“Investing in the Environment” 30-31 October, 1995 | London, UK
In late October 1995 over 150 financiers from more than 20 counties attended a highly productive two day conference produced by the United Nations Environment Programme and hosted by the European Bank for Reconstruction and Development
. The Conference objective was to bring together members of the public and private financial sectors in order to introduce materials to all attendees, and to discuss and develop a dialogue that has gone beyond the Conference on the subject of financing environmentally related initiatives. More specifically, the Conference focussed on issues that relate to the underpinnings of investing from both a debt and equity perspective, in sustainable development related activities from an environmental perspective, and why it makes sound financial sense. The Conference focused on five strategic areas relevant to the private sector of the financial services industry:
I. Defining the Issues Overall Discussion
The need to move beyond liability management that is purely regulation-driven emerged as the most important issue at present. This is true in two senses, first in terms of liability management and moving beyond regulatory agenda towards a real acceptance of environmental responsibility, and second, to move toward recognizing the investment opportunities within the environment. In order to be effective, we need to focus upon the key areas of activity. In terms of the locus of financial capital, the private sector, already three times larger than the public sector, and growing, is moving toward the emerging markets, particularly in Asia. The focus is upon the industrial sectors where things are happening, e.g. power and water. The dual nature of the environmental responsibility of the financial services sector emerged as:
- Corporate ecology: i.e. in terms of paper and energy use, by the financial institution
- Product ecology: both in terms of threats (i.e. risk management), and in terms of recognizing environmental investment opportunities.
With respect to corporate ecology, the importance of a gradual approach and the need for top-level support from the beginning were stressed. The meeting recognized the problem of selling environmental issues within the banks themselves first, before attempting environmental investment. Possible tools and tactics for use by an environmental coordinator within a bank include all communication channels within the bank, integrating the message into all training programmes, publishing articles and documents, keeping it short and initially very simple, and above all, keeping the topic in front of the staff in any form. The bank also has to face the choice of training its existing staff in environmental technical skills or hiring environmental specialists and training them in banking. Activity No.1
One of the solutions is to integrate environmental investments into the normal deal flow of financial institutions. The issue is, how to do this? Activity No.2
A clearly identified problem by many of the participants is the lack of environmental reporting by companies that can be used by the financial sector. This does not mean to say that there is a lack of environmental information. There is however a need to develop new and effective tools for reporting and analysing environmental information so that it can be integrated into the investment decision-making process. Activity No.3
The financial services sector needs to use such new tools to move to environmental accountability, and thence from accountability to sustainability. In particular the energy sector suffers from a lack of environmental risk quantification methodology.
II. Risk Management in the Investment Process Overall Discussion
There is no doubt that sustainable development needs support from the financial markets, both to ensure that the existing flows of capital are directed towards development projects that minimize potential damage to the environment, and to direct capital specifically to sustainable development. Again the meeting stressed the need to move beyond risk avoidance towards positive environmental investment. The discussion focussed primarily upon water and energy sectors. The single biggest constraint is the difficulty experienced by the financial services industry in quantifying the potential environmental impacts. A significant issue here is the absence of universally accepted standards within or between industries. Although we have guidelines, there are no standards. To exacerbate matters, even where standards exist, for example for financial reporting, these standards are so inconsistent between countries as to result in completely different pictures of the same company. Some prototypes for the assessment of companies in environmental terms have been carried out, using selected key criteria. This work needs to be built upon, tested and modified as appropriate. Such efforts should be conducted cooperatively by the financial community, companies, rating agencies, investors and other stakeholders. Although the ultimate goal is to integrate environmental reporting fully into the financial reporting process of a company, this is still a long way away. A necessary first step would be to develop a workable and acceptable system for a separate environmental report. It is not absolutely necessary at this point in time, that all potential impacts be quantifiable in economic terms. Many other aspects of rating a company, for example the strength of the management team, are not always directly translated into financial terms. We must achieve, in communicating to the markets, knowledge of future cash flows and benefits. The focus of the message is frequently wrong. Reports tend to emphasize investment in environmental technology, e.g. highlighting the cash outflows, instead of emphasizing the future financial benefits. Significant opportunities exist for recognizing the potential financial benefits of investing in the environment, and should be reported as such. Environmental risk only differs because of its novelty, other risks have been incorporated for a long time. Another important issue is that, in the interests of credibility, an independent institution should perform the analysis, conduct the ratings and report thereon, as opposed to the company itself. This could take the form of a rating report. Another question is who should pay for the exercise, whether, as for a financial audit report the company should be liable or whether the potential user of the information should purchase it. In any event, the need for independence in carrying out the exercise was emphasised. Activity No.1
We need to develop an environmental risk rating that will inform the markets, a methodology that will focus on the bottom line as opposed to ethical questions. We must work on the premise that all risks need to be identified and analysed, weighed up against the company’s ability to deal with or absorb the risk. The result therefore will be the potential impact upon the company’s bottom line. The strategic value of a company, including its status vis a vis the environment, is what counts. Activity No.2
Making environmental risk management a reality can be facilitated by training line officers and analysts, using case studies, developing country and industry risk reports as well as company level reports. The greatest hurdles to be overcome in the process of integrating the environment into asset management activity is the lack of time, inaccessibility of data and the lack of appropriate analytical management tools. Activity No.3
Possible next steps for financial institutions in managing the risk process are the development and use shock value cases, creating appropriate indices and ratios, and creating standards and base line comparison reports. Activity No.4
We need to promote the recognition that environmental portfolio management is useful to enhance portfolio diversification. Considering the development of funds specifically aimed at the environment, two types of ecological funds exist:
- Environmental funds – specializing in companies that make their money in environmental technology, e.g. clean technology, eco-tourism, etc
- Green Funds – that select companies from various sectors, in order to maintain diversification, but select those companies that behave more ecologically than other investments in that sector
The portfolio management of ecological funds is also a new issue, and we need to look at how institutions can take the first steps towards establishing and managing such funds.
III. Financing Environmental Improvement Overall Discussion
A number of barriers to investment in cleaner production methods exist, e.g.:
- Existing cost accounting methods contain a bias away from showing the benefits of investing in cleaner technology
- The issue just is not in the basic vocabulary of many companies
- The amounts of money needed are often too small to receive the necessary focus
- Technical knowledge and innovative financing mechanisms still need to be developed
- There still is some negative perception of the “green industry”.
These barriers need to be recognized, analysed and appropriate means employed to overcome them. There is an important role for government in creating appropriate incentives for private investment in cleaner technology. A number of possibilities for financing mechanisms were mentioned, including joint concession activity between public and private sector, programme funding with the service sector, creation of regional venture capital funds, donor equity funds for start-ups, credit lines using EU funds and long security schemes (possibly using governmental guarantees). There may be significant regional differences in needs and approaches to the financing of cleaner production. For example, traditional financing instruments do not address all the needs and problems of countries in transition (CITs) who have to survive in a very dynamic situation. Environmental liability presents a huge problem in these countries and causes hesitation on the part of the Western private sector even though the potential investees may be viable business entities. There has been a wholesale collapse of the financing systems in CITs. All the available assets of the firms tend to be used for short term cash flow financing. These factors combine to cause very particular situations requiring singular solutions. The same may be true for other regions. Regulation and enforcement set the market at the moment. This has to and will change as institutions increasingly perceive opportunities. The big World Bank projects create a lot of spin off opportunities, and these may present specific opportunities to smaller business entities all over the developing world. Opportunities are increasingly being recognized, within for example, the energy sector. Much depends on the regulatory framework. Some innovative mechanisms have been developed that have been based upon lobbying for regulatory change that makes opportunities more accessible, e.g. the “Brownfields” cases in the U.S. Fears associated with “brownfield” development are the cost of clean-up, the stigma attached to brownfield, potential downstream liability, the time needed to complete the necessary clean up and the regulatory requirements. Activity 1.
Significant opportunities for collaboration between the public and private sectors exist and should be explored. Activity 2.
There is a great need to develop regional and situation specific financing mechanisms. Activity 3
Considerable change to existing approaches to lender liability can and must be made and in the context of creative entrepreneurship, brownfield redevelopment can present great environmental investment opportunity..
IV. Environmental Capital Formation Overall Discussion
This session focussed on the need to convince mainstream financiers that environmental investment is relevant and presents a sector of opportunity. In addition some key foci for private sector capital formation are doing more and smaller deals allowing for more of a cookie cutter approach to specific transactions, looking at the entire business life cycle as many environmental projects have long paybacks, not allowing regulation to drive the market, managing and reducing misinformation, acknowledging the role of smaller companies and recognizing the critical need for disclosure of information and education of investors. Also, there is a need for a paradigm shift from risk avoidance to looking at opportunity identification. This should in part follow from an enhanced flow of information, but also there needs to be a new awareness of opportunity in the sector. The perceptions of mainstream financial institutions till need to change. There is a lot of misinformation concerning the environment, and therefore the need for some concerted awareness raising/information activity. Regulation cannot be relied upon to drive the market on its own. Internecine warfare should cease. The environmental finance community needs to collaborate to support the development of appropriate mechanisms for environmental reporting. Whatever the imperfections of proposed analytical models they are still better than nothing. Although there are significant opportunities in developing countries, particularly because of the lack of local finance, there are also some specific problems, e.g. the issue of macro-stability. This can partially be overcome by the use of contractual covenants, firm commitment from local and national government, guarantees, etc. Other items that the potential investor needs to look at are confirmation of the consumers’ “willingness to pay”, a clear understanding of which governmental institution is in charge of what, the potential of maturity mis-matches and the regulatory environment as a whole. Political risk, a frequent problem can sometimes be insured against, as well as local currency devaluations, etc. One would also simply operate where the cash benefits have the potential to be greatest. In any event, the more stable of the developing countries will simply be the ones to attract the capital. Only the relevant governments have the ability to make the necessary changes to attract capital. Activity No.1
Possible areas of focus are water and energy, and in particular in transitional and developing economies. Here the potential benefits are very evident and thus easier to respond to. In particular they represent huge opportunities in the developing world where the local governments who would usually take the responsibility for the provision of freshwater and energy very often just do not have the finance to do so. This presents great opportunity to the private sector who can frequently deliver the commodity at a lower cost than government. Activity No.2
The role of government in the process is crucial. There is a real need for government to be involved in some catalytic way. In the first place, government must enact an institutional situation that would incentivise the flow of private capital into environmental investment. However, government should not change the way that the private sector would do it, i.e. there is a need to avoid distorting effects. Activity No.3
The financing role of government should be just to make capital available to avoid bottlenecks. They may also be required to reduce risks that the private sector is unable to, e.g. force majeure. Activity No.4
It is clear though, that both in developing as well as in developed countries, there is a need for better dialogue between governments and the financial services sector. We have to work within the given market structure. Therefore the role of government in defining the given market structure is crucial, for example in the elimination of subsidies. Activity No.5
On the other hand, the financial services sector has to reform itself within the concept of sustainability. It needs to develop and apply appropriate tools to carry out environmental investigation, environmental risk appraisal and environmental evaluation control. It needs to work with environmental experts to formulate appropriate policy and procedures. Activity No.6
We need to consider how to adapt technologies and to sponsor innovation to accelerate the process of change to sustainable investment.
V. Greening the Financial Sector Overall Discussion
It is clear that governments on their own are not capable of solving the world’s environmental problems. As public concern over issues such as global warming increases, the financial sector will begin to respond by changing its investment patterns accordingly. Proactive action is required on the part of the financial sector. In any event there are significant business rewards for the front-runners. The financial sector will have to think carefully about its strategic approach to liability legislation. Although there is much opportunity for increasing the effectiveness of existing legislation, to oppose stricter liability regimes would be to oppose a key legislative tool for driving cleaner production. Activity No.1
Trade associations can play a significant role in the process of greening the financial institutional sector. Possible areas of activity include the sharing of good practice, nationally and internationally, representing the banking industry in preparatory work on legislation and regulation, and acting as a forum for the exchange of information and the sharing of good practice, nationally and internationally. There is ample evidence that capital markets react negatively ex post to known environmental risks. Information that would allow capital markets to recognize and evaluate environmental risks in advance would benefit investors and improve the efficiency with which capital markets allocate investor funds. This would benefit the environment because corporate managers and directors would have a stronger and more immediate stake in environmental improvement. From the banking perspective, lending means, first of all, risk assessment. Thus where environmental considerations have already found their way into financial customer rating systems, those banks are able to make more risk aware lending decisions and offer more favourable business terms to eco-efficient customers. Investment however, means opportunity assessment. This is where information is still a problem, both in terms of producing usable information that companies can use, and with respect to the sources of information. Often the information produced is voluminous and complex. Activity No.2
Financial institutions need short, easy-to-read and understandable reports.