Private sustainable finance practices are failing to catalyse deep transitions

Key messages

  • Financial markets are crucial for delivering net zero, especially in economic sectors with heavy climate impacts. However, private sector “sustainable finance” practices are not yet catalysing the profound and rapid transformations needed to meet climate targets.
  • The large majority of today’s sustainable finance practices are designed to fit into the financial sector’s existing business models rather than to allocate capital in ways that would provide the most impact on combating climate change. The result is that a large share of sustainable finance practices to date do not have strong impacts for shifting capital; they are only moderate drivers of sustainability.
  • Implementing and strengthening climate policy measures, such as carbon prices and taxes, minimum standards, and support measures for low-carbon solutions, remain most important for directing economic incentives towards climate solutions and thus shifting capital towards these solutions.
  • Private sustainable finance practices must also advance rapidly so that they are better aligned with climate policy efforts and enhance those efforts. To this end, policymakers need to develop policies aimed directly at the financial sector that (a) significantly improve on the transparency of emissions embodied in investments and savings; and (b) ensure that capital flows become aligned with the Paris targets in ways that have real impacts on emissions and resilience in our economies.

Insight explained

Societal decarbonisation involves almost all business sectors and requires large investments in new technologies and practices. As a consequence, financial markets are crucial in the transition to net zero, especially for raising the sustainability performance for economic sectors with heavy climate impacts and enabling effective adaptation across the global economy. The financial sector can seem like a giant tanker that takes a long time to change course, but its climate-focused global initiatives are finally helping to shift the direction of business activities. Among them are the Task Force on Climate-related Financial Disclosures, the Network for Greening the Financial System, and the EU Taxonomy for Sustainable Activities in response to climate change risks. So-called climate finance, green bonds and socially responsible investment (collectively sustainable finance and investment, or SFI) are also all on the rise.

Negotiations surrounding climate finance continue to be contentious, but some progress was made at COP26. The Glasgow Climate Pact provides entry points for public and private financiers to make good on their climate pledges. Further, the private finance sector has launched initiatives such as the Glasgow Financial Alliance for Net Zero, which manages US$130 trillion of assets, the Net-Zero Insurance Alliance, and the Green Finance Platform. The number of signatories by investment companies to the Principles for Responsible Investment rose from 63 in 2006 to 1,715 in 2018. This signified a change in assets held from US$6.5 trillion to US$81.7 trillion. Climate finance is also growing, averaging US$632 billion in 2019–2020, as is sustainable debt, which stood at US$1.6 trillion in 2021.

But climate finance needs to move faster. Recent research shows that private sector sustainable finance practices are not influencing the real economy to the point that could catalyse the deep and rapid transformations needed to meet the climate targets, and in some cases can encourage environmentally damaging practices that erode resilience for humans and the planet. There is a lack of evidence for sustainable practice claims made by sustainable firms who “fail to clarify the real impact…on people and ecosystems”. In a similar vein, it has been found that there are limited sustainability outcomes of SFI in the context of the European Union, and there are only modest impacts resulting from SFI. It has been noted that it complements but cannot replace strong policy measures such as carbon prices and taxes and regulatory standards.

Reforms in the governance of climate metrics and disclosure are needed to ensure that claims of capital allocation to climate-friendly investments lead to low-carbon development and climate resilience in real economies. One solution, widely endorsed by finance scientists and professionals, is to develop decision-support tools such as metrics, rankings, ratings and standards. There should also be a monitoring mechanism to ensure that these standards are being followed. However, issues such as inconsistencies in international standards and in governmental involvement in green bonds need to be resolved, probably through harmonisation, to overcome the differences between markets, in the practices of governments and institutions, and in environmental focus areas including carbon and ecosystems.

One promising area is the potential for global financial services and capital markets to drive climate action via sustainable finance. There is a strong positive correlation between active engagement by the “Big Three” investor companies (BlackRock, Vanguard and State Street Global Advisors) and reduced emissions of the chief emitters. Institutional investors can improve environmental, social and governance (ESG) performance via engagement with the companies they have ownership stakes in.

Looking ahead, various green financial standards might be enacted by combining different models that can be tailored to local circumstances. The task could be achieved through the efforts of governments and intermediary actors, together with progressive financial institutions. To be sure, stronger public action and policies will be crucial to facilitating the shift in private capital needed to achieve the climate targets. Such means could include direct public financing, public risk mitigation and national regulating (including of the financial sector itself), as well as carbon taxes and pricing.


The financial sector must shake off endemic greenwashing

The financial sector is in an early stage of reckoning where it faces the multifaceted challenges related to climate change. The key constraints to demonstrating the material addition of sustainable finance include the data-related gaps in climate disclosure and metrics as well as inadequate analytical tools such as ESG ratings. These are obstacles to the orderly transition to low-carbon economies, as evidenced by the financial sector’s lateness in recognising corporate greenwashing and the related risks for effective sustainable finance practices. One study found no difference in the environmental performance of ESG and non-ESG mutual fund companies, only differences in the level of voluntary ESG disclosure (Chen and Zhao, 2021). In essence, sustainable finance is hobbled by the greenwashing practices endemic in sustainability reports. Consequently, the financial sector needs to build capacity towards assessing and managing the flaws evident in sustainable investment practices so that tangible sustainability-improving outcomes are prioritised.

Implications & Recommendations

Most sustainable finance practices do not deviate from existing expectations on profit in the financial sector. In addition, the global finance system currently suffers from critical constraints, such as data gaps in climate disclosure and metrics as well as inadequate analytical tools that limit the finance sector’s ability to effectively align the allocation of capital with climate targets.

Climate negotiators and decision makers at all levels – international, national and local – need to:

  • Develop strong policies requiring high levels of transparency and accuracy in the reporting of the emissions associated with investments, savings and economic activity, especially in the banking sector and in capital markets given the direct link between credit and economic activity.
  • Facilitate financial sector transparency: decision makers must develop or strengthen policies and tools that ensure that those companies and the sectors responsible for the largest share of emissions are accurately reporting their emissions throughout their value chains and not engaging in greenwashing.
  • Develop policies aimed directly at the financial sector that ensure that capital flows become aligned with the Paris climate targets, with a particular emphasis on the real economy impacts of this alignment.
  • Adopt broader climate policies that ensure that climate-friendly investments are economically viable and that emissions-intensive activities become increasingly economically unviable, thus creating incentive structures that strongly incentivise financial actors to direct capital towards climate solutions.

 The finance sector needs to:

  • Develop and implement improved and more-transparent methods to assess the climate impacts of the capital they manage and the climate-related risks and opportunities they face in the transition to net-zero by the mid-century.
  • Develop clear strategies with both short-term and long-term targets/milestones for how they will align their capital allocation with the targets of the Paris Agreement.
  • Ensure that the sustainable finance practices adopted to allocate capital to climate-friendly investment actually lead to low-carbon development and climate resilience in the real economy.
Figure 7. Sustainable Finance annual issuance and market outlook. This graph includes green, social, sustainability, sustainability-linked, and transition labelled debt. Cumulative total labelled issuance stood at USD3.3tn at the end of H1 2022. Redrawn from Sustainable Debt Market Summary H1 2022 (August 2022), Climate Bonds Initiative (https://www.climatebonds.net/market/data/)

Where do we stand?

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What to do?

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