A principled approach

The UK government will be unveiling 'The London Principles' at Johannesburg in September – which will set out how the financial sector can contribute to sustainable development. Brian Pearce explains

The growing evidence that corporate sustainability pays is moving finance for sustainable development out of its green investment and banking niche. In the past six months, the Centre for Sustainable Investment at Forum for the Future, a leading UK-based sustainable development think tank, has analysed how financial institutions in the UK are responding to the opportunities and risks emerging from sustainable development issues and policy measures.

This work is part of the 'London Principles of Sustainable Finance' project.This initiative, whose conclusions will be unveiled by UK prime minister Tony Blair at the WorldSummit on Sustainable Development in Johannesburg in September, has set out to examine what financial services firms can do to support sustainable development.

The study raises its sights from green investing and banking to examine how sustainable development can be encouraged (or discouraged) by the mainstream financial services sector – in how it prices equity and debt and provides new capital and risk management products.

Investment in assets, particularly longlived network assets such as transport and communications infrastructure, can constrain the development path for many years. It is therefore important to get the allocation of capital right. The financial sector’s role as an intermediary makes it a critical channel through which price signals, regulation and civil society action can direct capital to more or less sustainable economic activity.

The aim of the project is to identify how to incorporate financial markets into sustainable development (rather than the reverse, which is the role of social investing and banking), both in developed and developing economies. It has examined case studies covering a number of innovative financial processes, products and markets, which will be published in early August. It is also to set out seven principles to help financial institutions and policy-makers identify where to innovate in future to improve the financing of sustainable development.

• There have been several stages to putting the project together:
• assessing how sustainability is being integrated into mainstream financial services activities;
• identifying case studies of financial innovations that support sustainable development;
• seeking practitioners’ ideas for future innovation; and
• constructing the seven ‘London Principles of Sustainable Finance’.

Integration
In the flurry of exciting product developments in weather derivatives, socially responsible investment products and carbon trading reported in the pages of Environmental Finance, we rarely get a chance to take a viewof how these fit into the financial sector as a whole and its role in financing sustainable development. Table 1 steps back from these various niches and shows how they, and more mainstream products, fit into the key functions of the financial system in:

• pricing debt and equity, and responsibly exercising equity ownership rights;
• providing new capital; and
• providing risk management products.

It is through these functions or channels of influence that the market mechanisms of the financial services sector affect the decisions of business to engage in more, or less, sustainable activities. For the market to work efficiently and to reflect the increase in environmental and corporate governance legislation and the impact of these issues on branding and reputation, the following needs to happen:

• asset prices should reflect sustainability performance;
• ownership should be exercised to promote sustainable asset use;
• due diligence among corporate financiers should account for sustainability risks; and
• risk management products need to be developed to insure against these emerging risks.

In response to these risks – and the opportunities that also exist in helping to finance sustainable development – there have been a great many financial innovations in processes, products and markets of the sort described in these pages every month. Each has a place in the jigsaw of financial innovation and, while also responding to commercial opportunity, plays an important role in enhancing the contribution of the financial system towards sustainable development.

Case studies
The study identified a wide range of financial innovations in UK financial markets in the past decade that will support sustainable development. These include process innovations such as environmental credit risk management tools, product innovations such as socially responsible investment (SRI) funds, and market innovations such as the UK’s carbon market, the UK Emissions Trading Scheme.Taken as a whole, these innovative financial products are starting to play a significant role in the financing of sustainable development.

A selection of these innovations has been examined in more detail for lessons thatcould be applied elsewhere and by other institutions. These are all initiatives seeking commercial returns or the commercialisation of the business they are financing – they are all ways of making the market work for sustainable development.Table 2 gives some idea of the variety of innovations that have taken place in the UK.

Ideas for future innovation
Discussions with over 40 financial institutions and a subsequent workshop in December last year with a further 80 participants raised a number of ideas about how the role of financial services in sustainable development could be improved through innovation by financial institutions, or regulatory innovation by government.

The explicit focus is on how financial market mechanisms could be used to generate sustainable development benefits. In particular, there is an emphasis on eliminating market imperfections of information or transaction costs that hinder the financing of sustainable development.The discussion is also set within the context that governments are the democratic agents through which society's preferences are set.

Financial institutions, while quite rightly seeking profitable opportunities, must operate within this framework as well as within a generally accepted set of business ethics. Government needs to play its part in a couple of ways:

• through appropriate regulation and taxation of environmental and social impacts, in other words helping to create the business case, where necessary, for the financing of sustainable development, and
• by ensuring a predictable, fair and efficient regulatory environment for finance and providing the conditions to enable the flow of private finance where high risk is preventing the capture of potential high social returns.

The seven ‘London Principles’
Out of this experience, we have drawn up a set of seven ‘Principles’ that propose conditions for a financial system, and the role of financial institutions within that system, that will enhance the financing of sustainable development (see table 3).The idea is to provide a framework for private financial institutions and policy-makers to focus on where innovations are required to further improve the role of the financial system in financing sustainable development.

Whereas many guidelines focus on environmental performance or perhaps environmental and social impacts, these principles are designed to emphasise the financial sector’s primary role in promoting economic prosperity as well as influencing environmental protection and social development. Within each of these three ‘sustainability’ categories, the principles describe the role of financial services in providing access to capital, pricing risk, promoting high standards of corporate governance and a number of other features. They are currently being fine-tuned in discussions with a number of financial institutions the UK and will be published in their final form at the WSSD. EF

Brian Pearce is director of the Centre for Sustainable Investment at UK-based sustainable development think tank, Forum for the Future. E-mail: b.pearce@forumforthefuture.org.uk.