Change mindsets, not rules, to make the financial system more sustainable - missed points in the H-LEG report

The EU High-Level Expert Group on Sustainable Finance (H-LEG) issued an impressive report on financing a sustainable European economy. There is a lot of wisdom in the report, but also a big missed point: that this is a change process - and mainly about people. People keep forgetting that the financial system is made up of... people. Banks, regulators, asset managers, pension funds, consultants: all of them are run by people who respond not just to rules and incentives, but also to the politics within their organizations and their own biases and (lack of) knowledge. Once you recognize this as the behavioral and cultural challenge it is, you can manage for it. A change in mindsets is needed, not just new rules, to make the financial system more sustainable.

Why change?

During yesterday’s H-LEG consultation meeting at the Dutch Central Bank, people were asking: is there sufficient need for sustainable investment? For me as a portfolio manager in impact equities, that’s a no-brainer. Society and the real economy are changing, with externalities from for example carbon and tobacco, increasingly being internalized. The effects are clearly visible in our investee companies: these impact companies are better prepared for change, and drive that change. As a result, they are less risky than the overall market (yes, I wrote LESS risky). And even more surprising to most: impact companies also have more opportunities, higher growth rates, and higher profitability than the overall market. But many investment professionals still don’t see this and continue to invest according to short term metrics while extrapolating the past into their assumptions for the future. This is the mindset challenge we face.

Why more rules would be bad

The kneejerk reaction is to put in place more rules, on top of the existing ones. But that would probably be counterproductive: more rules just means more cynism and box ticking. Lots of people are already very frustrated with the large amount of rules. Tellingly, compliance is the fastest growing job segment in a financial sector that is shrinking. I liked Willem Vosmeer suggestion during the meeting: please get rid of the recommendation to impose more ESG reporting standards - we have plenty of that. Encourage competition and innovation on sustainability, not on compliance. We need more (constructive) rebels rather than bureaucrats and cynics. So, get rid of the existing obstacles.

One step back: what are the obstacles?

• Dogmatic benchmark thinking. Pension funds might set sustainability targets but continue to judge their asset managers on recent performance against a specific benchmark. The result: even sustainability oriented funds are typically under pressure to invest in assets they’d prefer to avoid (oil, tobacco, etc.), as not having them entails ‘benchmark risk’. benchmark investing (along with quant and passive investing!) means that the social role of finance is rarely fulfilled, namely steering capital towards its most productive ends - including externalities. In our fund, we solve this by comparing our performance to a peer group and a set of reference index, not a single benchmark.
• Outdated finance education that teaches that sustainability is irrelevant. A lot of progress has been made on sustainable finance, with a growing body of evidence that E matters; that S matters; that G matters; and that engagement matters. But this does not trickle down to the finance textbooks that finance professors use in their bachelors / masters programs. Hence, we get graduates who have no clue about integrating sustainability into financial decisions - they don’t even know it matters.
• Large informational asymmetries between and within organizations. The knowledge gaps between and within organizations are so big that good decision making is extremely difficult and at best very slow.
• Box ticking tendencies. Standards can be a force for the good, but they also entail the risk of mere compliance / box ticking. Take ESG ratings, which are often used so dogmatically as to equate high scoring companies with being better companies. But ratings have multiple flaws and should just be a starting point for analysis - not an excuse to stop thinking.

Again, there are more barriers.. but getting rid of these would be great. And they all boil down to mindsets.

How to change mindsets?

To change mindsets, people need to be liberated from false perceptions. The most important misconception is that sustainability supposedly costs performance (which is only true for the sub-branch of ethical investing), whereas it actually offers lots of opportunities to make money at lower risk - which is of course incomprehensible if you believe in perfectly efficient markets... And there are many more misconceptions. So please stimulate finance education that integrates sustainability. Show that fiduciary duty can (and should) include sustainabilty and that there is room to manoever - much more than perceived. Recommend people not to rely on single numbers but on several ones - and to always take the context into account. Share positive examples and celebrate wins. Signal that courage will be rewarded, not passiveness. Repeat these messages. Show leadership.

PS don’t be shy and fill out H-LEG’s consultation questionnaire by 20 September:

https://ec.europa.eu/eusurvey/runner/sustainable-finance-interim-report-2017