Unsafe working conditions. The use of child or forced labour. Environmental impact in protected areas. More and more investors are looking at issues and factors that go beyond traditional financial analysis when making decisions about their money.
The purpose of sustainable finance is to help society better meet today’s needs and to ensure that future generations are also able to meet theirs.
The IMF’s latest Global Financial Stability Report (GFSR) discusses the link between sustainable finance and financial stability and proposes policies for moving forward in the future.
Sustainable finance incorporates ecological, social, and governance (ESG) principles into corporate decisions and investment strategies. The idea encompasses many issues, from climate change and pollution to labor practices, consumer privacy, and the competitive behavior of companies.
Efforts to incorporate such considerations into finance began thirty years ago, but it is only in recent years that they have accelerated.
The principles of sustainable finance (ESG) and financial stability
Environmental, social and governance issues can have a considerable impact on corporate performance and the stability of the financial system more generally. Governance weaknesses in banks and firms contributed to the Asian crisis and the global financial crisis.
Social risks, in the form of inequalities, can induce authorities to excessively facilitate household consumption indebtedness, which could lead to financial instability in the medium term. Environmental disasters have caused great losses to companies and insurance companies.
Climate change is a prominent aspect of sustainable finance. Here, there are two main channels of risk. Physical risks, which include damage from weather events and broader climate trends.
Transition risks, which arise from changes in the price of abandoned assets (assets such as coal and oil that will not be used during the phase-out of fossil fuels), and which are related to economic shocks arising from climate policies, technology and market attitudes during the transition to a lower-carbon economy.
The financial risks of climate change are difficult to quantify, although most studies estimate economic and financial costs in trillions of dollars. Insurance losses from climate-related natural disasters such as droughts, floods and forest fires have already quadrupled since the 1980s.
Asset prices may not yet fully incorporate the costs of climate risk and the transition to a cleaner economy. Late recognition of these risks could lead to a moment of stress when investors would suddenly demand that risk be incorporated into the value of assets, which could have detrimental consequences for financial stability.
ESG principles in portfolio investment
The application of sustainability principles began in equity markets through investor activism, as an attempt to influence corporate actions, and subsequently extended to fixed income markets, mainly with so-called green bonds, which finance environmental projects.
The impact of sustainable finance
Companies do not report on sustainability on a regular or systematic basis, particularly on the environmental and social dimensions. Investors therefore find it difficult to incorporate ESG principles into their portfolios. What external providers of ESG ratings try to do is provide standardized assessments, but sometimes they find it difficult to get an accurate picture because of a lack of information.
There is also uncertainty about how to measure the effectiveness of ESG activities in achieving goals such as reducing emissions or improving labour standards.
Ecological money laundering – i.e. misrepresentations about the compliance of assets and funds with ESG principles – is also a concern that can give rise to reputational risks.
Ambiguous data on the performance and impact of ESG funds complicates the task of investors to incorporate these principles into their investments, especially in the case of public sector pension funds.
Companies also face challenges: although they benefit from the integration of ESG factors into their business models, positive results are often seen in the long term, while high disclosure costs are immediate.
Strong policies needed
For sustainable finance to effectively address key risks, urgent and decisive policies are needed in four key areas:
- Standardisation of terminology on ESG investments, as well as clarifications on activities related to E (ecological), S (social) and G (governance) issues.
- Systematic reporting by companies to encourage investors to use ESG data.
- Multilateral cooperation that encourages the participation of more countries and avoids the setting of non-standardized standards.
- Implementation of policies that promote investment in sustainability, and that require the disclosure of information on the cost of inaction.
The IMF will continue to incorporate considerations of ESG issues, particularly those related to climate change, where it is central to the macroeconomy, through its multilateral surveillance work, such as the Fiscal Monitor report and future GFSR reports, as well as its bilateral surveillance activities.