Description
The purpose of this paper is to demonstrate that the relatively new concept of sustainable
finance, although very apt and timely, needs to address many major issues for it to be meaningful and
if it is to achieve its desired objectives.
Accounting Research Journal
Why should sustainable finance be given priority?: Lessons from pollution and
biodiversity degradation
Clevo Wilson
Article information:
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Clevo Wilson, (2010),"Why should sustainable finance be given priority?", Accounting Research J ournal,
Vol. 23 Iss 3 pp. 267 - 280
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Why should sustainable
?nance be given priority?
Lessons from pollution
and biodiversity degradation
Clevo Wilson
School of Economics and Finance,
Queensland University of Technology, Brisbane, Australia
Abstract
Purpose – The purpose of this paper is to demonstrate that the relatively new concept of sustainable
?nance, although very apt and timely, needs to address many major issues for it to be meaningful and
if it is to achieve its desired objectives.
Design/methodology/approach – The study identi?es some of the major issues that need to be
clari?ed and addressed including: de?ning the kind of sustainability that is envisaged; examining
issues relating to the use of high-discount rates and its compatibility with the goals of sustainability;
the case of excessive pollution due to adverse selection, moral hazard and lobbying; and specialisation
and path dependent systems that are detrimental to future production.
Findings – The paper demonstrates why the concept of sustainable ?nance is timely and why it is
necessary to take into account the potential major issues that need to be considered and adequately
addressed.
Research limitations/implications – The challenges that lie ahead are many, and the sooner they
are addressed, the more credible and potent sustainable ?nance will be.
Practical implications – This paper discusses the major issues and examples of pollution and
biodiversity degradation that need to be considered with sustainable ?nance. The paper also shows
why economic growth without considering pollution impacts and path dependent systems is
detrimental to future production, which violates the concept of sustainable ?nance.
Originality/value – Sustainable ?nance is a relatively new concept that is fast becoming important
as ?nancial investments are increasingly required to prove sustainability credentials. However,
despite its increasing popularity many major issues need to be dealt with if this concept is to be truly
meaningful and potent in achieving its objectives.
Keywords Economic sustainability, Finance, Economic growth, Pollution
Paper type Research paper
1. Introduction
The concept of sustainable development has received much attention since the
publication of the Bruntland report (World Commission on Environment and
Development (WCED, 1987)). However, sustainable ?nance is a relatively new concept
that is fast becoming important as ?nancial investments are increasingly required to
prove sustainability credentials[1]. Although a clear de?nition of sustainable ?nance is
warranted, the broad consensus is that it would encompass economic, environmental
and social sustainability of ?nance. However, with regards to this special journal issue,
the onus is on environmental and social sustainable ?nance. In this study, however,
sustainable ?nance issues relating only to the environment are dealt with.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
Sustainable
?nance
267
Accounting Research Journal
Vol. 23 No. 3, 2010
pp. 267-280
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309611011092592
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As resource degradation and pollution impacts increases, future investments with
potential negative externalities are likely to be scrutinised over the environmental
impacts and the long-term environmental sustainability of such projects. Be it
government or private investment capital, funding of such projects will be increasingly
tied, amongst other factors, to the environmental sustainability of such projects.
Agood case in point is the Gunns Limited paper mill project in the Tamar Valley (www.
gunnspulpmill.com.au/) in Tasmania, Australia, where private capital is not so easily
forthcoming, mainly based on serious doubts raised on the environmental impacts of the
project, public protests and its long-term environmental sustainability.
As pointed out by a World Wildlife Fund (WWF, 2006) report, the ?nancial sector’s
environmental and social responsibility during the last decade and a half was driven to
a “large degree by outside pressures”. As the report states:
Beginning in 2000, environmental organisations such as Friends of the Earth (FoE) and the
Rainforest Action Network (RAN) challenged the industry with high-pro?le campaigns that
highlighted cases in which commercial banks were “bankrolling disasters”. In 2002, a global
coalition of non-governmental organisations including FoE, RAN, WWF-UK and the Berne
Declaration came together to promote sustainable ?nance in the commercial sector.
As we nowknow, this informal network has evolved into BankTrack (www.banktrack.
org/), whose vision for sustainable ?nance was expressed in the Collevecchio
Declaration of January, 2003 (www.evb.ch/es/p25001979.html). The ?rst of the six
commitments to key principles under this declaration is a commitment to environmental
and social sustainability. Following this declaration, “(The) Equator Principles” (www.
equator-principles.com/) were developed in 2003 by four of the largest private sector
banks. They were the Citigroup, ABNAMRO, Barclays and WestLB. The principles are
an industry benchmark set for the ?nancial industry to manage environmental and
social issues in project ?nancing. These principles are based on the International
Finance Corporation’s (www.ifc.org/about) environmental and social safeguard policies
(WWF, 2006). With the major institutions governing ?nancial institutions lending
support to environmental and social sustainability, it is to be expected that commercial
organisations are likely to endorse and become signatories either due to increasing
industry needs, coercion or due to genuine acceptability of the environmental and social
responsibilities of capital investments.
All indications are that sustainable ?nance will be increasingly embraced by the
?nancial industry judging by the initial reaction to this concept (WWF, 2006). However,
there are many issues that need to be clari?ed and addressed if environmental ?nancial
sustainability is to be truly meaningful.
It is clear from the available literature on sustainable ?nance that the path of
environmental sustainability the ?nancial industry seeks to pursue is unclear. In other
words, there is no benchmark that the industry is striving to achieve. Another
important issue that need to be examined is the relationship between high discount
rates and the concept of environmental sustainability. Are the two issues compatible?
In other words, could high discount rates prevail and yet achieve sustainability? This
has enormous implications for the concept of sustainable ?nance as will be dealt with
in this study.
Furthermore, an issue that should be kept in mind with sustainable ?nance is that
unfettered markets do not take into account freely available non-marketed goods
and services. In such cases many of the social costs may not be taken into account.
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It is likely that environmental credentials of investors will be over emphasised.
Adverse selection and moral hazard issues are likely to arise.
Another major issue that needs to be taken into account is that of industry lobbying
that seek weaker instruments of pollution control that are likely to be ineffective in
internalisingexternalities. Furthermore, issues relatingto the concentrationof production
that are likely to lead to the degradation of resources also need to be addressed. Finally,
it is important to demonstrate that economic growth without considering pollution
impacts and path dependent processes is detrimental to future production. This paper
strives to address these various issues.
The paper is set out as follows. Section 2 provides an overview of the sustainability
issues, production process and discount rates in relation to the concept of sustainable
?nance. Section 3 presents a discussion on what are the other likely issues that should be
kept in mind in dealing with sustainable ?nance. Examples from pollution and
biodiversity degradation are discussed in Section 4 where the case of excessive
production, pollution and biodiversity degradation are highlighted. In Section 5, it is
shown that economic growth without considering pollution impacts and path dependent
systems, as is nowhappening, is detrimental to future productionandis inviolationof the
concept of sustainable ?nance. Section6 concludes witha discussionof the main?ndings.
2. Sustainability issues, production process and discount rates
Sustainability is a popular phrase and de?nitions pertaining to sustainability abound.
However, a widely used and one of the best-known de?nitions which should ideally
capture the concept of sustainable ?nance is that given by the Bruntland Commission
(WCED, 1987). It de?nes sustainable development as “development that meets the
needs of present generations without compromising the ability of future generations to
meet their own needs”.
Another de?nition that is very apt when we discuss sustainable ?nance is that
given by the Norwegian economist, Asheim (1994). According to him sustainability is
“a requirement to our generation to manage the resource base such that the average
quality of life we ensure ourselves can potentially be shared by all future generations”.
Although no formal de?nition of sustainability has been provided, what this new
emerging ?eld of sustainable ?nance implicitly assumes is that “?nance”, corporate or
otherwise, should be used in a manner to generate economic activity that does not
compromise the future ability to produce the same level of economic activity. The
concept of sustainability implicitly refers to intra as well as inter generational
sustainability. As Hanely et al. (2001) point out “two main features of these de?nitions
of sustainable development are: (i) fairness across generations; and, (ii) fairness within
generations. Sustainability is thus principally an equity, rather than ef?ciency issue”.
Interestingly, ?nancial investment valuation takes into account only costs and
bene?ts in terms of their impact on ?rms and shareholders. One method applied is the
net present value (NPV) test. This simply asks whether the sum of discounted gains
exceeds the sum of discounted losses. The project is accepted if NPV . 0. The major
problem in simple ?nancial investment appraisal or in a cost-bene?t analysis is that
the valuation of non-marketed goods (for example, wildlife, landscapes, environmental
sinks, ecosystem and agricultural complexity) is ignored. Hence, subjecting projects to
a NPV test is not a test of environmental sustainability. Hence, NPV tests should be
subject to sustainability constraints when dealing with sustainable ?nance.
Sustainable
?nance
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Another important issue that arises when dealing with sustainability in general or
sustainable ?nance in particular is the type of sustainability which the ?nancial
industry is seeking to follow. Is the ?nancial industry planning towards weak or strong
sustainability? A weak form of sustainability is where there are no declines in capital
(Hanely et al., 2001). Such a system can be de?ned as follows:
No declines in : K
n
þK
h
þK
m
¼ K
where K
n
is natural capital, K
h
is human capital and K
m
is man-made capital. Kis total
capital stock. This concept means we can exhaust natural capital as long as we
substitute it with human and man-made capital so that the total capital stock remains
the same. This is consistent with the neoclassical economist’s view that natural and
created capitals are substitutes in production. As Goodstein (2008) points out “they are
technological optimists, believing that as resources become scarce, prices will rise, and
human innovation will yield high-quality substitutes, lowering prices once again”.
On the other hand, strong sustainability canbe de?ned as a systemwhere there are no
declines in K
n
or rather in critical capital, K
n
. Substitutability to maintain the total
capital stock is not permitted. This is the ecological economist’s view who argues that
natural and created capital is fundamentally complements. In other words, they are used
in production together and have lowsubstitutability. As Goodstein (2008, p. 119) states:
Ecological economists are technological pessimists – fundamentally they believe that rapid
increases in population, and even faster increases in consumption, are putting unsustainable
pressure onour natural resource base. Inindividual cases such as fuel cell-poweredcars, created
capital may substitute for natural capital. But at a general level, created and natural capital are
complements in production. This is to say, ecologicals believe that we are “running out” of the
inexpensive natural capital that forms the base of our economic well-being: both natural
resources, such as freshwater and topsoil, and the environmental sinks that absorb our wastes.
Another aspect that needs to be considered inrelationto sustainability is that of discount
rates. High discount rates could penalise investments with long-termpayoffs. Therefore,
high market discount rates, if not well planned (e.g. without environmental impact
assessments) and invested, could be incompatible with the tenets of both neoclassical
and ecological schools of thought and hence undermine the whole concept of sustainable
development as de?ned by WCED (1987) or Asheim (1994). High discount rates are
unlikely (in most cases) to result in environmentally friendly investments. As we know
corporate investments have shorter time horizons.
This is because private capital often requires rates in the range of 15 percent or
more to initiate an investment (Goodstein, 2008). As Goodstein (2008) points out this is
due to two reasons:
(1) They re?ect only the private bene?ts of investment and fail to account for the
external costs of growth.
(2) Such high returns are required to induce people to save and invest their income,
rather than consume it today.
This is referred to as positive time preference which refers to a desire to consume as
much in the short-term than waiting until a later date. Such preferences prevent the
investments with long-term payoffs, which is usually the case with environmental
bene?ts or sustainability.
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However, as Goodstein (2008) further points out, low discount rates are not always
“pro environment” either. For example, large dams with high up-front costs and a long
stream of future bene?ts may be favoured, since the public are likely to “enjoy cheap
electricity and recreational opportunities for decades”. It is worth noting that while
private capital requires high-discount rates, governments use a much lower discount
rate with environmental protection agencies using a discount as low as 3 percent
(Goodstein, 2008).
It is also worth noting that investments in products with high environmental bene?ts
(e.g. some renewable energy sources) with high returns do not necessary attract
suf?cient investments. This is because the returns take a long time to be generated.
On the other hand as Goodsetin (2008, p. 106) points out:
[. . .] private investors evaluate projects using high market discount rates, re?ecting the
private opportunity cost of their capital. The fact that energy companies can make a 20%rate
of return on conventional investments in oil properties means that they can earn their
investments back in 5 years. Access to these high market rates of return gives market actors
very short time horizons.
High discount rates seeking high returns which are based on private returns are likely to
lead to lowering/evading penalties or putting off internalising social and environmental
costs. High discount rates are also likely to encourage the concentration and
specialisationof production. These issues are discussedinmore detail inSections 3 and4.
3. What are the other likely issues that should be kept in mind in dealing
with sustainable ?nance?
An issue that should be kept in mind in discussing sustainable ?nance is that an
unfettered market systemdoes not take into account the true value of using non-market
(zero-priced), freely provided environmental resources and appropriate discount rates
that are conscious of the environmental impacts and long-term environmental
sustainability. Therefore, freely available environmental goods and services are likely to
be over utilized and unfettered markets with inappropriate discount rates will result in
resources being used inef?ciently from an environmental sustainability point of view.
As Turner et al. (1994) point out “there is a divergence between private and social costs”.
When output increases so does the amount of pollution which has to be assimilated by
the environment. However, with increasing production, the amount of pollution released
exceeds the assimilative capacity of the environment[2]. Hence, pollution released
becomes a problem. Figure 1 shows that at Q
A
, output produced is equal to the amount of
pollution released into the environment. When output increases beyond Q
A
, then the
environmental assimilative capacity is exceeded.
In order to avoid pollution damage to the environment and hence society, it is
important to take into account marginal external costs (MEC) and internalise them.
Sustainable ?nance should be mindful of this fact. When the pollution that is released
into the environment is greater than the assimilative capacity, the pollution begins to
impose external costs on society. Furthermore, the external costs increase with
increasing output. A simple illustration of this is shown in Figure 2. The ?gure also
shows the marginal net private bene?ts (MNPBs). As can be seen, MEC increase as
pollution accumulates with increasing production. Hence, the damage done to the
environment, too, increases when the per unit of output increases. Discount rates
selected are likely to in?uence the extent of the environmental damage.
Sustainable
?nance
271
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In Figure 2, the social optimum level of output is at Q
s
. This is obtained by subtracting
the external costs from the producers’ MNPB. It is the responsibility of the respective
environmental regulators to take into account the social costs of production and compel
polluters to pay for the pollution they generate. Only when these external costs are taken
into account (internalised) that production will move froma private pro?t driven market
optimal level of output to a socially optimal level of output. In other words, a private
?rm’s market decision rule is that output should be produced if the ?rmgains a positive
MNPB (i.e. if MR (marginal revenue) . marginal variable cost (MVC)), up to the point
where MR ¼ MVC, the market optimumlevel of output. If the regulators are to take into
account the costs of pollution, then the social decision rule is that external costs (MEC)
must be included in the market price of the good produced. In other words, polluters
should be made to pay for the pollution they generate in producing goods and services.
Figure 1.
Output, pollution and
assimilative capacity of
the environment
Source: Adapted from Turner et al. (1994, p.75)
Assimilative capacity of
the environment
Total amount of pollution
released into the
environment (e.g. litres
of oil and grease)
A
m
o
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t
o
f
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a
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i
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a
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Output Q
A
A
Figure 2.
MNPB, MEC and social
optimum level of output
Source: Adapted from Turner et al. (1994, p.76)
Marginal external costs
(MEC)
M
a
r
g
i
n
a
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e
x
t
e
r
n
a
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c
o
s
t
(
$
p
e
r
u
n
i
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o
f
o
u
t
p
u
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)
Output Q
A
Q
S
MNPB
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Hence, as demonstrated in Figure 2, there is a need for sustainable ?nance to account
for the social costs in market prices of manufactured goods and services. However, the
question that arises is whether sustainable ?nance will be benchmarked[3] against
social costs being taken into account. Even if such benchmarking is imposed, investors
who are not included in internalising externalities in order to maximise pro?ts, are
likely to get around this issue in at least two ways.
One method relates to adverse selection. A polluter with no environmental
credentials is unlikely to divulge all information regarding pollution generated from
production to potential lenders. In fact, the biggest polluters are likely to exaggerate
environmental credentials. This is also a good public relations exercise.
The second involves moral hazard. Investors, after obtaining ?nance for their
projects or those already in the industry may resort to the non-implementation of
promised environmental standards or in other cases resort to lobbying the relevant
regulators in order minimise the extent of external costs that needs to be taken into
account in the production process. As Goodstein (2008) states:
Because regulatory decisions impose substantial costs on affected industries, businesses will
devote resources to in?uence the discretion that regulators exercise (in ethical, questionably
ethical, and unethical manners) just as they devote resources to minimizing labour or energy
costs.
In the next section, a case where industry in?uence is applied to “capture” the regulator
in relation to pollution control is discussed. In this manner, regulation is supplied by the
regulator in response to the industry’s demand for regulation or the regulatory authority
is controlled by industry by coercion, in?uence and “other methods”. Section 4 also
discusses a problem that is less known, but yet is having a major impact on the
degradation of natural capital which sustainable ?nance has to be aware of and adopt
mitigating measures.
4. Examples from pollution and biodiversity degradation
This section discusses two issues which sustainable ?nance has to deal with if this
concept is to be truly meaningful and to make production and services environmentally
sustainable. They are as mentioned in Section 3, how industry would in?uence the
regulator to obtain the type of pollution control which industry prefers and which is
less harmful to their production activities and pro?tability. This relates to the case of
excessive production and pollution. The case of ?xed emissions standards being
preferred as opposed to a pollution tax is demonstrated. The second issue, which is not
well known in the literature, is the degradation of biodiversity, an important factor of
production, due to the emergence of “path dependent” systems of production being
created due to specialisation and concentration of production. As experience shows,
they are not easy issues to grapple with. However, the credibility of sustainable ?nance
thus lies in addressing such issues rather than the concept being a good public
relations motto for the ?nance industry and its investors to showcase.
4.1 The case of excessive production and pollution
Figure 2 in Section 3 showed that when the amount of pollution released exceeds the
assimilative capacity, external costs begin to increase. Theoretically, at least two
instruments can be used to internalise the external costs. This is shown in Figure 3.
Sustainable
?nance
273
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For example, introducing a ?xed standard for pollution generated should limit the
amount of pollution released into the environment. This is shown at Q
F
of ?rm’s output.
At this point, the amount of pollution released is W
F
. However, real world experience
shows that penalties for violating a ?xed standard have been historically set “too” low.
This is shown by the broken line. In such a case ?rms may only reduce pollution where
the penalty . MNPB. In other words, reducing output from Q
M
to Q
P
(reducing
emissions from W
M
to W
P
). On the other hand, the tax, t
*
has been set to achieve the
socially optimum output at Q
S
where pollution generated is W
S
. This is ef?cient,
where as if the penalty is to be ef?cient, then the level of penalty has to be increased to the
level of tax, t
*
. However, it should be noted that a pollution tax can also be set too “low”
due to pressure fromlobby groups. However, in reality, this is less likely than ?nes being
set too low.
One may wonder why penalties are set too low. One main reason as explained earlier
is due to lobbying or polluter pressure imposed on the environmental regulator. It is well
known in the regulatory economics literature that by design or not, the institution
that is meant to regulate is “captured” by industry. This is known as capture theory
(Viscusi et al., 1995). According to this strand of thinking, command and control (C&C)
regulation is supplied by the regulator in response to the industry’s demand for
regulation or the regulatory authority is controlled by industry by coercion, in?uence
and “other methods”. However, in both cases, regulators are “controlled” by an industry
or a ?rm. Turner et al. (1994) elaborate this point best:
This “capture” concept refers to the tendency for the regulator and the polluter to seek common
ground and cooperation. Once captured, administrators begin to see that they need to protect
existing members of an industry and, therefore, regulate it accordingly. New entrants are
excluded, subsidies are offered and dif?cult decisions are put off until prospects “improve”.
Figure 3.
Comparing the
effectiveness of a pollution
tax with a ?xed emissions
standard associated with
penalties
Source: Adapted from Turner et al. (1994, p.169)
Marginal external cost
(MEC)
V
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(
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)
0 Q
F
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P
Q
M
t*
Penalty
Fixed standard
MNPB
Pollution produced by firm
0 W
F
W
S
W
P
W
M
Firm’s output
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Young (1992) argues that this “rent seeking” behaviour is inef?cient and tends to bias
investment decisions and leads to further extensions in regulatory capture. Therefore,
the implication is that once the requiredcapital has been obtained, there is no mechanism
that prevents such a situation happening. This is an issue which sustainable ?nance has
to address if the concept is to be truly meaningful and effective. Otherwise, the whole
concept is likely to lose credibility. Interestingly, Kelman (1981) found from a survey of
industrialists in the US that 85 percent of them were opposed to pollution taxes on the
grounds that these increased the ?nancial burden relative to a C&Cregulatory approach.
4.2 Biodiversity degradation
In the last section, the case of excessive pollution was discussed in order to illustrate
some issues sustainable ?nance has to confront. In this section, another pertinent issue
which is well known is that of degradation of natural capital, an important factor of
production. The case of biodiversity degradation is discussed in this section.
While it is acknowledged that the extension of the market system by encouraging
concentration and specialisation of production has brought about large increases in
productionand fosteredtechnical ef?ciencies, sucha systemhas ledto many irreversible
externalities in the use of natural capital, an issue that remains ignored in the ?nancing
of agricultural/livestock investment projects. As Tisdell (2003, p. 370) points out “it is a
powerful force for loss of genetic diversity”. The negative externalities, in many cases,
have gone largely unnoticed. Needless to say, loss of genetic diversity in crops and
livestock can have adverse consequences for sustainable economic growth.
Interestingly, the concentration/specialisation of production in the agricultural sector
has further implications, which has gone largely unnoticed because of the nature of the
problem. Hence, another issue that sustainable ?nance needs to be cognizant because
such a system of production, too, violates the principle of sustainability discussed in
Section 2.
Before greater specialisation of production a wider variety of breeds were used than
it is today. For instance, until a couple of decades ago, individual producers did not
produce on a large-scale. Hence, in this situation, there was an incentive for a farmer to
use “all round” livestook breeds that produced, for instance, milk, beef, worked on the
farm, manure and transport. In other words, farmers were mostly self-suf?cient and
sold only their surplus in the market or traded it for some other commodity. However,
market extension has favoured the selection of specialised breeds and this has resulted
in the gradual loss of “all round” breeds (Wilson and Tisdell, 2006).
The use of “all round” breeds is a cost in a highly market-oriented production
system where specialisation is intensi?ed to produce a larger quantity for a larger
market and to maximise pro?ts. This is especially so with large market discount rates.
In such a situation, market-oriented production systems will select breeds that are not
“all round” but rather those that produce more of one commodity than few items of
“everything”. Figure 4 shows a “before and after” globalisation situation.
The vertical axis in Figure 4 shows the economic bene?ts and the horizontal axis
shows the diversity of economic attributes of different breeds that are available for
selection in the production process. For ease of presentation and clarity, the diagram is
divided into breeds that produce mainly one or two items and “all round” breeds.
Those closer to the origin, are breeds that produce fewer items and produce smaller
quantities of an item. As the breeds move closer to the centre the breeds produce larger
Sustainable
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quantities and bring larger economic bene?ts to producers, but at the same time the
“all round” qualities also begin to increase. As we move towards 1 the “all round”
characteristics of breeds become prominent. For instance, at a point close to 1, the “all
round” qualities are so great that they are not considered in commercial production. As
shown, points at 0 and 1 are extreme cases. Those breeds close to 1 are of little interest
to commercial producers on a large-scale, but they are valuable breeds to small-scale or
semi-subsistence farmers who depend on such breeds for their livelihoods.
For the hypothetical producer, breed L is the preferred choice before globalisation.
This breed provides the maximumeconomic bene?ts. Breed Kis the preferred one after
globalisation. Breed L gives an economic bene?t to the producer of an amount
corresponding to C before globalisation, but only an amount corresponding to D after
globalisation. The more specialised breeds could provide the producer with an
economic bene?t corresponding to A after globalisation, which was only B before
globalisation. In scenarios such as those explained in Figure 4, diverse attributes of a
breed is not an asset, but diversity become a threat to the survival of the breed.
As specialised production and genetic manipulation of selected breeds increase and
prices of commodities fall, they also displace small-scale farmers that mainly rely on “all
round” breeds for their form of production and livelihoods. This process, as is being
witnessed currently, is accelerating the extinction process (Wilson and Tisdell, 2006).
Hundreds of breeds (livestock and plant) have either become extinct or are on the
verge of extinction mostly as a result of specialisation, genetic manipulation of selected
breeds and concentration of production of production. According to Food and
Agriculture Organisation (FAO) statistics, 10 percent of the world’s livestock have
already become extinct and another 20 percent are facing extinction (FAO, 2000). The
highest rates of extinctions have occurred in Europe and North America where
Figure 4.
Economic bene?ts of
breeds available to a
typical producer before
and after globalisation
based on different degrees
of diversity of economic
attributes or
characteristics dictated by
their genetic make-up
Diversity of economic attributes of available breeds (an index)
More specialised breeds Less specialised breeds
Source: Adapted from Wilson and Tisdell (2006)
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After globalisation
A
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Breed L
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concentration and specialisation of production based on narrowing of genetic material
have taken place the most. As globalisation increases, this trend is rapidly spreading to
other continents. A good example is Asia where the dilution of pig breeds is continuing
at a rapid pace in Vietnam where the pure local breeds such as the Mong Cai are
becoming a casualty. For a detailed discussion on this issue, see Wilson and Tisdell
(2006). Table I shows the extent of the “disappearance of the biodiversity” problem for
livestock breeds.
As shown in Table I, the percentage of breeds that are at risk of extinction is highest
in Europe and North America where globalisation of production is also the highest.
Extinction of breeds is more than half the breeds not at risk for the same two continents.
In other continents, where globalisation and economic development are still at a lower
level, the breeds that have become extinct and those at risk of extinction are less than the
breeds not at risk. However, if breeds are not conserved, this will change as globalisation
of production proceeds rapidly in Asia (especially in China and India) as shown in
Figure 4.
Other factors such as the demand for leaner meat, tastes, availability of
storage/refrigeration, foreign aid/technology transfers accelerate the process of
specialisation and concentration of production. Other production systems such as the
provision of inputs are also developed for such production systems and they place greater
reliance on such processes. This has happened in agricultural production systems such
as grain (e.g. wheat and rice) or livestock production. This results in several “path
dependent” systems of production being created. These are powerful forces at work that
are graduallyunderminingthe genetic diversityof the productionsystemthat sustainable
?nance has to confront and address if such a concept is to achieve its desired objectives.
5. Economic growth without considering pollution impacts and path
dependent systems is detrimental to future production
As discussed in Section 4, a myopic, pro?t maximising ?rm or ?rms is likely to favour
a system where it pays less for pollution. Specialisation and concentration of
production, as also explained in Section 4 and is being currently witnessed will result
in creating “path dependent” systems. Such a strategy, although increases production
and results in higher economic growth and output (measured as gross domestic
product (GDP)), the social costs are likely to reduce output in the medium and in the
long term-due to pollution damage to factors of production in the form of natural
Region
Extinct breeds
(%)
Breeds at risk
(%)
Breeds not at risk
(%)
Unknown breeds
(%)
Europe 18 40 31 11
North America 18 29 20 33
South and Central America 08 19 41 32
Africa 05 12 49 34
Asia and the Paci?c 05 12 49 34
Near east 04 07 42 47
World 10 20 39 32
Source: FAO (2000)
Table I.
Status of livestock breeds
of the world in 2000
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capital (land and biodiversity), health (labour) and capital. Stiglitz (2009) mentions such
a situation in a paper entitled “GDP fetishism”. This scenario is shown in Figure 5.
The line ABC represents economic growth when pollution is checked. Economic
growth is assumed to be constant. This is a sustainable path where the pollution released
into the environment is cleaned up. The environmental and health impacts are not major.
This limits economic growth, but is more sustainable. However, if external costs are not
taken into account, more output will be produced. This is because onlythe private costs of
production are considered. When such a system is adopted at time t
1
, high economic
returns (GDP) are generated, whichis shownbyline BDE. Under sucha system, economic
returns (output) are much larger because social costs of production are not taken into
account. However, the system has a problem. It is unsustainable. This is because the
pollution released is greater than the assimilative capacity of the environment and very
little clean-up is involved, pollution begins to impact on production and hence economic
growth. This is shown by the falling broken line, EF. Production will continue on FGline
and will remain so for a long time if factors of production have been damaged or
disappeared. On the other hand if the environment recovers, economic growth may take
place at a higher level shown by the upward sloping line, FH. With time, it is possible to
reach the ABC line. However, such a process is time consuming and may take decades to
fully recover. The arguments above basically sums up the concept of sustainability
discussed in Section 2.
6. Conclusions
As discussed in the paper, the issue of environmental sustainability, especially with
regards to sustainable ?nance is complicated. As it stands, there is no formal
benchmarking of sustainable practices, but only a mention of achieving environmental
sustainability. The question that arises is whether it is a weak or a strong form of
sustainability that is envisaged. Furthermore, the compatibility of high-market discount
Figure 5.
Economic growth without
considering pollution
impacts and biodiversity
degradation is detrimental
to future production
Source: Adapted from Wilson (2010)
D
E
H
F G
A B
Production system that takes
into account the social costs of
pollution
Production system not mindful of pollution
impacts/biodiversity degradation, such a system is
unsustainable
Production system that will prevail if
production collapse due to
environmental/biodiversity degradation
t
1
t
2
Time
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rates with environmental sustainability needs to be clari?ed. As is apparent, lowreturns
are unlikely to induce people to save and invest their income. High discount rates re?ect
only the private bene?ts of investment and fail to account for externalities.
As pointed out, it is also imperative that issues relating to adverse selection, moral
hazard and industry lobbying, which is increasingly recognised as a major issue
hindering the work of the environmental regulators and decision-makers needs to be
addressed. This is because when the regulator is “captured” by industry, in this case by
the ?nancial sector and its investors, it is unlikely that the most effective instruments of
pollution control will be used to internalise externalities. In such a situation
sustainability is compromised.
The issue of natural capital due to specialisation and concentration of production for
a global market is a major concern. This is another issue that needs to be addressed
urgently to halt the rapid decline of such an irreplaceable factor of production. The cost
of irreversibilities are extremely large, which threatens the quality of life of the present
and future generations. Finally, it is also demonstrated that it is important to ensure that
current forms of production (as measured by GDP) are sustainable even if this means
slowing down current rates of economic growth. However, the challenges that lie ahead
for sustainable ?nance are many, including polluter and consumer opposition,
overcoming political and bureaucratic hurdles. In any case, the ?nance sector in many
respects has few options left other than to switch to production that ensures the needs
of the present generation are met without compromising the ability of future generations
to meet their own needs. The ?nancial sector and the concept of sustainable ?nance
are at an important stage of development. At least with respect to sustainable ?nance,
what happens in the next decade will decide the legitimacy of the concept itself.
Notes
1. This refers to the investment merits of sustainable ?nance projects.
2. This is likely to be exacerbated by the discount rates used.
3. Refers to a standardbywhichthe quality/effectiveness of sustainable ?nance canbe measured.
References
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p25001979.html (accessed 23 March 2010).
Food and Agriculture Organisation (FAO) (2000), World Watch List for Domestic Animal
Diversity, Food and Agriculture Organisation, Rome, October.
Goodstein, E.S. (2008), Economics and the Environment, 5th ed., Wiley, Hoboken, NJ.
Hanely, H., Shogren, J. and White, B. (2001), Introduction to Environmental Economics, Oxford
University Press, Oxford.
Kelman, S. (1981), “Economists and the environmental policy muddle”, Public Interest, Vol. 64,
pp. 106-23.
Stiglitz, J.E. (2009), “GDP fetishism”, The Economists’ Voice, available at: www.bepress.com/ev
Tisdell, C. (2003), “Socioeconomic causes of loss of animal genetic diversity: analysis and
assessment”, Ecological Economics, Vol. 45, pp. 365-76.
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Turner, R.K., Pearce, D. and Bateman, I. (1994), Environmental Economics – An Elementary
Introduction, Harvester Wheatsheaf.
Viscusi, W.K., Vernon, J.M. and Harrington, J.E. Jr (1995), Economics of Regulation and Antitrust,
2nd ed., The MIT Press, Cambridge, MA.
WCED (1987), Our Common Future, Oxford University Press, Oxford.
Wilson, C. (2011), “Why do policy decision-makers opt for command and control environmental
regulation? An economic analysis with special reference to Sri Lanka”, in Kelegama, S. and
Gunewardena, D. (Eds), Economic and Social Development under a Market Economy
Regime in Sri Lanka, Vol. II, Vijitha Yapa Publishers, Colombo.
Wilson, C. and Tisdell, C. (2006), “Globalisation, concentration of genetic material and their
implications for sustainable development”, in Aurifeille, J., Svizzero, S. and Tisdell, C.
(Eds), Leading Economic and Managerial Issues, Nova Science, New York, NY, Chapter 17.
WWF (2006), Shaping the Future of Sustainable Finance – Moving from Paper Promises to
Performance, available at: www.wwf.org.uk/?lelibrary/pdf/sustainable?nancereport.pdf
(accessed 23 March 2010).
Young, M.D. (1992), Sustainable Investment and Resource Use, Parthenon, Carnforth.
Further reading
BankTrack (2010), Of?cial home page of BankTrack, available at: www.banktrack.org/ (accessed
23 March 2010).
(The) Equator Principles (2010), Of?cial website of The Equator Principles, available at: www.
equator-principles.com/ (accessed 23 March 2010).
Gunns Limited (2010), Bell Bay Pulp Mill, available at: www.gunnspulpmill.com.au/ (accessed 23
March 2010).
About the author
Clevo Wilson is an Associate Professor at the School of Economics and Finance, Queensland
University of Technology, Brisbane, Australia. He can be contacted at: [email protected]
ARJ
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This article has been cited by:
1. Sanda Renko, Ivan KovacFinancial Sustainability of Innovative Technology in Retailing 295-309.
[CrossRef]
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doc_559573857.pdf
The purpose of this paper is to demonstrate that the relatively new concept of sustainable
finance, although very apt and timely, needs to address many major issues for it to be meaningful and
if it is to achieve its desired objectives.
Accounting Research Journal
Why should sustainable finance be given priority?: Lessons from pollution and
biodiversity degradation
Clevo Wilson
Article information:
To cite this document:
Clevo Wilson, (2010),"Why should sustainable finance be given priority?", Accounting Research J ournal,
Vol. 23 Iss 3 pp. 267 - 280
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Why should sustainable
?nance be given priority?
Lessons from pollution
and biodiversity degradation
Clevo Wilson
School of Economics and Finance,
Queensland University of Technology, Brisbane, Australia
Abstract
Purpose – The purpose of this paper is to demonstrate that the relatively new concept of sustainable
?nance, although very apt and timely, needs to address many major issues for it to be meaningful and
if it is to achieve its desired objectives.
Design/methodology/approach – The study identi?es some of the major issues that need to be
clari?ed and addressed including: de?ning the kind of sustainability that is envisaged; examining
issues relating to the use of high-discount rates and its compatibility with the goals of sustainability;
the case of excessive pollution due to adverse selection, moral hazard and lobbying; and specialisation
and path dependent systems that are detrimental to future production.
Findings – The paper demonstrates why the concept of sustainable ?nance is timely and why it is
necessary to take into account the potential major issues that need to be considered and adequately
addressed.
Research limitations/implications – The challenges that lie ahead are many, and the sooner they
are addressed, the more credible and potent sustainable ?nance will be.
Practical implications – This paper discusses the major issues and examples of pollution and
biodiversity degradation that need to be considered with sustainable ?nance. The paper also shows
why economic growth without considering pollution impacts and path dependent systems is
detrimental to future production, which violates the concept of sustainable ?nance.
Originality/value – Sustainable ?nance is a relatively new concept that is fast becoming important
as ?nancial investments are increasingly required to prove sustainability credentials. However,
despite its increasing popularity many major issues need to be dealt with if this concept is to be truly
meaningful and potent in achieving its objectives.
Keywords Economic sustainability, Finance, Economic growth, Pollution
Paper type Research paper
1. Introduction
The concept of sustainable development has received much attention since the
publication of the Bruntland report (World Commission on Environment and
Development (WCED, 1987)). However, sustainable ?nance is a relatively new concept
that is fast becoming important as ?nancial investments are increasingly required to
prove sustainability credentials[1]. Although a clear de?nition of sustainable ?nance is
warranted, the broad consensus is that it would encompass economic, environmental
and social sustainability of ?nance. However, with regards to this special journal issue,
the onus is on environmental and social sustainable ?nance. In this study, however,
sustainable ?nance issues relating only to the environment are dealt with.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
Sustainable
?nance
267
Accounting Research Journal
Vol. 23 No. 3, 2010
pp. 267-280
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309611011092592
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As resource degradation and pollution impacts increases, future investments with
potential negative externalities are likely to be scrutinised over the environmental
impacts and the long-term environmental sustainability of such projects. Be it
government or private investment capital, funding of such projects will be increasingly
tied, amongst other factors, to the environmental sustainability of such projects.
Agood case in point is the Gunns Limited paper mill project in the Tamar Valley (www.
gunnspulpmill.com.au/) in Tasmania, Australia, where private capital is not so easily
forthcoming, mainly based on serious doubts raised on the environmental impacts of the
project, public protests and its long-term environmental sustainability.
As pointed out by a World Wildlife Fund (WWF, 2006) report, the ?nancial sector’s
environmental and social responsibility during the last decade and a half was driven to
a “large degree by outside pressures”. As the report states:
Beginning in 2000, environmental organisations such as Friends of the Earth (FoE) and the
Rainforest Action Network (RAN) challenged the industry with high-pro?le campaigns that
highlighted cases in which commercial banks were “bankrolling disasters”. In 2002, a global
coalition of non-governmental organisations including FoE, RAN, WWF-UK and the Berne
Declaration came together to promote sustainable ?nance in the commercial sector.
As we nowknow, this informal network has evolved into BankTrack (www.banktrack.
org/), whose vision for sustainable ?nance was expressed in the Collevecchio
Declaration of January, 2003 (www.evb.ch/es/p25001979.html). The ?rst of the six
commitments to key principles under this declaration is a commitment to environmental
and social sustainability. Following this declaration, “(The) Equator Principles” (www.
equator-principles.com/) were developed in 2003 by four of the largest private sector
banks. They were the Citigroup, ABNAMRO, Barclays and WestLB. The principles are
an industry benchmark set for the ?nancial industry to manage environmental and
social issues in project ?nancing. These principles are based on the International
Finance Corporation’s (www.ifc.org/about) environmental and social safeguard policies
(WWF, 2006). With the major institutions governing ?nancial institutions lending
support to environmental and social sustainability, it is to be expected that commercial
organisations are likely to endorse and become signatories either due to increasing
industry needs, coercion or due to genuine acceptability of the environmental and social
responsibilities of capital investments.
All indications are that sustainable ?nance will be increasingly embraced by the
?nancial industry judging by the initial reaction to this concept (WWF, 2006). However,
there are many issues that need to be clari?ed and addressed if environmental ?nancial
sustainability is to be truly meaningful.
It is clear from the available literature on sustainable ?nance that the path of
environmental sustainability the ?nancial industry seeks to pursue is unclear. In other
words, there is no benchmark that the industry is striving to achieve. Another
important issue that need to be examined is the relationship between high discount
rates and the concept of environmental sustainability. Are the two issues compatible?
In other words, could high discount rates prevail and yet achieve sustainability? This
has enormous implications for the concept of sustainable ?nance as will be dealt with
in this study.
Furthermore, an issue that should be kept in mind with sustainable ?nance is that
unfettered markets do not take into account freely available non-marketed goods
and services. In such cases many of the social costs may not be taken into account.
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It is likely that environmental credentials of investors will be over emphasised.
Adverse selection and moral hazard issues are likely to arise.
Another major issue that needs to be taken into account is that of industry lobbying
that seek weaker instruments of pollution control that are likely to be ineffective in
internalisingexternalities. Furthermore, issues relatingto the concentrationof production
that are likely to lead to the degradation of resources also need to be addressed. Finally,
it is important to demonstrate that economic growth without considering pollution
impacts and path dependent processes is detrimental to future production. This paper
strives to address these various issues.
The paper is set out as follows. Section 2 provides an overview of the sustainability
issues, production process and discount rates in relation to the concept of sustainable
?nance. Section 3 presents a discussion on what are the other likely issues that should be
kept in mind in dealing with sustainable ?nance. Examples from pollution and
biodiversity degradation are discussed in Section 4 where the case of excessive
production, pollution and biodiversity degradation are highlighted. In Section 5, it is
shown that economic growth without considering pollution impacts and path dependent
systems, as is nowhappening, is detrimental to future productionandis inviolationof the
concept of sustainable ?nance. Section6 concludes witha discussionof the main?ndings.
2. Sustainability issues, production process and discount rates
Sustainability is a popular phrase and de?nitions pertaining to sustainability abound.
However, a widely used and one of the best-known de?nitions which should ideally
capture the concept of sustainable ?nance is that given by the Bruntland Commission
(WCED, 1987). It de?nes sustainable development as “development that meets the
needs of present generations without compromising the ability of future generations to
meet their own needs”.
Another de?nition that is very apt when we discuss sustainable ?nance is that
given by the Norwegian economist, Asheim (1994). According to him sustainability is
“a requirement to our generation to manage the resource base such that the average
quality of life we ensure ourselves can potentially be shared by all future generations”.
Although no formal de?nition of sustainability has been provided, what this new
emerging ?eld of sustainable ?nance implicitly assumes is that “?nance”, corporate or
otherwise, should be used in a manner to generate economic activity that does not
compromise the future ability to produce the same level of economic activity. The
concept of sustainability implicitly refers to intra as well as inter generational
sustainability. As Hanely et al. (2001) point out “two main features of these de?nitions
of sustainable development are: (i) fairness across generations; and, (ii) fairness within
generations. Sustainability is thus principally an equity, rather than ef?ciency issue”.
Interestingly, ?nancial investment valuation takes into account only costs and
bene?ts in terms of their impact on ?rms and shareholders. One method applied is the
net present value (NPV) test. This simply asks whether the sum of discounted gains
exceeds the sum of discounted losses. The project is accepted if NPV . 0. The major
problem in simple ?nancial investment appraisal or in a cost-bene?t analysis is that
the valuation of non-marketed goods (for example, wildlife, landscapes, environmental
sinks, ecosystem and agricultural complexity) is ignored. Hence, subjecting projects to
a NPV test is not a test of environmental sustainability. Hence, NPV tests should be
subject to sustainability constraints when dealing with sustainable ?nance.
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Another important issue that arises when dealing with sustainability in general or
sustainable ?nance in particular is the type of sustainability which the ?nancial
industry is seeking to follow. Is the ?nancial industry planning towards weak or strong
sustainability? A weak form of sustainability is where there are no declines in capital
(Hanely et al., 2001). Such a system can be de?ned as follows:
No declines in : K
n
þK
h
þK
m
¼ K
where K
n
is natural capital, K
h
is human capital and K
m
is man-made capital. Kis total
capital stock. This concept means we can exhaust natural capital as long as we
substitute it with human and man-made capital so that the total capital stock remains
the same. This is consistent with the neoclassical economist’s view that natural and
created capitals are substitutes in production. As Goodstein (2008) points out “they are
technological optimists, believing that as resources become scarce, prices will rise, and
human innovation will yield high-quality substitutes, lowering prices once again”.
On the other hand, strong sustainability canbe de?ned as a systemwhere there are no
declines in K
n
or rather in critical capital, K
n
. Substitutability to maintain the total
capital stock is not permitted. This is the ecological economist’s view who argues that
natural and created capital is fundamentally complements. In other words, they are used
in production together and have lowsubstitutability. As Goodstein (2008, p. 119) states:
Ecological economists are technological pessimists – fundamentally they believe that rapid
increases in population, and even faster increases in consumption, are putting unsustainable
pressure onour natural resource base. Inindividual cases such as fuel cell-poweredcars, created
capital may substitute for natural capital. But at a general level, created and natural capital are
complements in production. This is to say, ecologicals believe that we are “running out” of the
inexpensive natural capital that forms the base of our economic well-being: both natural
resources, such as freshwater and topsoil, and the environmental sinks that absorb our wastes.
Another aspect that needs to be considered inrelationto sustainability is that of discount
rates. High discount rates could penalise investments with long-termpayoffs. Therefore,
high market discount rates, if not well planned (e.g. without environmental impact
assessments) and invested, could be incompatible with the tenets of both neoclassical
and ecological schools of thought and hence undermine the whole concept of sustainable
development as de?ned by WCED (1987) or Asheim (1994). High discount rates are
unlikely (in most cases) to result in environmentally friendly investments. As we know
corporate investments have shorter time horizons.
This is because private capital often requires rates in the range of 15 percent or
more to initiate an investment (Goodstein, 2008). As Goodstein (2008) points out this is
due to two reasons:
(1) They re?ect only the private bene?ts of investment and fail to account for the
external costs of growth.
(2) Such high returns are required to induce people to save and invest their income,
rather than consume it today.
This is referred to as positive time preference which refers to a desire to consume as
much in the short-term than waiting until a later date. Such preferences prevent the
investments with long-term payoffs, which is usually the case with environmental
bene?ts or sustainability.
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However, as Goodstein (2008) further points out, low discount rates are not always
“pro environment” either. For example, large dams with high up-front costs and a long
stream of future bene?ts may be favoured, since the public are likely to “enjoy cheap
electricity and recreational opportunities for decades”. It is worth noting that while
private capital requires high-discount rates, governments use a much lower discount
rate with environmental protection agencies using a discount as low as 3 percent
(Goodstein, 2008).
It is also worth noting that investments in products with high environmental bene?ts
(e.g. some renewable energy sources) with high returns do not necessary attract
suf?cient investments. This is because the returns take a long time to be generated.
On the other hand as Goodsetin (2008, p. 106) points out:
[. . .] private investors evaluate projects using high market discount rates, re?ecting the
private opportunity cost of their capital. The fact that energy companies can make a 20%rate
of return on conventional investments in oil properties means that they can earn their
investments back in 5 years. Access to these high market rates of return gives market actors
very short time horizons.
High discount rates seeking high returns which are based on private returns are likely to
lead to lowering/evading penalties or putting off internalising social and environmental
costs. High discount rates are also likely to encourage the concentration and
specialisationof production. These issues are discussedinmore detail inSections 3 and4.
3. What are the other likely issues that should be kept in mind in dealing
with sustainable ?nance?
An issue that should be kept in mind in discussing sustainable ?nance is that an
unfettered market systemdoes not take into account the true value of using non-market
(zero-priced), freely provided environmental resources and appropriate discount rates
that are conscious of the environmental impacts and long-term environmental
sustainability. Therefore, freely available environmental goods and services are likely to
be over utilized and unfettered markets with inappropriate discount rates will result in
resources being used inef?ciently from an environmental sustainability point of view.
As Turner et al. (1994) point out “there is a divergence between private and social costs”.
When output increases so does the amount of pollution which has to be assimilated by
the environment. However, with increasing production, the amount of pollution released
exceeds the assimilative capacity of the environment[2]. Hence, pollution released
becomes a problem. Figure 1 shows that at Q
A
, output produced is equal to the amount of
pollution released into the environment. When output increases beyond Q
A
, then the
environmental assimilative capacity is exceeded.
In order to avoid pollution damage to the environment and hence society, it is
important to take into account marginal external costs (MEC) and internalise them.
Sustainable ?nance should be mindful of this fact. When the pollution that is released
into the environment is greater than the assimilative capacity, the pollution begins to
impose external costs on society. Furthermore, the external costs increase with
increasing output. A simple illustration of this is shown in Figure 2. The ?gure also
shows the marginal net private bene?ts (MNPBs). As can be seen, MEC increase as
pollution accumulates with increasing production. Hence, the damage done to the
environment, too, increases when the per unit of output increases. Discount rates
selected are likely to in?uence the extent of the environmental damage.
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In Figure 2, the social optimum level of output is at Q
s
. This is obtained by subtracting
the external costs from the producers’ MNPB. It is the responsibility of the respective
environmental regulators to take into account the social costs of production and compel
polluters to pay for the pollution they generate. Only when these external costs are taken
into account (internalised) that production will move froma private pro?t driven market
optimal level of output to a socially optimal level of output. In other words, a private
?rm’s market decision rule is that output should be produced if the ?rmgains a positive
MNPB (i.e. if MR (marginal revenue) . marginal variable cost (MVC)), up to the point
where MR ¼ MVC, the market optimumlevel of output. If the regulators are to take into
account the costs of pollution, then the social decision rule is that external costs (MEC)
must be included in the market price of the good produced. In other words, polluters
should be made to pay for the pollution they generate in producing goods and services.
Figure 1.
Output, pollution and
assimilative capacity of
the environment
Source: Adapted from Turner et al. (1994, p.75)
Assimilative capacity of
the environment
Total amount of pollution
released into the
environment (e.g. litres
of oil and grease)
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Figure 2.
MNPB, MEC and social
optimum level of output
Source: Adapted from Turner et al. (1994, p.76)
Marginal external costs
(MEC)
M
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Output Q
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Hence, as demonstrated in Figure 2, there is a need for sustainable ?nance to account
for the social costs in market prices of manufactured goods and services. However, the
question that arises is whether sustainable ?nance will be benchmarked[3] against
social costs being taken into account. Even if such benchmarking is imposed, investors
who are not included in internalising externalities in order to maximise pro?ts, are
likely to get around this issue in at least two ways.
One method relates to adverse selection. A polluter with no environmental
credentials is unlikely to divulge all information regarding pollution generated from
production to potential lenders. In fact, the biggest polluters are likely to exaggerate
environmental credentials. This is also a good public relations exercise.
The second involves moral hazard. Investors, after obtaining ?nance for their
projects or those already in the industry may resort to the non-implementation of
promised environmental standards or in other cases resort to lobbying the relevant
regulators in order minimise the extent of external costs that needs to be taken into
account in the production process. As Goodstein (2008) states:
Because regulatory decisions impose substantial costs on affected industries, businesses will
devote resources to in?uence the discretion that regulators exercise (in ethical, questionably
ethical, and unethical manners) just as they devote resources to minimizing labour or energy
costs.
In the next section, a case where industry in?uence is applied to “capture” the regulator
in relation to pollution control is discussed. In this manner, regulation is supplied by the
regulator in response to the industry’s demand for regulation or the regulatory authority
is controlled by industry by coercion, in?uence and “other methods”. Section 4 also
discusses a problem that is less known, but yet is having a major impact on the
degradation of natural capital which sustainable ?nance has to be aware of and adopt
mitigating measures.
4. Examples from pollution and biodiversity degradation
This section discusses two issues which sustainable ?nance has to deal with if this
concept is to be truly meaningful and to make production and services environmentally
sustainable. They are as mentioned in Section 3, how industry would in?uence the
regulator to obtain the type of pollution control which industry prefers and which is
less harmful to their production activities and pro?tability. This relates to the case of
excessive production and pollution. The case of ?xed emissions standards being
preferred as opposed to a pollution tax is demonstrated. The second issue, which is not
well known in the literature, is the degradation of biodiversity, an important factor of
production, due to the emergence of “path dependent” systems of production being
created due to specialisation and concentration of production. As experience shows,
they are not easy issues to grapple with. However, the credibility of sustainable ?nance
thus lies in addressing such issues rather than the concept being a good public
relations motto for the ?nance industry and its investors to showcase.
4.1 The case of excessive production and pollution
Figure 2 in Section 3 showed that when the amount of pollution released exceeds the
assimilative capacity, external costs begin to increase. Theoretically, at least two
instruments can be used to internalise the external costs. This is shown in Figure 3.
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For example, introducing a ?xed standard for pollution generated should limit the
amount of pollution released into the environment. This is shown at Q
F
of ?rm’s output.
At this point, the amount of pollution released is W
F
. However, real world experience
shows that penalties for violating a ?xed standard have been historically set “too” low.
This is shown by the broken line. In such a case ?rms may only reduce pollution where
the penalty . MNPB. In other words, reducing output from Q
M
to Q
P
(reducing
emissions from W
M
to W
P
). On the other hand, the tax, t
*
has been set to achieve the
socially optimum output at Q
S
where pollution generated is W
S
. This is ef?cient,
where as if the penalty is to be ef?cient, then the level of penalty has to be increased to the
level of tax, t
*
. However, it should be noted that a pollution tax can also be set too “low”
due to pressure fromlobby groups. However, in reality, this is less likely than ?nes being
set too low.
One may wonder why penalties are set too low. One main reason as explained earlier
is due to lobbying or polluter pressure imposed on the environmental regulator. It is well
known in the regulatory economics literature that by design or not, the institution
that is meant to regulate is “captured” by industry. This is known as capture theory
(Viscusi et al., 1995). According to this strand of thinking, command and control (C&C)
regulation is supplied by the regulator in response to the industry’s demand for
regulation or the regulatory authority is controlled by industry by coercion, in?uence
and “other methods”. However, in both cases, regulators are “controlled” by an industry
or a ?rm. Turner et al. (1994) elaborate this point best:
This “capture” concept refers to the tendency for the regulator and the polluter to seek common
ground and cooperation. Once captured, administrators begin to see that they need to protect
existing members of an industry and, therefore, regulate it accordingly. New entrants are
excluded, subsidies are offered and dif?cult decisions are put off until prospects “improve”.
Figure 3.
Comparing the
effectiveness of a pollution
tax with a ?xed emissions
standard associated with
penalties
Source: Adapted from Turner et al. (1994, p.169)
Marginal external cost
(MEC)
V
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Pollution produced by firm
0 W
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Firm’s output
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Young (1992) argues that this “rent seeking” behaviour is inef?cient and tends to bias
investment decisions and leads to further extensions in regulatory capture. Therefore,
the implication is that once the requiredcapital has been obtained, there is no mechanism
that prevents such a situation happening. This is an issue which sustainable ?nance has
to address if the concept is to be truly meaningful and effective. Otherwise, the whole
concept is likely to lose credibility. Interestingly, Kelman (1981) found from a survey of
industrialists in the US that 85 percent of them were opposed to pollution taxes on the
grounds that these increased the ?nancial burden relative to a C&Cregulatory approach.
4.2 Biodiversity degradation
In the last section, the case of excessive pollution was discussed in order to illustrate
some issues sustainable ?nance has to confront. In this section, another pertinent issue
which is well known is that of degradation of natural capital, an important factor of
production. The case of biodiversity degradation is discussed in this section.
While it is acknowledged that the extension of the market system by encouraging
concentration and specialisation of production has brought about large increases in
productionand fosteredtechnical ef?ciencies, sucha systemhas ledto many irreversible
externalities in the use of natural capital, an issue that remains ignored in the ?nancing
of agricultural/livestock investment projects. As Tisdell (2003, p. 370) points out “it is a
powerful force for loss of genetic diversity”. The negative externalities, in many cases,
have gone largely unnoticed. Needless to say, loss of genetic diversity in crops and
livestock can have adverse consequences for sustainable economic growth.
Interestingly, the concentration/specialisation of production in the agricultural sector
has further implications, which has gone largely unnoticed because of the nature of the
problem. Hence, another issue that sustainable ?nance needs to be cognizant because
such a system of production, too, violates the principle of sustainability discussed in
Section 2.
Before greater specialisation of production a wider variety of breeds were used than
it is today. For instance, until a couple of decades ago, individual producers did not
produce on a large-scale. Hence, in this situation, there was an incentive for a farmer to
use “all round” livestook breeds that produced, for instance, milk, beef, worked on the
farm, manure and transport. In other words, farmers were mostly self-suf?cient and
sold only their surplus in the market or traded it for some other commodity. However,
market extension has favoured the selection of specialised breeds and this has resulted
in the gradual loss of “all round” breeds (Wilson and Tisdell, 2006).
The use of “all round” breeds is a cost in a highly market-oriented production
system where specialisation is intensi?ed to produce a larger quantity for a larger
market and to maximise pro?ts. This is especially so with large market discount rates.
In such a situation, market-oriented production systems will select breeds that are not
“all round” but rather those that produce more of one commodity than few items of
“everything”. Figure 4 shows a “before and after” globalisation situation.
The vertical axis in Figure 4 shows the economic bene?ts and the horizontal axis
shows the diversity of economic attributes of different breeds that are available for
selection in the production process. For ease of presentation and clarity, the diagram is
divided into breeds that produce mainly one or two items and “all round” breeds.
Those closer to the origin, are breeds that produce fewer items and produce smaller
quantities of an item. As the breeds move closer to the centre the breeds produce larger
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quantities and bring larger economic bene?ts to producers, but at the same time the
“all round” qualities also begin to increase. As we move towards 1 the “all round”
characteristics of breeds become prominent. For instance, at a point close to 1, the “all
round” qualities are so great that they are not considered in commercial production. As
shown, points at 0 and 1 are extreme cases. Those breeds close to 1 are of little interest
to commercial producers on a large-scale, but they are valuable breeds to small-scale or
semi-subsistence farmers who depend on such breeds for their livelihoods.
For the hypothetical producer, breed L is the preferred choice before globalisation.
This breed provides the maximumeconomic bene?ts. Breed Kis the preferred one after
globalisation. Breed L gives an economic bene?t to the producer of an amount
corresponding to C before globalisation, but only an amount corresponding to D after
globalisation. The more specialised breeds could provide the producer with an
economic bene?t corresponding to A after globalisation, which was only B before
globalisation. In scenarios such as those explained in Figure 4, diverse attributes of a
breed is not an asset, but diversity become a threat to the survival of the breed.
As specialised production and genetic manipulation of selected breeds increase and
prices of commodities fall, they also displace small-scale farmers that mainly rely on “all
round” breeds for their form of production and livelihoods. This process, as is being
witnessed currently, is accelerating the extinction process (Wilson and Tisdell, 2006).
Hundreds of breeds (livestock and plant) have either become extinct or are on the
verge of extinction mostly as a result of specialisation, genetic manipulation of selected
breeds and concentration of production of production. According to Food and
Agriculture Organisation (FAO) statistics, 10 percent of the world’s livestock have
already become extinct and another 20 percent are facing extinction (FAO, 2000). The
highest rates of extinctions have occurred in Europe and North America where
Figure 4.
Economic bene?ts of
breeds available to a
typical producer before
and after globalisation
based on different degrees
of diversity of economic
attributes or
characteristics dictated by
their genetic make-up
Diversity of economic attributes of available breeds (an index)
More specialised breeds Less specialised breeds
Source: Adapted from Wilson and Tisdell (2006)
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Before globalisation
After globalisation
A
Breed K
Breed L
C
B
D
0 1
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concentration and specialisation of production based on narrowing of genetic material
have taken place the most. As globalisation increases, this trend is rapidly spreading to
other continents. A good example is Asia where the dilution of pig breeds is continuing
at a rapid pace in Vietnam where the pure local breeds such as the Mong Cai are
becoming a casualty. For a detailed discussion on this issue, see Wilson and Tisdell
(2006). Table I shows the extent of the “disappearance of the biodiversity” problem for
livestock breeds.
As shown in Table I, the percentage of breeds that are at risk of extinction is highest
in Europe and North America where globalisation of production is also the highest.
Extinction of breeds is more than half the breeds not at risk for the same two continents.
In other continents, where globalisation and economic development are still at a lower
level, the breeds that have become extinct and those at risk of extinction are less than the
breeds not at risk. However, if breeds are not conserved, this will change as globalisation
of production proceeds rapidly in Asia (especially in China and India) as shown in
Figure 4.
Other factors such as the demand for leaner meat, tastes, availability of
storage/refrigeration, foreign aid/technology transfers accelerate the process of
specialisation and concentration of production. Other production systems such as the
provision of inputs are also developed for such production systems and they place greater
reliance on such processes. This has happened in agricultural production systems such
as grain (e.g. wheat and rice) or livestock production. This results in several “path
dependent” systems of production being created. These are powerful forces at work that
are graduallyunderminingthe genetic diversityof the productionsystemthat sustainable
?nance has to confront and address if such a concept is to achieve its desired objectives.
5. Economic growth without considering pollution impacts and path
dependent systems is detrimental to future production
As discussed in Section 4, a myopic, pro?t maximising ?rm or ?rms is likely to favour
a system where it pays less for pollution. Specialisation and concentration of
production, as also explained in Section 4 and is being currently witnessed will result
in creating “path dependent” systems. Such a strategy, although increases production
and results in higher economic growth and output (measured as gross domestic
product (GDP)), the social costs are likely to reduce output in the medium and in the
long term-due to pollution damage to factors of production in the form of natural
Region
Extinct breeds
(%)
Breeds at risk
(%)
Breeds not at risk
(%)
Unknown breeds
(%)
Europe 18 40 31 11
North America 18 29 20 33
South and Central America 08 19 41 32
Africa 05 12 49 34
Asia and the Paci?c 05 12 49 34
Near east 04 07 42 47
World 10 20 39 32
Source: FAO (2000)
Table I.
Status of livestock breeds
of the world in 2000
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capital (land and biodiversity), health (labour) and capital. Stiglitz (2009) mentions such
a situation in a paper entitled “GDP fetishism”. This scenario is shown in Figure 5.
The line ABC represents economic growth when pollution is checked. Economic
growth is assumed to be constant. This is a sustainable path where the pollution released
into the environment is cleaned up. The environmental and health impacts are not major.
This limits economic growth, but is more sustainable. However, if external costs are not
taken into account, more output will be produced. This is because onlythe private costs of
production are considered. When such a system is adopted at time t
1
, high economic
returns (GDP) are generated, whichis shownbyline BDE. Under sucha system, economic
returns (output) are much larger because social costs of production are not taken into
account. However, the system has a problem. It is unsustainable. This is because the
pollution released is greater than the assimilative capacity of the environment and very
little clean-up is involved, pollution begins to impact on production and hence economic
growth. This is shown by the falling broken line, EF. Production will continue on FGline
and will remain so for a long time if factors of production have been damaged or
disappeared. On the other hand if the environment recovers, economic growth may take
place at a higher level shown by the upward sloping line, FH. With time, it is possible to
reach the ABC line. However, such a process is time consuming and may take decades to
fully recover. The arguments above basically sums up the concept of sustainability
discussed in Section 2.
6. Conclusions
As discussed in the paper, the issue of environmental sustainability, especially with
regards to sustainable ?nance is complicated. As it stands, there is no formal
benchmarking of sustainable practices, but only a mention of achieving environmental
sustainability. The question that arises is whether it is a weak or a strong form of
sustainability that is envisaged. Furthermore, the compatibility of high-market discount
Figure 5.
Economic growth without
considering pollution
impacts and biodiversity
degradation is detrimental
to future production
Source: Adapted from Wilson (2010)
D
E
H
F G
A B
Production system that takes
into account the social costs of
pollution
Production system not mindful of pollution
impacts/biodiversity degradation, such a system is
unsustainable
Production system that will prevail if
production collapse due to
environmental/biodiversity degradation
t
1
t
2
Time
E
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o
m
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e
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s
C
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rates with environmental sustainability needs to be clari?ed. As is apparent, lowreturns
are unlikely to induce people to save and invest their income. High discount rates re?ect
only the private bene?ts of investment and fail to account for externalities.
As pointed out, it is also imperative that issues relating to adverse selection, moral
hazard and industry lobbying, which is increasingly recognised as a major issue
hindering the work of the environmental regulators and decision-makers needs to be
addressed. This is because when the regulator is “captured” by industry, in this case by
the ?nancial sector and its investors, it is unlikely that the most effective instruments of
pollution control will be used to internalise externalities. In such a situation
sustainability is compromised.
The issue of natural capital due to specialisation and concentration of production for
a global market is a major concern. This is another issue that needs to be addressed
urgently to halt the rapid decline of such an irreplaceable factor of production. The cost
of irreversibilities are extremely large, which threatens the quality of life of the present
and future generations. Finally, it is also demonstrated that it is important to ensure that
current forms of production (as measured by GDP) are sustainable even if this means
slowing down current rates of economic growth. However, the challenges that lie ahead
for sustainable ?nance are many, including polluter and consumer opposition,
overcoming political and bureaucratic hurdles. In any case, the ?nance sector in many
respects has few options left other than to switch to production that ensures the needs
of the present generation are met without compromising the ability of future generations
to meet their own needs. The ?nancial sector and the concept of sustainable ?nance
are at an important stage of development. At least with respect to sustainable ?nance,
what happens in the next decade will decide the legitimacy of the concept itself.
Notes
1. This refers to the investment merits of sustainable ?nance projects.
2. This is likely to be exacerbated by the discount rates used.
3. Refers to a standardbywhichthe quality/effectiveness of sustainable ?nance canbe measured.
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About the author
Clevo Wilson is an Associate Professor at the School of Economics and Finance, Queensland
University of Technology, Brisbane, Australia. He can be contacted at: [email protected]
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