Financing sustainable development needs private capital – and smart governments

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Take-ins from the OECD conference financing sustainable development.

Sustainable development requires capital from commercial, institutional and private investors. Public funding will not be enough. The annual investment gap for the implementation of the United Nations Sustainable Development Goals (SDGs) is around $ 2.5 trillion, according to UNCTAD.

The OECD Conference on Finance for Sustainable Development in Paris (28.-30. Jan 2020) provided a good overview of the current state and challenges of financing. The agenda included e.g. blended finance, impact investing, measuring impact, risk mitigation and using taxation to finance sustainable development. Some of the topics covered are often discussed in public and in the media. Some other should clearly be communicated better to the non-finance-sector public.

Financing sustainable development is now part of the mainstream

The general observation at the conference was that attitudes have changed. Financing for sustainable development is now part of the mainstream in the financial sector. Among participants there were large commercial financiers, asset management companies and institutional investors, among others J.P. Morgan Chase & Co Bank, that just had announced the creation of its own development finance institution. Customers and owners of these entities now demand responsible financial operations, preferably including credible reporting of the impacts of the financed businesses. In the past, such issues attracted relatively few interested. The change has occurred especially during the past year. It appears that markets are responding to this demand, and many new players, instruments and operating models are emerging around both responsible and impact investing. The Global Impact Investment Network (GIIN) estimates that the global impact investment portfolio (AUM) was about USD 502 billion at the end of 2018, compared to $ 230 billion a year earlier.

… But there are challenges

At the same time, directing private money to sustainability faces number of challenges, especially in developing countries and emerging markets.

Return or responsibility or both? For example for institutional investors such as pension funds, financing sustainable development often involves balancing between returns and responsibility/impact, especially in poor countries and emerging markets. How do you cope with the perceived high risk associated with these investments? Pension funds are responsible for the funds they manage. They want to finance sustainable development, but at the same time they need to get enough return on their investments to meet future pension payment obligations.

Financial regulation. Regulation and fiduciary standards of the finance sector often discourage risk-taking. In particular, following the financial crisis that began in 2008, the regulation of financial institutions, has been tightened. The stability of national and international financial systems is good. But the stabilising measures may limit investments in emerging markets. At the conference, some pension funds came out with requests to review regulation, for example, when investing in emerging markets with entities who are well aware of the risks of operating in those markets, such as development banks or development finance institutions. The involvement of such an entity reduces the risk.

What are responsibility and impact? How are impacts on sustainability measured and reported? Not very many of financiers calling themselves impact investors pursue, assess and report same things. Of the investors who responded to GIIN’s most recent (2019) survey, only 47% assessed all their projects against the SDGs. 20% did it for some investments, and 38% still do not link their impact to the SDGs at all. There are also countless models and practices for impact assessment, monitoring and reporting. The sector is still quite unorganized, which has given rise to many harmonization initiatives. Illustrative, they do not all very well coordinate with each other.

Solutions are known, but implementation is not easy

In principle, solutions to challenges are known. But implementing them is not always simple.

To reduce the perceived risk (and thus the expected return on an investment) financing has to be structured so that large investors, such as those managing pensions savings, can be provided sufficiently secure returns so they can meet their payment obligations. To this end, there are instruments and procedures in place in the financial sector (different kinds of guarantees, taking the riskiest position like equity or subordinated loans in financial packages, hedging currency risk, etc.). These tools and approaches must now be used on a large scale to finance sustainable development. Public funding and public actors play a key role here.

In order to reduce perceived risk, knowledge of emerging markets, their operating environments and investment opportunities are also required. Indeed, the risk associated with developing countries can be understood as information asymmetry. Many commercial and institutional investors may not have previously operated outside western countries, in circumstances where, for example, customer information is not always available or reliable. Such financiers need to be given sufficient information so that they feel their risk/return ratio becomes acceptable.

Financial market regulation needs to be developed to better allow investments in emerging markets for which risks have been credibly assessed and at least some of them sufficiently mitigated.

Private money is needed, but governments and policy makers also have a big responsibility

Market development and the mobilization of large-scale investment now requires good understanding and adequate inputs from public actors. Financial instruments and individual investments need to be structured to allow for risk-return profile of institutional investors. Adequate provision of information on emerging markets and their opportunities, as well as on credit risk and its materialisation, is needed. Financial regulation must respond to the needs of sustainable financing models.

Much depends on private, commercial and institutional capital. But governments, and international institutions have a significant role and responsibility in mobilizing this capital. Financiers, such as development finance institutions, which are familiar with emerging markets and have operated there for a long time, face high expectations.

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