Connecting the Dots Between Sustainable Finance and Financial Stability

IMF Blog, October 10, 2019

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Authors: Evan Papageorgiou, Felix Suntheim (also credited: Evan Papageorgiou, Jochen Schmittmann, and Felix Suntheim).
Publication date: October 10, 2019.
Theme: How sustainable finance—incorporating environmental, social, and governance (ESG) principles—relates to firms’ performance and the stability of the financial system.
Background: Efforts to incorporate ESG considerations in finance started 30 years ago but accelerated only in recent years.
Definition: Sustainable finance incorporates environmental, social, and governance (ESG) principles into business decisions and investment strategies and covers issues from climate change and pollution to labor practices, consumer privacy, and corporate competitive behavior.

Governance failures at banks and corporations contributed to the Asian and the global financial crises.
Social risks (for example, inequality) may prompt policymakers to unduly facilitate household borrowing for consumption and could lead to financial instability over the medium-term.
Environmental catastrophes have caused large losses to firms and insurers.
Climate change risk channels:
- Physical risks: damages from weather-related events and broader climate trends.
- Transition risks: changes in the price of stranded assets (assets such as coal and oil that will not be used during the fossil fuel phase-out) and economic disruptions from climate-related policies, technology, and market sentiment during the adjustment to a lower-carbon economy.
Financial risk observations:
- Financial risks from climate change are difficult to quantify, but most studies point to economic and financial cost estimates in trillions of dollars.
- Insurance losses from climate-related natural disasters such as droughts, floods, and wildfires have quadrupled since the 1980s.
- Asset prices may not yet fully internalize climate risk and the transition to a cleaner economy; delayed recognition could lead to a cliff-like moment when investors suddenly demand this risk be priced into asset values with potentially detrimental consequences for financial stability.

Historical evolution:
- Elements of ESG principles (particularly on corporate governance) have long been incorporated in portfolio investment strategies.
- Sustainable investing began in equities markets through investor activism and later extended to fixed income markets, primarily with bonds that finance environmental projects, so-called green bonds.
Assets under management:
- The assets under management of ESG-related funds range between $3 trillion and $31 trillion, depending on the definition.
Investment strategies:
- Initial approach: screening out firms or entire sectors viewed as being unsustainable.
- Newer approaches: focus on positive attributes of firms (e.g., strong shareholder engagement, minimum environmental or safety standards, commitments to invest in sustainable activities) motivated by the expectation that companies that “do good, do well.”

Disclosure and measurement issues:
- Corporations don’t report on sustainability regularly or consistently, particularly with respect to the environmental and social dimensions.
- Third party providers of ESG scores aim to provide standardized assessments, but sometimes it’s difficult for them to arrive at an accurate picture given a lack of information.
- There is uncertainty measuring the impact of ESG activities in achieving goals such as reducing emissions or raising labor standards.
Risks and incentives:
- Greenwashing—false claims of ESG compliance of assets and funds—is a concern that may give rise to reputational risks.
- Mixed evidence on the performance and impact of ESG funds complicates incorporation of ESG principles by investors, especially public sector pension funds.
- Firms face a timing mismatch: potential long-term benefits from integrating ESG factors versus immediate high costs of disclosure.

Urgent and decisive policies are needed in four key respects:
- Standardization of ESG investment terminology, as well as clarifications of what activities constitute environmental, social, and governance.
- Consistent disclosure by firms to incentivize investors to use ESG data.
- Multilateral cooperation to encourage participation from more countries and avoid setting different standards.
- Implementation of policies incentivizing investment in sustainability, and requiring public disclosure of the cost of inaction.

The IMF will continue to incorporate ESG-related considerations, in particular related to climate change, when critical to the macroeconomy through its multilateral surveillance work, such as in the Fiscal Monitor, future Global Financial Stability Reports, as well as its bilateral surveillance efforts.

Source: Connecting the Dots Between Sustainable Finance and Financial Stability (IMF blog, October 10, 2019).