The financial industry plays an indispensable role in the modern economy by allocating society's savings to borrowers engaged in productive pursuits. It could also play a crucial role in facilitating the investments needed to combat climate change, but only after it is restructured for that purpose.
LONDON – Since the 2008 financial crisis, the question of how to guide activity in the sector has featured prominently in public discourse, particularly in debates about building a sustainable future. In its most basic form, finance is a means of arbitrage between savers and borrowers: its purpose is to direct society’s savings toward productive ends. For those who provide financing, the goal is to support projects that promise a high return relative to a given level of risk, and to shy away from projects perceived as too risky for the return on offer. Most large corporations conduct the same kind of assessment when deciding how to allocate capital.
The problem is that some of society’s greatest challenges are in areas where the possible risks may outweigh the likely returns. If the financial industry is left to “self-regulate” – as it was in the West between the mid-1980s and 2008 – lending will be channeled primarily toward areas perceived to be relatively low-risk and high-return. But, as the fallout from the financial crisis showed, a self-regulating industry’s collective judgment of those risks and returns can be deeply mistaken. Financial-market sentiment, after all, tends to veer between fear and greed, each representing an extreme that is rarely correct.
Given these shortcomings, it is clear that the finance business should be more diversified, so that aggregate judgments and market signals do not reflect mere “groupthink.” Different types of lenders need to be driven toward different purposes, and with different sets of incentives. Among traditional investment banks and other highly leveraged entities, there should be some with a specialty in risk management to serve as intermediaries in higher-risk projects. At the other end of the spectrum, there should be utility-like financial providers to intermediate for lower-risk investments.
As for the challenges associated with sustainability, I will focus here on the United Kingdom. But many of the key insights that apply to the UK no doubt are valid for many other countries, too.
Before her departure this summer, former British Prime Minister Theresa May introduced a “statutory instrument” in Parliament that commits the UK to achieving net-zero carbon dioxide emissions by 2050. At the time of writing, no other G7 country has adopted such an ambitious target, which raises the question of whether it is credible. As the Chancellor of the Exchequer’s office was quick to point out, the attendant costs to the UK economy could exceed £1 trillion ($1.25 trillion).
In its current state, the financial system simply is not set up to handle a challenge on this scale. If Parliament intends to take May’s target seriously, it will have to introduce significant reforms. Among other things, the Bank of England may need to add new levels of risk weighting to its regulatory framework, which could require an expanded mandate from the government.
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But the UK is also confronting at least three other domestic challenges linked to the issue of sustainable finance. First, the UK economy has deep regional imbalances, with some areas registering such low productivity for so long that many financial providers have written them off.
Fortunately, since 2014, when then-Chancellor George Osborne adopted the Northern Powerhouse plan, the government has taken steps to close regional productivity and investment gaps, and many of the candidates to succeed May also focused on this issue. Looking ahead, it may be time for policymakers to provide stronger guidance and incentives for financial providers on the “utility” end of the risk spectrum, as well as a larger allocation of government-backed capital through the British Business Bank and other development bodies.
The second challenge is infrastructure investment. Politicians are happy to tout big, shiny rail projects like High Speed 2 (HS2), but they rarely go into detail about how these massive outlays will be financed. With so much investment needed in transportation, energy, and other sectors, it is clear that the UK will need a much larger source of “patient” capital.
The third related challenge is industrial policy. Those politicians calling for a rescue of Britain’s declining steel industry need to stop and ask themselves how that goal serves the larger effort to tackle climate change. Regardless of whether steel is produced domestically or imported, it will have some bearing on the net-zero emissions target. Should financial institutions be required to adopt risk-weighting methods that favor the steel or auto industry, or should they favor zero-carbon activities?
These are just a few examples of the issues that policymakers will have to consider. What is immediately clear is that the financial system is currently in no position to meet the sustainability challenge.
Still, there are hopeful signs of change coming from within the financial sector itself. New concepts like “impact investing” and “business with purpose” are gaining popularity, as are angel and venture-capital funds with socially oriented missions. There is also a generational shift underway. For millennials and those who will come after them, it is simply obvious that finance must play a more productive role in averting catastrophic climate change. These are still early days. But I am confident they will put their money where their mouths are.
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LONDON – Since the 2008 financial crisis, the question of how to guide activity in the sector has featured prominently in public discourse, particularly in debates about building a sustainable future. In its most basic form, finance is a means of arbitrage between savers and borrowers: its purpose is to direct society’s savings toward productive ends. For those who provide financing, the goal is to support projects that promise a high return relative to a given level of risk, and to shy away from projects perceived as too risky for the return on offer. Most large corporations conduct the same kind of assessment when deciding how to allocate capital.
The problem is that some of society’s greatest challenges are in areas where the possible risks may outweigh the likely returns. If the financial industry is left to “self-regulate” – as it was in the West between the mid-1980s and 2008 – lending will be channeled primarily toward areas perceived to be relatively low-risk and high-return. But, as the fallout from the financial crisis showed, a self-regulating industry’s collective judgment of those risks and returns can be deeply mistaken. Financial-market sentiment, after all, tends to veer between fear and greed, each representing an extreme that is rarely correct.
Given these shortcomings, it is clear that the finance business should be more diversified, so that aggregate judgments and market signals do not reflect mere “groupthink.” Different types of lenders need to be driven toward different purposes, and with different sets of incentives. Among traditional investment banks and other highly leveraged entities, there should be some with a specialty in risk management to serve as intermediaries in higher-risk projects. At the other end of the spectrum, there should be utility-like financial providers to intermediate for lower-risk investments.
As for the challenges associated with sustainability, I will focus here on the United Kingdom. But many of the key insights that apply to the UK no doubt are valid for many other countries, too.
Before her departure this summer, former British Prime Minister Theresa May introduced a “statutory instrument” in Parliament that commits the UK to achieving net-zero carbon dioxide emissions by 2050. At the time of writing, no other G7 country has adopted such an ambitious target, which raises the question of whether it is credible. As the Chancellor of the Exchequer’s office was quick to point out, the attendant costs to the UK economy could exceed £1 trillion ($1.25 trillion).
In its current state, the financial system simply is not set up to handle a challenge on this scale. If Parliament intends to take May’s target seriously, it will have to introduce significant reforms. Among other things, the Bank of England may need to add new levels of risk weighting to its regulatory framework, which could require an expanded mandate from the government.
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Access every new PS commentary, our entire On Point suite of subscriber-exclusive content – including Longer Reads, Insider Interviews, Big Picture/Big Question, and Say More – and the full PS archive.
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But the UK is also confronting at least three other domestic challenges linked to the issue of sustainable finance. First, the UK economy has deep regional imbalances, with some areas registering such low productivity for so long that many financial providers have written them off.
Fortunately, since 2014, when then-Chancellor George Osborne adopted the Northern Powerhouse plan, the government has taken steps to close regional productivity and investment gaps, and many of the candidates to succeed May also focused on this issue. Looking ahead, it may be time for policymakers to provide stronger guidance and incentives for financial providers on the “utility” end of the risk spectrum, as well as a larger allocation of government-backed capital through the British Business Bank and other development bodies.
The second challenge is infrastructure investment. Politicians are happy to tout big, shiny rail projects like High Speed 2 (HS2), but they rarely go into detail about how these massive outlays will be financed. With so much investment needed in transportation, energy, and other sectors, it is clear that the UK will need a much larger source of “patient” capital.
The third related challenge is industrial policy. Those politicians calling for a rescue of Britain’s declining steel industry need to stop and ask themselves how that goal serves the larger effort to tackle climate change. Regardless of whether steel is produced domestically or imported, it will have some bearing on the net-zero emissions target. Should financial institutions be required to adopt risk-weighting methods that favor the steel or auto industry, or should they favor zero-carbon activities?
These are just a few examples of the issues that policymakers will have to consider. What is immediately clear is that the financial system is currently in no position to meet the sustainability challenge.
Still, there are hopeful signs of change coming from within the financial sector itself. New concepts like “impact investing” and “business with purpose” are gaining popularity, as are angel and venture-capital funds with socially oriented missions. There is also a generational shift underway. For millennials and those who will come after them, it is simply obvious that finance must play a more productive role in averting catastrophic climate change. These are still early days. But I am confident they will put their money where their mouths are.