preferences, technologies, markets, and regulations driven by increased awareness and action against climate change.

To mitigate these risks, it is essential to document the environmental and social impacts of human activities and take regulatory action to contain economic activities within safe limits. This may require phasing out certain destructive activities, phasing in restorative activities, combining action on prohibitions and performance standards (e.g., energy efficiency) and market mechanisms tackling externalities, e.g., carbon pricing penalising destructive activities, and subsidies incentivising transition and green activities.

While the financial sector can assist economic agents in voluntarily considering environmental and social externalities in investment decisions, it remains incumbent on governments to legislate externalities away.[8] Regulation to date has focused on sustainability disclosures and the fairness of sustainability claims – certainly, transparency and accountability matter, but they need to be part of a broader, more comprehensive approach. Without clear and credible signals about substantive action from governments, including a robust regulatory framework (stringent and enforced rules) and a concrete schedule for action (binding emissions targets, comprehensive carbon pricing mechanisms, support to research and development), economic agents will continue to prioritise short-term gains over long-term sustainability, and the financial industry will continue to lend support to this project.

Finance is a formidable force serving the economic system and should consider itself a custodian and steward of the common good. Unfortunately, this ethos has too often been insufficiently shared across the industry, to put it kindly. Indeed, the industry has been found to exploit or engineer informational asymmetries for the benefit of its employees and principals, engage in regulatory arbitrage, take excessive risks, and even commit downright fraud, contributing to its ambiguous public image. Self-selection, incentive structures, and human resources management have contributed to the facilitation of questionable, unethical, and at times illegal behavior. These excesses, evident throughout history, most recently culminated in the Global Financial Crisis, leading to significant economic instability and a widespread loss of trust in the industry.

Incorporating sustainability into the industry’s decision-making processes is a matter of self-preservation but could powerfully contribute towards allocating capital towards sustainable investments. The industry, however, is uniquely positioned to adopt a proactive role and have a pivotal influence on other sectors. This is because it is both central in the economy and has as its specialty the consideration of a variety of risks across time. As such, the industry should put its expertise in long-term capital budgeting and risk assessment to use, helping its clients recognise and navigate sustainability risks and opportunities, adopting sustainable practices and contributing to the required economic transformations. A lot can be done through the provision of financial services and advice to households and SMEs. The industry should also direct its ability to innovate towards developing financial instruments and solutions that could facilitate key transition and adaptation investments; this is a matter of particular relevance to large corporations and governments.

Financial researchers and educators have an important role to play in this transition of finance. Researchers need to produce better models to quantify the financial impacts of climate change, design new techniques to manage climate-related investment risks, and create innovative risk transfer solutions. This includes developing advanced climate risk assessment tools, updating investment management approaches, and creating new financial instruments to spread and manage the risks of extreme weather events and other climate-related disruptions. Educators must update degree and continuing education programmes to promptly transform research advances into actionable knowledge and skills. They also need to incorporate ethics into training - not for ticking a compliance box, but to support a shift in the culture, towards acceptance of the industry’s particular responsibility of custody and stewardship in support of sustainability and social good.

Humanity stands at a crossroads, facing unprecedented challenges from climate change and the imperative to transition to sustainable and resilient economies. The finance industry, despite its checkered history, has a crucial role to play in this collective effort. By committing to a new paradigm that prioritises long-term sustainability and ethical stewardship, finance can significantly contribute to the systemic changes needed to meet these challenges. This transformation will not only protect the industry’s viability but also ensure a resilient and sustainable future for all. However, this significant shift cannot happen in isolation. Government action is crucial to provide the necessary regulatory frameworks, set concrete schedules, and ensure enforcement. Only with clear and credible signals from public authorities will the finance industry fully align its efforts with the overarching goals of sustainability.

Footnotes

[1] The expression appears in the Headline Statements of the Synthesis Report of the Sixth Assessment Report of The Intergovernmental Panel on Climate Change (IPCC, 2023).

[2] GDP is projected to reach USD110 trillion this year (IMF, 2024). Annual government expenditures make up over a third of GDP globally. The global stock of financial assets is in excess of USD250 trillion (BCG, 2023) and represents about half of the total wealth (in the sense of private assets that are measurable and tradeable within markets).

[3] According to the latest synthesis report of the Intergovernmental Panel on Climate Change (IPCC), investments in clean energy and energy efficiency need to increase by three to six times throughout this decade to limit global warming to 2°C or 1.5°C above pre-industrial levels (IPCC, 2023), which amounts to trillions of dollars annually. And, due to delayed climate action, the adaptation finance gap has increased to USD194bn-366bn p.a. for the decade, with needs being 10-18 times as great as current international public adaptation finance flows (UNEP, 2023).

[4] Rent-seeking refers to the attempt to gain economic advantages through exploitation or manipulation of the social and political environment, rather than through productive economic activities. This can include lobbying for monopoly rights, advocating for regulations that create barriers to entry for competitors, seeking undue subsidies or tax breaks, and engaging in non-competitive practices. While criminal activities such as outright corruption of legislators, supervisors, or economic decision-makers, or participation in an illegal cartel can facilitate rent-seeking, rent-seeking activities themselves do not necessarily violate social norms.

[5] In a market economy, this is typically understood as maximising profits for shareholders. Shareholder primacy was established gradually. Initially, many companies operated on the principle of "one man, one vote." As corporations required significant capital investment, the principle of “one share, one vote” began to take hold. The rise of neoliberal economic policies from the 1970s entrenched the concept of shareholder primacy, with changes to corporate governance aligning management interests with those of shareholders. While this trend was particularly marked in the United States, it also influenced corporate governance models in the European Union. However, the impact in Europe was moderated by existing stakeholder-oriented practices, especially those influenced by Germany’s codetermination model, where employees have significant representation on company boards.

As some negative impacts of shareholder primacy became evident in the 1990s, there were calls for companies to adopt a broader view of their social responsibility and to shift towards stakeholder capitalism. This approach extends the role of companies beyond profit maximisation, which primarily benefits shareholders, to creating long-term value for all stakeholders. While this perspective was more traditional in Europe, it gained traction in North America.

In 2019, the Business Roundtable, an association of CEOs of leading US companies that had championed shareholder primacy, endorsed stakeholder capitalism in a significant rhetorical shift. However, its recent activism against enhanced ESG transparency has raised questions about the sincerity of this commitment. The shift towards stakeholder capitalism can be attributed to societal pressure, changing investor demands, regulatory changes, governance trends, and the growing business case for sustainability. While fossil fuel interests have scored significant victories against sustainability on both sides of the Atlantic (for a relation of the fossil fuel attack on sustainability transparency, refer to our Policy Contribution titled “Scope for Divergence”), there is evidence of an ongoing global shift towards a broader definition of corporate purpose, with organisations making genuine efforts to integrate stakeholder interests into their core strategies. .

[6] Information asymmetries, however, can result in capital being allocated to projects with insufficient economic returns, leading to low economic efficiency, financial losses, and potential distress, with systemic consequences. These asymmetries may also be exploited or engineered by financial institutions at the expense of their clients. Additionally, the financial system may facilitate the development of financial imbalances, such as rapid credit growth and asset price booms, which increase the risk of financial instability and the likelihood, depth, or length of real economic recessions. Regulatory frameworks need to be designed to reduce information asymmetries (increase transparency) and promote fair, efficient, and stable financial markets.

[7] i.e., costs (or benefits) that result from an economic transaction but are not directly borne (or enjoyed) by the parties involved in that transaction. For example, pollution from a factory affects the general public, and the costs of these consequences are not included in the price of the factory's products.

[8] In the appendix to our Policy Note titled “Scope for Divergence,” we explain how fossil fuel interests organised a backlash against the world’s largest asset manager for its advocacy of considering environmental risks and its support for net-zero policies.

References

• BCG, 2023. Global Wealth Report 2023 – Resetting the Course. P. Czerepak, D. Frankle, L. Haider, M. Jha, M. Kahlich, D. Kessler, B. Liu, O. Rahman, A. Soysal, F. Werner, and I. Zupa. Boston Consulting Group (June).
• IPCC, 2023: Climate Change 2023: Synthesis Report. Contribution of Working Groups I, II and III to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, H. Lee and J. Romero (eds.)]. IPCC, Geneva, Switzerland, pp. 35-115.
• International Monetary Fund, 2024. World Economic Outlook—Steady but Slow: Resilience amid Divergence. Washington, DC. April.
• UNEP, 2023. Adaptation Gap Report 2023: Underfinanced. Underprepared. Inadequate investment and planning on climate adaptation leaves world exposed. United Nations Environment Programme, Nairobi.