Stephan Schmidheiny

Financial markets and Eco-efficiency

Lecture of Stephan Schmidheiny at the book presentation of "Financing Change",Technological University of the Helvetian Confederation (ETH), Zurich, Switzerland.

April 17, 1996

At the Rio Summit in 1992, the theme of "sustainable development" was discussed comprehensively and globally for the first time. Two years earlier I invited Maurice Strong to form together with leading representatives from the industry a platform for the business community, and to present a global business perspective on this issue. The report of the Business Council for Sustainable Development has been published as a book called "financing change" for the Rio Conference, and the book has since been translated into thirteen languages.

In "Financing Change" the term eco-efficiency was shaped firstly. It links the economy with the ecology and means continuous improvement in resource productivity, thus increasing the creation of added value with decreasing consumption of raw materials and energy, and therefore with less waste and emissions. The term eco-efficiency has since been included in the international language and is used more and more.

During the composition of the Business Council, we gave deliberately attention to a balanced representation of all sectors and regions. The representatives of the financial world, however, showed little interest. "The industry causes environmental damage, not us," was the common opinion. Therefore, Banks and insurance companies were practically not represented in the Business Council.

Nevertheless, we included in the "financing change" a chapter on capital markets, which demonstrates its crucial importance for sustainable development. However, we had to leave it like a brief overview of the relationships.

Since then much has changed. Awareness of the environment and the need to shape the future development in a sustainable way has increased worldwide, not only in industry but also in the financial world. As the first ones, insurance companies had to take note that they are increasingly concerned directly. Liability claims for environmental damage, contaminated land and the rapidly rising amounts of loss in natural disasters, which may be linked to global climate change, have opened their eyes. Banks began to realize that land looses its deposit value, if contamination from past uses is suddenly discovered, and that borrowers lose their credit rating if they are held liable for environmental damage.

As the Business Council was newly constituted in the beginning of 1993, the topic of financial markets was taken up again. As usual, we asked experts to gather existing knowledge and practical experience. But that was not very productive. Typical answer: "a most interesting subject, but there are no publications about ongoing investigations." We had to break new ground.

The investigation should answer the basic question: Are the financial markets of the world, with their mechanisms - stocks, bonds, debt, monetary policy instruments - and the financial world in general, a means for sustainable human progress, or rather a hindrance? The question recognizes the crucial role that is played by financial markets in developing our trade and commercial activities as well as our personal lives. It assumes that any form of development, whether sustainable or not, has to be financed largely by these markets.

To find answers to this question, we invited a team of internationally recognized financial experts to jointly examine the question from different angles of the different actors, and to work together to find answers on how this could contribute to promote the goals of eco-efficiency and sustainable development.

A first observation was rather disappointing. We set up seven core hypotheses in order to analyze them separately afterwards, in the hope of being able to refute them:

• Sustainable development requires investment with a long Payback time. Financial markets favor short payback times.

• Efforts for eco-efficiency often lead to the fact that current profits sink for the benefit of future earnings potential. Financial markets tend to favor companies that are making large profits at the moment, than those with good prospects for the future.

• In the case when the prices of resources are low and a company can "externalize" the costs for a large part of its environmental impact, so they do not appear in the cost calculation, then the financial incentive to reduce eco-efficiency is low. Eco-efficient companies of the financial markets are often not preferred.

• Sustainable development requires massive investment in developing countries. The financial markets impose a high risk premium for investments in developing countries.

• High taxes of labor costs increase labor productivity and thereby increase unemployment, while low prices of resources promote their waste, thus hindering the eco-efficiency.

• In accounting and financial reporting, neither the risks nor the potential opportunities for the environment are adequately expressed. Financial markets are therefore forced to make decisions based on incomplete information.

• Sustainable development means that the future has a high priority. The financial markets use to see the future to be discounted heavily.

We addressed these hypotheses in the chapters of our book in several places. To find answers and solutions, we studied both the mechanisms of financial markets - the established and the emerging - and the roles of various actors in the financial world. We asked how these actors react to the environmental demands towards their occupational group. The results are contradictory, but we also discovered quite encouraging approaches that the conventional wisdom, the financial world has never heard of the concept of sustainable development, at best, reject them flatly or worst, negate them, can be refuted.

In all professions there are approaches to identify problems and to take them seriously, albeit in varying degrees. And a growing number of players in the financial world begin to deal with the eco-efficiency of the economy in their own interest.

Business leaders were the first to register the impact of environmental changes. As a result, most large corporations have become more eco-efficient, insofar as they create more and more value while consuming fewer resources and polluting less the environment.

Their wide-ranging responsibility has taught business leaders to understand the, sometimes conflicting, needs of their key stakeholder groups and weighing them against each other, to then include them in a joint program. We note, however, that smaller and medium-sized enterprises that have less pressure from public interest groups need other incentives to make efforts to improve their eco-efficiency.

We encourage all business leaders, to integrate the criterion of sustainable development into their business strategy, because if the markets reward eco-efficiency more systematically in future, they will need appropriate strategies, trained and fit-for-service employees and loyal reference groups.

Most of the time, professional investors do not care about environmental issues because it is a moral question that they see outside their area of responsibility. The members of the financial world manage the assets of others and refer to their legal obligation to maximize the return on investment, without asking for environmental ethics and social justice.

However, we see signs of change. Investors are beginning to pay attention to the environmental costs and the liabilities of the company by potential environmental damage and how they affect the share price development.A small but vocal minority of investors and their agents are beginning to fully understand the fiduciary function. Some are questioning the common understanding of responsibility, which dates back to the 19 Century, and look for opportunities to take also the current social issues into consideration. Already today, pension funds assign small amounts to be invested in socially important but financially risky projects. And so-called ethical investors use their position on the markets in order to initiate a dialogue with management about the importance of eco-efficiency.

The markets must be enabled to consider the environment better, in the best way by set prices. This can be achieved by means which are based on market mechanisms, such as tradable emission allowances. Furthermore, in the interest of efficient markets, "shareholders" who do not directly dispose of their capital - such as pensioners and common stockholders - should obtain the necessary information so that they can influence those who make decisions on their behalf.

Bankers know that they can be made legally responsible by society under certain circumstances for the environmental sins of their borrowers ​​. In order to minimize their risk, bankers look out increasingly for eco-efficiency in their commercial lending, in the belief that companies with a poor environmental record represent a high financial risk. They begin to understand that the creditworthiness of a company depends more and more of its eco-efficiency.

Insurers already suffered from direct financial loss through environmental problems. Claims on the insurance due to damage caused by asbestos and improper disposal of hazardous waste in the United States cost insurers an estimated two trillion dollars, putting their ability to pay at stake. Now, the insurers are concerned about the impact of possible climate change and the losses they might suffer in future. Some of them argue that insurers should understand that they have other interests than those who sell or burn fossil fuels on a large scale. We notice that more and more voices are raised, that the insurers should lobby for political orientations that reduce the risks of climate change.

We recommend to the insurance industry, when investing their funds, to consider the same experiences that they have made ​​in the risk business. They should not invest in the shares of companies, which do not provide for a marketable risk protection for environmental reasons.

Accountants are aware that many of their colleagues in the financial world expect from them systems that can be used to express environmental and economic risks and opportunities in numbers. Above all, auditors know that they bear a heavy responsibility, when assessing whether the accounts correctly reflect the viability of a company in a changing world. But the accountants are in a quandary. They have to follow the rules, and thus the most ecological aspects are excluded. They are also aware of the issue that it is about giving value to those things that have a value to society - and that is to fix a price for things that are still considered externalities, such as damage to common resources. From the academics among them, some represent very decidedly the concept of sustainability, and they have already presented concrete ideas about how their profession could take sustainability into account. Some practitioners, especially those who advice business mergers and acquisitions, identify environmental risks that reduce the value of the company, and these decisions are reflected in the markets.

We suggest that accountants should support eco-efficient companies, to convey to the markets their progress (and the business benefits), and they should help the markets to understand the benefits, so they can reward them accordingly.

The accountants could get help by rating agents to assess the creditworthiness of companies and countries, and begin slowly to consider environmental criteria in their assessment. Through this slowness others could come into play, experimenting with ways to register the environment with prices and to make life easier to their colleagues in the financial world that may need this information.

In our point of view, eco-efficient companies could communicate their progress to the market by their credit ratings. We believe it is likely that traditional rating agencies will make even greater efforts in order to identify the environmental risks that are associated with their products. We call on them to provide the opportunities that may establish a new environmental orientation.

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Our society and its financial markets are torn between the short-term goals of individuals and the long-term desire of civilization to sustain itself. Society has to think more in the long-term to establish the required conditions, so that firms are rewarded when they create more value, but at the same time consume less recourses and harm less the environment, thus when they become more eco-efficient. Only then society can expect that the financial markets will support sustainable development.