Introduction

Rarely has an issue pushed its way onto the financial sector’s agenda so forcefully as sustainability. Even just a few years ago, it was still a niche topic dealt with by a handful of staff at banks, insurers and asset managers. Things were not much different among financial regulators, and boards of directors; supervisory boards and financial supervisory authorities touched the issue at all mostly tangentially.

This has now fundamentally changed. Today, sustainability is a core topic that managers across the board count among their top priorities. It is also a key issue in financial policy legislation and for the European Commission. Sustainable finance is one of the most important fields of activity for the responsible EU Commissioner, Valdis Dombrovskis, along with the Directorate-General for Financial Stability, Financial Services and Capital Markets Union reporting to him.

The aim of a sustainable economy is to foster prosperity and secure it over the long term against economic, social and ecological risks. Climate change has a large role to play here, but there are also other environmental risks that jeopardise our prosperity over time. These include the advancing extinction of species along with the loss of fertile agricultural land to agri-business. Our finite natural resources are also under threat from overfishing of the seas and increasing marine pollution. All of this calls into question the economic, ecological and social sustainability of the high standard of living we currently enjoy.

Alongside the ecological aspect to sustainability, it is important not to lose sight of its social dimension. Its significance is reflected in political debates among our European neighbours: the Yellow Vest movement in France demands that wealth be fairly distributed between core and peripheral regions government members in Italy are pressing for the introduction of a universal basic income in order to provide some security to those in need, while in Germany thousands of people have been protesting in view of rising rents in the major cities. Other overarching issues include maintaining jobs and social security, as well as the increasing gap between rich and poor. Even in the US, home of market capitalism, the possible introduction of a wealth tax is being discussed. Why? Because increasing numbers of politicians are seeing wealth inequality as a risk for democracy and social stability. This offers further proof that past economic development has been partly unsustainable, and should not continue as it is. Given all these signals, we cannot keep on with “business as usual” for the economy and globalisation. There needs to be a refocusing of the economic and financial management of globalisation, a challenge which neither the financial system nor individual economic stakeholders can shirk back from.

Sustainability must therefore always be conceived of in terms of a triad of economic, ecological and social factors. These three aspects form a whole, and must not be pit against one another.

But why was it that sustainability in general and climate change in particular established their relevance so quickly within the institutions, becoming a new challenge for the financial system? Why did the European Commission set up a High-Level Expert Group on Sustainable Finance and incorporate its recommendations into proposed regulations in record time? Why did the European Parliament instruct the Environment Committee and the Economic and Monetary Affairs Committee to consider this issue and draw up initiatives? Why have central banks created a network and why has the FSB (Financial Stability Board) of the G20 countries set up a task force in this area? Why has the issue been placed on the agenda for the most recent annual conferences of BaFin, EIOPA (European Insurance and Occupational Pensions Authority) and other supervisory bodies?¹

The breakthrough in 2015

The meteoric rise of sustainability in the financial system might appear surprising at first glance. After all, the issue has been around for a long time . It has been about 30 years since the Club of Rome referred to the significance of sustainability in its report “The Limits to Growth”. In most parts of the world, economic growth – so the basic argument goes – is quite simply unsustainable and will eventually collapse, as it does lasting damage to critical natural resources, or destroys them completely.

At more than 20 years old, the climate debate is also nothing new. This is already apparent from the fact that the Paris Climate Agreement was concluded at COP21. The abbreviation COP stands for “Conference of the Parties”, a general term used by the United Nations, which encompasses both countries and institutions. The number 21 only means that the annual conference was being held for the twenty-first time. However, for twenty years only scientists, ecologists, some select industrial sectors and a few environmental politicians addressed climate change and other sustainability issues.

What was it that happened during year 21 that brought the financial system into the spotlight? It was the inclusion of one plain and simple clause in Article 2 of the Paris Agreement of 15 December 2015. According to the agreement, financial flows would have to be redirected in order to achieve climate goals. The Article provides that: “This Agreement […] aims to strengthen the global response to the threat of climate change, in the context of sustainable development […] including by […] making financial flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.”

It is remarkable that the foreign ministers address financial flows, as they normally do not deal with this issue. It is even more remarkable that, in doing so, they raised the question as to how global finance flows can be redirected and rendered compatible with sustainable development, . Shortly after the Paris Agreement, many leaders concluded that this redirection of financial flows was required not only from a climate perspective but also in order to ensure general economic sustainability. Only a small step was therefore required in order to establish a link with the much broader debate within the Club of Rome, and with recent United Nations sustainability objectives. It became clear that the way in which financial flows are to be directed must be examined across the board, not only in order to slow down climate change but also to allow wealth to develop sustainably in economic, ecological and social terms.

The field of sustainable finance was born.

The significance of the financial system within the debate on sustainability

Why is the financial system so important for sustainability? The financial system plays a key role in the economy, with banks, insurers and asset managers operating as financial intermediaries. These bodies are involved in virtually all investmentdecisions other than those financed out of own funds.

In addition, since financial institutions are heavily regulated and subject to individual supervision, it seems natural to policy-makers to intervene in an attempt to redirect capital flows.

Naturally, this must not undermine the principles of the market economy and decentralised decision-making. But the unavoidable – and never truly neutral – impact of regulation on the market economy is clear; for instance, in the rules on capital requirements for government bonds. Banks and insurers may hold any government bonds in the European Union without having to set aside any capital, while there are capital requirements for all types of corporate bonds. This rule applies despite the restructuring of Greece’s debt, which has involved haircuts worth hundreds of billions of euros. Moreover, it also applies even though some countries would be insolvent without monetary support. If regulation can never be entirely neutral anyway, so the argument goes, why should it not be focused on the principles of sustainability?

The significance of sustainability for the financial system

Why, on the other hand, is sustainability so important for the financial system? There are essentially three reasons. First, many decisions within the financial system have long-term consequences, such as those concerning investments, loans and other forms of corporate financing. Their success depends upon an ex ante examination of risks over the medium or long term, and often involves looking a number of years into the future. It is not only the specific instrument that matters. It is just as important to recognise systemic connections and to look beyond the horizon of pure financial arithmetic, taking account of the broader economic, social and even environmental context.

The costliest example of a lack of economic sustainability in the last two decades was the US subprime mortgage disaster. Hundreds of billions in loans were unsustainable, both on a financial and a socio-political level. Mortgage loans were granted to US residents with no other assets, often without any income and sometimes even without a job.

European banks invested hundreds of billions of euros in the US, having been blinded by sales pitches, misled by incorrect information from rating agencies and spurred on by pressure to make money. In return they received securities which had to be largely written off when the bubble burst, and partly refinanced by taxpayers. As early as the summer of 2008, the immediate write-offs alone on US subprime loans for the 20 hardest-hit European banks amounted to around 100 billion euros² – and this would be followed by many further write-offs over the course of the crisis. The way in which junk mortgages were financed is a dramatic example of what happens when sustainability considerations are ignored. In addition, the crisis also called into question the structures and practices of financial market regulators and supervisory bodies.

The second reason why sustainability is essential for the financial system lies in its social significance. Sustainability is a mainstream issue, sailing with a truly powerful political and social wind in its sails, supported by practically all parties, generations and social strata. This reflects the fact that individual citizens and society as a whole wants to safeguarde the future. People as forward-looking beings have a fundamental need, both individually and also at the societal level, to know that the sustainability of their continued existence has been secured. It is therefore important for the financial system to engage with this issue in order to make sure that it does not end up on the wrong side of the debate.

The third reason follows on from the second. Having been partly discredited during the financial crisis, sustainability now offers the opportunity for the financial sector to rebuild a positive relationship with society. There is an opportunity here for it to position itself as part of the solution and to work actively towards achieving greater financial, social and ecological sustainability.

Regarding the issue of sustainability and the financial crisis, it should be noted that banks were in part wrongly branded by the public and in the media as having been responsible for causing it. Actually, the banking sector was just the place where the crisis became visible to the general public, as banks were the ones holding worthless assets on their balance sheets. However, primary responsibility for the financial crisis lay with the financial markets and rating agencies. They had bundled together substandard mortgages into complicated structures, valued these incorrectly and assigned them misleading ratings. This is what allowed the build-up of pressure on banks to buy these ostensibly high-yield securities with purportedly excellent creditworthiness. Naturally, managers at banks went with the flow, if for no other reason than the fear of missing out. However, anyone who overlooks the actual cause of the global financial crisis in financial markets is not telling the full story.

This is important, not least because it has been repeatedly demonstrated that financial markets – and not financial institutions – represent the greatest risk to the sustainability in the financial system. This risk is fuelled by short-term thinking, a focus on quick returns and the constant pressure exerted on businesses to prioritise short-term profits . Those looking to redirect capital flows in order to further sustainability will first have to take on the financial markets.

This is an important point, as debate is still very heavily focused on banks, insurers and pension funds, thus bypassing the real issue. The greatest danger to stability and sustainable growth lies in financial markets.

Events to date

Anyone who engages with the issue of sustainability and finance will quickly notice that the field is so broad it can be hard to make out one side of it from the other, being populated by a practically limitless number of proposals and initiatives. However, this complexity can be reduced if the issue is broken down into two core questions. First, how can possible sustainability risks for the financial system be better understood, made more transparent and monitored? Second, how can the financial system enhance the sustainability of economic prosperity, in particular through increased investment? In a nutshell, this means “understanding risks” on the one hand, and “taking action through investment” on the other. These are the two points of reference within debates on sustainability in the financial system. That the latter issue is by far the more important one, and also the thornier.

In 2017 the EU set up the High-Level Expert Group on Sustainable Finance, which presented a comprehensive report at the start of 2018 containing numerous recommendations. Thereafter, in the spring of 2018 the European Commission presented an action plan³ transforming a number of these recommendations into proposed regulations and policy measures. Some of these have already come as far as the decision-making stage, while others are still being discussed by legislators. Owing to the European elections, most of these recommendations will only be implemented after the new Commission has taken office.

A whole range of proposals and measures are being debated, which should help to achieve a better understanding of sustainability and of the related risks. The specific goal is that businesses in both the real economy and in finance should engage intensively with the issue of sustainability, and discuss and communicate its influence on corporate strategy. Supervisory boards should also consider this issue at regular intervals. Supervisory bodies should develop methods in order to identify sustainability risks. Investors should obtain more information as to whether or not businesses are focused on sustainability. Corporate reports should explicitly address sustainability issues and incorporate them into financial reporting if possible.

The Commission specifically proposes, inter alia, the following:⁴

• Governance: The Commission examines the extent to which banks, insurance undertakings and pension funds take sufficient account of sustainability aspects, both within their general business decision-making and also as part of risk management. EIOPA is currently consulting on whether sustainability is sufficiently taken account of within regulations applicable to the insurance industry, and the Commission is contemplating incorporating the results into the review of Solvency II in January 2021.
• Ratings: The Commission has instructed ESMA (European Securities and Markets Authority) to analyse the financial ratings market and to assess whether environmental, social and regulatory considerations are sufficiently taken into account. The Commission is contemplating including these criteria in its guidelines on disclosure for credit rating agencies and to adopt additional guidelines, where necessary.
• Reporting: The Commission is contemplating expanding the already comprehensive reporting on non-financial information by companies and to include reporting on possible climate risks in financial reports, as proposed by the FSB Task Force on Climate-Related Financial Disclosures (TCFD).
• Financial analysts: The Commission plans to carry out a comprehensive study into how sustainability aspects are taken into account by financial analysts.
• Fiduciary duty: The Commission plans to overhaul the duties of institutional investors and asset managers in relation to sustainability aspects. In particular, its goal is that institutional investors and asset managers should expressly take sustainability aspects into account in decision-making processes in order to make the way in which these sustainability factors are considered more transparent for end investors.
• Enhancing supervision: Many supervisory authorities in Europe have started to engage in detail with the issue of sustainability and to take greater account of it in supervisory activities. The Commission is encouraging the EBA (European Banking Authority), EIOPA and ESMA to follow this approach.

A second group of proposals and initiatives is intended to result in increased investment in sustainability. The European Commission is proposing inter alia the following specific measures:⁴

• The introduction of an EU classification system for sustainable activities. This EU taxonomy is intended to identify activities that are sustainable from climate change, environmental and socio-political perspectives. The classification system is also to serve as a basis for supporting sustainable solutions through various other measures, such as conformity marks and supervisory board rules.
• The Commission plans to step up its efforts to curb short-termism within the financial system. In particular, the European Financial Reporting Advisory Group (EFRAG) is charged with assessing the effects of new IFRS⁵ on sustainable investments. The Commission is contemplating drawing on alternative accounting principles in order to ascertain market value and to examine whether mark-to-market valuation promotes short-term thinking within the financial system.
• The Commission also plans to examine whether capital markets exert undue short-term pressure on companies and whether high turnover and brief holding periods (e.g. for shares) are practices that put excessive short-term pressure on the real economy.

Sustainability as an opportunity for the financial system

Taking sustainability seriously and putting it into practice offers three opportunities for the financial system.

First, linkage with the real economy will be enhanced. This is because ensuring the economic, ecological and social sustainability of our standard of living is a challenge for the real economy and the real economy has to provide the solutions. The call by former European Central Bank (ECB) President Jean-Claude Trichet in the wake of the financial crisis for the financial system to “serve the real economy”⁶ will be met by promoting sustainability considerations. This also recognises and emphasises the social role and significance of the financial system.

Second, attention will be refocused on the long-term perspective. This is because all solutions for sustainability call for a long-term horizon. This is evident in relation to investments in energy, infrastructure and transport, but it also applies to investments in research and technology, education and jobs. Essentially, anything that creates real economic value is long-term in nature.

Third, sustainability enhances the stability of the financial system. Anyone who thinks about long-term risks, who takes into account aspects from outside the financial sector, such as natural resource consumption and social issues, and whose strategy follows a precaution-based approach, ultimately contributes to stabilising the system as a whole. As mentioned above, the US subprime crisis might have turned out differently had there been a greater focus on sustainability.

Risks and obstacles on the path towards more sustainability in the financial system

However, rooting sustainability in the financial system not only offers opportunities but also entails risks Three main risks should be considered

First, the embedding of sustainability could further complexity the already extremely detailed and complex European regulatory framework. By global standards, the European financial sector is already the most highly regulated financial system. This is apparent in terms of both the sheer volume of applicable regulations and their detail.

This high regulatory density may partly be due to the architecture of the EU itself because, in the end, more than 25 different national systems have to be governed by this framework. Since each national system features its own characteristics, the various components, operations and processes must first of all be defined at EU level. Thereafter, they must somehow be standardised. The ultimate goal is to create a uniform market across these national systems and ensure a consistent impact in the interest of consumer protection. All of this entails a significant volume of regulation.

However, the introduction of even more complex regulation for sustainability reasons would not only impair the smooth operation of the financial system, but could even potentially do more harm than good. Indeed, the various sustainability initiatives in the past have not been driven by regulation, and it may well be the case that they could not have been achieved on the same scale if they had been regulated. The European Commission is aware of this issue.

The second risk lies in the possibility that new regulations might simply be “tacked on” to existing regulations rather than the existing regulations being appropriatley amended. While amending regulations is still part of the plan, this has always proved to be the more difficult option. If one is to increase support for sustainability within the banking and insurance sector, limited adjustments should also be made to Basel III, Solvency II and IFRS with a view to promoting a long-term approach. In particular the IFRS, with the requirement that equity values in the real economy must be reported in the balance sheet at current and highly fluctuating prices (IFRS 9), give rise to significant balance sheet volatility, thus dampening sustainable investment.

The third risk is that some individual issues might attract attention, while other important topics are potentially disregarded (even the proverbial elephant in the room). If the goal is to reconfigure the financial system as a whole in line with sustainability considerations, it does not make sense to tackle individual areas. The major issue here is short-termism, which is essentially fuelled by the capital markets. Here we refer not to investment or trading in short-term papers, but rather to short-term trading in long-term papers or securities that generate a yield over the longer term, such as shares and bonds. The problem of short-termism is that various actors on the financial market use – or one might say abuse – long-term instruments in order to earn short-term profits.

But what do we mean by short-term and long-term? Something is long-term where it reflects real or fundamental economic results in a given financial instrument. For equities, these materialise after at least a year, possibly even several years. While the definition of short-term may be somewhat blurred, there is probably consensus that large-scale trading in equities over a horizon of days, weeks or months amounts to short-term action. In the US, the “short-swing profit rule” therefore applies to supervisory boards; this rule imposes a particular tax disadvantage on the selling of equities within six months. This is based on the idea that transactions under which shares are held for fewer than six months are short-term in nature. Official Commission statistics show the scale of the problem of short-term equities trading in the EU. Equities are held for eight months on average. If one remembers that many investors hold on to equities for many years, this average figure gives an impression of the size of the short-term market.

The following question therefore arises: can a financial system be considered sustainable where high-frequency trading in equities occurs every day on such a large scale?⁸ Is it acceptable for assets worth billions and entire corporations with thousands of employees to be traded back and forth within a fraction of a second, or for hedge funds to speculate in shares over periods of days or months? The supposed liquidity that such trading entails is not a compelling argument, as this liquidity is the first to evaporate in the event of instability or a crisis, and even leads – in situations involving a “flash crash” – to systemic instability. In addition, the gains made from high frequency trading correspond to losses for long-term investors.

The personnel and financial resources dedicated to short-term finance may result in a private benefit, but they are not beneficial to society as a whole. A thriving financial system does not need them. Thus, any spanner thrown into the works of short-term trading – whether through a low transaction tax or a kind of short-swing profit rule – can only be good news for sustainability.

Three principles for successfully achieving a sustainable financial system

How can the opportunities and risks be reconciled with one another? A solution is proposed here, based on three principles.

First, as already stressed, sustainability must always be conceptualised with reference to environment, society and the economy. In other words, it is not enough simply to ensure ecological sustainability, or even to only slow down climate change; this must also be achieved in parallel with social and economic sustainability. The one-sided focusing of economic or financial and political systems on ecology to the detriment of social or economic sustainability cannot represent a viable solution for a social market economy such as Germany.

A good example in this regard is the current status of the German energy transition. While it has been possible to raise the share of electricity generated from renewable energy to more than 30%, the construction of 27,000 wind turbines and the implementation of large-scale overhead power line projects has entailed serious environmental damage through deforestation and the depletion of species diversity. Also, it must not be forgotten that electricity prices have doubled, thus affecting both private and business customers. This is in addition to the large financial losses resulting from sudden write-downs to functioning systems. Due to the rapid shift, local producers of the technology have not been able to establish themselves domestically; as a result, solar panels in particular come almost exclusively from China – which has knock-on effects for jobs in Europe and the environment in China. In addition, as is known, CO2 emissions have barely fallen: it has not been possible to reduce the burning of coal and gas on the same scale, as these sources of energy have had to make up for the phasing out of nuclear power. Overall, the energy transition has proved to be a very mixed bag: despite subsidies of around 250 billion euros, not much sustainability has been achieved in terms of the economy, the environment and emissions.

Overall, the next few years will show whether or not pan-EU and German climate targets, seeking to achieve a massive decline in CO2 emissions within the space of a few years, have amounted to a mistake (in negotiations). Or just they would constitute a negotiating mistake if they proved to be unachievable in terms of environmental, social and economic sustainability, whereas the relevant goals of negotiating partners are entirely achievable.

It must not be forgotten that climate targets specific to individual countries or to the EU are not grounded in science, but are rather purely the results of negotiation.

In Paris, the EU agreed to cut emissions to around 30% below current levels;⁹ China by contrast secured permission to continue to increase emissions until 2030, without being subject to any maximum limit; scientists expect the world’s largest emitter to produce between 10% and 20% more emissions by then, which would then put emissions around 380% higher than they were in 1990. Moreover, the US agreed in Paris to lower emissions to around 10% below the 1990 mark, and that was before Donald Trump decided to withdraw from the Paris Agreement.¹⁰ This shows how differently the global target was divided up over the various regions. Massive investment in the research and development of new technologies will be key if these targets are to be achieved without further environmental and economic damage.It is here that the financial system will come into play to foster relevant investment. However, this will require perseverance and cannot be achieved under short-term pressure from the capital markets.

The second principle is that there must be clarity about the overarching goal of all efforts. It is understandable to control current risks; however, this cannot be the dominant (let alone the only) way of approaching the issue of sustainability in finance. The core issue, as the challenge of CO₂ targets shows, is how to mobilise the financial system in order to achieve significantly higher long-term investment.

When engaging with the issue of sustainability, regulators and supervisory bodies may be tempted to focus on the current financial structure in order to identify any existing sustainability and climate risks.

This is apparent from the example of AXA, which announced to divest from coal , and thus sent out a global signal calling for a climate-conscious investment policy within the insurance sector. The investments affected, which amounted to 500 million euros, made up 0.1% of the assets managed by AXA.¹¹ Even if this had resulted in any losses, it would not have had any implications for financial stability as the investments had been backed up with sufficient capital and were continuously monitored.

Ideally, there should be dialogue concerning sustainability issues between supervisory bodies and business undertakings. However, this is not the real issue. In fact, the introduction of complicated climate stress tests could run the risk of breaking the proverbial nut with a hammer.

Rather, the key question is how long-term investments are to be promoted. Mobilising investment is in the first instance a matter for regulators, and naturally for economic policy. This should specifically allow for diversity, as there is currently great technological room for manoeuvre in relation to a wide range of sustainability issues. It is by no means evident, for instance, that electrical vehicles will establish themselves as the dominant solution.¹² It is also possible that fuel cells or synthetic, zero-emission gases may be used, for example.

Thirdly, considerable restraint should be exercised in adopting additional regulations, given that the EU financial system is one of the most heavily regulated in the world. This is because costs increase for financial actors exponentially, rather than in a linear manner, with each additional regulation, as all rules interact with one another.

It is thus important to appreciate that the European Commission’s action plan is not based solely on regulations, but rather on a whole variety of other measures, including voluntary initiatives as well. This is because sustainability is ultimately a core interest for all banks with long-term assets and long-term liabilities. Many initiatives taken by companies, such as the divestment from coal by AXA mentioned above, are based solely on business considerations and not on regulations. Companies have a clear view of all opportunities and risks, and they are free to decide how to react appropriately to them in line with their own business models.

In addition, reflection upon new regulations should always involve a critical examination of existing ones. This means specifically that existing regulations should be examined in order to establish whether they are sufficiently conducive to long-term investment, or whether they impair it. Consideration should be given to the considerable complexity within regulations and their focus on a rather short-term horizon. For instance, the horizon of most regulations, such as Basel III and Solvency II, is one year – far shorter than a sustainability horizon. Moreover, IFRS 9 does not consider sustainability at all. It is also necessary to take account of the short-term pressure on companies from capital markets. Many investors have a much shorter horizon than a company’s managers. Most analysts base their company recommendations on a timeframe of between one and three years – this too is much shorter than the sustainability horizon. Putting sustainability in the hands of investors is therefore probably not the best idea.

Concluding remarks

The issue of sustainability is so interesting because it is actually self-evident. Humans as forward-looking beings, civil society as a structure promoting stability, and the interests of the economy itself: all of these are essentially directed at sustainability. Two of the most interesting questions are therefore why sustainability has had to be re-invented as an issue within the modern economy, and what possible obstacles could stand in the way of a natural focus on sustainability. This article has considered a few areas, in particular short-term trading in long-term financial instruments. As long as this is allowed in its current form, the financial system will never be sustainable. This means that, here too, there can be no “business as usual”.

The issue of sustainability is also so topical due to the focus in recent times on how to better manage globalisation. Presumably, neither German diesel engines nor the country’s remaining coal-fired power stations are the real “climate killers”, especially as China ,to take only one example, burns 15 times more coal and is planning hundreds of new coal-fired power stations. It seems that the real “climate killer” is globalisation itself, specifically due to the depletion of natural resources and internationalised production chains with their unfathomable volumes of globally transported semi-finished and finished goods. The global shipping industry, which shifts all of these goods around the globe, emits more than a billion tonnes of CO₂ on its own. Unfortunately however, this is not apparent when the goods turn up on the shelves of electronics retailers, supermarkets, hardware stores and clothes shops.

Therefore, anyone who thinks through the issue of sustainability will eventually have to ask how globalisation can be better managed so as to retain its enormous benefits, while at the same time reducing the disadvantages for the local economy, the welfare state and the environment. The guiding principles here should be “local production”, “regional employment”, “transition from industrial to biological agriculture”, and many more.

The illusory efficiency of global markets and prices, which end up masking natural resource depletion, should be subjected to critical scrutiny. Increased investment in the local production of goods of all types will not only be good for the climate, but will also bring economic and social benefits. The new catchword could be “think globally and invest locally”. Here, too, there are major opportunities for the financial system, for investment and for financial stability. It will be an exciting journey.

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