Ernst Hobma: Sustainability buyouts hinder sustainability

March 5, 2024

By Ernst Hobma, Economic Researcher at Triodos Investment Management

Assessing and managing risks is the quintessential way in which the financial sector can contribute to society. It would benefit society as a whole to make the financial sector carry socially relevant risks.

Suppose you own an agricultural company, a steel factory or a chemical factory in a rich Western country. You are having more and more hassle with new rules regarding pollution and local residents and other stakeholders are also starting to have a hard time. What are you going to do? Adjust your company as quickly as possible? Switch to sustainable farming or manufacturing?

Not if money is important to you. Then it's better to wait until someone else comes along with a bag of money to buy you out. Buyout and associated 'moral hazard' thus lead to stagnation in the transition to a sustainable society. And what applies to these entrepreneurs applies even more to the financiers.

Sustainability risks are becoming increasingly embedded

In recent years, sustainability risks have been embedded throughout the financial sector, led by supervisors. An important component of these sustainability risks are transition risks: the financial risks associated with the transition to a more sustainable economy, for example if a polluting company has to close and therefore does not repay its loan.

The idea is that by controlling or reducing this risk, a financial institution will incur fewer losses. Society also benefits from this. If financial markets start pricing unsustainable industries as financial risks, they will invest less (cheap) capital in these industries, resulting in less activity. In this way, anticipating a sustainability transition by financial institutions can accelerate the transition itself.

Sustainability risks are not yet sufficiently priced

Markets are currently not sufficiently pricing sustainability risks, according to the ECB, among others. It is often assumed that this poor pricing is due to limited information, both that provided by the ECB and, for example, that about house prices in the Netherlands.

Although inadequate information can play a role, there is still a major condition for financial markets to price sustainability risks. This condition is that the threat of transition risks must be credible. I do not mean the 'threat' that there will be a sustainability transition at some point.

In order for financial markets as a whole to price sustainability risks, sufficient financial institutions must believe that they will be left out in the short term if they continue to finance unsustainable parties. If markets, as now, price almost no sustainability risks, this may mean that they do not believe in this threat.

Hardly any transition risk for financial markets

It would not be surprising if financial markets did not take this threat seriously: so far, there are hardly any transition risks for financial markets. There are several recent examples. For example, the German energy company RWE will receive €2.6 billion in state aid to accelerate the closure of lignite mines.

Public resources are also used to accelerate sustainability in the buyout of an asphalt factory in Nijmegen and the support package for Tata Steel in the United Kingdom to make it more sustainable. And the buyout scheme for farmers in the Netherlands will partly be used to repay loans.

In all these cases, financiers are (partially) compensated, while a transition risk does materialize. For example, there is no credible threat, financial markets are discouraged from anticipating sustainability transitions, and therefore delay these transitions.

Sustainability does not always have to be achieved through buyout

Of course, sustainability does not always have to be achieved through buyout. For example, coal-fired power stations in the United Kingdom are closing without compensation, simply due to tightened standards. But in order to achieve rapid social change, we will occasionally have to and want to offer public safety nets in the coming decades to citizens who are disproportionately affected by transitions.

However, the scarce public resources spent on compensation should never compensate the financial sector. Estimating and managing risks is the ideal way in which this sector can be socially useful. It would benefit society as a whole if the financial sector actually took on the risks that are socially relevant.