Why Asian investors should consider environmental, social and governance factors in their investment decisions.
Many Asian countries have set ambitious targets for climate change mitigation. Governments all over the region are devising green growth strategies, aiming to reconcile economic growth with low carbon emissions as well as trying to limit other forms of environmental degradation such as soil, water, and air pollution.
“What is needed is a “green transformation” to put green growth at the heart of development. ”
Public finance alone will certainly not suffice to make this change. Even though public finance will be crucial in supporting the green transformation, a large chunk of the necessary financial resources must come from private investors. And the financial sector will have to play a key role in allocating green finance for sustainable investment and development (Volz et al., forthcoming).
The financial sector—or at least parts of it—is responding to the challenge. Financial firms, including banks, mutual funds, pension funds, and insurance companies, are showing a growing interest in sustainable finance.
According to the latest Asia Sustainable Investment Review (ASrIA 2014), assets worth $45 billion were managed using sustainable investment strategies in Asia (excluding Japan) in 2013.
According to the Review, sustainable investment assets managed in the region grew by 22% per year during 2011–2013. This is impressive, but it cannot gloss over the fact that sustainable investments still account for only a tiny fraction of the total market.
“ Environmental and social risk screening needs to become an integral part of financial firms’ core business. ”
The role of financial authorities
To make headway with the green transformation, environmental and social risk screening needs to become an integral part of financial firms’ core business. The aim should be bold: mainstreaming sustainability in financing and investment, and not just nurturing a niche market for do-gooders. There are important reasons why financial authorities should care about environmental risk (Volz 2014).
- First, even though few central bankers and regulators will think of environmental risk when considering forms of systemic risk, there should be little doubt that environmental risk—and risk arising from climate change in particular—constitutes a significant systemic risk for the financial sector. As Leaton et al. (2013: 23) point out: “[t]he rules that guide and govern the operation of financial markets need to evolve to address this systemic risk.”
- Second, the provision of finance for socially undesirable activities—such as carbon-intensive businesses—can be characterized as a market failure. Of course, environmental regulation and carbon pricing should be the preferred policy tools to correct this market failure and prevent or discourage such investments, but as long as carbon pricing markets are not functioning and environmental policies are neither in place nor effective, there is a case for financial authorities to make use of their powers to affect credit creation and allocation.
- And thirdly, the case for an environmental role for financial authorities can be made for developing countries, where these institutions typically have a strong institutional standing in the policy framework, while environmental regulation is often ignored, or weakly or not implemented because environmental authorities lack clout.
From theory to practice
All this may sound very theoretical, but the threats of climate change and environmental degradation are real, and they are too serious to easily dismiss the thought that financial authorities may have a role to play in this story.
Indeed, a number of Asian central banks and financial regulatory authorities are the vanguard that has already stood up to this challenge.
Already in 2011, Bangladesh Bank, the central bank of Bangladesh, introduced a comprehensive green banking framework.
In 2012, the China Banking Regulatory Commission of the People’s Republic of China (PRC) issued Green Credit Guidelines “for the purpose of encouraging banking institutions to, by focusing on green credit, actively adjust credit structure, effectively fend off environmental and social risks, better serve the real economy, and boost the transformation of economic growth mode and adjustment of economic structure” (CBRC 2012).
Also, in 2014, the People’s Bank of China, the PRC’s central bank, launched a large research program to analyze whether and how environmental risk should be included in its macroprudential analysis.
“ Governments need to remove barriers to green investments and create an environment conducive to sustainable investment.”
For sure, all of these frameworks, guidelines, and roadmaps have their shortcomings, and the effects they have had on financial market outcomes are negligible to date.
But we are just seeing the beginning of a greater trend, where more and more central banks and financial authorities are starting to respond to the challenges posed by climate change by requiring adequate management and disclosure of climate and other environmental risks from financial firms.
As the impact of climate change on business is increasingly felt across Asia and the associated risks are rising, financial firms need to strengthen their capacity for environmental and social risk analysis and integrate ESG into the investment and lending process.
At the same time, governments need to remove barriers to green investments, such as energy subsidies and ambiguous, unsteady regulation, and create an environment conducive to sustainable investment.
For financial firms, it is better to actively embrace the opportunities that sustainable investment and lending offer and be ahead of the curve, rather than waiting for prospective green financial regulation to bite.
This article first appeared on Asia Pathways and was republished with permission.