IMF calls for connecting dots between sustainable finance and financial stability

Environmental, social and governance (ESG) issues can have a material impact on the performance of firms and stability of a financial system more broadly, according to the International Monetary Fund (IMF).

That is why more and more investors are looking at issues and factors beyond traditional financial analysis when directing their money. These issues include unsafe working conditions, use of child or forced labour and environmental impact on protected areas.

Sustainable finance aims to help society better meet today's needs and ensure that future generations will be able to meet theirs too, said IMF in a blogpost written by Evan Papageorgiou, Jochen Schmittmann and Felix Suntheim.

It said sustainable finance incorporates ESG principles into business decisions and investment strategies. It covers many issues from climate change and pollution to labour practices, consumer privacy and corporate competitive behaviour.

Governance failures at banks and corporations contributed to the Asian and global financial crises. Social risks, for example in the case of inequality, may tempt policymakers to unduly facilitate household borrowing for consumption and could lead to financial instability over the medium-term.

And environmental catastrophes have caused large losses to firms and insurers. Hence efforts to incorporate these kinds of considerations in finance which started 30 years ago accelerated only in recent years.

Elements of ESG principles -- particularly on corporate governance -- have long been incorporated in portfolio investment strategies. Today, the assets under management of ESG-related funds range between 3 trillion and 31 trillion dollars depending on the definition.

Applying principles of sustainability began in equities markets through investor activism as an attempt to influence corporate action. Later, it extended to fixed income markets primarily with bonds that finance environmental projects, the so-called green bonds.

Mixed evidence on the performance and impact of ESG funds makes it challenging for investors, especially public sector pension funds, to incorporate these principles in their investments.

Firms face challenges as well. Although they stand to benefit from integrating ESG factors in their business models, the positive outcomes are usually long term. But the high costs of the disclosure are immediate.

For sustainable finance to effectively address critical risks, said IMF, urgent and decisive policies are needed in four key respects. One: standardisation of ESG investment terminology as well as clarifications of what activities constitute ESG. Two: consistent disclosure by firms to incentivise investors to use ESG data.

Three: multilateral cooperation to encourage participation from more countries and avoid setting different standards. And four: implementation of policies incentivising investment in sustainability and requiring public disclosure of the cost of inaction.