The rise of sustainable finance

How investors and markets can climate-proof the economy. Green bonds anyone?
Rob Gerlsbeck
Piggy bank with plant growing out of it


f you read The Wall Street Journal, Report on Business or other financial papers, you’ll know one thing about central bankers. They always, always! err on the side of caution. Audacious claims are not in their nature.

No wonder, then, that recent statements by former Bank of Canada Governor Mark Carney made headlines. In an interview with the British newspaper The Guardian in December, he predicted that firms that don’t move to zero-carbon emissions will go bust.

Carney, head of England’s central bank until March, was commenting on the massive economic transition that needs to happen to deal with climate change. “There will be industries, sectors and firms that [will] do very well during this process [transitioning to a zero-carbon world] because they will be part of the solution,” Carney said. 

“Companies that don’t adapt will go bankrupt without question,” he added.

Carney’s point is that we are living in a climate-change world. It is now finally being recognized as the issue of our time. Helping the planet survive and making it sustainable will require an enormous effort. Sustainable finance is one part of the solution.

Not familiar with sustainable finance? Don’t fret. In this article, we’ll examine what it is, what it does and why it’s important. To help, we’ve enlisted some experts: Smith professors Sean Cleary and Ryan Riordan. They’re key figures in the new Institute for Sustainable Finance, a national organization set up last fall, housed right here at Smith School of Business. Cleary, BMO Professor of Finance, is the institute’s executive director; Riordan, Distinguished Professor of Finance, is its director of research. So, let’s get started with the obvious question.

What exactly is sustainable finance? Is it different from regular finance?

Sustainable finance simply means aligning financial systems to promote long-term environmental sustainability and economic prosperity, says Cleary. “That includes channelling investments toward climate solutions and managing climate-related financial risks.”

Investors, especially large ones such as pension plans and sovereign wealth funds, exert enormous influence on companies and businesses. These investors decide where the money goes, after all. So they can play an important role in tackling climate change. How? By investing in green businesses and funding the efforts of “brown” or polluting businesses to become greener. Certain sectors of the economy vulnerable to climate shocks, such as transportation and insurance, also need help. For example, they’ll need better information to price climate-change risks into their businesses.

“Sustainable finance,” says Riordan, “puts the environment into everyday business and investment decisions. Previously, finance ignored sustainability, as if the environment were a costless and riskless input. Now, we’re finally realizing it needs to be thoroughly taken into account in investing, lending and any other kind of financial decision. Otherwise, we’re missing a huge source of risk, a huge source of costs and, potentially, a huge source of returns.”

Sean Cleary

Why is sustainable finance important now?

Climate change is a significant threat to the global economy. Making the world sustainable is critical, Riordan points out. According to The Economist Intelligence Unit, a two-degree Celsius average global temperature increase will trigger financial losses of around US$4.2 trillion. A six-degree warming adds up to $13.8 trillion in losses.

Either scenario has vast implications for investors and businesses. Financial suffering would also be experienced by individuals; for example, seniors who depend on retirement income from pension plans.

But it’s not all bad news. There is a massive financial value — around $26 trillion worth — in shifting economies to avoid the worst-case climate scenarios, says Cleary. That includes spending on climate-smart infrastructure, emissions-reducing technology and updated electricity grids.

“It’s becoming apparent that factoring climate change into [company] decisions is an important part of their fiduciary duty.”

Sean Cleary

So, are investors just shifting their money away from industries that pollute?

Some investors are divesting themselves of such companies, yes. Norway, for example, is ditching oil-and-gas exploration investments through its $1-trillion sovereign fund. 

But not all investors believe divestment is effective. They argue that working with companies to improve sustainability is the better route. Among such investors is Japan’s $1.3-trillion national pension fund, whose strategy is to work with companies to make them greener. An RBC survey found that 39 per cent of investors believe engagement is more effective, compared to 10 per cent who say divestment is smarter (16 per cent think both are equally good).

Regardless of which side of the debate you’re on, sustainable finance has an important role to play in creating markets wherein investors can factor the environment and climate change into their decisions. Take financial disclosure for instance.

Few companies have yet to take climate into account in their financial filings. But investors are pushing for it. After all, they need information that is reliable, consistent and comparable in order to accurately assess investment opportunities and risks, says Cleary. “It’s becoming apparent that factoring climate change into their decisions is an important part of their fiduciary duty.” Indeed, when financial markets don’t have adequate information they struggle to price assets correctly. Think of the lack of information investors had during the tech bubble or the financial crisis. “Information is key to promoting capital flowing in the right direction,” Cleary says.

In 2017, the Task Force for Climate-related Financial Disclosures (TCFD), an industry-led group chaired by Michael Bloomberg, issued a framework for climate-related disclosures. It wants all organizations to make such disclosures a part of their financial filings, with emphasis on the risks and opportunities related to the move to a lower-carbon economy. Meanwhile, two types of bonds now exist – green bonds and transition bonds – to help investors fund green initiatives.

Ryan Riordan

Green bonds? Transition bonds? What are those?

Let’s start with green bonds. These are a specific type of bond to invest in good-for-the environment projects. “Green bond issuers commit to providing investors with detailed, ongoing information on the bond-funded projects,” says Riordan. The world’s first green bond was issued by the World Bank in 2008, becoming the blueprint for today’s green-bond market.

The first Canadian green bond was issued by the province of Ontario in 2014. Since then, green bonds have funded a number of transit and energy-efficiency projects. Canada’s green-bond market is still quite small compared to those of the U.S., China and France; but it’s growing. The total value of green bonds issued in Canada last year was C$3.2 billion.

Transition bonds are relatively new. As the name suggests, they provide money for a company’s transition to sustainability. “The idea is that if companies are in a brown industry, and they want to become more green, these bonds are a way to fund those initiatives,” Riordan says. For example, an energy company might issue transition bonds to pay for moving a significant portion of its generation capacity from coal to natural gas.

Transition bonds may prove especially important to Canada where heavy industries like mining and oil and gas will require significant funds to become greener.

“Sustainable finance puts the environment into everyday business and investment decisions.”

Ryan Riordan

Speaking of Canada, how does sustainable finance impact this country? 

Let’s start with the risks of climate change. Climate analysis shows that Canada is warming twice as fast as the global average. That will have financial impacts and increase risks for businesses (think flooding, extreme weather and forest fires). The Bank of Canada has identified climate change as one of six key vulnerabilities of Canada’s financial system.

Riordan says his research shows that Canada is one of the highest carbon-risk countries in the world, according to investors, up there with South Africa and Brazil. (Spain, Italy and Japan are considered among the lowest-risk countries.) Without a sound sustainable finance strategy, Canada risks losing potential sources of capital. “Large investors like pension funds look 30 years down the road,” Riordan says. “And with climate change, it could become too easy for some of them to skip over us and put their money somewhere else.”

But there’s good news, too, for Canada. Dealing with climate change will create huge economic opportunities here. According to the Smart Prosperity Institute, “Canadian demand for low-carbon technologies will double through 2030” and “the size of the clean-technology investment opportunity will reach a cumulative $184 billion from 2020 to 2030.” To capitalize on these opportunities and attract global financing, Canada will need to embrace sustainable finance. More importantly, it will need to create a made-in-Canada sustainable finance system that’s appropriate for the Canadian economy, says Cleary.

Other geopolitical entities are already working on their own systems. The European Commission, for instance, is developing a financial system to support sustainable growth. This system includes disclosure rules for climate-related financial risk and definitions for what will be considered an environmentally sustainable economic activity. But not all economies are the same. Many of the European rules are unlikely to work well in Canada without appropriate adaptations.

The trouble with relying on foreign sources for financial data and risk modelling was made clear last June at the Green Finance Conference, co-hosted by Smith and the Institute for Intergovernmental Relations at Queen’s University. In one presentation, Craig Stewart, vice-president of federal affairs for the Insurance Bureau of Canada, noted that the Fort McMurray wildfire in 2016 was never modelled as a risk. He added, “when flooding happened in Beauce, Quebec, all the homes that were flooded were considered low risk by our industry. Why? Because all the flood models used by the country’s insurers are from U.S., Europe, and the U.K. The U.K. model didn’t account for ice jams, because they don’t experience them in the U.K.”

To transition to a low-carbon economy while still attracting international investment, Canada will need to develop its own sustainable-finance system and rules. That’s where the Institute for Sustainable Finance (ISF) comes in. Launched last November here at Smith, the ISF connects government, the private sector and academia on sustainable-finance issues. Education, research and collaboration are among the ISF’s priorities. “Businesses don’t have the information they need, nor do they have the internal capacity required to make a lot of these decisions around climate change,” says Cleary. “We can provide the information and education for the people who control the capital.”

Looking ahead, the end-goal of sustainable finance initiatives is to “transform the real economy, with all the resulting benefits to society of living in a low-carbon world,” says Riordan. When that happens, “we won’t be calling it sustainable finance anymore. Sustainability will just be a factor considered every day in finance for allocating capital, managing risk and making investment decisions,” Cleary says. “This transformation is already in motion – we need to accelerate and inform this movement.” The sooner that happens, of course, the better.

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