Today (10th March 2020), the Financial Inclusion Centre publishes its new report, called Time for Action, looking at the degree to which the financial system (financial markets, financial institutions, and individual consumers) contributes to tackling the climate crisis.
The report also assesses the daunting barriers holding back the financing of what we term sustainable, responsible, and social impact (SRI) activities; and makes over 40 policy recommendations to ‘green the financial system’ and increase the level of SRI financing. Some of these interventions are radical and far-reaching. But, the scale of the climate crisis, and need for the financial system to play its full part in tackling that crisis, requires radical interventions.
We are hugely grateful to Friends Provident Foundation for sponsoring this report and the support provided throughout the project stages.
We look forward to engaging with stakeholders on our findings and recommendations over the coming months.
The key findings and recommendations are summarised below. The report itself can be found here: Time for Action – Greening the Financial System FIC FPF Report
KEY FINDINGS AND RECOMMENDATIONS
There would seem to be a growing consensus that, to tackle the climate crisis, we need to change the way:
• We live: the choices we make about how and what we consume.
• We work and produce: the nature of economic activity and the corporate behaviours society expects.
• The financial system works: the allocation of resources by financial institutions, and the choices we make about how our money is used.
• Global markets are governed and regulated: the climate crisis is a truly global issue and so requires a global, collaborative approach to governance and regulation.
Our new report focuses on the role of the financial system. It is certainly an interesting time to be considering the role of the financial system. The social utility of financial markets and their contribution to the climate crisis is under intense scrutiny. The credibility of, and trust in, the sector remains low due to the role it played in the financial crisis of 2008, and a litany of misselling scandals.
Benchmark interest rates and government bond yields were driven down in the aftermath of the 2008 crisis. The effects are still being felt today. Savers, investors, and pension scheme members are exposed to new financial risks, while the allocation of financial resources to the real economy has been distorted.
The financial system is under renewed stress driven by fears of the potential economic impacts of the Coronavirus and disruption in the oil markets. It is likely to be some time before interest rates and bond yields return to typical pre-crisis levels (if they ever do).
But, this ‘new normal’ of low interest and bond rates should also create opportunities for finance for good – sustainable, responsible and social impact activities which we refer to collectively as SRI. Financial institutions and households are looking for ways to generate decent returns to offset the low yields on deposits and bonds (the ‘search for yield’). The sheer scale of the assets available in financial markets and savings, investment and pensions portfolios creates a huge pool of potential resources to be channelled into SRI activities.
This report, therefore, set out to assess the potential for SRI growth. To do so, we asked two questions:
• Do previous behaviours give us hope for the future? Specifically, in the post 2008 low rate world have financial institutions and investors significantly increased the amount of resources allocated to SRI activities?
• What are the barriers that limit the financing of SRI activities, and what policies are needed to promote greater levels of SRI financing?
Our findings confirm that SRI has indeed moved up the agenda, attitudes have become more positive, and there has been some growth in assets allocated to the sector. But, it must be said, there is a long way to go before SRI is mainstreamed into financial markets.
The proportion of total assets held by financial institutions and households in SRI remains very low – particularly seen against the amount invested in alternatives (such as hedge funds or private equity), banks have lent to other parts of the financial system or to the property market, and households have invested in the buy-to-let property market. On the retail investment side, just 1.4 percent of total assets under management are invested in ethical funds.
Globally, the value of funds managed with explicit environmental, social, and governance (ESG) criteria is still under one percent of total global assets under management. ESG assets under management would seem to be growing at a slower rate than mainstream assets under management. Similarly, specific green bonds represent a small fraction of the vast global bond markets.
UK company boards are not coming under sustained pressure from shareholders to realign company operations to SRI goals. The UK scores poorly on issuing green bonds for domestic use compared to other countries with smaller financial centres. The UK has regularly failed to meet its targets for direct investment in clean energy projects. Bank direct lending to green projects has also been disappointing, while the Bank of England’s QE programme has been skewed towards high carbon sectors of the economy. It is not surprising therefore that the level of economic activity in the green sector has also been disappointing still representing around one percent of total economy turnover.
The barriers and factors constraining SRI financing
What explains the disappointing performance so far? There are daunting barriers to overcome if we want to see the necessary level of financial resources allocated to SRI.
Specific nature of SRI projects Long payback periods and the perceived higher risk of SRI assets can be unattractive to risk averse, short-termist financial institutions and markets.
Institutional factors A range of factors including the type of liabilities institutions face, tolerance to risk, and the need for liquidity reduces the viable pool of resources available for SRI.
Financial regulation Misconceptions about legal duties can constrain willingness to finance SRI. Gaps in consumer protection means that less sophisticated investors are vulnerable to misselling of supposedly ‘green’ financial products which could undermine confidence and trust in SRI. Growing awareness of SRI increases the risk of ‘greenwashing’ in the financial system and the real economy.
Information and perception barriers There is a lack of clear definitions and criteria for determining whether an economic activity complies with SRI goals, and a lack of trustworthy benchmarks and inconsistent ratings to judge how well loans and investments comply with SRI criteria. Data and research on risks and rewards associated with SRI assets is very limited. The amount of effort and cost required to identify potential SRI financing opportunities can deter financial institutions.
Limited market infrastructure to support SRI This includes a lack of an appropriate primary and secondary market infrastructure for raising capital and trading of SRI assets, and collective investment vehicles for managing the risk of investing in smaller scale SRI projects. But, promoters of SRI face a catch 22 situation. Sufficient resources are unlikely to be committed to developing the necessary research base and infrastructure unless those asset classes become more popular. But, SRI is unlikely to become mainstream without the necessary research and supporting infrastructure. This is a particular problem for smaller or early stage SRI ventures.
Dominant culture of short termism and shareholder value Market short-termism is at odds with the long payback periods associated with direct investment in SRI, and is a constraint on listed companies who wish to spend time and money ‘greening’ their operations. Greening the UK economy will require significant investment in research and development (R&D). But the UK has a low level of spending on R&D and corporate investment compared to other major economies. The emphasis on shareholder value appears to lead to lower levels of investment and holds back innovation.
Limited availability of suitable SRI ventures The lack of viable SRI ventures creates a natural barrier restricting the amount of SRI finance that can be channelled into economic transformation.
Other market factors Passively managed funds now represent 25 percent of total UK assets under management in UK. Passive funds automatically include shares of companies from energy-intensive sectors in their portfolios, and are not actively managed so fund managers do not seek out potential SRI opportunities not listed on markets. Investment consultants influence investment and asset allocation decisions on £1.6 trn of pension assets (out of a total of around £2 trn). Similarly, nearly 80 percent of money managed on behalf of retail investors is done on an advised basis. Persuading these influential gatekeepers of the merits of SRI will be a priority.
So, what needs to be done? There are a number of existing civil society and market-led initiatives designed to promote greater use of SRI which we support. But our analysis of the structural barriers tells us these are unlikely to go far enough to mainstream SRI into financial markets. We make 41 specific policy recommendations grouped around the core policy aims of:
– Increasing the availability of consistent, trustworthy SRI information, research, and analysis
– Raising awareness of and promoting confidence in SRI assets
– Encouraging investors, lenders, and intermediaries to engage with SRI
– Embedding SRI into decisions made by lenders, investors, and financial intermediaries
– Better aligning financial market behaviours with SRI goals
– Creating a more supportive regulatory architecture
– Ultimately, increasing the resources allocated to SRI by the public and private sector.
Details of the policies can be found in the report. The key recommendations are:
• Stakeholders should collaborate on developing a central repository of information, research, and risk analysis on SRI. This should be accessible to financial institutions, regulators, pension trustees and citizen-investors.
• Post Brexit, UK stakeholders should prioritise the development of a UK SRI classification system to help regulators, lenders, and investors identify the degree to which economic activities, sectors of the economy, and individual listed and larger private companies comply with SRI goals. To address the risk of greenwashing, stakeholders should develop a new SRI compliance rating system based on the new taxonomy published on an accessible, central database. For retail investors, an SRI rating label should be developed and included in comparative information tables.
• SRI funds/ financial products, and firms that provide and promote those funds/ products, should come under the same FCA regime as mainstream financial products and covered by the Financial Ombudsman Service (FOS), and Financial Services Compensation Scheme (FSCS).
• Regulators should introduce deterrence factors for ‘brown assets’ and penalties for financing economic activities that damage SRI goals, not incentivise through ‘green supporting’ factors.
• Financial institutions should be mandated by regulators to assess how lending, investment, and insurance decisions contribute to SRI goals; and publicly report the results of those assessments using the SRI classification mentioned above.
• Government should consider new tax structures including a financial transactions tax (FTT) to encourage long term investment horizons, early stage SRI financing, and long term investment in research and development (R&D) with a focus on climate related projects and cleantech.
• Stakeholders should develop collective investment and lending schemes to allow institutional and retail finance to be channelled into early stage/ small scale SRI ventures in a way that minimises costs and diversifies risks. Stakeholders should work with investment industry experts to develop a wider range of SRI index funds.
• The market on its own will not deliver the necessary financing. The state needs to play an active role. There is a strong case for a national SRI Investment Bank to finance early stage SRI ventures and take equity stakes in established ventures. The British Business Bank should also be given a specific new objective to finance SRI projects. Government should issue Green Sovereign Bonds to finance larger scale SRI initiatives. National Savings and Investments (NS&I) should offer Green Finance and Social Housing Bonds to allow citizens to play a role in financing SRI. Government should support local authorities in developing community Green Finance and Social Housing Bonds.
• The Bank of England should be given a new statutory objective to promote financial market behaviours that contribute to economic and environmental sustainability. The FCA and Prudential Regulation Authority (PRA) should be given new obligations to support and have regard to the impact of their policies on the Bank of England’s sustainability objective.
• The FCA should be given responsibility for overseeing how financial institutions, listed companies and larger private companies disclose compliance with SRI criteria. Reporting on SRI compliance should be made a statutory requirement rather than voluntary, with appropriate sanctions for non-compliance with reporting standards.
• Government and Bank of England should establish a Financial Sustainability Committee (FSC) along the lines of the Monetary Policy Committee (MPC). The FSC should take responsibility for the Bank’s new statutory objective described above and coordinate the work of all the regulators involved in managing climate related risks – the Bank of England, PRA, FCA, and The Pensions Regulator (TPR). The FSC should publish an annual report on its activities plus a wider triennial review on progress against its objectives. The FCA, PRA, and TPR should also publish an assessment in their annual reports on how their activities have contributed to the objective of the FSC.
• The government should lead a new strategy to green the ‘real economy’. Building on the work of the Committee on Climate Change (The CCC), government and relevant regulatory authorities should undertake a ‘transformation audit’ of the main economic sectors to assess the contribution each sector has made to the greening of the economy; and develop a transformation action plan for each sector. Government should establish a single agency to coordinate this strategy. This new agency, along with the National Audit Office (NAO) should develop new metrics to judge the performance of each sector, and publish annual updates and a formal triennial review of progress made against the transformation strategy.
• It is not yet clear how Brexit will affect initiatives to develop SRI financing. Therefore, policymakers and civil society should collaborate on analyses to assess the implications of Brexit on UK initiatives to promote SRI. In particular, this should consider the effect if the UK is no longer a key player in the European Union’s ambitious Capital Markets Union (CMU) project and Action Plan for Financing Sustainable Growth.