More and more companies and boards are realising that climate change will have substantial impact on their businesses in the coming years. With this realisation, they’re beginning to close the gap between what companies were doing to tackle climate change (not very much) and what many stakeholders have been demanding (quite a bit more).
Many companies have started with sustainability plans to limit further damage to the planet from their activities. But truly sustainable companies must act not only in their operations, but also in their finances to fund themselves in greener ways.
This brings companies and their leaders together with financial institutions and other financial players such as shareholders, debt holders, capital markets and regulators/central banks. They all have an important role to play in tackling the challenges ahead. Importantly, for companies and financial institutions, this is also an opportunity to develop novel products that are in high demand by their customers, investors and other stakeholders.
My new book explores how financial decision-making and climate-related risks are inextricably linked, and how developing the corporate-finance relationship will be key if we hope to achieve the transition to a lower-carbon world. And it explores many important issues board members should pay attention to.
Climate and finance: two sides of the same coin
Climate impacts finance. The new risks and opportunities for companies brought on by climate change have obvious financial implications. Many long-term investors, including pension funds and sovereign funds, are worried that failure to act could endanger long-term returns on their assets. For companies, there’s a high cost in acting now. The cost of not acting will be even higher.
Finance also impacts climate. Calls for action to address the climate crisis come from company stakeholders (customers, employees, and so on), political leaders and regulators. Investors are pressuring companies to provide additional climate-related disclosures, to carry out stress tests and to manage exposure to stranded assets. They want companies to incorporate climate risks into their forecasts, and to have clear low-carbon transition strategies.
The green transition will require trillions of dollars in private capital. Demand for financial instruments related to climate change, sustainability and ESG is growing and will continue to do so in the coming years. Different finance tools, new ESG metrics and novel financial instruments such as green bonds, all contribute towards companies taking concrete actions to reduce their carbon footprint, and thus help in the transition.
In short, climate and finance are two sides of the same coin.
New risks and opportunities
In my book, I first explore the need for capital, covering corporate investment and financing needs, the roles of executives and boards, climate risk assessment at the corporate level, and supply chain aspects. Then I analyse the roles of different suppliers of capital such as banks and bondholders, but also equity investors, including pension funds, sovereign funds and other large institutional investors.
Many companies are realising that their assets will not be safe. Some will need to be written off entirely. While countries in Asia and the Global South will be disproportionately affected, developed nations such as the United States will also face adverse consequences. Beyond extreme weather events such as flooding, there will be higher inflation, supply chain disruptions, healthcare costs and productivity issues.
Globally, the green transition implies different degrees of risk for different sectors. Top executives and boards will need to carefully factor possible impacts across different parts of the firm’s operations.
Amid the increasingly clear and dire toll of climate change, and in the face of governments lacking the funds needed to support an energy transition of dramatic scale, private investors are being called upon to help foot the bill and avert—or at least diminish—future weather-related catastrophes.
The surging demand for green bonds, sustainability linked loans, sustainable supply chain finance, and many other novel financial instruments, is a positive step. These instruments align objectives, and help bring this topic into the company’s operations, and beyond the board room.
For instance, sustainability-linked loans (SLLs) incentivise borrowers to achieve green objectives. Their terms are linked to the borrower’s sustainability performance as measured by predefined ESG criteria: better sustainability performance lowers the interest rate, while unmet targets can lead to a rate spike. Banks are often willing to lower interest rates for companies making bigger green strides. Sustainable supply chain finance allows companies to cascade their objectives throughout their supply chain, while benefiting suppliers’ financial conditions at the same time.
Financial innovation and sustainability
Green bonds, SLLs, and other novel financing instruments are great innovations, with the potential to help companies and financial institutions align themselves with the goals of the Paris Agreement.
However, several challenges lay ahead. Lack of standards is a key one. Also, to prevent greenwashing concerns, sustainable targets should be clearly announced, linked to strategy, and imply a clear commitment to change. They cannot be too easy, or too shallowly defined, or lacking in transparency. They cannot merely pay lip service to sustainability.
Companies, financial institutions and investors will play a role in financing the transition and redirecting capital flows to sustainable projects. There is no single solution, but many important ones. Among them, an engaged board of directors is key to guiding businesses to more sustainable outcomes.
Nuno Fernandes is professor of finance and governance at IESE Business School, and the author of the book Climate Finance.