Green finance’s institutional dilemma 1: Green fintech and how it helps unlock sustainable capital

It is curious, perplexing and downright frustrating that the investment industry continues to tolerate any level of debate or delay in what is such a critical need. Supporting ‘industry’ in its transition, and at pace, can be no debate. It needs to happen now before it is too late.  

On average approximately $6trn per year needs to be deployed, according to the G20. The finance industry has a key role to play in mobilising and directing private capital to support the necessary transition to a low carbon world.

As this table from the Chartered Institute of Banking demonstrates, global investment into green and sustainable initiatives amounts to trillions of dollars.

Estimate investments to achieve green objectives (credit: CIB)

To activate capital flows, the entire financial value chain has to be enabled. Top down, the institutional investor is the catalyst. And this is where the challenges start.

Green may be greener on the other side – lack of global taxonomy and frameworks for evaluating sustainability investments

Despite undoubted progress in recent years, green finance is still on the ‘periphery’ for many professional financiers.

Green bonds, green loans, Environmental, social and governance (ESG) investments and other markets may be growing, and quickly, but they still account for only a small proportion of financial services overall. 

The green and sustainable bond market, for example, makes up only a small percentage of the overall bond market.

There are a number of significant challenges that still need to be overcome for capital to be released. 

Top-down institutional investors need to: 

  • overcome transitional risk associated in portfolio and fund design and implementation
  • adapt to policy and regulatory challenges
  • solve the lack of data availability and quality on businesses they directly or indirectly invest in.

What needs to change for capital flows to be unlocked

Policy and regulations

First and foremost policy makers need alignment on the definitions for green and sustainable finance.  

There is a lack of global consistency in regulatory guidance requiring investment managers to incorporate ESG factors.

Absolute guidance is not evident yet for capital adequacy ratios (Basel III and Solvency 2), which will restrict the flow of capital to green and sustainable projects due to relative capital weightings. 

Less green associations

The roles of global forums in spreading the word of green finance are invaluable and necessary. The G20 is an international forum for finance ministers and central bank governors from 20 major economies to collaborate to drive green finance.  

Current members include Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, the United States, and the European Union. 

However, when you overlay the myriad of other compelling programmes such as the:

  • United Nations Environment Programme Finance Initiative (UNEP FI)
  • UN Environment (UNEP) Inquiry into the Design of a Sustainable Financial System 
  • Principles for Responsible Investment (PRI) 
  • Principles for Responsible Banking (PRB)
  • Green Climate Fund which supports the efforts of developing countries to respond to the challenges of climate change
  • Financial Stability Board brings together major central banks and financial regulators to promote international financial stability

Then active participation and adherence by the finance industry is costly and resource intensive.

Greater understanding around ESG measures and manipulation

So far, ESG criteria is the default baseline for assessing viability in sustainability investing.

Typically, ESG scores of companies (most of which are publicly listed) are used to gather information for:

  • Benchmarking
  • Reporting requirements
  • Risk assessment
  • Portfolio construction
  • Portfolio management and performance
  • Brand image and reputation
  • Responding to client or shareholder demand

The issue is that there are currently over 100 metrics for risk exposure and more than another 100 metrics on policies, programmes and performance data across over 30 industry-specific issues. 

With over 130 providers including exchanges, independent data service providers and non profit bodies, ESG data suffers from a lack of consistency and standardisation. Low correlation between ESG data providers also creates difficulties in quantifying the ESG credentials of a project.

The irony of the situation is that this ‘moving’ target is what fund managers globally use to define their sustainability baseline. Even the PRI (mentioned earlier) directly link the valuation and performance of companies against risk and lower cost of capital to ESG integration.

More ESG uniformity will boost capital flows 

The risk while we wait on uniformity in scoring approaches, is that capital is unable to flow as freely or is confined to well known, public companies where public data is more available.

Although Europe is leading the way with the adoption of standards, the pursuit of non-listed and less known projects is still often left to a limited pool of impact investors. They make it their thesis to research the market and take the risk associated with direct investments despite data being unavailable or limited. 

ESG and green investments are not interchangeable.  ESG offers a framework for investment decisions, while only direct investments where the operational nature of an investee company delivering on an environmental commitment or benefit can be considered green. But with funds on the rise at an impressive rate, the potential for green washing is rising in close correlation.

How does fintech provide a solution?

Fintech business models, including digital platforms, data analysis and distributed ledgers, can aid the institutional investment dilemma in a number of ways:

New AI analysis offers more informed investment decisions 

Artificial Intelligence (AI) and quantum computing can analyse terabytes of unstructured data to help investors make more informed decisions across their portfolio. This includes data in the public domain potentially  relevant to direct investments or portfolio activity but lacked by current ESG scoring tools. 

Improved risk management

Improving risk management by enabling easier access to, and analysis of data over a wide range of green finance-related areas (e.g. climate data, emissions tracking). This makes it easier for financial institutions to identify, assess, manage and disclose.

Blockchain reduces costs

Technologies such as distributed ledger (blockchain) and smart contract technology enables the tracking and direct transfer of digital assets without the need for trusted intermediaries, further reducing costs.

Further reductions in the cost of issuing bonds and other securities are possible, making it easier for smaller businesses and projects to receive funding  currently only accessible by larger issuers.

The future 

The race is on to unlock the capital, products and services that are truly needed as we rapidly pursue a low carbon economy. An opportunity for innovation and entrepreneurship emerges yet again. The ‘green value chain’ will require re-imagining and the shifting power from financiers to the new ‘green’ industry is what counts. 

In my next blog I will take a look at the role and needs of the emerging ‘green’ industry alongside the next level of the green finance and green fintech opportunity.

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Financial Technology Innovation for a Greener Planet

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