Only once, in 18th and 19th century Britain, did the transformation of energy to coal, transport to railroads and industry to steam power take place via the market co-ordination of investment, without a push from above © Oxford Science Archive/Print Collector/Getty Images

The writer is a political economist at the University of Duisburg-Essen

The holy grail of sustainable finance is figuring out how to distinguish sustainable from unsustainable investments. Get this right, and the public and private sectors have a guide to their decision-making. Get it wrong, and everything downstream becomes haphazard.

The EU’s new sustainable finance strategy and Green Bond Standard show what is at stake. Their aim is clear: to help create the first climate-neutral continent by 2050. But the way that sustainability is defined will determine whether such schemes succeed or fail.

Plenty of credible definitions of sustainability have been developed over the past decade, but they tend to focus on system-level results such as national CO2 emissions, or society-wide health and literacy outcomes. What’s required instead is investment-level classification: how can investments with good system-level impacts be separated from those with bad ones?

As I concluded from research I conducted for Belgium’s Royal Academy of Science and SFPI-FPIM, the country’s sovereign wealth fund, this can only be achieved with a degree of central planning. Any other approach falls short.

Project-by-project analysis, for instance, is a dead-end. Are investments in Belgium’s traditionally strong chemicals sector sustainable? That would depend on factors like future feedstock sources, renewable energy supplies, or how business and consumer clients use and recycle their products. The sustainability of investments in electric vehicles, meanwhile, depends on urban planning decisions, public transport investment and the future of remote working. In short, the entire ecosystem matters. 

Relying on the market might seem like a better bet. If greenhouse gas emissions and other externalities were accurately reported, and their costs taxed, price changes might show which investments are (or are not) sustainable. Here, the role of sustainable finance would be to help investors anticipate these changes. Relevant shadow pricing techniques have been pioneered by the likes of Puma and Kering. 

Upon closer consideration, however, this approach is also found wanting. Tackling climate change requires transforming at least five provisioning systems: energy, transport, buildings, industry and agriculture. The price mechanism struggles with coordinating rapid transformation at this scale.

To see how, consider that market economies have existed across history. Many — most famously China during the late Song Dynasty — have had the technologies needed for an industrial revolution. But only once, in 18th and 19th century Britain, did the transformation of energy to coal, transport to railroads and industry to steam power take place via the market co-ordination of investment, without a deliberate push from above. Those odds are not good enough. We need these transformations and we need them now.

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What is the alternative? Instead of waiting for the market to speak, a planning body — whose composition and accountability require careful consideration — should formulate plans for each of the five systems, which should then be translated into project-level criteria for sustainable investments.

The EU’s sustainable finance strategy represents this approach in embryonic form. Its heart is a taxonomy: a list of criteria that individual activities, such as electricity generation or construction, must meet in order to be considered sustainable. Suitably developed, it could be an effective instrument.

Even at its best, this approach is not flawless. It will inevitably get things wrong, both because of imperfect knowledge and because the future is inherently uncertain. But there is no perfect method: what we need is one that enables experimentation and learning at scale and at speed. Today, the biggest danger is too little risk-taking.

Letter in response to this article:

Sustainable infrastructure label will aid investors / From Noel Quinn, Group Chief Executive, HSBC Chair of the Sustainable Markets Initiative’s Financial Services Task Force

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