24 Nov 2015

Financial markets: From villains to heroes?

By Klas Eklund, climate economist (Sweden)

Financial markets have no doubt been partly responsible for global warming and environmental degradation. Historically, banks have often lent to polluting production facilities and funded exploration for fossil fuels.

That, however, is changing. Investors increasingly want their assets managed in a sustainable way. Bank clients want to have access to “green” products. Employees want to work for a company they can be proud of. NGOs and ratings agencies add to the pressure by measuring the environmental and social performance of banks.

That’s good. If capital is allocated without environmental consideration, financial markets will play a destructive role. But if capital is directed towards investment in green technology, if assets are managed in a sustainable way and if credit is given to responsible companies—then we’re talking.

Governments can help, primarily by changing taxes and subsidies in a way which punishes “black” production and consumption and supports “green” activities. When relative prices make environmentally detrimental products and services more expensive to users, demand will fall—and financial resources will flow into greener sectors, which in turn will spur technical development.

That is now happening—albeit slowly—as more countries reduce subsidies for fossil fuels and instead add CO2 taxes, introduce emissions rights trading and impose fees on other pollutants. Authorities are gradually putting a price on nature—“internalising externalities” as the economists say—thereby affecting calculations in the financial sector.

One example is the commitment of the G7 countries to phasing out fossil fuels. The conclusion among banks and financial institutions is that a substantial amount of coal and oil must remain underground. Consequently, companies whose balance sheets have included fossil reserves must now see some of these assets as “stranded”. That is a major revolution for energy companies.

This has taught financial analysts that they must get better at including long-term environmental factors in their analyses. How might global warming affect valuations of companies? How should banks assess their corporate clients’ ability (or inability) to handle technical and social challenges from environmental stress—and is management up to the task?

All big banks are now building analytical capacity to be able to answer those questions. My employer, SEB, is working to set up internal guidelines for how to deal with a number of environmentally important sectors from a green perspective. As far as I know, most banks are trying to do the same.

This also exerts strong transformation pressure to innovate. New financial products are being born. SEB has been involved in starting up the green bond market, which helps investors tap the immense resources of the capital market for green investments—in climate mitigation, land remediation, renewables, modern infrastructure, etc.

This development is not without challenges. It can be tempting to call any bond “green” in order to lure investors into the net. Therefore, it is of great importance that the new markets for green products are monitored, and that the “greenness” of projects is vetted, preferably by independent researchers.

Green financial markets are still relatively small—but they are growing rapidly. The long-term aim must be to eradicate the differences between “traditional” and “green” investments and credit. One day, all undertakings of the financial markets should be green, long-term and sustainable—without the need for special labels.

Then we might go from villains to heroes.

Klas Eklund

Klas Eklund

Senior Economist at SEB, adjunct professor of economics at the University of Lund

Has published more than 950 articles and columns and a number of books. One of his latest publications was a book on the economics of climate change.
Photo: Elisabet Ohlsson Wallin