As we move ahead in what many climate scientists call the “decisive decade”, the global sustainable finance effort needs to be strengthened in five areas.
Area 1: Theory of Change
Many sustainable finance initiatives (SFIs) are vague about the issues they address and fail to specify how their interventions will lead to the emergence of holistic sustainability at the system level. In other words, they lack a robust theory of change.
The dominant logic is that the investable universe can be segmented into “Paris-aligned” and “Paris-misaligned” assets. Implicit in this approach is the hope that a one-by-one shift from high-carbon to low-carbon assets will produce the socially and environmentally sustainable future envisioned by the Paris Agreement.
Yet true sustainability is an emergent property of the system we call society. It comes about as a manifestation of how the different elements within that system interact. As a result, it must be conceived and approached in a holistic, systemic manner, not through a reductionist and atomistic approach.
Many SFIs are vague about the issues they address and lack a robust theory of change. One of the reasons is that it is not entirely clear how financial flows, and the financial system at large, relate to sustainability transitions.
Area 2: Angle of Attack
Many SFIs focus on secondary markets—most notably stock exchanges—and thus operate at a distance from the real economy. The causal chain between the actions of an investor and their effect on environmental and social outcomes can therefore be very long.
Further, this focus on secondary markets is the main reason why most SFIs frame the challenge of sustainable finance as one of mobilising capital (a quantity view) as opposed to figuring out how, exactly, capital needs to be deployed in order to generate system-level impact (a quality view).
What remains, in many cases, is a wide chasm between what an SFI does and where it intends its impact to materialise. The future of society will not be determined by stock markets but by the investments we make in real places where people live, work, and play. Sustainable finance at large has yet to turn its gaze toward place-based investing and build a bridge between the capital realignment objective set out in Article 2.1c of the Paris Agreement and the IPCC’s call for transforming socio-technical systems.
Area 3: Risk vs. Value
The defining narrative of how climate change affects capital markets is a story about risk. Many SFIs expend a great deal of effort to help investors analyse, disclose, and manage risks. This is necessary and welcome, but on its own insufficient, because the transition to a more sustainable future will not happen solely through a race to the (risk) bottom.
Instead, investors must start paying more attention to the other side of the coin: value. More specifically, they must be able to provide a compelling answer to the following question: If we no longer invest in unsustainable assets, what do we invest in instead? In other words, how can investments not merely prevent the financial consequences we hope to avoid but generate the societal outcomes we want?
So far, the climate finance community has responded mostly by funding projects in the relatively neat, low-risk, and mature sectors of renewable energy and energy efficiency. In contrast, systems like transportation, agri-food, cities, forests, and oceans—while just as important for society to prosper—are more complex and thus harder to transform, and have therefore received much less attention. In these systems, conceptualising and measuring impact is more difficult, especially in relation to elusive concepts such as biodiversity, resilience, justice, and inclusiveness. Going forward, SFIs must find ways of defining how investments in such complex systems can create both financial and societal value.
The defining narrative of how climate change affects capital markets is a story about risk. Yet the transition to a sustainable and prosperous future will not happen if investors focus solely on minimizing risk and neglect the other side of the coin: value.
Area 4: Epistemology
In describing their goals and methods, very few SFIs explicitly reference systems theory, the discipline concerned with how different parts are interconnected and produce their own behavioural pattern over time.
Nor do they take a systemic approach to investing, for instance by interrogating the investable universe through the lens of strategic portfolios or by searching for leverage points, feedback loops, and drivers of self-organisation. Instead, most SFIs continue to advocate for the use of predictive models and the single-asset approach.
So there is a discrepancy between the finance sector’s view of the world as a complicated system and its actual nature as a complex adaptive system, generating an urgent need to evolve the epistemology of finance.
Area 5: People
Finance is a highly depersonalised domain, and yet like any other community, the financial industry is ultimately the result of the actions of its people. So why do so many SFIs underappreciate the human element as a potent place for intervention? Some engage with it, but mostly in the context of capacity building. Few go to the literal heart of the change agents within the financial sector, speaking directly to people’s values, mindsets, and their sense of agency—thereby neglecting a potent lever of change.
The climate crisis also presents an opportunity to rethink the roster of people participating in financial markets. At present, many SFIs uphold a centralised operating model with big banks, large asset managers, and multilateral development finance institutions at the core. Many also uphold crude dichotomies, such as between the private sector and the public sector and between the “Global North” and the “Global South”.
As the SDG-related funding gap remains wide, these traditional notions of industrial organisation and economic hierarchy have the potential to perpetuate ineffective response strategies. The sustainable finance effort would benefit from abolishing unhelpful categorisation and from building more diverse investment partnerships across the public, institutional, private, civic, and philanthropic domains.
There is now an urgent need to rethink who participates in financing sustainability transitions and how risks and rewards are shared. Systemic transformation is often a distributed and participatory process and therefore depends on more democratised forms of finance.
To appreciate how fundamental these considerations are, it is useful to make explicit what they imply.
Society will need to have a conversation about the purpose of money in the 21st century. This conversation has already started on the fringes of the financial system but must now move towards its core.
It is a conversation that is closely related to the one about values. What is it that societies should appreciate in the coming decades? What is considered valuable and thus worthy of creation and protection on a planet inhabited by 10 billion people, stressed by environmental degradation, and threatened by social inequality?
These questions are important because the challenge we face is not just to overhaul the category of finance but to redesign the economic system at large and therefore the financial system that structures and enables it. Being bystanders will no longer be an option for investors—capital will have to induce change, not just follow it.
Doing so opens the door to reframing the climate finance challenge beyond notions of “green”. Climate change is an environmental challenge driven by complex social factors. A reductionist approach centred on environmental indicators—as opposed to a broader and more systemic approach—carries the risk of biasing our actions towards interventions with easily quantifiable outcomes, such as CO2 reductions. Sustainable finance needs new assessment and accountability frameworks that pay tribute to the interconnectedness of our world.
Last but not least, the time has come for investors to increase their risk tolerance. Continuing to try and safeguard financial wealth through risk minimisation on a single-asset level might unlock capital flows in the short term but could lead to the deterioration of the global asset stock in the long term, diminishing everybody’s wealth in the process.