Keywords

1.1 Introduction

When it comes to the discussion on the relation between sustainability and finance, the policy and academic debate has been focused thus far on the possible role of the latter to support the transition towards a climate-neutral economy and a fairer society. In this respect, concepts and frameworks such as sustainable finance, green finance or climate finance have progressively emerged.Footnote 1 These concepts and frameworks have also been consolidating within the financial industry in the form of new financial instruments (e.g. green bonds and sustainable funds), listing options (e.g. dedicated segments for sustainable securities in several stock exchanges worldwide), certification possibilities (e.g. green and climate labels for financial securities) or specific financing supporting initiatives (e.g. the World Bank or the European Investment Bank sustainability programmes). A new stream of literature is also progressively emerging dealing with these matters (e.g. Lehner 2016; Ziolo and Sergi 2019; Migliorelli and Dessertine 2019a).

Nevertheless, little attention has been given so far to the specific relationship linking sustainability and financial risks. That is, to the discussion on how factors such as climate change, environment degradation or social inequality, among others, can impact financial actors and markets. Indeed, this relationship, which is referred here as the sustainability-financial risk nexus, is of the utmost importance and may have systemic-wise consequences. For some observers, the failure of the various components of the financial industry to correctly integrate sustainability-related risks into financial risks frameworks may represent in the longer term a threat to the stability of the financial system as a whole (e.g. EC 2018a; BIS 2020).

To deepen the analysis on this issue, this chapter is structured as follows. First, Sect. 1.2 gives an overview of the role played nowadays by finance in fostering sustainability. To do that, the political and societal processes culminated with the adoption of the Sustainable Development Goals (SDG) and the signature of the Paris Agreement in 2015 are presented, as well as the expected contribution of finance in the resulting agendas. Then, Sect. 1.3 introduces the role of the sustainability-financial risk nexus within the general sustainable finance framework. In this respect, a review of the (scarce) literature dealing with this issue is also given. This dissertation is followed by Sect. 1.4, proposing a more comprehensive approach to the understanding of the relation between sustainability-related risks and financial risks. To this extent, a structured taxonomy linking the different types of risks is proposed. Finally, Sect. 1.5 concludes with a scrutiny of the key element of pricing of financial services when fully considering sustainability-related risks. Such an analysis includes the recognition of possible new market failures resulting from the progressive consolidation of these risks.

1.2 The Role of Finance in Fostering Sustainability

1.2.1 The Sustainable Development Goals (SDG) and the Paris Agreement

The concern of the sustainability of human activities have been discussed for decades (e.g. Renneboog et al. 2008; Berrou et al. 2019b). However, a significant acceleration in the political and societal debate has been observed only in the last few years. In this respect, the adoption of the Sustainable Development Goals (SDG) in September 2015 and the Paris AgreementFootnote 2 reached in December of the same year landmarked a new era for the fight against climate change and the transition towards a sustainable economy.Footnote 3

The SDG are part of the “2030 Agenda for Sustainable Development” adopted by the United Nations (UN) General Assembly. The Agenda is “a plan of action for people, planet and prosperity. It also seeks to strengthen universal peace in larger freedom” (UN 2015). The SDG, to be achieved by 2030, have the merit to clearly identify the priorities of the international community in the attempt to reach a sustainable society, highlighting the importance of protecting the environment, of ensuring decent living conditions for all human beings and limiting the negative impacts of economic development. Table 1.1 reports the 17 SDG. In addition, 169 targets and 242 global indicators were also set to monitor the progress towards the realisation of the goals. In point of fact, the SDG reflect all the three distinctive dimensions of sustainable development: the economic, social and ecological dimensions. The wide acceptance of the SDG at the highest political levels represented with no doubt an important success and a significant step forward for the recognition of sustainability as one of key issues to be solved in the interest of humankind as whole.

Table 1.1 Sustainable Development Goals (SDG)
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Resulting from a parallel process, the Paris Agreement was conceived within the United Nations Framework Convention on Climate Change (UNFCCC), a global environmental treaty aiming at limiting global greenhouse gas (GHG) emissions. Starting from 1995, signatories of the UNFCCC have met on a yearly basis, through the Conferences of the Parties (COP). The Paris Agreement was signed during the COP 21,Footnote 4 when world leaders committed to strengthen the global response to the threat of climate change by “holding the increase in the global average temperature to well below 2℃ above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5℃”. To reach these ambitious objectives, appropriate mobilisation and provision of financial resources, a new technology framework and enhanced capacity-building were given specific and unprecedented attention. The agreement requires all Parties to put forward their efforts through Nationally Determined Contributions (NDC) and to report regularly on their emissions and on their implementation efforts. The Parties also bore a responsibility to meet every five years on the subject and set up a robust, transparent and accountable reporting system to track their progresses.Footnote 5 Although the global reach of the Paris Agreement is undeniable, further work is still needed to ensure its concrete impact on climate change (Berrou et al. 2019b). In fact, the agreement is only partially legally binding and there are no means of systematically verifying if the Parties are reaching their objectives.Footnote 6 Some important items were also discarded from the debate, including carbon pricing and the possible discontinuation of fossil fuel extractions. Furthermore, in 2018, the Intergovernmental Panel on Climate Change (IPCC)—the United Nations body for assessing the science related to climate change—launched the alarm stating that the world needs to limit temperature increase to 1.5 ℃ with respect to pre-industrial levels to reduce the likelihood of extreme weather events and emphasised that GHG emissions need to be reduced with far more urgency than previously assumed (IPCC 2018).Footnote 7

The adoption of the SDG and the Paris Agreement and the growing awareness of the civil society for sustainability issues are progressively imposing a new agenda to both governments and international institutions (e.g. EC 2019a). The changeover implies a deep reflection on the economic and social structures today in place and needs strong political commitment, ambitious technology investments, adapted regulations and likely a change in the consumption and behavioural patterns of the population (e.g. EC 2018b). In such a context, the availability of financial resources to support the transition has consolidated as an essential enabling factor.Footnote 8

1.2.2 The Rise of Sustainable Finance

Defining precisely what it is today called sustainable finance is not an easy task. As a matter of fact, financial institutions, governments and international organisations tend to create definitions according to their underlying motivations (UNEP 2016; IFC 2017). In addition, trough time a number of possibilities to account for the connection between finance and sustainability have flourished. Among them, it should be highlighted the concern with environmental, social and corporate governance (ESG) criteria (e.g. Friede et al. 2015), the impact investing and the social responsible investing (SRI) approaches (e.g. Vandekerckhove et al. 2012; Hebb 2013), the analysis of the impact of financial development on environment degradation (e.g. Tamazian et al. 2009), the concern with climate change and human rights (e.g. Alm and Sievänen 2013), the assessment of the effect of finance in terms of negative externalities (e.g. Ziolo et al. 2019), the new role of sustainable finance for financial institutions having a formal dual bottom-line approach and for which financial performance need to coexist with social goals (e.g. Migliorelli 2018).

Nevertheless, the framework provided by the SDG can today be used as a new reference in the attempt to better circumscribe the perimeter of action of sustainable finance and its various components. In this respect, sustainable finance may be considered to embrace all the financial stocks and flows mobilised to achieve the SDG, irrespectively of their labelling or the technical implementation of the underlying financial instruments. Furthermore, what today is generally refereed to green finance and climate finance can be considered to be specific parts of the wider sustainable finance landscape.Footnote 9 To this extent, green finance can be referred to the financial stocks and flows aiming at supporting the achievement of the environment-related SDG,Footnote 10 while climate finance can be associated to that component of green finance focussing on climate action (in the form of climate change mitigation and climate change adaptation Footnote 11). These relations are graphically reported in Fig. 1.1.

Fig. 1.1
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(Source Adapted from UNEP 2016)

SDG, sustainable finance and its components

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The various components of sustainable finance have experienced a remarkable growth in recent years, and in particular as it concerns green finance. For example, from the first issuance by the European Investment Bank in 2007, the market of green bonds has registered average annual two-digit growth, with new emissions being over USD160 billon in 2018,Footnote 12 while sustainable or green equivalents of traditional securities are today getting available for the different types of investors. In point of fact, a large part of the financial industry and several policymakers have embraced the change and are putting in place a number of initiatives in the attempt to mainstream sustainable finance.Footnote 13,Footnote 14 The European Commission’s “Action Plan for financing sustainable growth” issued in 2018 and its follow-up initiatives is probably the most noteworthy example of this commitment (EC 2018a).

1.3 Sustainability and Finance: A Two-Way Relationship

1.3.1 Positioning the Sustainability-Financial Risk Nexus

The policy and academic debate are consolidating around the analysis of how finance can contribute to the transition towards a sustainable society by ensuring that the necessary financial resources are available when and where needed. In this respect, the role of banks and other financial actors is a key one when simply considering their traditional function of funds intermediaries. As a matter of fact, adequate financing to the sustainability transition cannot be achieved without the full involvement of the financial industry. However, little attention has been given thus far to the possible impact of sustainability-related risks on financial actors, that is to the sustainability-financial risk nexus. Factors such as climate change, environmental degradation or social inequality, and others, can indeed result in direct or indirect financial risks for financial actors. An example can help illustrating this issue. Considering climate change, abounded evidence exists today demonstrating that the continuous increase in GHG emissions in the atmosphere ultimately results in a substantial increase in the frequency and magnitude of climate change-related extreme weather events such as droughts, floods or storms (e.g. IPCC 2018). Beyond the (regrettable) direct consequences on the populations and their social implications, extreme weather events may also have relevant impacts on insurance companies and banks, as unexpected and important reductions in the productivity of the economic assets typically materialise in the areas affected. For insurance companies, this can produce unexpected higher levels of payments on the previously insured risks. For banks, higher levels of impairments on outstanding credits due to higher rates of insolvency of their clients.

Underestimating the impact of sustainability-related risks on financial actors may have two main drawbacks. Firstly, it can result in a flowed assessment of the commitment and the capacity of the financial industry to support sustainable investments, in particular in the areas expected to be more affected by sustainability-related risks. Situations in which banks or insurance companies refuse to take-in additional financial risk when highly dependent of sustainable-related risks can eventually materialise. This would be for example the case of banks limiting credit to farmers in regions hit by increasing desertification, as considered to be less productive in the mid-term. Or of insurance companies refusing to insure households living in areas subject to increasing risk of floods. On the other side, a systematic underestimation by banks and insurance companies of the long-term impact of sustainability-related risks on their core businesses could bring to a situation in which financial stabilityFootnote 15 can be undermined. As little historical data (and knowledge) is today available for financial actors as concerns the possible incidence of sustainability-related risks, and the occurrence of these risks is expected to grow in future both in terms of frequency and magnitude (so that past experience cannot be used to predict the future), eventually very little information is today available as concerns the financial actors’ assets under the risk of climate change or other sustainability-related risks (e.g. ECB 2019).Footnote 16

Hence, the sustainability-financial risk nexus merits today a throughout attention and it should be considered as a crucial element of the sustainable finance framework.Footnote 17 Clearly, solving the sustainability-financial risk nexus implies two separate dimensions of analysis. On the one hand, the assessment of the possibilities of reducing the magnitude of sustainability-related risks. This can be done through policy and societal actions aiming at fostering a climate-neutral economy and a fairer society. As a matter of fact, the development of sustainable finance securities, products and services can be embedded in this dimension. On the other hand, the consideration of the sustainability-financial risks nexus triggers the need of controlling for the impact of the key sustainability-related risks on financial actors. In this respect, an assessment of the existing risk management frameworks should be systematically carried out to test for their capacity to take into account these new risks.

1.3.2 Sustainability-Related Risks and Observed Channels of Transmission to the Financial Markets

Limited literature exists dealing with the sustainability-financial risk nexus. In this section the main references to date are reported as concerns the impact of climate change (in the form of physical risk, transition risk and liability risk), distressed commodity markets, environmental degradation and social inequality.Footnote 18

1.3.2.1 Climate Change: Physical Risk, Transition Risk and Liability Risk

Central banks have been among the first actors to recognise that even though significant macroeconomic effects from climate change may occur in a somehow distant future, some impacts are already beginning to be felt (ECB 2019). As a consequence, in the last few years, and in line with their activity of supervision and control of systemic risks, they have started to identify some specific financial risks linked to climate change (BoE 2015; TCFD 2017; ACPR 2019; ECB 2019). Namely:

  • Physical risks, defined as the impacts today on insurance liabilities and the value of financial assets that arise from climate and weather-related events that may damage property or disrupt trade.Footnote 19

  • Transition risks, that is the financial risks that could result from the process of adjustment towards a low-carbon economy, such as changes in policy, technology and physical risks that could prompt a reassessment of the value of a large range of assets as costs and opportunities become apparent (the case of stranded assets).

  • Liability risks, that is the impacts that could arise tomorrow if parties who have suffered losses or damages from the effects of climate change seek compensation from those they hold responsible (such claims could come decades in the future, but have the potential to hit carbon extractors and emitters and, if they have liability cover, their insurers).

Nevertheless, the limitation to climate change and a substantial lack of data to properly assess the impact of these risks make this recognition still a marginal improvement in the understanding the relationship between sustainability-related risks and financial risks.Footnote 20

1.3.2.2 Distressed Commodity Markets

Rising temperatures and changing patterns of precipitation can be expected to have direct impacts in particular on agriculture and fisheries (e.g. ECB 2019), even though with uneven influence between the different regions worldwide. In this respect, some regions are already substantially affected by both global climate variations and commodity price fluctuations.Footnote 21 This is valid also when considering that the impact of changing weather conditions on commodities’ production and yields are strongly dependent of technology availability and sophistication (Brown and Funk 2008).

Today, financialisation of commodity markets can be considered a structural trend. In this respect, it can also be argued that commodities-driven fund management have become a proper investment style for many institutional investors (e.g. Adams and Glück 2015). This means that, as those institutional investors continue to target their managed funds into commodities, spillovers effects between commodities markets and financial markets will probably increase. Hence, higher volatility in the commodity markets can be considered today a specific source of concerns for fund managers, including when triggered by climate change.

1.3.2.3 Environmental Degradation and Social Inequality

Abundant and substantially unanimous literature today exists demonstrating the detrimental effect on the environment of the traditional model of economic development, in particular due to resources depletion and negative externalities (e.g. Tamazian et al. 2009; IPCC 2018). Land degradation, land erosion, waters and air pollution, deforestation are among the most visible signs of this pattern. In this vein, the behaviour of companies in terms of environmental and social consideration has been mostly studied in the framework of the analysis of the relationship between environmental, social and governance (ESG) performances and economic and financial performances. The large majority of studies show positive relationship of ESG performances on economic and financial performances, with the impact appearing to be stable over time (e.g. Friede et al. 2015). Nevertheless, the aspect of how environmental degradation or social inequality can negatively impact economic development and eventually financial markets and actors have thus far not been explored in depth.

1.4 A Wider Look at the Sustainability-Financial Risk Nexus

A more comprehensive approach to the study of the sustainability-financial risk nexus can be proposed. In this respect, Table 1.2 suggests a taxonomy linking sustainability-related factors and risks to the corresponding risks for business, banks and insurance companies.Footnote 22 The relationship portrayed are assumed and not backed by data. Nevertheless, such taxonomy can help identifying potential indirect and direct financial risks for banks and insurance companies stemming from sustainability-related factors. In this respect, indirect risks for financial intermediaries have to be considered the ones coming from the exposure to sustainability-related factors by the clients (businesses) they serve.

Table 1.2 A taxonomy for sustainability-related risks and financial risks
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Four main sustainability-related factors are considered: climate change, environmental degradation, social inequality, policy and technology shifts. To these main factors, specific sustainability-related risks potentially affecting businesses and financial actors are linked. For example, to climate change are associated risks of increase in the frequency and magnitude of floods, droughts and storms, of distressed commodity markets, of permanent change in climate conditions, of increase in the level of seas and of accusation from citizens to polluting businesses to cause climate change. These sustainability-related risks can be associated to concrete risks for businesses (hence also indirectly triggering risks for banks and insurance companies). For instance, the increase in the frequency and magnitude of floods, droughts and storms can result for businesses in loss of production, in a reduction in assets’ value or in the disruption in the supply chain or in the operations. These risks for businesses can be hence analysed with respect to corresponding risks for banks and insurance companies. To this extent, the reduction in assets’ value of their clients can cause, for banks, a reduction in the value of the real guarantees (e.g. covering a loan) or an increase in clients’ insolvency risk. As a matter of fact, both these risks are credit risk-related. For insurance companies, this can translate in higher payments on insured risks. This implies an exposure to liquidity risk and physical risk.

In addition to indirect risks, financial actors can also be impacted directly by sustainability-related risks. As an example, distressed commodity markets can result for both banks and insurance companies in a specific market risk due to the increase in the volatility of the value of the investment portfolios (when they are invested, at least in part, in commodities or in financial instruments having commodities as underlying assets). Similarly, possible unfair treatment of workers, discriminatory treatment of women or minorities (linked to social inequality as main sustainability-related factor) can rise a reputational risk and possibly the need of compensation due to proven responsibility (that is, in this latter case, a liability risk).

As it is shown in the taxonomy, sustainability-related risks typically result for banks and insurance companies in an increase in the risks already under management, such as credit risk, market risk, liquidity risk, liability risk, operational risk or reputational risk. This conclusion can have indeed significant consequences in terms of risk management practices for financial intermediaries. In fact, a strong argument can be made according to the idea that the correct management of the sustainability-related risks in the financial industry has to derive from a proper refinement of the existing frameworks, more than a complete change in paradigm.Footnote 23 In this respect, it seems nevertheless necessary to develop specific forward-looking approaches and methodologies able to cope with the lack of data and information on the specific relationship between sustainability-related and financial risks.Footnote 24

The structure offered by the taxonomy in categorising sustainability-related risks and their impact on financial risks is likely a first-of-a-kind. It suffers some limitations due to the lack of data on the significance and strength of the relations proposed and it is limited in scope, not including, inter alia, the role of households and of financial actors other than banks and insurance companies (e.g. investment funds). In this respect, we should be conscious of the fact that for a framework to be useful, it must have clear testable implications, so that the proposed patterns may be supported or refuted by data. Further empirical research will hence be needed to test the effectiveness on the ground. Nevertheless, the taxonomy can be considered a limited but concrete first step in better framing the sustainability-financial risk nexus.

1.5 Pricing the Sustainability-Related Risks and New Market Failures

As mentioned, the need for financial actors to systematically take into account sustainability-related risks in their core business is progressively becoming material. Nevertheless, this desirable new attention could also engender some negative side effects. When relevant, the full consideration of the sustainability-related risks by financial intermediaries in their risk management frameworks may have two possible outcomes: an adjustment in the pricing components of financial services (in particular as concerns credits and insurance services) and a reassessment of their risk-taking strategies. The effects of these outcomes on the real economy will probably be uneven between geographies or economic sectors and, also depending on the progressive development and sophistication of the risk management practices, may be concentrated in the areas more affected (or expected to be more affected) by sustainability-related risks.

On the one hand, the pricing outcome may result in an increase in the cost of accessing financial services for economic agents in (some) proportion to their exposure to sustainability-related risks. This may be the case for example of companies operating in regions under increasing risk of hurricanes, which may need to face an escalation in the cost of insurance. Or for oil companies that may experience a substantial increase in the cost of accessing external financing due to limitations in availability of funds following policy decisions to discourage the use of fossil fuels. However, correctly pricing the incidence of sustainability-related risks on their financial risks is probably the most effective way for financial actors to be shielded from unexpected financial and economic losses. In addition, such a possible development would be in compliance with the principles and structures of existing prudential regulations and hence the one likely to be encouraged by policymakers in the years to come.

On the other hand, pricing adjustment may not be effective in the case of sustainability-related risks of significant magnitude. Following a reassessment of their risk-taking strategies, financial actors could eventually refuse to keep providing credit or insurance services to some of their existing and potential clients, in consideration of the high impact of sustainability-related risks on the financial risks they would need to bear. As a matter of fact, a number of sustainability-related risks may become uninsurable and a number of banks’ clients may lose their creditworthiness due to sustainability-related factors. This can be the example of businesses located in areas increasingly hit by floods and hence subject to substantial degradation of their economic potential or households living in islands under the threat of the rise of sea level. New market failures can hence materialise in future as following a deeper assessment of the impact of sustainability-related risks on the different economic agents.

Even though it can be expected that pricing adjustments and market failures will be in many cases relatively small or even absent, this will still build a case for the need of periodically assessing the social impact of the management of sustainability-related risks by financial actors. In this respect, the problem could be exacerbated by the substantial lack of data and reliable information on the specific relationship linking sustainability-related and financial risks and the possible adoption, in particular in the short-term, of excessively precautionary approaches. Eventually, a specific policy intervention may also become necessary. This may be in the form of price control or cost support for the access to key financial services, promotion of ad hoc reinsurance schemes, more favourable fiscal treatment for stranded assets. As a matter of fact, these measures, which are limited to easing the possible impact of the side effects of the full consideration of sustainability-related risks on financial risks, can only supplement the wider policy strategies to foster a more sustainable society. In this respect, they may be considered by policymakers within the broad category of transition measures.