Credit: NanoStockk

Sustainable finance ended 2018 on a high. Never before has so much capital been committed to integrating environmental, social and governance (ESG) factors. But financial markets also entered an unnerving cycle. If we are not careful, growing financial turbulence could divert attention away from the urgent need to scale up investment in climate action and sustainable development. Instead of being knocked off course, we need to identify ways not just of surviving potential shocks in 2019, but also of making financing sustainable development the way of avoiding another crisis.

First, the good news. In market after market, responsible practices and sustainability factors are being embedded into finance. Investors have led the way and institutions with over US$80 trillion in assets have backed the Principles for Responsible Investment. The banking sector, however, is the largest segment of the global financial system and in November 2018, it finally stepped forward with the launch of its own set of Principles for Responsible Banking. Central banks and regulators have come in from the sidelines, formed their own club – the Network for Greening the Financial System (NGFS) – and are raising their expectations on how banks, pension funds, insurers and capital markets more generally manage sustainability risks, most notably climate change.

Yet 2018 was the year of synchronised volatility for the financial system. Major equity and bond markets both ended the year down. Many equity markets had their worst year since 2008, with China leading the way – the Shanghai composite fell by a quarter, the MSCI All Country World Index down by 11%, and Wall Street’s S&P 500 dropping 6%. In the debt markets, the Bloomberg Barclays Global Aggregate Bond Index also fell – by a modest 1%.

Brewing storm clouds

Ten years after the global financial crisis, a powerful set of structural, cyclical and circumstantial fault-lines are being revealed, all against the backdrop of the continuing destruction of natural systems and rising social instability. Three concerns stand out in particular.

  1. The growing debt burden of the global economy. Debt per unit of output is continuing to rise. According to the International Monetary Fund, total non-financial sector debt in major economies stands at $167 trillion, up from $113 trillion in 2008, a rise from more than 200 per cent of Gross Domestic Product to close to 250%. This shift was strongly enabled by the era of ultra-low interest rates engineered by central banks since the crisis. As monetary tightening gets underway, this increased debt dependency creates new fragilities.
  2. The removal of monetary support – which could further impact equity markets and reveal a host of corporate, national and household borrowers exposed to rising interest rates. Already 2018’s G20 president, Argentina, has been forced to seek help from the IMF, while one analyst at the Financial Times has described “the woes at General Electric as a harbinger of a major reckoning, just as the downgrading of US carmarkers Ford and GM in 2005 triggered a credit spasm. One duly forgotten until 2008 dawned.”
  3. Rising interest rates – which could disproportionately impact investments in the ecological transition. A sustainable economy often tends to be a more capital-intensive economy – with more upfront investment, for example, in wind turbines or efficient lighting, which is then offset by much lower resource consumption. This makes the cost of capital critically important for scaling up investment. What many have taken as a straightforward structural shift towards a zero-carbon economy may well have had a powerful cyclical dimension in the form of historically-low interest rates, a phase which is ending. It remains to be seen how rising rates will impact green investments, but marginal projects look likely to be impacted.

All this means that the recent surge in sustainable finance could face headwinds in the year ahead. Already the global green bond market appears to be hitting a plateau. At the end of 2018, annual issuance of green bonds had reached $161 billion, on a par with the 2017 result of $162 billion. The final tally is likely to be higher. But this is a striking flattening for a market that has been the icon of green finance. In 2017, issuance was almost double the 2016 level of US$87 billion. Last year’s green bond results are also far below expectations, with the Climate Bonds Initiative, for example, expecting $210 billion. Deleveraging in China has been a contributing factor.

Economic growth is slowing worldwide and forecasts are being cut further, with the risk of protectionist measures led by the US intensifying in 2019. No one knows, of course, whether today’s turbulence will translate into a full-blown crisis. But if it does, the consequences for sustainable finance could be serious if policymakers and market participants are not prepared. Back in 2008, for example, the shock of the global financial crisis to the real economy severely damaged carbon trading as the premier tool for tackling climate change, sharply driving down prices in the EU’s emissions trading system. After many years in the doldrums, EU carbon credits finally bounced back in 2018, hitting a 10-year high, up 230% on the year.

Sustainable finance has weathered crises before. Indeed, looking back, the bust of 2000 and the credit crunch of 2008 both ultimately revealed the need for system-wide action to connect finance with responsible practice and sustainable development. The task now is to anticipate possible shocks and plan ahead: downturns happen when there are opportunities for systemic change.

Five actions to divert a crisis

So, what can financiers and policymakers do to fend off these threats – and, more than that, to align investments with the zero-carbon, resilient and inclusive development model of the next decade?

1. Don’t panic: fast-forward

The first priority is not to panic but rather to fast-forward essential reforms. Crises tend to shorten time-horizons, putting off vital long-term actions. Weak and uncertain policy remains one of the major obstacles facing financiers wishing to back the transition. As nearly 400 investors representing US$32 trillion in assets made clear at the COP24 Climate Conference in Katowice, it is essential that governments close the ambition gap between what is needed to realise the Paris Agreement and the policies currently in place. This gap erodes policy credibility and continues to favour capital misallocation, not least when carbon pollution is encouraged through fossil fuel subsidies.

2019 therefore needs to be the year when governments put in place the long-term strategies for decarbonisation to give confidence to markets on the strategic road ahead. Europe’s Climate Neutral 2050 strategy is one example of the economy-wide response that is needed. On the sustainable finance front, a key opportunity for 2019 is the agreement of a shared language for green investments, a process led by the EU’s work on a taxonomy. This could provide the basis for leading countries and institutions to build a common framework, easing the way for governments and financial institutions to move capital in the right direction at speed and scale.

2. Connect the environmental and the social

For too long the agenda for financing climate action has been separate from the need for social inclusion. The recent gilets jaunes protests against the Macron Administration’s eco-tax highlighted the pitfalls of introducing climate policies without factoring in questions of political acceptability and distributional impacts. Instead, measures can and need to be designed so that they positively benefit low- and middle-income families, delivering a ‘just’ and managed low-carbon transition.

New ways are needed to bring together the green finance and impact investing communities. Housing will be a key sector here, making sure that energy poverty is eliminated through zero-carbon homes for low-income families; a new generation of asset-backed securities must be created to make this happen. At a global level, this means getting serious about channelling far more climate finance to developing countries.

3. Deliver a second and more sustainable ‘green stimulus’

Back in 2008, many governments responded to the global financial crisis with a fiscal stimulus. Some of these were tailored to promote the green economy, helping to spur renewables, energy efficiency and mass transit investments, notably in China and the United States.

This time round, it is not clear the extent to which stagnation will be due to a demand or supply shock. The former corresponds to a rise in collective saving and decline in economic confidence associated with, for example, financial deleveraging; a fiscal stimulus will contribute to recovery. Stagnation caused by a supply shock might reflect the impact of demographics as well as trade, capital and labour flow restrictions, and the effects of growing monopoly power and lower competition on productivity. In this case a fiscal stimulus will merely crowd out private investment and fuel inflation. However, while inflation and interests rate remain low, and while policy rates remain close to the zero bound, the scope for additional fiscal stimulus to boost demand and output cannot be ruled out.

Already governments are exploring options to respond to new economic and financial shocks. Here, the first priority is not to stimulate yesterday’s resource-intensive, high-carbon economy. In China, Greenpeace’s Lauri Myllvvirta warns, “a new round of industry and construction stimulus would condemn global emissions to grow for another several years”.

Calls for an ambitious Green New Deal are back on the table, not least in the United States. Importantly, governments have the experience of the last stimulus before them to guide what to do now in the face of intersecting monetary, trade and macroeconomic challenges. Here, governments could usefully focus public investment on projects that can get off the ground quickly, which build an efficient, sustainable and productive economy for decades to come. Such projects would afford good value for money for taxpayers and promote fiscal sustainability. With public debt still funded at close to zero real interest rates, investment in new assets would improve public sector net worth and bolster fiscal sustainability through securing a more resilient future tax base.

One of the weaknesses of the previous green stimulus was its stop-start nature, with positive fiscal support removed in subsequent rounds of austerity. This time any stimulus should be designed so that it generates steady and durable incentives for growth sectors. The annual budget cycle gives governments the opportunity to load the dice in favour of the transition, removing perverse incentives and giving preferential treatment for measures that increase the shift of the capital stock towards sustainable assets. Here, the role of national and multilateral development banks will also be crucial, providing precious patient capital at a time of mounting uncertainty. It will be vital for these institutions to better use their ample balance sheets to build the pipelines of assets where private actors fear to tread.

4. Green the financial rules of the game

Another response to the last financial crisis was the introduction of quantitative easing, which saved the economy, but with a variety of knock-on impacts for markets and inequality. One of these was a blindness to the environmental and social quality of bond purchases. This time around, central banks are winding down QE. But they can still play a vital role by sending clear signals that they will integrate ESG factors into the management of their balance sheets, including in the collateral they accept.

More broadly, current market conditions give an urgency to efforts by the world’s leading central banks to green the financial system. The first report of the Network for Greening the Financial System due in April will be an important milestone, with market players looking for clarity on how prudential regulators will bear down on the risks facing high-polluting assets.

5. Boost confidence with the coordinated sovereign bond issuance

At times of uncertainty, markets yearn for direction. Sometimes these are statements that the authorities will do ‘whatever it takes’. Those governments that see the strategic opportunity in sustainable development could use 2019 as the moment to launch a coordinated issuance of sovereign bonds directed towards climate action and sustainable development. This would not only help to bolster the green bond market, but it would also provide a way for governments to deliver the first four priorities.

Key participants could include all EU member states along with other major players in the G20 (notably Canada, China, India, Indonesia, Mexico, South Africa) as well as pioneering developing countries (such as Fiji and Nigeria, two of the earliest to issue green bonds). A coordinated rolling issuance of, say, US$100 billion in 2019 would help bring confidence to the markets – and help meet unmet investor demand for assets aligned to the transition. This would still be a tiny percentage of annual issuance and not impact the overall debt burden. In the second quarter of 2017 alone, for example, gross sovereign issuance from the EU28 alone totalled €626.8 billion.

Time is of the essence

Policymakers and financiers need to start drawing up plans now to make sure that flows of sustainable finance are not deflected just at the moment when a substantial scale-up is required. In fact, if done well, strategic action to get ahead of market disruption could make 2019 the year when there was an irreversible shift to a more sustainable financial system.

The author is grateful to Dimitri Zenghelis for his contribution to the analysis of possible stimulus measures, and to Sam Fankhauser, Cameron Hepburn, Jan Steckel and David Wood for comments on an earlier draft of this commentary.

The views in this commentary are those of the author and are not necessarily those of the Grantham Research Institute.

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