Finance In Transition, a newly published booklet by the Rotterdam School of Management at Erasmus University, is a proposal for a positive finance transition. With Business-As-Usual no longer an option for the economic system, it maps the significant risks of system failure, lays bare the shortcomings of the mainstream ESG response, and maps a scenario on which the survival of finance may depend. We interviewed co-author Willem Schramade.
1. Your analysis starts with an observation: the current economic model is unsustainable and will lead to shock driven market transitions. What possible scenarios do you foresee for the financial system?
The unsustainability of the current economic model may be obvious to most readers of this blog, but it is not for most others in the financial system. Let us spell it out: the dangers of climate change have been known for decades, but the overexploitation of the planet continues, and the problem is aggravated by the way the global financial system functions. The financial system is a complex regime of institutions, organisations, regulations, practices, and cultures that has effectively become focused on transforming ecological and human capital into financial capital as efficiently as possible. It produces economic benefits and financial growth for a relatively small groups of people and institutions, while externalising significant costs and risks borne by society and nature. This creates economic and financial system risks. The system cannot continue to develop along these lines indefinitely: tensions and pressures to transform will mount. Change will come and the longer it is postponed, the worse the disruption is likely to be. People need to acknowledge this and start acting accordingly.
So how can it play out? We explore four scenarios, of which only one has a positive outcome – we call it the positive finance transition. The other three have very negative outcomes, both for society and the financial system. We label them hypercapitalism; complete definancialisation; and socio-economic collapse. In hypercapitalism, the current trends of market concentration and corporate capture first become even more severe, resulting in further deterioration of social and environmental outcomes. This undermines the financial system itself as well and can result in the rise of authoritarian regimes. In the complete definancialisation scenario, governments take over and dismantle most of the financial system, resulting in world trade coming to a halt and the likely failure of food production and health systems. In socio-economic collapse scenario, neither the financial sector nor public authorities are able to control the development pathway and societal dynamics, resulting in civil unrest and chaos. All three scenarios result in devastating social and environmental outcomes.
These scenarios are all undesirable, but they can happen. Human creativity and entrepreneurship will hopefully find alternative pathways, but we better not leave that completely to chance. The main point, then, is not to predict the future, but to create awareness on the disastrous direction we are heading into: that assuming business as usual is unrealistic; and, hence, that the financial system needs to change, and that we’d better govern to achieve positive outcomes.
2. Can you describe what you envision as a positive finance transition?
A positive finance transition entails the movement to a financial-economic system in which corporations and financial institutions are managed for long-term value, within social and planetary boundaries. That means that profits remain a necessary condition for corporate survival, but not the overarching goal – just like breathing is necessary for human life but not its goal. Rather, companies should create social, ecological and financial value alike. And they should focus their attention on the type of value where they fall short. For example, oil companies should have a credible path to net zero emissions; tobacco companies should have a credible path to zero health harm, etc. In some cases, that means phasing out businesses completely, and more often it means transforming the business model. The financial sector plays a crucial role in achieving this, since it’s the financial sector that directs resources to and from companies – and despite some improvement, it currently still tells companies to maximize profits almost regardless of social and environmental value. The reason is simple: the financial sector does not estimate social and ecological value, but uses proxies at best, such as ESG scores and GHG emission intensity. It is therefore partly blind. This may change from the outside (as governments and clients force financial institutions to value the social and ecological side of businesses) and from the inside (as financial institutions decide to systematically do such assessments). Such change is stimulated by redesigning all relevant structures (taxation, corporate law, national accounts, business education, reporting requirements, etc.) accordingly; and it involves high levels of fairness and transparency. But it helps a lot if we start by imagining such a positive finance transition and turn it into a story and strategy in which people can participate. But clearly, there is still a long way to go.
3. How would a positive financial-economic system be governed?
This needs to be a collective effort since no one is in charge of the financial system and its transition. Therefore, transition governance is about empowering, mobilising, connecting and guiding initiatives and actors that are already exploring a positive transition. What forms of agency and action are already working on transforming the financial system? And what is the emergent direction for such a transition? Many examples and initiatives point towards a financial system that creates value for nature and people. But so far, we lack an over-arching, collective strategy that mobilises enough transformative power to disrupt the dominant finance regime. Such a collective strategy should be made explicit. We formulate three guiding principles for a positive finance transition:
1. From financial to integrated value: we need institutions to measure, report and target integrated returns (which combine financial, social and environmental returns), rather than purely financial returns. Effective systems are needed for transmitting information on social and environmental capital to and from corporates, citizens and governments. It also requires new mental models and new business school programmes based on integrated value creation;
2. Stewardship based on a direct link between financiers and companies: the current long and complicated investment chains mean that lots of valuable information is lost in translation. So, we need a revival of the direct dialogue between financiers and companies; and to target it on integrated value. Asset managers and asset owners can do that in more concentrated ownership stakes, deeper engagement, and shorter investment chains;
3. Capital allocation based on long-term societal value: as positive and negative impacts of investments are better quantified and accounted for, they increasingly drive investment decisions. Investors increasingly take a transition perspective and actively participate in financing sustainability transitions. They will embrace the different financial logics of a circular, non-extractive economy based on service and sharing.
Responsibility for such a collective strategy lies both with the sector itself and the authorities that regulate the sector.
4. Must the transition come from the outside, from within, or both? What role for investors?
Both. The inside of the system knows best what the bottlenecks are, but is also burdened by existing structures that block change. It therefore needs intrapreneurs who stick out their neck to make change happen. It also needs outside pressure to keep momentum for change. And perhaps most importantly, the outside brings new ideas to do things differently – just like Tesla transformed the car industry from the outside by building cars in a very different way.
Investors can take a leading role here, by asking companies (including financial institutions) to report and steer on integrated value. In addition, they need to respond to sustainability transitions that emerge in economic sectors such as energy, food, mobility or healthcare, where we see a shift from linear, fossil and financial growth to renewables, circularity and broad welfare. These transitions should have fundamental implications for financial models, returns on investment and (distribution of) profits. However, the majority of the financial system, including investors, banks, and companies, considers sustainability mainly from a risk mitigation perspective. They use ESG ratings to minimise financial losses from sustainability trends. This route is based on the implicit assumption of gradual change, where ESG ratings, regulation (e.g. the European green taxonomy) and technology will keep the system afloat. Financial performance remains the goal, subject to minimising (ESG) risks modelled on historical data. ESG thinking is actually more similar to traditional finance than to transition finance and in a way also hampers sustainability transitions (see Table below).
Table: From traditional to transition finance
The desired transition should be guided and accelerated all the relevant levels in the financial system:
• Level 1 – The overall finance transition: the transition to a financial system that manages for integrated value;
• Level 2 – Financing sustainability transitions: ensuring that other sustainability transitions, such as those in energy and food, are financed;
• Level 3 – Financial institutions in transition: how financial institutions can participate in and accelerate the above two transitions;
• Level 4 – Financial professionals in transition: what financial professionals can do in the above three transitions.
At each level, professionals in government, regulation, business, finance, research and education need to work together to support a positive finance transition. This means i) developing an integrated value and nature-positive culture and mindset; ii) changing existing structures, incentives, indicators, and conditions to that end, and iii) mainstreaming and normalising routines and practices, inside and outside the financial system, that work for planet and people.
This change can be kickstarted with methods such as transition arenas that create networks of transformative professionals with shared discourses and agendas. They can deliberately support desired transitions through their daily activities and thus make their work more transformative. Methods like these help people visualise alternative futures, link these back to daily practices and begin transforming their default mindsets and ways of working to make positive outcomes a reality.