Finance is the circulatory system of a modern economy, providing the lifeblood to help it grow and prosper. Getting sustainable finance flowing is essential to achieve progress on climate change and economic growth at the same time. Yet so far, sustainable finance remains underdeveloped in Canada and risks losing momentum during the recession.
Sustainable Finance 101
Sustainable finance is lending or investment, risk management, and financial processes that consider environmental, climate change, and social factors in order to promote sustainable economic growth and long-term financial system stability. In practice, however, it is not always clear what qualifies as sustainable. Some define it as excluding certain sectors, companies, or practices such as coal or fossil fuels. The EU sustainable finance taxonomy includes economic activities that make a substantive contribution to one of six environmental objectives (including climate change mitigation and adaptation), do no significant harm to the other five, and meet minimum safeguards (such as the UN Guiding Principles on Business and Human Rights). Sustainable finance has also been strongly associated with improving company financial disclosure relating to climate change transition and physical risks and opportunities, and with ESG (environment-social-governance) investment and the emerging dimension of social purpose. Canada has the opportunity to develop and refine its own definition, consistent with our circumstances and objectives, but aligned where possible with the EU taxonomy that will guide EU investors and financiers.
Addressing climate change requires changing investment patterns
Reducing greenhouse gas emissions in line with Canada’s 2030 and 2050 goals will require both a shift in capital investment and new incremental investment aimed at low-carbon infrastructure and technologies. Limiting the costs of a changing climate will also necessitate significant capital directed towards resilient infrastructure and adaptation.
A mix of private and public investment will be required, but private investment is key to achieving the scale consistent with Canada’s climate change goals. Private investment in low-carbon electricity generation, low-carbon fuels, and infrastructure such as electricity transmission, electric vehicle charging stations, and hydrogen-compatible pipelines can support low-carbon transition. It can also support buildings and roads resistant to flood, fire, and permafrost thaw, as well as grey (concrete and steel) and natural (vegetation, soil and water) infrastructure to stabilize soil, attenuate floods and storm surges, cool buildings and cities, and absorb and channel excess water. On the technology side, private investment can push emission-reducing technologies for high-emitting sectors along the innovation chain so that they are cost-effective and feasible at commercial scale when we need them.
Responding to global transition requires recognizing climate change risks and opportunities
Sustainable finance is not just about achieving climate goals. It is also about positioning Canada to thrive as global markets shift.
Globally, many private investors have started to factor climate risk into decision making. In a January 2020 public letter, Larry Fink, the chair of Blackrock Capital (a market-leading global investor and asset manager) stated that climate change has become a defining factor in companies’ long-term prospects. Companies perceived to be lagging on climate change could increasingly struggle to find investment and access to credit.
There is also a global race to capture transition opportunities. Canada has a chance to be competitive and attract capital directed by sustainable finance. If we look at our largest low-carbon exports today, they are in low-carbon electricity, bioenergy, low-carbon transport technologies such as electric buses, energy efficiency technologies, and clean energy equipment. And there are also opportunities in a world adapting to a changing climate, such as water technology. Yet despite having products with significant future potential, many Canadian cleantech companies face challenges in accessing the financing they need to grow. These challenges are exacerbated as capital flows slow during the recession.
Policy can accelerate the growth of sustainable finance in Canada
The 2019 final report of the Expert Panel on Sustainable Finance emphasized the role of financial markets in accelerating the low-carbon transition and helping households and businesses manage climate risks. Yet it also found that governments have not fully leveraged that role.
Ultimately, sustainable finance works best in parallel with new policy. Government action can address key barriers to sustainable finance:
- Governments can oversee and regulate sustainable finance activity and risk management, notably by clarifying and standardizing expectations on disclosure practices related to climate risks, low-carbon transition, and business impacts. Private sector financial entities are struggling with some of the basics—such as appropriate definitions and standards related to sustainable finance in Canada, inconsistent approaches to climate-related financial disclosure, gaps in climate data, a lack of well-defined risk assessment methodologies, and uneven risk management practices.
- Governments can also help ensure that companies have better analysis of national, regional, and sectoral physical and transition risks and opportunities associated with climate change, including the identification of possible systemic risks to the financial system and economy. The Bank of Canada, and external organizations such as our Institute, can help provide scenario analysis that supports improved company-level disclosure and risk management practices.
- Public sustainable investment by governments, specialized entities and Crown corporations can help to build private market capacity, address market gaps, and provide public goods that generate a benefit to society and the economy, but not a financial return. Government-owned financial institutions such as Export Development Canada (EDC), the Business Development Bank of Canada (BDC), and the Canada Infrastructure Bank—could do more to address barriers to financing clean energy and clean technology, helping reduce risks for private investors and making clean investments more attractive than competing alternatives. Creating new targeted “green banks” could also address specific market segments such as building retrofits.
- Most importantly, policy developed at all levels of government can create incentives to get sustainable finance flowing. The greatest barrier to sustainable finance is the limited size of the Canadian market for sustainable products and technologies. Since markets do not fully factor in the long-term environmental or societal costs of greenhouse gas emissions, or the physical risks of a changing climate, the most significant driver of sustainable market size will continue to be government policy. In Europe and China, for example, ambitious policies such as carbon pricing, regulations, and green stimulus are driving significant investment in renewable energy and electric vehicles. If Canada wants to see more of this type of investment, we need investors to be confident that government policies will drive market growth here too.
No pressure, no flow
Canada has the technical expertise and innovative capacity to secure a competitive advantage and build regional or even global leadership in market segments for sustainable investment and finance. It just needs a little pressure to get things flowing. If sustainable finance is the circulatory system of the economy of the future, then smart policy is the beating heart.
Glen Hodgson is an economist, financial consultant, Senior Fellow with the C.D. Howe Institute, and Fellow with the Public Policy Forum. He currently sits on the Institute’s Adaptation Panel.