Sustainability and the role of finance

The term ‘Tragedy of the Commons’ was coined by 19th century British economist William Foster Lloyd to describe a hypothetical situation involving the overgrazing of common land in medieval Britain. It is a metaphor for the degradation and eventual depletion of shared resources.

The dilemma at its heart relates to the link between self-interest and open access, where individuals put self-interest above the common good. And it is a classic example of coordination failure, which could be resolved by dividing the resources into individual parcels, or through the introduction of a government-enforced quota system.

This lies at the heart of many of the sustainability issues we encounter today. A recent example involves CO₂ emissions from the global shipping industry. Due to the principle of freedom of the open sea, shipping companies had escaped regulations to reduce greenhouse gas emissions that according to the Economist magazine were higher than the whole of Germany.

This changed in April 2018 when the International Maritime Organization set binding targets to bring the industry in line with the ambitions of the Paris Agreement. These include cutting greenhouse gas emissions by at least 50% by 2050 (compared with 2008 levels). International collaboration has proven to be key in resolving this coordination problem.

Aviation, an industry not directly included in the UN climate agreement, also has a plan in place to reduce emissions. It has set out three goals: a global average fuel efficiency improvement of 2% per year up to 2050; carbon-neutral growth from 2020 onwards; and a 50% absolute reduction in carbon emissions by 2050 (compared with 2005 levels).

As an alternative to regulation, governments could choose to put a price on carbon to solve the coordination problem – for instance, via a cap and permit system, or by means of a simple levy. While this is already happening to a limited extent, an estimated 85% of global emissions are currently not covered by such measures.

Related to the tragedy of the commons is the fact that the world’s population is expected to approach 10 billion by 2050. Despite ongoing innovation and productivity increases, future generations will face increasing resource scarcity and challenges linked to climate change – not just environmental consequences, but also social effects such as climate migration.

These developments strongly indicate the need for a more circular economy, based on much lower rates of natural resource extraction and use, in contrast to today’s largely traditional linear economy. According to the OECD, the amount of materials extracted from natural resources and consumed worldwide has doubled since 1980 and is ten times higher than in 1900. The rapid industrialization of emerging economies and continued high levels of consumption in developed countries are responsible for this trend.

Therefore, the challenge for businesses and economies is to grow in a way that can be facilitated by the Earth’s natural resources in the long term without depleting them. Circularity can play a key role in countering the negative effects of the current over-consumption crisis.

For the role that finance can play, targeted investment can be instrumental in the redeployment of capital to sustainable activities. A key role of financial markets is the efficient allocation of resources to the most financially viable companies, not just in the present, but even more critically, in the future.

Financial materiality is the critical link at the intersection of sustainability and business performance. More specifically, investors should focus on identifying the most important intangible factors (sustainability factors) that relate to companies’ ability to create long-term value. For instance, lowering energy consumption in manufacturing processes results in significant cost-saving opportunities and has a direct impact on a company’s bottom line.

Going a bit deeper, financial materiality is defined as any intangible factor that can have an impact on a company’s core business values. These are the critical competencies that produce growth, profitability, capital efficiency and risk exposure. In addition, financial materiality includes other economic, social and environmental factors such as a company’s ability to innovate, attract and retain talent, or anticipate regulatory changes.

These matter to investors because they can have significant impacts on a company’s competitive position and long-term financial performance.