Decoding Sustainable Finance

Anna Sophie Herken, Business Division Head at Allianz Asset Management and a “40 over 40” Germany 2020 Alumna, knows there is more to be done when it comes to protecting our planet. In this episode of our new series Questions on Finance, she explains what exactly sustainable finance entails, and how it has the potential to save us from global warming

by Anna Sophie Herken | 06 Apr, 2022
Questions on Finance with Anna Sophie Herken

A superhero in tights once said, “with great power comes great responsibility.” In lieu of Spiderman coming to our planet’s rescue, the world of finance is trying to live his credo. In this series on sustainability, we attempt to explain sustainable finance, what it is, and how it may be the secret weapon for saving the planet from global warming.

But first, how did we get into this hot mess? The history of civilization, among other things, has been a story of increasing prosperity for people around the world. Technological innovation, trade, and commerce have been instrumental in decreasing poverty and raising the living standards for millions of people globally. But this progress has come at great environmental cost. The scale at which humans exploited Earth’s resources has far outpaced its ability to replenish. We now face an existential reckoning wrought by decades of carbon emissions, deforestation, loss of biodiversity, and melting polar ice caps.

Being an intelligent and adaptive species, we have made some important adjustments to our ways of doing businesses. Scientists have provided ample proof to raise awareness of climate change at every level of society. Policy makers, companies and households have answered the call to action. The United Nations led the way during the 2015 Paris Summit, where nations made a historic pledge to combat climate change by investing in a low carbon, resilient, and sustainable future. The goal of the pledge is to limit global warming to well below 2 degrees Celsius, preferably to 1.5 degrees Celsius. The Paris Agreement and associated member country commitments have become the guiding path for realizing a sustainable planet.

Pledges are just words, until they become action.

But pledges are just words, until they become action. Here is where the global financial sector comes into play, being the principal conduit through which capital flows. The financial sector comprises about 20-25% of the global GDP. Imagine how this muscle can influence sustainable finance by channeling money into positive environmental projects and diverting money away from harmful ones. The financial sector has the power, and the resources, for instance, to deprioritize a coal powered thermal power plant over a wind farm or to invest in sustainable agriculture, which helps preserve rain forests’ biodiversity.

As primary sources of capital to industry, the onus lies with the finance sector and policy makers to ensure that their investments are sustainable. In its broadest sense, sustainable finance refers to the integration of sustainability in the decision-making process of all financial market actors (investors, investees, regulators, pension funds, governments, etc.); Environmental, social, and governance (ESG) considerations are accounted for when making investment decisions, leading to more long-term investments in sustainable economic activities and projects in all industries. 

Environmental considerations include climate change mitigation and adaptation, preservation of biodiversity, pollution prevention, etc. Social considerations refer to issues of inequality, inclusiveness, labor relations, as well as human rights issues. Governance relates to the administration of public and private institutions including management structures, diversity, employee relations, and executive remuneration.

The financial sector involves a large group of industries like banking, insurance, lending, investments, and others. It is the bedrock of industries that rely on it to channel money to them.

Given this power of the financial sector, it has a responsibility to lead in changing how the world does business and stops destroying the planet in search of profits.

To do this in an efficient and scalable fashion, the financial sector needs a policy and regulatory framework that can integrate sustainability risks into financing and investment decisions. Asset owners (like large pension funds), investment managers, and banks are beginning to self-embed ESG factors into business transactions, viewing ESG as a differentiator and aligning their investment and financing strategy accordingly. By redirecting capital flows, sustainable finance is a precondition to achieving the goals of the Paris Agreement. Governments alone cannot fund the climate financing gap.

Did you know that…

As per the industry group Global Sustainable Investment Association, Broader ESG-related assets account for one in three dollars managed globally – (2022)

As per a Bloomberg Intelligence finding, the total value of ESG assets at the end of 2021 stood at around $35 tril globally – in comparison the size of the US economy was $23 tril – (2022)

According to the European Commission’s website on Sustainable Finance, the EU needs to invest approximately €350 bil more every year (nearly 10% of the German GDP) during the 2021-30 decade than it did during the previous decade, in order to meet these 2030 climate and energy targets – (2022)

And do not underestimate your power as a financial consumer. The next time you pay your insurance premium or buy a mutual fund, you too can influence the money flow by choosing a fund that uses ESG criteria when investing in companies or by choosing an insurer that has committed not to underwrite harmful practices.

Reason for Optimism

Demand for green and sustainable investments is increasing. Consumers are seeking climate-friendly products and custom investment plans that have a positive social or climate objective. Companies are navigating away from ESG risks that negatively impact the planet as well as their reputation and financial performance. Public policies and regulations are stimulating sustainable investments, and the financial industry is beginning to act and self-regulate according to ESG principles.

Financial institutions have engaged in voluntary commitments to increase transparency. Corporations have invested in building ESG competencies and/or acquiring external expertise – new specialists have emerged offering ESG data and tools. Some public and private stakeholders have developed definitions (“taxonomy”) to determine what qualifies as green/sustainable for their institution or jurisdiction.   

While we’re moving in the right direction, a unified approach will speed progress. What’s needed is a clear and universal understanding of which economic activities contribute towards a green/sustainable environment and therefore qualify as sustainable finance (we will look at the state of taxonomy in one of our following pieces.) Coherent policies and stringent regulations will help create a level-playing field for the transition.  

Combating climate change doesn’t take superheroes, just coordinated action from governments, the private sector, civil society, and the international community.

Combating climate change doesn’t take superheroes, just coordinated action from governments, the private sector, civil society, and the international community. The power and responsibility of finance lies in changing the endgame from maximum profits to sustainable growth. For this transition to be credible, it requires engagement of the entire financial system. Power and responsibility must meet.

The journey is well underway to create a world where profits and the planet need not be a trade-off.

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