Finance in 2040 - China Dialogue

Finance in 2040

Resource crisis, fiscal crisis, climate crisis – it’s clear our economic structure isn’t working. But what’s the alternative? Alice Chapple jumps into the future to see what more sustainable markets look like.

It’s clear from all indicators that, as a global society, we are depleting resources at a rate much faster than they can be replaced and generating waste at a rate that natural systems are unable to process. At some point, it will simply become impossible to continue business as usual because we will bump up against environmental limits.

Right now, we have a choice between a managed transition to a low-carbon, resource-efficient economy and continuing on the unsustainable, business-as-usual train exploiting, consuming and wasting natural assets until we hit the buffers with an almighty crash. But the window of opportunity for making that choice is shrinking all the time.

Forum for the Future (the UK-based environmental NGO where I work) has been working on sustainable development challenges with public and private sector organisations for 15 years and we see the increasingly urgent need for change. The role of the capital markets is critical because finance underpins all economic activities. Last week, Forum for the Future launched a report “Sustainable economy in 2040 – a roadmap for capital markets” which outlines a framework for a sustainable economy, sketches out what this means for some key sectors in 2040, and indicates the particular aspects of capital markets that will need to change.

Currently, capital flows to a range of unsustainable activities because they generate attractive short-term commercial returns. Yet these activities are storing up risks for the future, which will threaten financial returns in the long-term, as well as poor outcomes for society. What would a finance system that drives and supports a sustainable economy look like?

Firstly, many different types of financial institution and instrument would be providing financial products and services, and this diversity would make it less vulnerable to shocks than it is today. There would still be multinational banks and insurance companies delivering services at scale to their global clients, but their market share would be significantly smaller. 

Peer-to-peer lending would take place for small and specialist transactions. More financing would happen through community-driven and mutual models that draw on the experiences of early microcredit institutions and co-operatives, many based around local and regional investment. In addition, there would be an increased use of “time banking” or “banking in kind”, where for example people provide care for others when healthy and use these “credits” when they are elderly or ill. Venture capital funds, private-equity funds and investment funds would continue to provide capital to businesses in the economy to support the different stages of their development, but crucially they would take a long-term perspective in their investment strategies.

Secondly, investors would have found ways to properly value companies’ capital. These valuations would account for the company’s use of and dependency on natural capital (the ecosystems like water, soil, biodiversity and a stable climate), human capital (the skills and talents of individuals) and social capital (relationships with communities such as suppliers and customers). Investors would therefore be able to identify the companies likely to thrive in the future and this would influence their investment decisions. Companies would be required to report on their strategy to address long-term sustainability challenges like resource constraints, water shortages, ageing populations and so on. Financial institutions would  “stress test” their portfolios under different social and environmental scenarios.

Thirdly, asset owners would be awarding fund managers mandates on the strength of expertise in social and environmental issues, knowing that these issues are critical to managing risk and identifying opportunities. This will be generating increasingly high-quality analysis of social and environmental drivers of value as fund managers compete to be seen as the best in this field.

Fourthly, tax relief would be available for investments in portfolios that have a strategy for transition to the sustainable economy. This makes sense for government as these investments have less social and environmental cost for the economy, saving public sector expenditure in the future. 

Fifthly, insurance companies would be charging higher premiums for activities that create systemic risk by contributing to climate change, the depletion of natural resources and/or social instability. 

Sixthly, the remuneration and appraisal system would reinforce and reward behaviour that creates value for society rather than only for individual gain. The culture of the financial markets would have changed significantly to one in which respect for peers depends primarily on how they demonstrate that their activities support growth in human, natural, social or manufactured capital. 

Finally, the sustainable financial market would be designed to make the best use of the combination of public and private investment. Public-sector investment, guided by the latest scientific evidence on environmental boundaries, would be used wisely to support the early-stage deployment of new technologies. The public sector would also invest alongside the private sector to share the risks of investment in developing countries where activities might reduce poverty. The public sector would share in the upside when investments earn strong returns.

So what are the chances that the finance system will shift in these ways?  

There are many reasons for resistance from within the finance sector. One important dimension is the perception that the market is efficient and prices will move when they need to do so to drive capital to particular parts of the economy. However, this hypothesis has been severely tested by the financial crisis and by the evidence of market failure (for example, on climate change) where prices do not reflect real value or future cost.

We know that the current financial system does not serve us well and that short-term profit-seeking will deliver neither robust long-term financial returns nor a world we want to live in. But we need to push harder for a different approach, both from the people that manage our savings and from the governments responsible for the policy frameworks. The features described above are all possible but they won’t happen far enough and fast enough unless we deliberately set out to make them happen.

Alice Chapple is director of sustainable financial markets at Forum for the Future.

Homepage image by Sean Naber