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Velfungerende grønne markeder - finansielle aktørers rolle

Summary and conclusions

This study of environmental practices in the Danish financial community shows that financial institutions pay attention to the environment matters in their evaluation of companies. Hence, many financial institutions check whether the companies to whom they extend credit or in which they invest, comply with environmental regulation.

However, the study also finds that the financial community primarily considers risk-related environmental factors. Hence, there is only limited faith within the Danish financial community that environmentally sustainable companies will generate superior returns, as is otherwise suggested by parts of the international financial community. This study, therefore, does not support expectations that sustainable financial markets, where financial institutions act as a driving force for environmentally oriented businesses, will emerge of their own accord. For the financial institutions to increase their environmental focus the sector must have stronger economic incentives than market signals are currently offering.

On the other hand, nothing in the study indicates that green businesses are faced with financial barriers due to scepticism in the financial sector.

Background and research question

The study Environmentally sustainable markets: the role of financial actors examines the role of financial actors in bringing about environmentally sustainable markets, i.e. markets in which all market transactions include environmental parameters.

The financial community can promote environmentally sustainable markets through two mechanisms: Firstly, as a supplier of risk bearing capital the financial institutions constitute a framework for the development of cleaner technologies, cleaner products or sustainable production processes. Secondly, the financial sector may serve as a driving force for increased sustainability among their customers by including environmental criteria in their credit and investment valuations. The present study focuses on the latter mechanism, primarily, since this involves by far the larger share of the activities of the financial community.

The present study examines the following question: How do financial actors incorporate environmental parameters in their investment and lending activities? We were interested in knowing if and how environmental issues affect the way financial institutions evaluate risk factors as well as profitability of specific financial engagements. The analysis identifies key barriers to as well as opportunities for increased environmental focus in the financial market. Furthermore, we propose a simple model for how financial actors might include environmental aspects in their financing decisions.

Financial actors in this context refer to banks, pension funds, investment associations, venture capital companies and other institutional investors. Individual investors are also included in the analysis as a separate study group.

Data

The analysis is based on a detailed study of two cases: intensive pig farming and textile production. In each of the case studies we examine specific examples of credit or investment decisions. The purpose of this approach is to develop detailed insight into which issues are considered in financial assessments, and which criteria actually determine the decisions. To broaden the study, the case analyses are supplemented with personal interviews with a number of financial actors; these include representatives of traditional financial institutions as well as bankers and investors with an explicit ethical and/or sustainable profile. The object of the study is the financial community in general, rather than explicitly green financial institutions. Following this, the specific examples examined in the case analyses do not concern explicitly green companies.

Individual investors are included in the analysis in order to ascertain the interest of this segment in investment products based on sustainable/ethical investment principles. This part of the analysis is based on interviews with investment associations that offer investments targeting sustainable businesses. But also pension fund representatives have been interviewed for this part of the study, as these funds have been in the public spotlight regarding investment principles. Thus, we examine whether pension fund customers, who can be likened to individual investors, put pressure on their funds to introduce ethical and sustainable investment principles.

The data collection method is largely qualitative interviews, either in person or by telephone. Qualitative interviews offer depth of understanding rather than breadth, so the study cannot claim to be statistically representative of the financial sector. However, it is our assessment that the study offers an adequate view of the prevailing practices and rationales of the sector, partly because the study covers a broad range of actors and partly because the study reveals a high degree of homogeneity in the financial sector regarding environmental issues.

Rationales for environmental focus in the financial community

Under the auspices of the United Nations and other lending international institutions, there is a widespread discourse concerning the responsibility of the business community for bringing about a sustainable global economy (environmentally and otherwise). The financial sector has been identified as a potential driving force in this process. In countries such as the United States and the United Kingdom many, so-called socially responsible investment funds have emerged, founded on value-based investment principles such as environmental sustainability. The arguments for socially responsible investment fall into two categories: one is an ethical approach to environmental sustainability; the other rests on economic motivation. The ethical – or political – approach rests on the viewpoint that the financial sector carries a moral responsibility for contributing to sustainable development. The economic approach simply argues that it is in the economic interest of the financial institutions to do so, as, goes the argument, socially and environmentally responsible corporations will outperform traditional corporations and therefore represent better investments.

The economic argument involves both negative and positive drivers for focusing on environmental issues. Companies who handle environmental matters in a sloppy, irresponsible or illegal manner risk liability suits, fines and damages to their reputation, all of which entail financial risk, which is of concern to risk aversivebanks and investors. Negative environmental drivers in the financial sector therefore concern risk assessments in lending and investment decisions.

But some take the economic argument one step further and claim that financial institutions should be concerned with the value creating potential of environmentally sustainable business practices. Corporations at the cutting edge of integrating environmental concerns into their products and production processes may realise savings due to resource optimisation and obtain competitive advantages; in the best case scenarios, sustainable practices may result in a branding effect. Positive drivers thus relate to the profitability of investments.

Findings and conclusions

The main findings of the study are summarised below, as this section outlines the practice and attitudes of the Danish financial sector regarding incorporation of environmental criteria in their credit and investment decisions.

The role of environmental and other criteria in financial assessments

The key criteria when a financial institution assesses a credit application or an investment opportunity is that the company in question is in good economic standing, that it exhibits growth potential, and that it is run by a competent and forward-looking management. Environmental management may figure as one of many indicators of good management.

As concerns the status of environmental parameters, the study shows that creditors and investors generally do pay attention to environmental factors when they make financing decisions. But the level of attention paid ranges from a full-fledged probing of the environmental record of the company to a mere recognition that environmental factors could be important. For most of the financial institutions interviewed, environmental issues are limited to a simple check of the company’s compliance with environmental regulation. Banks in particular emphasise that they ensure that companies have obtained all permits required by law. Unlawful environmental conduct is considered a financial risk factor, and several banks state that they fear that a company’s unlawful or indefensible environmental conduct will hurt the image of the creditor.

The weight given to environmental factors in financial assessments varies with the character of the production in question and with the size of the financial engagement. Companies with potentially environmentally harmful productions receive a more thorough scrutiny, particularly as the size of the financial engagement increases. But financial institutions view environmental factors as one set of risk factors among many. Several of the interviewees point out that they are better off focusing their attention on risk factors other than environmental ones, for instance market conditions, because experience shows that failure to consider such factors are more likely to incur losses than failure to consider environmental factors.

The study further shows that the confidence in sustainable business practice as a positive economic driver is relatively limited in the Danish financial community. The interviewees generally recognise that proactive environmental management may lead to competitive advantages and resource savings, but most of those interviewed place environmental factors far from the top of the list of parameters that determine the success of a company. Only few of the financial institutions in thestudy consistently inquire about environmental management practices when considering a loan or an investment.

However, financial actors who have moved into the field of environmental and ethical investments indicate that they expect environmentally sustainable companies to deliver above-market returns. The extent of socially responsible investments (ethical, environmentally sustainable or cleaner technologies) in this study is estimated at 1.4 billion DKK² – a rather modest level.

Retirement funds to a lesser degree than other participants in the study focus on the economic implications of environmental management. Those retirement funds that consider environmental issues in their investment practices refer to ethical motivation. Generally, the pension funds focus more broadly on corporate governance; this applies to environmental issues to the extent that pension funds may abstain from investing in companies who act environmentally irresponsibly. The practice, thus, is one of negative screening, and environmental parameters do not appear to be a key principle in the investment decisions of retirement funds.

The study does not offer conclusive evidence of the potential demand among individual investors and pension fund clients for greener investment portfolios. Firstly, opportunities for demanding environmentally sustainable investments are a recent phenomenon, which requires more time for evaluation. Secondly, developments in the stock markets in recent years have discouraged new customers from entering the stock market (which is relatively small in Denmark). Thus, although investment associations had registered a large prior interest in ethical and sustainable investment products, the most recent offerings of such products have been met with lower-than-expected demand. This is explained with reference to the stock market situation. However, the pension funds have not experienced significant pressure for environmentally sustainable investments, neither now nor before the stock market plummeted.

Conclusions

The findings of this report can be summed up in these main conclusions:

- The Danish financial community is aware that it pays to check the environmental record of companies when considering loans or investments.

- The financial institutions include environmental factors in their assessments to the extent they consider it financially necessary, i.e. when suggested by the character of the company (regarding environmental impact) and the size of the financial engagement.

- The financial institutions generally focus on the risk factors associated with environmental conduct, including compliance with environmental regulation. But a few investment associations have gone a step further to establish investment portfolios with an environmental profile in the expectations that environmentally oriented companies will yield above-market returns, and that such investment products will answer market demands.

It can be concluded, then, that the financial community currently does not represent an actual driving force in a market-based environmental policy. The ambition to promote efficient sustainable markets rests on the assumption that market forces will encourage financial institutions to include environmental parameters in their decisions. But market signals at this point do not seem sufficiently clear to give financial institutions the impetus to include environmental parameters to any larger degree than they currently do.

On the other hand, the study does not indicate scepticism among bankers and investors regarding environmentally sustainable companies. There appears to be no financial barriers for the development of environmentally sustainable companies and products.

Barriers and opportunities

Based on the findings summarised above this section outlines the most important barriers to an increased focus in the financial community on environmental issues. It also lays out possible measures to overcome these barriers.

Barrier: The financial community lacks economic incentive to increase its environmental focus
As mentioned, the majority of the interviewees do not consider environmental matters to be decisive for the economic success of businesses in general, except for the financial risk associated with the lack of compliance with environmental regulation. Market signals have not been sufficiently clear to convince the financial institutions to increase the weight of positive environmental factors in their analyses and decisions. Several interviewees point out that consumer markets, with a few exceptions, have not rewarded sustainable products with significantly larger demand.

Measure: Document the economic benefits of including environmental factors in financial decisions
The analysis shows that it will be necessary to document to the financial sector the economic benefits of incorporating to a larger degree environmental parameters in their analyses. The economic incentive would be greater to the extent it would be possible to demonstrate the precise economic value of environmental management on the bottom line of companies, either in terms of negative value of environmental risk or positive value of market advantages or cost savings. Those interviewed request analytical tools that can demonstrate the correlation between environmental management and economic outcome, in a form that is relevant to financial analysts.

Furthermore, it is suggested by several of those interviewed that it would be valuable to bring to the fore positive examples that may provide inspiration: businesses whose key figures have improved due to proactive environmental practice, for instance through a better image. International examples of financial institutions that have benefited from paying attention to environmental issues would also lead the way and create the necessary attention to the issue.

However, empirical data on the correlation between environmental management and financial payoff is not unequivocal. An overview of studies of the relationship between socially responsible investment practices and rates of return indicates that while such investment principles do not diminish investment returns, they also do not yield above-market returns as suggested (UBS Warburg).

This implies that, if a political objective is to promote sustainable financial markets, it may be necessary to stimulate such markets through public contributions to the proper incentive structures. The interview persons suggested that sustainable businesses be rewarded economically, for instance through the tax structure, in order to increase their value as investment objects.

Barrier: The financial institutions do not acknowledge expectation that they should act as a driving force
The participants in this study tend to point to other actors whom they consider in a better position to push for sustainability in the economy.

Production companies
The interviewees find that Danish companies are well ahead of the financial institutions when it comes to awareness and knowledge of environmental factors. Assessment of environmental factors typically requires technical expertise. Such expertise is often on hand within the companies or with their advisers, while financial institutions by their own account generally lack the necessary expertise to carry out environmental assessments of a specific company. The financial community considers this an appropriate division of labour. Likewise, the companies are better positioned to know the specific markets for their products, and are therefore quicker to detect market trends, including opportunities for marketing products with a high environmental profile. Investors tend to follow the movements of companies and consumers, rather than vice versa.

Furthermore, financial institutions tend to view environmental management and profiling as a management issue; the financial institutions do not see it as their role to get involved at that level of strategic considerations.

To sum it up, the financial sector, as represented in this study, is of the opinion that Danish businesses are so well aware of environmental issues that the financial institutions would have nothing to contribute as a driving force.

Consumers
Representatives of the financial community also point to consumers as a central driving force in the development of sustainable businesses. If consumers were to signal to businesses and the financial sector that they prefer and are willing to pay for environmentally sustainable products, the financial sector will increase its investments in such companies.

The public sector
Representatives of the banking sector identify the public sector as a very important actor in the effort to increase the environmental focus of the business sector. They point out that government through environmental regulation has driven the development for higher environmental standards, and through environmentally oriented subsidies and other support they have contributed to a rather high environmental awareness among Danish businesses.

Retirement funds
Finally, some interviewees point out that individual investors and pension funds could influence the rest of the financial community by demanding environmentally sustainable investment products. Given the large sums controlled by the pension funds in particular, a different investment profile here could swiftly change the focus of the rest of the financial community.

Opportunity: Stimulate other markets and actors
There appears to be a need for a continued effort to stimulate consumer markets for environmentally sustainable products so that these may in turn send the market signals necessary for the financial community to take further initiatives.

As for individual investors and retirement funds, development towards greater environmental focus is hampered by the current climate in the stock markets. This means that the potential for change in this domain appears somewhat limited at present. But as pension fund customers are offered increasingly free choice among pension funds, it might be useful to highlight the opportunity for including environmental parameters in their selection criteria.

Measure: Develop dialogue with the financial sector
If it is a policy objective eo ipso to increase the environmental focus on the financial sector it may be worthwhile entering into a dialogue with the institutions of the financial community about the role of this sector in the promotion of environmentally sustainable markets.

Barrier: lack of attention to environmental matters due to specific Danish circumstances
Several interview persons suggest that the attention to the role of the financial community for the development of sustainable markets has been relatively sparse in Denmark compared to other northern European countries. They offer several explanations:

• Large Danish companies tend to have decent environmental track records; hence there have been only few environmental scandals. Few such instances have generated considerable debate about environmental responsibilities of companies and have also brought into focus the power of financial actors.

• Denmark, as opposed to Sweden, has a rather rudimentary private shareholder culture; relatively few Danes own stock – or they own stock collectively through mandatory workplace-related pension funds. This leads to low awareness about investment principles of the funds, because few people have been faced with making active choices.

• The structure of the Danish business sector with its many small and medium-sized enterprises implies that the influence of large institutional investors on the Danish business sector is somewhat limited. Many companies do not obtain capital from external investors, and those who do constitute a rather insignificant share of the portfolios of institutional investors.

No specific measures are suggested, as we expect that some of the other measures suggested will also help increase attention to the role of the financial sector in an environmentally sustainable economy.

Barrier: Inadequate information
Several of the investment funds that apply sustainability principles to their investments call for easy-to-grasp, relevant and well-organised information about environmental matters of a given company. Small financial institutions participating in the study request easily accessible information about environmental issues pertinent to specific trades or businesses – information that would allow them, for instance, to conduct simple screenings for relevant environmental issues during processing of an application.

Measures: Information tools
It is our assessment that the financial community at large has no need for a comprehensive and detail-oriented tool for analysis of environmental management. But it might be useful to initiate development of a simple accounting method regarding individual companies’ environmental records, for instance based on the Environmental Accounting Management developed under the auspices of the United Nations.

Also several participants have called for an easily accessible information source for preliminary screening of potential environmental factors relevant to a given trade. We suggest therefore examining if existing information sources are applicable (e.g. contact persons for specific topics or trades or works of reference). A single entry point into the environmental regulatory and advisory system might be useful for efficient processing of inquiries to relevant resource persons or tools. In case such an entry point were established it would be beneficial to run an information campaign in the financial community.

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