Olaf Sleijpen: Sustainable investment - the perspective of the Dutch
central bank
Speech by Mr Olaf Sleijpen, Executive Board Member of Monetary Affairs and Financial
Stability of the Netherlands Bank, at the jointly hosted Erasmus/Netspar Symposium
"What's cooking in sustainable investing?", Utrecht, 16 May 2024.
* * *
th
One month ago, on April 11 , it was European Green Energy Day. On that day the
European Union had used up all its available green energy for the current year. For the
rest of the year, the EU is still dependent on fossil energy. For the Netherlands, Green
th
Energy Day fell even earlier, on the 8 of March, although the good news is that we are
catching up. As the energy transition progresses, Green Energy Day shifts in the right
direction by a few days each year. But the shift is going too slow. In order to achieve the
Paris goal of being fully carbon neutral by 2050, we have to double our speed. The
energy transition is as urgent as ever.
Shaping that transition, and accelerating it, is a responsibility we all share. Each in our
different roles. Governments are in the driving seat. They have the democratic mandate
and the position to lay down a long-term vision and strategy, to set goals, and to design
and implement policies. They also have the economically most effective and efficient
tools at their disposal. Here I think of setting standards and imposing regulation,
adequate pricing of externalities, and encouraging innovative, sustainable investment,
for instance through subsidies. Striking the balance between the medium to longer term
gains of the energy transition and short-term transition costs may be the most
complicated task for a government whose mandate is in most cases not longer than
four or five years.
At De Nederlandsche Bank, we may not be in the driving seat, but we are definitely part
of the team. A part of the team in three different ways, in three different roles. As a
supervisor and regulator, as a central bank and as a leader by example.
As a supervisor and regulator we have a responsibility to make sure that financial
institutions manage their climate- and nature-related risks. Those risks have a bearing
on the financial soundness of financial institutions, which is something we are watching
over. And ignoring these risks is not compatible with sound risk management.
As a central bank, our objective is to maintain price stability and to safeguard financial
stability. Climate change definitely has an impact on both and, hence, squarely falls
within our mandate.
And as a public institution at the heart of the financial sector we want to lead by
example and, albeit in a small way, contribute to international sustainability goals.
International goals regarding climate change and legislation also applies to us,
evidently. This is why we are committed to integrating sustainability considerations in all
our core tasks by the end of next year.
Two things stand out. First of all, no matter how you look at climate change, it will have
an impact, one way or the other. Ignoring mitigation of climate change, will increase the
costs of adaptation and will pose serious risks for the economy as we know it. But
effective climate risk mitigation also comes at a cost in the short term, that may impact
the economy, financial institutions and financial stability. However, the cost of dealing
with the consequences of climate change far outweighs the cost of a timely transition.
Whatever the route will be, central banks and financial supervisors will, given their
mandate, always prefer a predictable and orderly transition path.
Secondly, green policies need to be coordinated at an international level to make them
more effective and to create a level playing field for economic actors. But that doesn't
mean waiting for the others. If we don't take the lead as the developed world, with our
technological and financial might, countries like India and China will be even less
inclined to speed up their energy transitions.
Let me now focus on the role of financial institutions, in particular sustainable
investments, which is at the heart of this seminar.
So in our role vis-à-vis financial institutions, what do we - as supervisor and regulator -
find important? We do not tell financial firms how they should run their business. Our
primary concern is that they have their management of climate- and nature-related risks
in order. To give you an example. Engagement is a hot topic at the moment, in other
words trying to change the course of a company as a financier, versus divesting,
stopping with financing. Given our role, we have always remained relatively agnostic in
this debate. As a financier, you can influence a company's decisions. A company that is
if
currently a polluter can make a substantial contribution to the transition it has a
credible transition plan in place. You can also argue about how the world will be helped
if you sell your shares or stop financing a company out of sustainability concerns, which
may only open the door to other financiers with less green interests who are eager to
take advantage of this 'opportunity'. For us, it's important that a financial institution can
explain how it manages the risks resulting from a financing decision. And I think it's
obvious that companies without a credible transition plan or ones that structurally fail to
deliver on their promises will become uninvestable over time. That means the risks for a
financial institution that remains invested in such companies will continue rising.
What else do we find important? Well, a significant portion of the Dutch financial sector
has signed the climate commitment, pledging to support the Dutch government's
climate objectives and taking initial steps towards impact investing. DNB welcomes this
initiative and has recently analysed the action plans the institutions have published in
this regard. Financial institutions have created an important reference point by setting a
long-term climate target. And they have taken a significant step in the right direction by
establishing a monitoring framework for their action plans.
At the same time we see that financial institutions are facing challenges in implementing
their action plans, that require them to take not only financial considerations into
account, but also non-financial considerations. While investing in a prudent manner
remains at all times essential, it's important that the commitments the institutions have
made result in concrete actions. Otherwise, they may face legal or reputational risks.
Greenwashing is increasingly a source of legal action, with the number of climate-
related court cases worldwide more than doubling since 2017. That's why DNB is both
supportive and vigilant. We applaud the financial sector's dedication to the climate
transition. At the same time, we expect the sector to meet its commitments, to mitigate
the risks of reputational damage and litigation.
In general, financial supervisors are intensifying their focus on climate- and
environment-related risks. The ECB has put climate- and nature-related risk high on the
agenda. Banks under its supervision must comply with the supervisory expectations for
good risk management by the end of this year. At DNB, we are on the same track for
the banks, insurers and pension funds under our supervision. While there has been
progress, we are still not where we need to be. As supervisors, we are doing what we
can to nudge the sector in the right direction, for example with good practices. But if
these efforts prove insufficient, enforcement will come into view as a viable option.
As I said, more and more financial institutions have indicated they want to go beyond
managing climate-related risk. They want to actively contribute to the green transition.
And that brings me to the topic of impact investing. The World Bank defines impact
investing as an approach that aims to contribute to achieving measurable positive social
and environmental impacts. An approach that looks to the future instead of to the past.
Impact investing and lending creates a significant opportunity to mobilise capital into
investments that target measurable positive social, economic or environmental impact
alongside financial returns.
So what exactly is the difference between impact investing and traditional investing?
Traditional investing aims for financial value, seeking an outcome on the risk-return
curve known as the efficient frontier. ESG risks could be taken into account as a first
step, meaning that companies assess the potential financial consequences of physical
or transition risk events when looking at the risk-return curve. This is what DNB expects
from the financial institutions we supervise, and this is generally known as taking 'single
materiality' into account. To truly move towards impact investing, this two-dimensional
framework changes to a three-dimensional one, as ecological and societal impacts are
included in an investment decision. The sum of financial, ecological and societal value
forms the target variable for optimisation. Or, in a slightly 'lighter' form, some minimum
requirements for the ecological and societal impacts are formulated when optimising for
the financial value.
Determining an impact value is not always an easy process, but increasingly
quantitative methods are being proposed, for instance by Dirk Schoenmaker and
Willem Schramade in a corporate finance book they published last year.
In essence, they propose to find a monetary value and a quantity for the impact a
financing decision has (or the harm it does). Think of the cost of a tonne of CO2
emitted, or the shadow price of a life year saved by a certain new medical technology.
The resulting annual value streams can be discounted with a similar discounted cash
flow model that is used for financial flows, although the discount rate may be different.
The three-dimensional approach makes it possible to arrive at an integrated value,
where financial value and impact value are taken together. But let me stop here with the
technical elaboration and recommend that you read Willem and Dirk's book if you want
to know more.
Putting this into practice is complicated. For one thing, a lot of the shadow prices,
quantities and ways to discount are unknown or strongly debated. I know it may also be
scary: financial institutions have a tendency towards herd behaviour and feel a
substantial 'first-mover disadvantage'. And let's be honest: it is not only our own
decision to make. It is what investors, customers and partners demand. So, if we base
our position on this ESG mindset, if we incorporate impact investments and loans into
our portfolios, we will not only apply proper and prudent risk management, but we will
also contribute to a sustainable future.
How can financial institutions make this work? Well, there are three elements to this.
First of all, tailoring the operational processes towards impact investments. Here I think
of investment processes and customer acceptance, credit judgement and revision. That
means impact needs to be part of the parameters for decisions about investments,
alongside risk and return. That means daring to move away from the broad market
benchmark and choosing a smaller portfolio of impact-oriented companies. And you
have to make it clear to your stakeholders what the implications may be for the
diversification of your portfolios.
Secondly, finding the right people and creating the right processes to make this work.
That means recruiting the appropriate capacity and competences and reorganising
organisations. That means defining new or additional KPIs that reward decisions that
contribute to impact goals and place less emphasis on classical views, like beating the
benchmark.
And the third element is being more transparent about what you do and the results you
are aiming for. That means: moving away from the short-term focus towards a
sustainable, long-term future.
As a guardian of financial stability, we encourage you to embrace impact investing as a
means to accelerate the green transition and thereby reduce systemic risks. In my view,
this also means that we as a regulator need to ensure that we are not a barrier to your
transition to impact investing. That means that we have to change too.
For instance, when we assess financial risks for investments, we have to consider
whether or not they are future-proof. Or when applying the prudent person principle,
one could argue that we should be concerned not only with the financial returns that
participants will receive from fund investments in the short run, but also whether these
returns are sustainable in a longer term perspective.
It is important to note that impact investing is often associated with illiquid and more
complex products, such as venture capital and private equity. We have to take account
of that in our supervision. Of course, such investments require a sufficient level of
knowledge and expertise to manage these products responsibly.
To further tailor the way we supervise, we have developed a good practice guide for
sustainable risk management. We will update the guide this year and we also intend to
include Frequently Asked Questions to provide clear explanations and expectations. I
hope these tools will encourage the financial sector to use forward-looking indicators.
To apply scenario analyses rather than focus on historical track records. And motivate
the sector to implement a concrete transition plan and more long-term,
sustainabilityfocused KPIs.
I will now come to a conclusion. Financial institutions play a crucial role in our societies.
They play an important role in creating sustainable prosperity. So we need the financial
sector to act urgently. We need to speed up the transition to become climate neutral by
2050, in line with international goals. We have to shift that Green Energy Day on the
calendar as fast as we can. There is no time to lose. The world needs the financial
sector's help in financing the transition to a carbon-neutral society that is in harmony
with nature. And we need the sector to manage its climate- and nature-related financial
risks. They are often two sides of the same coin. We will only succeed if we join forces
- supervisors, governments, financial institutions and other private parties. So let's
check in today, and take up the task that lies before us - together.