Sustainable finance, climate change and the ‘tragedy of horizons’

Achieving the Paris Climate Goals and the Sustainable Development Goals requires a massive reorientation of financial flows. ‘Sustainable finance’ is one of the main tools for achieving this — now more than ever: the International Monetary Fund (IMF) has put ‘greening the financial system’ and prioritising green investment among its three top priorities. For sure, the terms ‘sustainable’ or ‘green finance’ make for nice, ‘green’ advertising for banks and investment funds. But what is really behind this buzzword? And what impact will the Covid-19 induced crisis have? Katharina Bryan, Head of ECA Member Eva Lindström’s private office, explains what sustainable financing is, why it is crucial to combating climate change and what the ECA is doing on the topic.

By Katharina Bryan, private office of Eva Lindström, ECA Member

Sustainable finance is crucial to reaching climate objectives

Global warming is increasing at an alarming rate. The decrease in emissions due to reduced economic activity because of Covid-19 is not going to make a difference to this fact. We might witness the largest ever fall in CO2 emissions in 2020, according to the International Energy Agency (IEA), but we would need to see this fall every year this decade to limit the temperature increase to 1.5°C above pre-industrial levels — the Paris Agreement’s objective. Overall, according to the International Panel on Climate Change (IPCC) emissions would need to be reduced by 45% from 2010 levels by 2030, and reach net zero emissions by 2050 to fulfil the Paris Agreement.

Achieving this requires an enormous effort. It requires a reallocation of capital and represents an immense investment challenge for the public and the private sector. At EU level, to reach its current 2030 targets of a reduction of at least 40%, the EU must reduce Greenhouse Gas emissions (GGE) by at least 1.4% per year, i.e. 70% faster than efforts made so far. This would already require additional investments of approximately €260 billion a year by 2030. That is over eight times more than estimated spending on climate-change mitigation and adaptation under the current EU budget (see Box 1). With the increase of the 40% reduction target to achieve the Paris Agreement, the €260 billion a year figure will need to be revised upwards. (1)

Clearly, money from the public purse is not going to be sufficient for the transition to a carbon-neutral economy and private and institutional capital will need to be mobilised and reoriented. ‘Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate resilient development’ has therefore been recognised as a key objective in the Paris Agreement (see Article 2c) and ‘Sustainable finance’ was to be one of the priorities for this year’s climate conference COP 26, postponed due to Covid-19.(2). So what exactly is sustainable finance?

Box 1-EU budget spending on climate change mitigation and adaptation

The European Commission estimates that over the whole 2014–2020 period a total of €209 billion has been spent from the EU budget (20% of the EU budget) to mitigate and adapt to climate change. We have previously reported on overestimates in this figure. See special report 31/2016: Spending at least one euro in every five from the EU budget on climate action: ambitious work underway, but at serious risk of falling short and highlighted unrealistic estimates for the next financial period 2021–2027. For that aspect, see also the ECA opinion 7/2018 concerning the Commission’s proposals for the Common Agricultural Policy for the post 2020 period.

Is sustainable finance really about finance and sustainability?

Sustainable finance is one of those concepts with a myriad of definitions and it is worth investigating what it really means. You might discover that it is not really about whether the finance, ‘the money’, comes from sustainable or green business in the first place, but about putting it into ‘sustainable’ or ‘green’ investments. Nor is it clear what ‘sustainable’ or ‘green’ means. To confuse things even more, the term ’climate finance’ can refer to something else, namely when developed countries provide financing/support to developing countries to help them reduce emissions or adapt to climate change. This usage of the term “climate finance” is often applied in international climate change negotiations. For example, the Paris Agreement set a USD100 billion a year target by 2020 for such ‘climate finance’. Over time, several and overlapping definitions of sustainable and/or green have developed. From ‘Socially Responsible Investment’ to integrating ESG (Environmental, Social and Governance) criteria into investment decisions, from ‘Green financing’ focusing on energy transition and combat of climate change to social or ‘impact’ investments which aim to reach certain social goals such as combating social exclusion. In addition, several labels and designations co-exist. The lack of one standard on how to define sustainable and/or green is one of the problems the EU is trying to tackle. It has developed criteria — a ‘taxonomy’ — to define when an economic activity is environmentally sustainable. This is the case when such activity contributes substantially to at least one of six environmental objectives (climate change mitigation; climate change adaptation; sustainable use and protection of water; circular economy, waste prevention and recycling; pollution prevention and control; protection of healthy ecosystems) and does no significant harm to the others, while taking into account minimum social safeguards. In addition to integrating specific angles or criteria in investment decisions, sustainable finance can be about additional layers to be considered — see definitions in Figure 1 below.

Figure 1 — Three definitions of sustainable finance

In its broadest definition, sustainable finance is about reorienting the financial system. Already in 2017, as part of its Mid-term Review of the Capital Markets Union, the European Commission wrote that ‘a deep re-engineering of the financial system is necessary for investments to become more sustainable and for the system to promote truly sustainable development from an economic, social and environmental perspective.’

There is at least one more dimension of sustainable finance: it deals with the preparedness and stability of the financial system itself. For example, climate change already affects the insurance industry: insured losses from natural disasters in 2018 were USD80 billion, double the inflation-adjusted average for the past 30 years. The impact of climate change, the shift in policy and new technology, is already prompting the reassessment of the value of financial assets (‘stranded assets’). This is why central banks and national supervisors have become involved at European and international level, with a specific focus on microprudential/supervisory issues, macro-prudential matters and activities to scale up green finance. In 2017, the Task Force on Climate-related Financial Disclosures (TCFD), created by the Financial Stability Board, issued a set of recommendations for corporate and financial institutions to assess and disclose climate-related risks and opportunities (TCFD 2017). The European Securities and Markets Authority (ESMA) has recently published its strategy on sustainable finance. The Eurosystem, consisting of the European Central Bank and the national central banks, is reviewing the extent to which climate-related risks are understood and priced by the market and is paying close attention to how credit-rating agencies incorporate such risks into their assessments of creditworthiness.

The tragedy of the horizons: why regulation is necessary

Although financial actors are increasingly taking sustainability considerations on board, the shift to sustainable finance is not happening, or happening quickly enough, for the urgency of climate change. This is because of the ‘Tragedy of Horizons’, the term coined by former Governor of the Bank of England, Mark Carney:

The persistence of external environmental and social costs that are not reflected in market prices and valuations means that sustainability is often not considered to be material now. This is the Tragedy of the Horizon. The catastrophic effects of climate change will be felt well beyond the traditional horizons of most actors — imposing a cost on future generations that the current generation has little direct incentive to fix.

Sustainable finance aims to bring this horizon into the cycle of decision makers, for example, by increasing consideration of climate risks by financial markets and actors, increasing disclosure of the environmental impact of economic activities, defining sustainable investments in order to channel funds, or introducing shadow carbon prices to compensate for the lack of a price, or an insufficient price, for CO2 emissions.

An audit perspective on sustainable finance

Sustainability was put, in the words of our ECA President Klaus-Heiner Lehne, ’…at the heart of our work for the audit and review tasks starting in 2020’, and one of the ECA’s highpriority audits concerns sustainable finance. We are examining whether the Commission’s actions contribute effectively towards mobilising private sustainable finance for climate action. The work is challenging, not least due to the fact that the 2018 Commission Action Plan on Financing Sustainable Growth is relatively recent and so are its actions. At the same time, a ‘renewal of the sustainable finance strategy’ has started, as announced in the European Green Deal. Possible changes to other key legislation e.g. the Non-Financial Reporting Directive (NFRD) or Solvency II (Insurance industry) are also being discussed. Much is therefore in the flow.

However, we already have important action on the ground from which lessons could be drawn. The concrete and ‘practical’ side to our ongoing work involves the audit of the infrastructure and innovation part of the European Fund for Strategic Investment (EFSI), of which 40% is supposed to go towards funding climate action. In fact, EFSI is — in terms of amounts — one of the most important EU finance tools for mobilising private sustainable finance to meet the EU climate and energy targets. EFSI is managed by the European Investment Bank (EIB), which will also implement its successor, called ‘InvestEU’.

Opportunity to build a sustainable future or another ‘tragedy of horizons’?

The audit has just become more topical with the Covid-19 induced economic crisis and the recovery measures being put in place. The Commission, in its consultation on the renewed sustainable finance strategy, stated that ‘[t]he ongoing Covid-19 outbreak in particular shows the critical need to strengthen the sustainability and resilience of our societies and the ways in which our economies function.’ The Joint (Commission and Council) Roadmap to the recovery states that ‘The Green transition and the Digital transformation will play a central and priority role in relaunching and modernising our economy.’ The Ministers of the Environment of 17 Member States have called for a green recovery, so has the European Parliament, the IMF, and leading European banks, insurances and investors. But it is not just the green side of sustainable finance which is increasingly in the spotlight. The Covid-19 crisis might be a pivot point to reorient or rebalance the discussion towards the social side of sustainability.

Finally, and from an early point in time, the last weeks have also been an opportunity to show that sustainability pays off. With a correlation between financial performance and a company’s ESG criteria already established in ‘normal’ times, first signs show that sustainable equity funds have performed better than their peers in the Covid-19 downturn.(3)

Sustainable finance is among the IMF’s priorities for a green recovery, which, in the words of its chair, Kristalina Georgieva, is ‘our bridge to a more sustainable future.’ The next months will show whether this bridge can be built or whether we face another ‘tragedy of the horizons’ where short-termism prevails.

(1) See for example in https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_ finance/documents/2020-sustainable-finance-strategy-consultation-document_en.pdf, p. 3

(2) On priorities of sustainable finance see for example: https://www.bankofengland.co.uk/-/media/ boe/files/news/2020/january/prime-ministers-finance-adviser-for-cop26-terms-of-reference. pdf?la=en&hash=28AA05B3D091655BA69215C2610851504D5A08EB

(3) See for example https://www.morningstar.com/articles/976361/sustainable-funds-endure-the-firstquarter-better-than-conventional-funds and https://www.responsible-investor.com/articles/nosurprise-sustainability-funds-outperform-the-market-despite-Covid-19

This article was first published on the 2/2020 issue of the ECA Journal. The contents of the interviews and the articles are the sole responsibility of the interviewees and authors and do not necessarily reflect the opinion of the European Court of Auditors