Resolving the Sustainable Finance Conundrum: Activist Policies and Financial Technology

The outbreak of the COVID-19 pandemic and its devastating impact on public health and social and economic systems should force a rethink of public policies directed at the achievement of the United Nations (UN) Sustainability Development Goals (SDGs). The current funding gap for the achievement of SDGs remains enormous. In a recent Article, I explain the funding gap as the product of three formidable obstacles: legal restrictions, lack of a framework for the monitoring and verification of the actual sustainability impact of green investments and policies, and finance models that narrowly measure investment risk and return. The latter often identify sustainable investments, especially in the developing world, as ones of high risk and low return. These obstacles act like a dam with regards to sustainable finance flows. Arguably, the dam may only be breached if public policy takes a stronger role in actively encouraging sustainable investment through tax and regulatory incentives.

To implement that policy, an accord among G-20 countries, from which most private investment flows originate, is required. Arguably, a tax that treats capital flows that do not have a direct or indirect sustainability impact, for example investments in the carbon fuel industry, as a negative externality would constitute a radical departure from the more benign policies tried so far such as reporting/disclosure and pricing of carbon emissions. To be effective it would require international consensus.

Augmenting sustainable investment could provide a substantial boost to economic and employment recovery in the aftermath of the COVID-19 pandemic. Therefore, there has never been a better time to raise the prospect of reaching an international consensus on taxing non-sustainable investing. Calls for a similar levy that could be used for development finance or to cut speculation in financial markets were also made in the aftermath of the Global Financial Crisis, without success. But the launch by US Treasury Secretary Janet Yellen of a G-20 initiative to create a global level playing field in corporate taxation suggests that this time may be truly different.

The Sustainable Funding Gap

Governments, central banks, and supra-national organizations like the European Commission—with the adoption of the European Green Deal—and the G20 are striving to increase flows to sustainable finance funds and products through a host of policies. These include specially designed investment vehicles, climate risk disclosure, product standardization and taxonomy. Still for business and investment models to overcome the short-termism and narrow focus on investment risk and return, public policy has to shift from a strong yet passive encouragement of sustainable finance flows into activist policies.

Public sector tax subsidies and regulatory waivers can be calibrated on a rising scale based on the predicted—and actual—impact of a specific sustainable investment portfolio. All such subsidies can be subject to robust ex post monitoring with clawbacks attached, if the investment does not achieve the predicted impact for any reason other than, perhaps, force majeure.

The utilization of financial-technology-powered processes can respectively offer a way to forecast sustainability impacts ex ante and verify such impacts ex post. It could also help to measure how much profit an investment portfolio would have made with a lower percentage of green investments for the purpose of calculating the size of public subsidies.

The Role of Cutting-Edge Financial Technology

Cutting-edge financial technology can be critical in terms of boosting sustainable finance and creating a scientifically accurate environment for the allocation of the proposed green taxes and subsidies among investment portfolios. First, measuring the impact of sustainable investments ex post through spatial finance analysis can verify the effectiveness of the investment in terms of furthering the SDGs and augment the credibility of sustainable finance products. Secondly, technology can also help to overcome another major obstacle: the problem presented by the characterization of sustainable investments as high risk and low return, under the traditional investment models. I have already suggested that a number of clearly defined quantitative indicators could be incorporated into investment models to calculate the sustainability impact of an investment.

The United Nations Environment Programme Finance Initiative (UNEPFI)’s Rethinking Impact lays out and develops the ideas behind the ‘as-yet under-explored potential’ of social, economic and environmental impacts to generate financial revenues via impact-based business models that can boost long-term enterprise value. Nonetheless, sustainability impact will have to be defined on the basis of quantifiable pre-set indicators. In my article, I propose the construction of a commonly accepted sustainability impact index to go hand-in-hand with World Economic Forum’s (WEF) standardized matrix for ESG impact assessment.

An Organisation for Economic Co-Operation and Development (OECD) High Level Expert Group—chaired by Joseph E. Stiglitz—has developed a number of indicators to measure so-called ‘current and future well-being’, which are, in part, capable of being quantified.  For example, indicators about income distribution among households, intra-household income distribution and gender wealth gap. But other indicators, such as measurement of quality of life and equality of opportunity, may prove hard to quantify in order to fit them into sustainability impact dashboards. International organizations should endeavor to standardize the measurable indicators of a sustainability impact index. Then each investment would be scored for its predicted contribution to the achievement of SDGs. The proposed impact index could be incorporated into sustainable investment models, namely models that would offer a clear indication of the interplay among expected risk, return, and sustainability impact.

The proliferation of spatial information can provide evidence about the environmental and social context of investments. Spatial finance can have a profound impact on the way financial institutions assess climate risks. But spatial finance can go beyond augmenting the quality of pricing and hedging of climate change risk. If used properly, it can revolutionize on-going and ex-post monitoring of sustainable finance projects.

Asset managers decide their investment strategies—asset allocation in a portfolio—mainly on the accepted rate of return for given risk and optimal diversification. These are derived through the use of mathematical abstractions or models. The most popular investment models measure the return of investments on the basis of Net Present Value (NPV), essentially the assets’ future cash flows discounted by a risk-free rate. Finance professionals also use non-linear or so-called stochastic models to capture random events. They try to imitate as much as possible forecasting models used in physics. It is, therefore, paradoxical that a very complex system like finance is principally seen as a bi-dimensional system. This contrasts with the way modelling is being used in most other complex systems such as molecular biology, weather forecasts, or climate change.

The perceived lack of synchronicity of CAPM models—namely that an investment is mostly assessed by reference to NPV, whereas sustainability impacts are assessed over time—is a false assumption. Most investment professionals today use the inter-temporal CAPM model developed by Robert Merton. I-CAPM is a more realistic approach of how investors build their portfolios over a number of years to shape their strategy as market conditions and risks change over time.

Any differences in predicted returns between the two-dimensional and the tri-dimensional models could be used to quantify the fiscal subsidy of a sustainable portfolio. In addition, based on expected returns, diversification rates, and historical performance, regulators could undertake to fine-tune capital, liquidity, and large exposure requirements for sustainable finance by banks and investment funds. That would provide additional resources to the achievement of SDGs and of the objectives of the Paris Accord.

Conclusion

Humanity today stands at critical cross-roads. Given the persistence of the discussed funding gap for the achievement of SDGs, more radical policies are required to reposition capital resources. We need a G-20 Accord to sanction a policy that utilizes fiscal and regulatory incentives to avoid arbitrage. Combining activist policies with the utilization of cutting-edge technology can revolutionize the mechanics of investing. With autonomous finance gathering momentum, increasing the number of investment dimensions from two to three to include sustainability impact has come within reach. Opening the scientific and policy-making debate to these new ideas could be another way to turn the COVID-19 pandemic into a window of opportunity for the achievement of sustainable economies and societies.

Emilios Avgouleas holds the Chair for International Banking Law and Finance at the University of Edinburgh.