Greening the EU economic and financial governance to stop the collapse of naturemai 27, 2020
Par Greg Ford, Finance Watch
Restoring our planet’s ecosystems and their biodiversity is a question of survival for humanity, but our economic activities are destroying them at a fast pace. Finance Watch’s new report « Nature’s return » shows ways to embed environmental goals at the heart of European policy-making. Below you can read the report’s executive summary.
Human activities are putting the environment under unsustainable pressure, through climate change and by degrading the earth’s natural systems.
Deteriorating trends in most aspects of our natural capital. Extract from our report « Nature’s Return », p.13
Up to a third of economic activity depends directly on ecosystem services provided by nature. Yet human activities are degrading the land, the oceans, and the atmosphere that sustain these services and the health of our natural capital continues to deteriorate.
Three types of project can help to halt this deterioration: conservation projects, for example designating areas as national parks and nature reserves; restoration projects, such as depolluting, renaturalising soils, or rewilding; and transition projects to adopt sustainable processes, such as switching to renewable energy or less intensive agriculture.
The ecosystem of preserving nature – extract from the report Nature’s Return, p.19
All these project types lack funding and as a consequence Europe is failing to meet its environmental targets. In this report we ask what type of finance could best fill the funding gap and which regulatory changes could mobilise private finance and unlock public finance for nature.
Recognizing the Limits of Private Finance
The funding gap for environmental projects in Europe, conservatively estimated at €400bn, has been hard to fill, despite abundant private liquidity. The nature of private investment is to focus on financial risks and returns and revenue streams, but many nature-related projects have no revenue source. Indeed, nature tends to benefit when there is less economic activity. Conversely, it can be easier to finance businesses that keep their costs low by harming nature. Attempts to create revenue sources from nature projects using innovative financing models have produced mixed results: ecotourism remains a niche; biodiversity offsetting has major conceptual flaws and a poor record of protecting nature; and Payments for Economic Services (PES) schemes such as conserving biodiversity or maintaining watersheds are, in reality, public subsidies.
Numerous attempts have been made to mobilise private finance to support nature-related projects. Today, we have very little evidence of projects succeeding in getting beyond the seed investment stage. Extract for our report « Nature’s Return », p. 24
What has worked well is where existing businesses use funding to switch to sustainable processes and create financial value through price premiums, adding to land values, or reducing the use of natural resources. Regulation can accelerate these effects. In agriculture, there are special problems such as balancing sustainability with crop yields or delivering finance for sustainability improvements to the world’s 450 million smallholders.
Nature projects are often too small for institutional investors to invest in directly. They are complex to understand, illiquid and take a long time to mature. Global capital markets provide an indirect way for investors to invest with instant pricing and liquidity. However, the industry’s reliance on CAPM and other structural factors mean that fund managers have little appetite for alternative or long-term investments.
Consumer demand for sustainable or ESG investing is on the rise and EU regulations now require funds to say how they integrate sustainability factors. By some estimates, sustainable investing represents around €22 trillion of assets under management in Europe, but the numbers and the impact depend on which sustainable investing approach is taken. Nearly half of these assets are subject to ‘negative screening’ which does not screen for nature loss and cannot directly change harmful behaviour. Other sustainable investing approaches may have greater impact.
Regulation could help to harmonise the different methodologies for assessing ESG factors, especially for biodiversity where techniques are less developed. But difficulties remain with obtaining and comparing underlying data on companies’ environmental impacts.
« So far, there is no empirical evidence that the capital allocation decisions of sustainable investors have affected corporate activities.” J. F. Kölbel et al. (2018) – MIT Sloan, University of Zurich
Overall, preferences among capital market participants for liquidity, a market price and benchmark-hugging mean that few mainstream funds have the freedom to invest in nature projects. It seems that sustainable investing is not yet ready to tackle biodiversity and nature loss, or at least to have an impact on a significant scale.
Doing More Within the Limits of Private Finance
The EU has responded to the private financing gap for nature with two initiatives. The first is the Sustainable Finance agenda, which aims to create a chain of ESG information to help private investors invest sustainably. This chain includes a taxonomy to define what is sustainable, updated rules on non-financial reporting that govern how companies report on the sustainability of their activities, and a set of labels and standards to say which financial products support sustainable activities. The focus is on improving information flows, not on making projects more bankable.
The ESG information chain – Extract from our report « Nature’s Return », p. 51
The second is the European Green Deal Investment Plan, which among other things provides a framework for blended finance, where public money is used to make projects more attractive for private finance. The approach has been used in development finance, in funding the SDGs, and in the EU’s ‘EFSI’ and ‘InvestEU’ programmes. It works by taking risks onto the public balance sheet through guarantees, grants and liquidity measures and is intended for projects that would not otherwise go ahead. Its main limitations are that it needs a revenue stream, which rules out a lot of nature-projects, and it can increase the reporting burden. Blended finance is already available for EU biodiversity and nature projects from the Natural Capital Financial Facility (NCFF) but has had a limited take-up.
Another way to protect nature is through economic instruments that send price signals and so shift profitability towards more sustainable activities. These include instruments to ‘marketize’ ecosystem services, such as creating claims linked to carbon sequestration, and cap-and-trade systems, which set an upper limit and then let the market decide who can pollute, fish, harvest etc. The failure of the EU’s Emissions Trading System shows the importance of configuring these correctly and resisting the use of offset markets, which create new allowances that dilute the cap. There has been relatively little EU use of fiscal levers, such as Denmark’s pesticide tax, or fiscal transfers for activities that benefit the environment, such as compensation for farmers who switch to organic methods.
Integrating Economic and Environmental Governance through the Green Deal
Given the scale of the problem, both private and public solutions are needed. Public finance is especially useful for projects that provide public value without being financially bankable themselves. The public value that nature brings is already targeted by the EU’s comprehensive body of direct environmental regulations. These seek to ban harmful activities, limit pollution, protect land etc. but have not been fully implemented. The opportunity cost of not implementing them, in terms of foregone environmental and other benefits, is estimated at up to EUR 80bn a year.
Public sector investment has the freedom and scale to address nature-loss and create positive externalities, such as ecosystem services, in ways that private finance cannot. But in Europe, public investment is constrained by the fiscal framework among other factors and has been declining as a proportion of GDP for decades.
Public investment at its lowest in 50 years in Western Europe. Extract for our report « Nature’s Return », p.68
Despite efforts to exempt public investment from the fiscal framework, there is no consensus yet for a proposed “green golden rule” to exempt green public investment. The rapid suspension of fiscal rules during the COVID-19 crisis showed, at least, a recognition that accounting rules are not an objective in themselves and can be treated with flexibility.
The EU’s use of “Rio Markers” to track its public investment in biodiversity overstates the amount invested. More accurate numbers could be obtained with tracking based on the BIOFIN approach or by developing new markers based on the EU green taxonomy.
The EU itself has dedicated very little public funding for nature projects, only EUR 5bn under the LIFE programme and various other pots that protect biodiversity as a secondary objective. On the other hand, it continues to provide very large subsidies for harmful farming processes under the Common Agricultural Policy, as well as subsidies for fossil fuels and harmful fishing and forestry activities.
With limited firepower at the EU level, public investments in nature will have to be increased at national level. The EU Semester oversees national public investment for member states and there is momentum for aligning the EU Semester process with environmental goals. Several tools exist for this, including embedding the SDGs and environmental metrics in the EU Semester process; using information on countries’ implementation of environmental laws as inputs for EU Semester country reports; and including countries’ biodiversity policies as inputs to EU semester country reports, alongside their energy and climate plans.Mapping of Finance Watch’s recommendations – Extract from the report « Nature’s Return », p.9
Finding the money to tackle the emergency of nature-loss will need a fresh mindset that looks beyond the markets-only approach of yesterday and combines public and private financing. Nature-loss is a far bigger threat to human wellbeing than COVID-19 and the response to this global pandemic shows what can be done when there is a will to tackle a crisis.
Well-directed private finance can help businesses to become more nature-friendly and there is much that regulators can do to encourage this. But policymakers should not expect too much; private finance is at best a partial solution. It is viable only when there is a source of revenue and many, if not most, nature projects do not provide one, even when the value they bring to the economy and the environment is enormous.
Public finance will be needed at a scale that calls for national as well as EU budgets to invest directly and alongside private capital. The EU has tools to make this happen and the investment will be far less than the cost of responding to the COVID-19 crisis, indeed it could and should be part of the EU’s post-Corona recovery plan, perhaps framed as a “Recovery and Transition Plan”.
We look forward to the EU adopting a strong target-led nature strategy that will maximise the private sector’s contribution without relying too much on it, and unlock national and EU public funding at a scale that can reverse the damage that our economy has been inflicting unsustainably on nature.