How financial authorities can build a sustainable financial system part 1: Addressing investor challenges

Executive summary

Financial authorities can play an important role in building a stable, sustainable financial system that rewards long-term responsible investment, to the benefit of investors’ clients and beneficiaries and the environment and society as a whole. This Sustainable Investment Policy Toolkit explores this topic in two parts which are published separately. Part one of this two-part report provides an updated framework analysing sustainable finance policy approaches. It examines:

• the challenges faced by investors^[1] in scaling up responsible investment in line with their duties and obligations to address system-level sustainability-related risks and support a just economic transition;
• financial authorities’ sustainability-related policy ambitions observed across the G20 countries; and
• the policy measures that financial authorities can implement to:
  • create an enabling environment for responsible investors;
  • fulfil their mandates; and
  • respond to emerging, sustainability-related government goals and related risks, opportunities and impacts.

Part two (published separately) provides deep dives into specific policy measures identified in part one.

Together, the two parts of the Sustainable Investment Policy Toolkit may also guide and support investors in their own engagement with policy makers on broader sustainable finance and economic policy reforms.

Challenges for investors in pursuing responsible investment practices

Investors face six major challenges in pursuing responsible investment practices:

1. Lack of incentives resulting from issues such as externalities, entrenched short-termism and collective action problems. These have limited investor actions to address the root causes of sustainability-related investment risks even if addressing them may align with financial objectives or systems stability.
2. Incomplete capital markets, reflected in the shortage of investable project pipelines, mispricing of sustainability-related risks and restrained supply of capital, particularly for projects that involve high levels of risk, require significant upfront investment or have long time horizons before generating returns. These conditions restrain the efficient allocation of capital in line with a just economic transition that enhances long-term economic sustainability, security and competitiveness.
3. Policy inconsistency and uncertainty further constrain the long-term allocation of capital to support a just economic transition. Sources of uncertainty or inconsistency can include, for example government willingness, plans and policy implementation to drive the economy-wide transition or market players’ responsibilities and discretion to manage sustainability-related risks and impacts.
4. Lack of transparency and credibility as a result of inadequate availability of standardised and comparable data and metrics, and a lack of verification mechanisms to monitor and understand sustainability-related risks, impacts and claims. This limits investors’ ability to accurately price and incorporate sustainability-related risks, opportunities and impacts into investment decision-making.
5. Principal and agent challenges may lead to misaligned incentives across the investment chain and increased transaction costs. Such challenges are reflected in differing goals and time horizons between asset owners with diversified portfolios seeking long-term sustainable returns and system-level stability, investment managers seeking risk-adjusted returns across different portfolios and for a variety of clients, and corporate managers prioritising the maximisation of single company profits, potentially at the expense of broader systems stability.
6. Lack of awareness, capacity and sustainability expertise which limits investors’ ability to fully address material sustainability-related risks and opportunities in pursuit of long-term risk-adjusted returns. This lack is driven by insufficient skills and resources to meet the emerging demands of managing sustainability-related risks and opportunities, as well as limited awareness of the feedback loop between individual investments and wider systems stability.

Relevance of sustainability factors to financial authorities’ mandates

Governments or other legally authoritative bodies generally mandate financial regulators with three main objectives, all of which interact with sustainability issues.

• Financial stability: sustainability-related risks can impact the stability of the financial system and individual financial institutions; some sustainability-related risks, such as climate change, degradation of nature and excessive inequality, can trigger system-level financial risks.
• Market integrity and efficiency: financial authorities oversee the fairness, effective functioning and transparency of financial markets. As such, they aim to support a system in which capital markets accurately reflect all material risks, including those related to broader sustainability challenges and goals. They also aim to reduce regulatory arbitrage and unnecessary regulatory burdens. Regulators operating with mandates to support the economic transition are expected to ensure that capital can be allocated to opportunities that contribute to these goals.
• Investor protection: sustainability-related risks can impact financial returns and other end-investor goals. Therefore, under their mandate to protect the interests of consumers in financial markets, financial authorities can put investor protection regimes in place to ensure that financial intermediaries incorporate sustainability factors into investment decisions and advice.

Beyond these mandates, there is impetus for governments to act in a coherent manner across financial, economic and broader public policies. This is what we refer to as a “whole-of-government” approach. Considering financial authorities’ mandates and objectives through this lens supports effective policy reforms and contributes to the creation of an enabling environment for responsible investment.

Levels of sustainability ambition of financial authorities observed across G20 jurisdictions

Financial authorities currently operate with differing mandates and varying levels of ambition regarding their role in addressing sustainability challenges. Some regulators are explicitly tasked with a secondary objective to support national efforts to transition the economy,^[2]  while others exercise independent discretion to interpret the scope of their role. These mandates and ambitions influence policy priorities and expectations for investor action.

Based on our analysis of key sustainable finance policy across G20 markets, this report identifies three levels of sustainability ambition that are cumulative in nature.

Level 1 – Managing exposure to sustainability-related risks

At this level of ambition, financial authorities aim to enhance resilience by ensuring that investors are equipped to respond to sustainability-related risks. Policy frameworks are designed to promote measures such as stress testing, scenario analysis, risk management and disclosure practices, allowing investors to effectively identify, monitor and address the impacts of sustainability-related risks on investments and financial stability. For example, investors may be expected to identify and assess the impacts of sustainability-related risks on their business operations and investments, and to establish governance oversight, risk management processes, strategies and transition plans to enhance resilience against such risks (see Table 1).

Table 1. Examples of commonly adopted financial policies to manage exposure to sustainability-related risks  

Level 2 – Addressing the drivers of sustainability-related risks

At this level of ambition, financial authorities aim to guide and support investors to consider – as part of their overall response to sustainability-related risks – how their investments impact investee entities. This impact will indirectly shape the impact of investee entities on the broader planetary and social conditions that may drive or mitigate system-level sustainability-related risks. Financial authorities may promote frameworks that guide investors to identify, measure and manage investment impacts that could drive, mitigate or enable adaptation to system-level sustainability-related risks. For example, financial and non-financial entities may be expected to implement a due diligence process to identify, prevent, mitigate and remediate adverse social and environmental impacts within their own operations, subsidiaries or value chains (see Table 2). 

Table 2. Examples of financial policies commonly adopted to tackle drivers of sustainability-related risks 

Level 3. Supporting governments in driving the economy-wide transition

At this level of ambition, financial authorities support broader government efforts to deliver the economy-wide transition to fulfil their mandate to enhance the financial stability and other objectives. This is not something that they can achieve in isolation. Instead, at this level, financial authorities support the government to implement a whole-of-government approach and to collaborate with real economy policy makers. The aim is to align responsibilities, ambitions and actions across the financial sector and the real economy to facilitate capital flow in line with transition goals. For example, financial authorities may facilitate the information flow between the wider government and financial sector. This can help to ensure that national transition strategies are investable and that transition planning by financial and non-financial entities is well informed by and connected with national transition strategies and sectoral transition roadmaps or pathways. In the meantime, financial policy and real economy policy work hand in hand. Pricing and non-pricing (i.e. standards and regulation) real economy measures that directly address externalities and build markets for solutions to sustainability challenges are essential to managing system-level risks and maximising opportunities for value creation. Without these, neither financial industry-led action nor financial policy reform will be sufficient to build a sustainable financial system. (see Table 3).  

Table 3. Examples of financial policies that can be adopted to support the economy-wide transition

By considering and pursuing all three levels of sustainability ambition, financial authorities can help to:

• ensure existing sustainability-related risks and challenges are addressed;
• reward long-term responsible investment;
• benefit the environment, the economy and society – on which financial returns and stability depend – as a whole;
• unlock the full potential of the financial sector to contribute to resilient, sustainable and inclusive economic growth.

 Ten policy tools for a sustainable financial system

Based on our analysis of existing policies and regulations across the G20, we have identified 10 sustainable finance policy tools that financial authorities can use to help address the challenges faced by investors and support a sustainable financial system. Each of these tools supports financial regulatory objectives, including enhancing financial stability, protecting investors and improving market efficiency and integrity.

1. Investor sustainability responsibilities: enabling investors to integrate sustainability factors into their investment decision-making, with the aim of contributing to financial stability, investor protection and market integrity.
2. Corporate sustainability responsibilities: setting out expected or required sustainability practices for non-financial companies (or the non-investment activities of financial companies).
3. Investor sustainability disclosure requirements: outlining the methodologies, key metrics and processes for sustainability reporting.
4. Corporate sustainability disclosure and accounting standards: establishing what should be covered in disclosure and analysis of current and forward-looking data regarding companies’ strategies, operations and performance on sustainability issues.
5. Regulatory frameworks for effective stewardship: defining expectations around investors’ stewardship practices and reporting, and removing obstacles to effective collaboration around systemic issues.
6. Transition plans: guiding financial and non-financial entities to describe their strategy to transition their processes, operations and business models to meet sustainability commitments within a specified timeframe.
7. Human rights and environmental due diligence requirements: supporting investors’ risk and impact analysis, enabling better-informed investee engagement and levelling the playing field for responsible corporate and investor practice.
8. An enabling policy environment for sustainable financial instruments: mobilising public and private capital to finance the just transition and solutions to tackle sustainability-related risks.
9. Service provider sustainability regulations: ensuring that service providers serve the best interests of their clients, taking sustainability-related risks into consideration.
10. Sustainability standards and classification instruments: for example taxonomies, scenarios, pathways and impact assessment standards built on scientific consensus and international norms. These would provide clarity on key terminologies and tools for identifying what is sustainable.

This report illustrates the relevance of sustainability to investors and financial authorities, based on a growing awareness of the material risks that sustainability crises pose to the economic, environmental and social systems which support financial value creation.

Through close examination of the challenges faced by investors in addressing sustainability-related risks, the role and level of sustainability ambition of financial regulators and subsequent expectations of investors, the report demonstrates why it is in regulators’ interests to consider and pursue all three levels of sustainability within the context of their mandates. By adopting all three levels of sustainability ambition, regulators can help to ensure a stable, sustainable financial system that rewards long-term, responsible investment. This will benefit the environment and society as a whole, thereby unlocking the full potential of the financial sector to contribute to resilient, sustainable and inclusive economic growth.

Part II presents a policy toolkit, detailing 10 key policy tools that financial authorities can apply to help address the challenges faced by investors while supporting financial regulatory objectives, including enhancing financial stability, protecting investors and improving market efficiency and integrity.