03 Jun 2021

Financial risk frameworks lack systemic view

The financial sector has great power to contribute to the rapid transformation needed for the world to deliver on the targets of the Paris Agreement and the Sustainable Development Goals. But failure of financial risk frameworks to account for environmental and social risk, will aggravate climate and other environmental change and set current sustainable finance initiatives off course, according to new research.

Two new articles in One Earth, led by GEDB executive director Beatrice Crona, illuminate the disconnect in financial risk frameworks between environmental and financial risk and how it plays out in practise for the ability of society at large, and finance in particular, to deliver on sustainability ambitions and global goals.

The last decade, rapid increase in various green investment instruments, like green bonds or sustainability-linked loans, indicates growth in sustainable finance, illustrating that climate and environmental change are a concern throughout large corporate and financial communities. Yet, how environmental problems are aggravated by investments are not equally recognized.

“These instruments fail to encompass the externalities or the large scale environmental change that the companies themselves are inflicting”, Beatrice Crona emphasises.  “To achieve real sustainability finance actors must learn to assess real impact and systemic risk.”

New tools required for an interconnected world

Climate, biodiversity loss, water, and land-use change are not isolated phenomena, but directly interconnected and mutually reinforcing processes. For example, deforestation to produce oilseed in one region leads to regional drought affecting the oilseed production itself, but also affecting geographically distant sectors, such as aquaculture reliant on oilseed for feed.

The first article, co-authored by Carl Folke and Victor Galaz, highlights that if these connections are not recognized in risk assessment tools, strategies, and solutions, they will miss the target and also risk creating systemic risk.  The authors stress that avoiding a scenario of escalated warming requires the financial sector to account for the wider set of biophysical processes, beyond greenhouse gases, that influence the functioning and resilience of our living planet.

Assessing the right things

To assess the sustainability of companies to invest in, investors increasingly use so called Environmental Social and Governance (ESG) metrics. However, many of the ESG investment strategies will not meaningfully contribute to sustainability. Either because they provide merely relative measures or because the metrics used to assess environmental impact of investments are flawed. For instance assessors rely on self-reported actions or measures and lack standardised metrics to assess them.

“Without a clear benchmark against which to judge the actual negative and positive contribution of a company to a particular variable, like CO2 or total area deforested, this type of screening provides a false sense of security in the progress of sustainable investment”, explains Beatrice Crona.

Ways forward

The research team identifies three ways the financial sector can change to contribute to actual sustainability:

First, recognise a wider set of Earth system processes (including the climate and hydrological flows in addition to greenhouse gases)

Second, acknowledge that current risk frameworks lack awareness of the risk of aggravating climate and large-scale environmental change.

And third, develop impact accounting systems that are aligned across different forms of financial investments (both equity and debt) and become a core part of capital allocation decisions.

Challenges for sustainable finance

In a commentary on the same theme, also published in One Earth, Beatrice Crona and colleagues at the newly formed Sustainable Finance Lab, lay out four challenges that currently prevent capital markets from contributing to a socially and environmentally sustainable economy and reflects on how these can be turned into opportunities. These challenges will form the basis for research at the Sustainable Finance Lab, which will be launched 11 June.

Challenge 1: Assessing real impact

New sustainability metrics are needed that also incorporate risks of transgressing planetary boundaries and fuelling social inequalities. Academics, investors, and regulators should join forces to rapidly develop sustainability criteria for investment decisions using the best-available science.

 Challenge 2: Systemic risk in an interconnected world

A global market dominated by large firms has increased the risk for shocks to propagate and be amplified across international supply chains. Academia can help develop new risk assessment approaches aiming to increase financing for innovative small and medium-sized enterprises in the green and social sector and significantly enhance the capacity of the financial industry to both ‘‘reduce harm’’ and increasingly ‘‘do good.’’

Challenge 3: Overcoming inertia and accelerating action

Norms that guide financial investments are the result of a long legacy of theory development within narrowly defined academic disciplines. Prevailing norms are a barrier to more inclusive, sustainable, and efficient financial markets. New arenas are needed where academics and practitioners come together to discuss and develop new ideas, test these, and through co-creation and experimentation transform preconceived traditions and practices.

Challenge 4: Developing an ecosystem for change

Regardless of investor type, the norms that shape risk frameworks, the criteria used for assessing the sustainability of investments, and the measurements of investment impact all need to be congruent across actors and be integrated as central decision criteria in parity with financial criteria. Developing an ecosystem of both incumbent and new and non-traditional actors will facilitate the development of innovative and sustainable yet commercially viable business ideas and financial practices that align with broader societal sustainability goals.

Crona, B., C. Folke and V. Galaz. 2021. The Anthropocene reality of financial risk. One Earth 4(5):618-628  Read article

Crona. B., K. Eriksson, L. Lerpold, M. Malmström, M. Sanctuary, J. Sandberg. 2021. Transforming toward sustainability through financial markets: Four challenges and how to turn them into opportunities. One Earth 4(5):599-601 Read commentary

Photo: Atmotu Images/ Alamy Stock Photo

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