Is Finance Ready to Go Green?
The financial industry plays an indispensable role in the modern economy by allocating society's savings to borrowers engaged in productive pursuits. It could also play a crucial role in facilitating the investments needed to combat climate change, but only after it is restructured for that purpose.
LONDON – Since the 2008 financial crisis, the question of how to guide activity in the sector has featured prominently in public discourse, particularly in debates about building a sustainable future. In its most basic form, finance is a means of arbitrage between savers and borrowers: its purpose is to direct society’s savings toward productive ends. For those who provide financing, the goal is to support projects that promise a high return relative to a given level of risk, and to shy away from projects perceived as too risky for the return on offer. Most large corporations conduct the same kind of assessment when deciding how to allocate capital.
The problem is that some of society’s greatest challenges are in areas where the possible risks may outweigh the likely returns. If the financial industry is left to “self-regulate” – as it was in the West between the mid-1980s and 2008 – lending will be channeled primarily toward areas perceived to be relatively low-risk and high-return. But, as the fallout from the financial crisis showed, a self-regulating industry’s collective judgment of those risks and returns can be deeply mistaken. Financial-market sentiment, after all, tends to veer between fear and greed, each representing an extreme that is rarely correct.
Given these shortcomings, it is clear that the finance business should be more diversified, so that aggregate judgments and market signals do not reflect mere “groupthink.” Different types of lenders need to be driven toward different purposes, and with different sets of incentives. Among traditional investment banks and other highly leveraged entities, there should be some with a specialty in risk management to serve as intermediaries in higher-risk projects. At the other end of the spectrum, there should be utility-like financial providers to intermediate for lower-risk investments.
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