Sustainable Finance PDF

SUSTAINABLE FINANCE HOW TO MAKE THE FINANCIAL SYSTEM WORK FOR THE ECONOMY, SOCIETY AND THE PLANET WHY IS IT ESSENTIAL? Stéphanie Mareva Failloux 1  SUSTAINABLE FINANCE...

SUSTAINABLE FINANCE HOW TO MAKE THE FINANCIAL SYSTEM WORK FOR THE ECONOMY, SOCIETY AND THE PLANET WHY IS IT ESSENTIAL? Stéphanie Mareva Failloux 1  SUSTAINABLE FINANCE HOW TO MAKE THE FINANCIAL SYSTEM WORK FOR THE ECONOMY, SOCIETY AND THE PLANET1 How Can Finance Contribute to a Just Transition Following the 2008 financial crisis, Finance has widely been seen as an obstacle to a better world. This course aims to provide a broad understanding of current financial challenges and how finance could fulfil its role in society and re-engineer the economy to avoid environmental, health and social crises. The Covid outbreak and ongoing climate, social and political disasters have highlighted the dysfunctions of our current paradigm and have made the need for redesigning our economic system even clearer and more urgent. Sustainable Finance has a key role in reshaping global markets and politics. This course is for anyone who would like to understand the finance system’s functioning and purpose, what it does in practice and how it impacts the real world - society and the environment. The overall objective is to embrace sustainability keeping in mind a sound and sensible perspective to finance and business. I will encourage you to think critically on how collectively and individually we can participate to the Impact Revolution and lead the transformation toward a new economy and a Just Transition. INTRODUCTION - FINANCE, SOCIETY AND SUSTAINABILITY The Mayans - In 1750, a small group of Spanish explorers came across the ruins of what was once a vast city… (here the Uxmal Pyramid) Why did the Mayan devote so much of their precious resources to building those temples just before their civilisation collapsed? The pyramids were used by an elite caste of priests to carry out rites, based on sophisticated mathematical calculations, which purpose was to keep the gods happy so that the crops would grow. But it didn’t work. A mixture of over-farming and climate change caused crop yields to decline, resulting to the collapse of the Mayan civilisation and abandonment of cities like Uxmal in 9th Century AD. 1 A large part of this section is derived from Nick Silver’s book « Finance, Society and Sustainability » 2 Canary Wharf - a monumental, temple like ensemble and structures. What a future archaeologist would make of the ruins of these buildings? Why did the 21st century civilisations devote so much time and so many resources to constructing these buildings? What were they for? If we visualise the finance sector, we picture a room full of men (mostly men) surrounded by computer screens with columns of numbers flashing at them. It’s not obvious how this relates to the day-to-day cares of ordinary people and even less so to man’s impact on the natural world, as manifest by such phenomena as climate change and biodiversity loss. What do the Mayans and Canary Wharf have in common? Climate change and the impact of men on the environment are not new, but the speed and scope of humans’ impact on the rest of the world is unprecedented. *** Finance sits within the human economy. Finance is like the control center of the economy, directing where our capital is allocated. Finance is a social technology which allocates economic surplus back into the economy. The economy itself is located in society and is reliant on social institutions, rules and norms by which people interact. If rules and norms break down (after crisis, wars, collapse), these societies are unable to maintain much of an economy. Society relies on the natural world (clean water, energy, air, favorable climate). The Mayan civilisation collapsed because of changes to the natural world, some of which they caused. What about our civilisation? Finance is embedded in the economy, which is embedded in society which in turn is embedded in the natural world. Finance decides where capital is allocated. 3  WHAT IS SUSTAINABILITY? We can define the sustainability of a system : « the ability of a system to maintain itself indefinitely without a high risk of it dropping to a lower level of complexity. » From the example of the Mayan civilisation: it had a high level of complexity with a large population, sophisticated mathematics, capable of building impressive monuments. After the collapse, it was no longer capable of maintaining a large population or high culture. The difference between the civilisation before and after it collapsed is encapsulated in this idea of complexity. Before introducing the components of sustainability, let’s look at today’s world and identify some pathologies I - Current Pathologies 1. Humans’ impact on the environment We are producing CO2 and other gases which cause global warming. The impact of global warming is uncertain but increased temperatures have caused the ice sheets in Greenland and Antarctic to melt, sea levels to rise of many meters, which has caused flooding in many places in the world, including major cities. The technology exists to go about our activities without producing these gasses. It’s not necessarily more expensive to deploy renewable energy than fossil fuels, but our existing capital is locked in the fossil-fuel economy. This inertia is similar to the « tyranny of served markets ». If we could shift this capital quickly into a low-carbon economy, catastrophic global warming could be avoided. Governments and organisations have become aware of this, the latest IPCC reports have been alarming and hopefully, rules and regulations will become more and more stringent. This will not be enough however, the responsibility is shared with all of us. The population of non-human vertebrates has declined by 60% over the last 40 years (WWF 2016 - what about Australia fires last year? and Amazonia burning every year?)2 The situation of the ocean life is even more daunting. Close to 90% of the sea fauna has been wiped out3. 2for more on our impact on the environment, check David Attenborough documentary: « A Life on our Planet » (2020) https:// www.attenborough lm.com/ (full documentary on Net ix). 7-min introduction: https://www.youtube.com/watch?v=hL_8KFIE_zI 3 for more information on our impact on the sea, check the documentary « Seaspiracy ». It’s on Net ix. 4 fi fl fl What has the financial system to do with these ecological problems? Can it be used to solve these problems or is it making them worse? 2. The outbreak of populism (or worse) Trumpism, Brexit, « illiberal » democratic governments or plain dictatorial ones spreading… I won’t write much about these here, as the recent events and current war are enough testimonies of this point. In many countries, real wages have stagnated and inequality has grown for some time (cf paragraph below). Such a situations are not supportive of democracy and moderation and tend to exacerbate extreme parties and movements. To what extent has finance participated to this rise of populism? What is the relationship between the financial system and politics? 3. Inequality and Global Poverty Global poverty has come down drastically over the years, but still 10% of the world population lives in extreme poverty (1.90$/day). In some countries like Sub-Saharan Africa, the number of people in extreme poverty has even increased and for the first time, extreme poverty has risen post-covid.. In terms of income distribution, some countries have been rapidly developing, but others are still mired in poverty. The number of billionaires has increased, but there are still 3bn people living on less than $2.50 In rich countries like the US, despite remarkable economic progress, a fraction of the population still lives in extreme poverty. This is the result of exceptionally high income inequality. In fact, in the US, income inequality has been on the rise in the last four decades, with incomes for the bottom 10% growing much slower than incomes for the top 10%. 5  Average annual income growth in the US over the period 1980-2014 – Piketty, Saez and Zucman (2016) Research shows that in the US the ‘ultra-rich’ are the group that has experienced the largest income growth in the recent period of growing income inequality. Each dot along the horizontal axis represents a different percentile in the income distribution, with the height marking the corresponding average level of income growth in the period 1980-2014 (after adjusting for inflation). Red and blue, respectively, show changes in incomes before and after taxes. The poorest individuals in the US have seen no real income growth in the period 1980-2014; while at the very top, the ultra-rich have enjoyed an average annual growth of about 6%. Without taxes and transfers, those at the bottom have actually seen their incomes shrinking. Since then, the trend has continued with the 90th and 50th percentile seeing their real wages stagnating while the 10th percentile saw their wages increase over the period. This has resulted to even greater inequality 6 Another striking fact is that the relationship is monotonically increasing: independently of where you are in the US income distribution, those who are richer have seen larger income growth. This doesn’t need to be the case. In fact, as Piketty and co-authors point out, in the US the relationship used to be monotonically decreasing: independently of where you were in the income distribution, those who were poorer used to enjoy larger income growth. This has switched in the past 40 years as confirmed in the Real Wage Growth (US) chart above. The income of the top 10% has increased dramatically in the last 40 years whereas the poorest people and even the average person has barely increased at all. The difference is even more striking if we look at the top 1%. According to the OECD, the share of people in middle-income households fell from 64% to 61% between the mid-1980s and mid-2010s. Moreover, while almost 70% of baby boomers were part of middle-income households in their twenties, only 60% of millennials are today. This is significant because a strong and prosperous middle class is crucial to sustain consumption; drive investment in education, health and housing; and support social protection systems. The last ‘COVID years’ has seen the gap between the rich and the poor widen even more because of the rise of asset (real estate, stock market) prices. According to the ILO, in 2020 about 9% of the global working hours disappeared, this is equivalent to 250mio jobs lost, ie 4 times larger than during the previous financial crisis. Capital has been shifting from the poorer world to the richer world and from the poorer individuals to the richer individuals, rather than the other way around. Why? Is this situation sustainable? II- Sustainability Components: Rather than trying to define sustainability, we will look at some of its components. 7 1. Businesses and Inclusive Growth4 Governments play a leading role in fostering inclusive growth through the stability and infrastructure they provide, regulatory environments they create, and education and social programs they administer. Business has a central role to play through the investments they make, the jobs they create, the products and services they provide, and the supply chains upon which they depend. It is time for companies to embrace this role, and to work hand-in-hand with governments to reduce inequalities and promote inclusive growth. Inclusive Growth is not just good corporate citizenship; it is the future of successful business. Inclusive growth is good for business, and inclusive businesses will grow sustainably. Companies benefit from inclusive growth through: a more educated and engaged workforce; a larger middle class of consumers with greater purchasing power; more stable operating environments; and a high level of trust from employees, customers and stakeholders. For instance, expanding workforce opportunities and skills benefits employees, but also drives performance. Advancing human rights within business operations and supply chains makes them safer, more secure and stable, and thus has the potential to boost productivity for all actors involved. Moreover, investors and financial markets are increasingly looking at corporate ESG performance as a way to best allocate resources and are developing impact investment to incentivize positive externalities. In short, inclusive growth drives long-term value creation, creating broad benefits for shareholders and other stakeholders alike. Here are examples of pillars for a new model of growth, fundamentals elements for inclusive business: Advancing human rights in direct operations and supply chains by working to: ◦ Combat child labour and forced labour; and ◦ Respect freedom of association. Building inclusive workplaces through: ◦ Good jobs with decent wages; ◦ Diversity and gender balance; ◦ Progress toward achieving pay equity across equality areas (e.g. gender, ethnicity, disability, sexual orientation); and ◦ Training, re-skilling and up-skilling to enable employees to adapt to the future of work. Strengthening inclusion in company value chains and business ecosystems by: ◦ Expanding access to and affordability of basic products and services; ◦ Working to provide workers in our supply chains with the opportunity to earn a decent income; ◦ Strengthening inclusive sourcing; and ◦ Supporting training and/or community development programs for vulnerable groups (e.g. unemployed youths and women) in territories where companies operate. The goal is to collectively define actions or strategies that can trigger systemic change. And for the most part, these actions or strategies need funding… 2. Sustainability of the Financial System 4 This section is based on the B4IG coalition « Business for Inclusive Growth » www.b4ig.org - The Business for Inclusive Growth (B4IG) coalition brings together the OECD and 40 major companies and organisations to ght against inequality. Each coalition member has committed to advancing human rights and promoting more inclusive workplaces, supply chains and ecosystems. 8 fi When we think about Finance and the Financial System, we can split Sustainability in 3 levels: (i) Self-sustainability: Can the financial system keep going indefinitely? The system proved to be not sustainable in 2007-08 when the global financial system would have collapsed had it not been rescued by coordinated actions by governments. There exists many books - and films - on this Financial Crisis, the documentary « Inside Job » by Charles Ferguson to me is the best depiction of the roots of the crisis. It is compulsory watching for anyone who is interested in understanding how the financial system has moved away from its original purpose of supporting the real economy. (ii) Economic sustainability: Does the finance system contribute to the sustainability of the economy? Finance is embedded in a « real » physical economy, the one that makes goods and provides services. The relationship between real economy and the financial system is complex. Take the Weimar Republic (which governed Germany after the First World War): its financial system collapsed in the 1930’s and was replaced by the different political, social and economic system of the Nazi regime. The cause of the immediate collapse of the Weimar Republic was the Wall Street Crash of 1929. However, the underlying factor and ultimate cause of the economic collapse of the Weimar Republic was the burden of unaffordable reparations for the WW1 which made it particularly vulnerable to a financial shock. We will see in the next section that finance doesn’t sufficiently support the real economy. Equity markets are seldom a source of new investment and banks are not lending into the « real » economy. Which leads to the question: How will the economy grow if such a small proportion is lent to the productive economy? (iii) Ecological and societal sustainability: Does the system contribute to environmental or social sustainability - how does it impact on resource use, environmental damage and social well-being? Just as finance is embedded in the real economy, the real economy is embedded in the natural world which provides our life support system. Without it, no air, no water, no food. What’s the link between finance and the destruction of the environment and how could finance be used to avoid ecological and social damage? Based on the above 3 components, we see that the current financial system has not been sustainable and we will explore the reasons why it has been this way. And we can also ask ourselves: To which extent is the financial system responsible for the pathologies we identified earlier: ecological, political, social? 9  WHAT IS THE FINANCIAL SYSTEM’S PURPOSE, IS IT SERVING US WELL? When I reflect on my teachers, or my daughter’s, some were remarkable people, capable of managing large classes of young distracted kids and teenagers with extreme dexterity, intelligence and patience. Everyone agrees that school and education are something useful to society. Then why is this usefulness or essentialness not reflected in the salaries? With the current crisis, there has been hope that things will change as we are gaining a new or renewed realisation of what essential jobs and essential workers are: nurses and other health workers, cashiers, food producers etc. We has seen some tiny improvements in some areas where there has been a scarcity of employees, but we are still far on the equality scale. What about people who work in finance? I know lots of people who work or used to work in finance, myself included, and it’s often not obvious to understand what they do exactly. Most of these people are paid over 10 or 20 times more than teachers or health workers. Surely, they must be doing something really useful to be so highly remunerated? And where does the money come from to pay them? And when there is a crisis, as in 2008 or this COVID crisis, have those finance workers seen their wages reduced? Not really… sometimes the opposite has taken place. The rest of the economy and industry pay the price instead. In the light of recent social crises, like the Yellow Vests in France, the current Covid crisis and ongoing climate urgency, can such discrepancies continue? Is the social system sustainable? What is Finance for? In 2012 John Kay was commissioned by the UK’s business department to investigate the impact of the equity market on the long-term economic performance of the economy. The report says: « UK equity markets are no longer a significant source of funding for new investment by UK companies ». The market capitalisation of the London Stock Exchange was £ 4000bn of which new issuance was £ 24bn, ie. 0.5% only ! Then, what on earth are the equity markets for? The review also finds that the asset managers are not doing the job they are paid for, and yet they are highly paid. Similarly, it finds out that banks are not lending when we look at the Deposit and Savings Channels or how Finance is Conducting the Economy. As seen earlier in the Sustainability Components part, the 2008 Financial Crisis has proven that the system is not managing risk properly, it is not self-sustainable. So, if the financial system is not lending nor investing into the real economy, how can it be expected to finance a sustainable economy? Let’s look more closely at what finance is for, how it directs where capital is allocated and how well it does it. This is a value judgement and depends on the end-user. Let’s assume that the end-user is a G7 country national, someone like me. For people living in remote areas in developing countries, the situation can be quite different as access to basic and essential (financial) services is not granted. 1. Payment system 10 This works perfectly well for someone like me. I can manage accounts from my computer, my phone, transfer money anywhere in the world in any currency, withdraw money from any ATM machines, whether I am in France or abroad on holidays. So as a payment system, finance seems to work rather well. 2. Risk management The financial system provides a number of financial products to manage our risks, some common ones: - a bank account: to store income, and transfer it to a limitless choice of assets. If my apartment burns down or is robbed, or if Paris has a drought, my income is safe with the bank. This would not be true of an African farmer with no bank account whose biggest asset is a cow. - insurance products: to protect against a range of unfortunate events: apartment fire or leak. Dying or getting ill. Or : - more esoteric risk management products (derivatives) : like a future to lock the price of oil or grain or other commodity, to protect from the risk of fluctuation/inflation. So the financial system seems to provide a wealth of risk management tools which we can generally rely on in the more developed economies. However, it crashed in 2008 which proves that as a system, it was not doing risk management well. The only reason I didn’t lose all my money in the bank and my financial assets in 2008 was because governments stepped in to save the system (more on this when we look at the Lessons from a Crisis). 3. Smoothing lifetime consumption Over a life time, we go through phases and the financial system can help us smoothe our earnings flows. At the start of our life, we can't earn a living, but we still need money to be spent on our behalf (for shelter, food, education etc). Then we get a job and our income may exceed our expenditure. Then this period ends as we get old, and again we have expenditure and no or less income. During our professional lifetime, our expenditure may exceed our income (when buying a house or a car for instance), finance can then provide a range of products to facilitate this, like a loan. It also allows saving into a pension to defer income until retirement. For any money that I save, there is a range of products I can invest in. If we assume and trust that the intermediaries are honest and won’t run away with my money, the only worry I have is whether the investment is good or not. Smoothing lifetime consumption is not trivial and the financial system seems to provide all the products to carry this out. However, how well these products work is another story (and one we will explore when looking at the Savings Channel and the Capital Markets) From our/my (G7) perspective, finance appears to perform the first 3 tasks relatively well. But I, like you, belong to a specific and favorable demographic: relatively affluent, financially literate, with a good credit rating, and living in Paris. To a small farmer living in a developing country and earning less than $2.50 a day (like 3bn other people), none of these financial products and services would be available. And even in developed countries like the US or the UK (and France!), there are far fewer products available to the modest or poor people, and when there are, they often have less favorable terms, such as short-term consumer loans with very high interest rates… 11 4. Matching savings with useful investments. This is where it gets tricky. When I put my earnings into a bank account or a pension fund or money markets or any other financial product to hopefully access them at a later date when I need them, what does the financial system do with my savings? As a saver, I could also be a user of capital. For instance, if I want to buy a house, I could get a mortgage from the bank. To fund the loan, the bank is using other people’s savings. Therefore the bank acts as an intermediary investing these savings by funding my purchase of a house. In this system, if you have a good job and a good credit rating, it’s easy to get a mortgage on a house, as it is easy to borrow on a credit card to fund consumer purchases. However, if you want to set up your own business or if you run a small company, it is much more difficult to borrow money. Banks do not play their role when you’re an entrepreneur. Banks barely dedicate 17% of their lending to the non-financial corporate sector. Hence, the bank takes my money but doesn’t lend it to enhance productivity; it lends it to finance consumption or asset purchases, like real estate. This is a major problem. The most fortunate people can easily and cheaply access finance to buy property, which increases in value making them wealthier, because collectively borrowing large amounts of the same assets pushes the prices of these assets up. A low income person will find it extremely difficult to do the same and can only borrow money at higher interest rates, or is trapped at a low consumption level. It’s a vicious cycle. This is made worse as small and medium sized companies can’t access finance to expand and employ these people so as to transition to a virtuous cycle. The finance sector has a crucial role to play in allocating capital but it does not finance the real economy or production capacities : the equity markets are not a source of new investment and banks are not lending to new businesses. Only a small proportion of lending is going into non-financial corporations (17%). The biggest lending sector is property which represents over 50% of loans to individuals and financial actors). Understandably people need to borrow for housing, but why do we have to pay so much? Because the asset prices are being pushed up which is in the banks’ interest as they can lend more to the sector and make more money - it’s a vicious cycle (for us). And that raises the critical question: How will the economy grow if such a small proportion is lent to the productive economy? So is finance serving its purpose well? The financial system works fine in some aspects, but where it chooses to allocate capital looks problematic. The system seems to divert resources toward asset purchases and consumption rather than toward productive purchases, such as a new business, to meet the needs of more affluent people only. The financial system has been creating more inequality. 12