Transparency is important but not enough for a greener financial system

The financial sector is facing increasing pressure to reduce its support for the carbon-intensive sector, with banks’ lending practices getting more attention. 

The main response from government bodies and regulators is to upgrade financial disclosure requirements to include climate risks and impacts. This aims to increase investors’ responsibility by making them report on the climate impacts of their investment portfolios. 

However, the problem is much larger and more complex to solve than just shining a light on current practices. 

While enhanced disclosures are an important step towards a sustainable economy, they are insufficient to fuel a mass diversion of capital towards the clean energy sector given the current financial system’s infrastructure. The idea that once we can see where the money is going, we can redirect it to sustainable portfolios may not be entirely feasible. 

Even in today’s opaque environment there is increasing uncertainty over the future demand for fossil fuel investments, while appetite is growing for companies with long-term sustainability goals. The ESG market has grown rapidly, with a third of the total $1.5 trillion global green bond market issued just this year, according to the Climate Bonds Initiative.

However, the issue with moving capital away from fossil fuels and towards clean energy is that the green investments market is still relatively small with low liquidity. 

Fossil fuels represent a long-standing and highly consolidated industry, having taken in large and stable investments over the past few decades. Only in the five years after the Paris Agreement, it’s been estimated that 60 of the world’s largest commercial and investment banks have collectively invested $3.8 trillion into fossil fuels.

In contrast, the renewable sector is young and fragmented. Despite its rapid growth over the past decade, it’s still characterized by many small participants, often operating in only one market. This results in lower revenues and market capitalization, limiting renewables’ ability to attract investment. 

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The green investment arena is simply not big enough to absorb the capital that needs to be diverted away from industries that damage the environment. 

And even if it were, switching from one to the other is not a clear cut environmentally friendly play. There are issues to be considered around the impact of divesting from fossil fuel industries. Even if an investment fund sells its ‘dirty’ assets, someone is purchasing it on the other end - could be a buyer with lower sustainability targets or who doesn’t have to be as transparent about their investments.   

Therefore, a downside of increased transparency for regulated entities could be that ownership will simply move away from public view, which is not necessarily a long-term, sustainable strategy.  

Moreover, the growing market for environmental investments is currently unregulated. Ratings agencies such as S&P Global or Morningstar issue “green” ratings on stocks and bonds, but these come without any regulatory checks. 

This problem is only now being addressed by the International Organization of Securities Commissions, which includes watchdogs from the US, Europe, Asia and Latin America. The organization recently issued some recommendations for its members in an effort to shine light on how ESG ratings are compiled and help combat greenwashing. 

But governments and regulatory bodies have a bigger part to play beyond regulating disclosures requirements and ratings. Climate and energy policy design should consider innovation in low-carbon financing and investor preferences, including their levels of risk appetite and available capital, to create a stronger ecosystem for green assets.

Overall, perhaps the bigger focus should be on expanding the financial sector and bringing clean energy investing into the mainstream. If sustainable portfolios become more attractive to investors, capital will follow.