It is wrong to believe the financial sector will contribute to ecological transformation. Economic and environmental policies remain key.
The financial sector should take responsibility and contribute to the decarbonisation of the global economy. This is increasingly how think tanks, bankers, economists and policy-makers advocate for ‘sustainable finance’. It is even a pillar of the Paris agreement. While sustainable finance is most often advanced with regard to climate change, the same notion is applicable to biodiversity and, for that matter, weapons, child labour and drugs.
Sustainable finance rests on the idea that money needs to be used for good. Astonishing amounts of private wealth are invested in the wrong assets or remain idle. At the same time, billions of dollars are needed to achieve the Sustainable Development Goals (SDGs) or to translate the Paris agreement into reality. Hence, banks and investors should invest this money in sustainable projects, while divesting from unsustainable ones.
Without money, the argument goes, the green transformation remains a dream. But thanks to sustainable finance, the required quantities of renewable energy, technological innovations and infrastructure projects can be realised. At the same time, production of fossil fuels can be reduced by withdrawing capital, depriving the companies of finance or, at least, raising their borrowing costs.
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The good news, it is said, is that sustainability has a ‘business case’. Investment in assets such as fossil fuels entails high risks best avoided (for example, the carbon bubble argument) and returns on sustainable assets are at least equal to those on conventional investments. Doing good with money goes along with good returns.
There are however fundamental flaws in this optimistic view. First, it relies on a monetarist conception of money. Money is assumed to be a limited quantity, controlled by the central bank, which inserts it into the economy, where it can be exchanged for goods, services and financial assets. This means we need to convince rich people and everyone who owns money to invest it sustainably.
In fact, however, money is ‘endogenous’: it comes into existence when a bank grants a loan to a borrower. Loan issuance entails the simultaneous creation of a bank deposit. Loans are on the asset side of the bank’s balance sheet while deposits are on the liability side. Since credit provision by banks is not limited, money is not limited either. Hence, any investment project can basically be financed without being restricted by the scarcity of money.
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Under capitalism, profitability is the driver of investment. This principle implies that any investment finds the capital it needs as long as it is profitable. Once the profitability condition is fulfilled, the banking system provides the required amount of money via the opening of credit lines. It is therefore no surprise that sustainable assets generate the same returns as conventional ones. For, if this were not the case, those sustainable investments would simply not occur.
Investment can be income-neutral or income-creating. The former applies, for example, to a portfolio manager who buys and sells financial assets—nothing changes in the real economy, because the assets already existed. Divesting from conventional assets to purchase sustainable ones thus does not have any impact. Likewise, it is not really useful to move a savings deposit from one bank to another, expecting that the latter would use it for sustainable projects—the investment has already taken place, as otherwise the deposit would not exist.
One may argue that divesting from certain unsustainable assets will make their prices fall. But selling an asset does not affect its cash flow and, as long as profitability is given, there will be a buyer.
Income-creating investment means the production of new assets (goods and services). In contrast to the simple trading of assets, it is ‘real’ because it requires the issuance of a new loan and thereby creates a new income. Again, the condition for this is the profitability of the investment project. This explains why the share of sustainable investment has not increased beyond single-digit rates: too many environmental problems are not profitable as business cases, even though they are of existential importance from society’s point of view.
On the other hand, hoping that ‘bad sectors’ such as the oil industry will run out of capital when investors divest is in vain. As long as oil production is a profitable business it will find finance sources, because money and credit are not limited.
Take the example of renewable-energy production, which is growing at high rates. This has been made possible by Germany’s pioneering role in research and industrial policy, as well as China’s promotion of large-scale production, lowering costs.
The sustainable-finance community celebrates the increase in sustainable assets because investment in renewable energy has increased. Yet the essential causal impact has come from policy—because, via research, subsidies and taxes, it has given renewable energy a business case. Subsequent observation of more sustainable assets in banks’ and investors’ portfolios is not a surprise but a tautological necessity. Likewise, if we achieve the SDGs in the future, such that our economy will be green, the balance sheets will inevitably be green as well.
At a smaller scale, sustainable finance may have a certain impact. For example, shareholder engagement in companies might be a possible avenue—though it is questionable whether shareholders are also willing to make business better when it reduces returns. Another approach may be that better information makes sustainability risks more transparent, such that companies make more effort to mitigate them.
It would be much more effective, however, not just to make those risks transparent but to make them real. It is up to policy to foster stricter laws and promote better technologies, to turn fossil fuels from a business case to a losing deal.
Finance is not limited. But it only flows to investments considered profitable. It will continue to finance production of fossil fuels, weapons and other ‘bads’ for as long as that is so. It will never finance projects for biodiversity and rainforest protection, because this does not bring returns.
Through prohibition, taxes, subsidies and public investment, economic and environmental policies are key to making sustainable assets profitable and bad assets unprofitable—100 percent sustainable assets then will be the simple consequence. It is wrong to wait for banks and financial markets to solve the biggest problem of our time.