Financing environmental change: a new role for Canadian environmental law.

• Author: Richardson, Benjamin J.

Financial institutions occupy a central role in equity and debt markets, providing the finance that shapes economic development and thus environmental pressures. Environmental regulation has traditionally focused on development itself but not those that financially sponsor developers. To achieve an environmentally sustainable economy in Canada, new regulations and policies to promote environmentally friendly financing in the financial services sector are necessary. This article explains why financing environmental change is crucial, surveys the main private financial institutions in Canada relevant to this task, and makes recommendations on how financial regulation and its broader institutional context can be reformed to support sustainable development.

Les institutions financieres occupent une place centrale dans les marches boursiers et obligataires. Elles fournissent les ressources financieres modelant le developpement economique et les pressions environnementales qui en decoulent. Au Canada, la reglementation environnementale s'est traditionnellement concentree sur le developpement economique plutot que sur son financement. Pour developper une economie durable, il est necessaire d'enoncer de nouveaux reglements et politiques promouvant des pratiques de financement respectueuses de l'environnement dans le secteur des services financiers. L'auteur explique les raisons pour lesquelles il est crucial de financer le developpement durable, passe en revue les institutions financieres pertinentes a cet egard, et recommande des reformes de la reglementation financiere et de son contexte institutionnel.

Introduction I. Environmental Aspects of Financial Markets A. Sustainable Development, Capital Allocation, and Financial Institutions B. The Ethical Investment Movement C. Environmentally Responsible Financing in Canada II. Reforming Financial Markets Regulation A. The Marginalization of Environmental Policy B. Bringing the Environment into Financial Services Regulation C. New Policies to Link Environmental Performance to Financial Performance D. Addressing the Heterogeneity of the Financial Sector III. Regulating for the Financing of Environmental Change: The Wider Context A. Corporate Governance B. Economic Instruments C. Environmental Liability for Financial Sponsors D. Corporate Environmental Reporting Conclusion Introduction

Environmental regulation in Canada, as in most other nations, hardly addresses the financial services sector--the banks and investors that finance development. To most environmental lawyers, this might seem a strange comment, as the province of environmental law is not normally associated with banks, pension funds, or other financiers. If anything, those who trade in money are seen as rather environmentally innocuous or irrelevant, away from the main action, whether it be tackling forestry companies in British Columbia or prosecuting midnight polluters in Ontario. Although Canada has made great strides in improving its environmental laws since the 1970s, this lack of interaction between environmental and financial policy is arguably Canadian environmental law's greatest handicap. Because financial markets shape decisions concerning future development and thus resulting environmental pressures, the reform of investment, banking, and other financial services to promote more environmentally sensitive financing should be a government priority.

The challenge for Canadian policy reformers, therefore, is to find ways to embed environmental standards and responsibilities into financial markets. Quite simply, when granting a loan for a development project or investing in a company's shares, financial organizations must be encouraged to take into account the possible environmental impacts of their financing. Notions of environmentally responsible behaviour must be extended beyond the companies that develop, pollute, and consume to include the financiers that make possible--and profit from--these often harmful activities. While financiers might wish to eschew supporting polluting activities where such activities directly erode investment returns or pose a credit risk, more often than not, environmental considerations tend to be ignored or trivialized by financiers. "Defensive" banking to avoid obvious environmental risks and to check that clients meet existing environmental regulations is usually insufficient to promote substantial change in corporate environmental performance.

This article considers how financial institutions can be reformed to promote environmentally responsible financing ("ERF"). It begins by examining the relevance of financial markets to sustainable development and the various techniques by which ERF is currently being furthered in Canada. Differences between pension plans, mutual funds, and other financial organizations are highlighted, as environmental reformers need to be sensitive to the institutionally specific characteristics of financial market entities. More generally, the article also canvasses broader reforms to financial markets as a whole, such as corporate governance and environmental reporting improvements. In addition to the Canadian perspective, some pertinent reforms from other countries such as the United Kingdom, United States, and Australia are considered to illustrate possible new directions for Canadian environmental law.

1. Environmental Aspects of Financial Markets

   1. Sustainable Development, Capital Allocation, and Financial Institutions

      The biggest environmental impact of private financiers is not their own ecological footprint, but their strategic role in allocating capital to other businesses. (1) Since the financial sector sponsors and profits from economic development, it arguably should share responsibility for ensuring that such development does not harm the environment. If economic growth is to be kept within ecological limits, market institutions that finance growth must be given the right directions, incentives, and information so that financial resources shift from polluting industries in favour of environmentally benign activities. Once appropriately informed and guided, financial institutions would, through their investment decisions, conditions of financing, and monitoring of companies, become an instrument of environmental governance. (2) Given their ability to provide financial leverage, financial organizations are in effect "gate keepers" to the economy. Schemes to diffuse environmental policy more effectively through the market must therefore target those strategically placed financiers that have the capacity to communicate and enforce policy goals and standards.

      Financial institutions are gate keepers principally because they have amassed vast empires of financial assets. The "institutionalization" of financial markets has put these assets increasingly into the control of banks, pension funds, and other financial institutions, rather than into the hands of individual retail investors. (3) The contraction of public sector financing for development has also been a factor in shaping the phenomenal rise in the number of private financial institutions. Philanthropic bodies including religious groups, universities, and foundations also participate in financial markets, but the vast bulk of money flows through private financiers. In 1997, institutional investors including mutual funds owned nearly fifty per cent of all shares in Canadian publicly traded corporations, up from ten per cent as recently as 1988 and considerably higher than a miniscule one per cent in the late 1970s. (4) By 1998, Canadian institutional investors had amassed financial assets equal to almost 116 per cent of the country's GDP, with pension funds holding the largest share. (5)

      Financial service providers are also risk takers, seeking to profit from the transformation of capital into a development resource. (6) Although businesses fund the majority of their investment projects from the income they generate through sales and other activities, both the development of new businesses and the expansion of established businesses often require turning to the financial markets. Businesses have two main choices for raising money in the financial markets--debt and equity financing. Firms perceived by financiers to pose a greater risk of business failure or underperformance can expect to pay higher rates of interest than others. Similarly, the higher rate of return required by equity holders will force the firm's stock price down.

      Contrary to economic theory, however, empirical evidence suggests that financial markets do hot always allocate capital efficiently. Unsustainable, speculative bubbles may suck in financial resources at some times, while underinvestment can arise at other times or in other sectors. Such distortions can be attributed to the "herd mentality" of investors, along with a preference for quick profits. (7) In the process, financiers are prone to ignoring the social and environmental effects of company and project investments unless they are perceived as "financially relevant". Numerous studies highlight market failures to address environmental impacts, including the undervaluation of ecological properties, the discounting of future environmental costs and benefits, (8) and an inability to address the problem of "scale', that is, keeping aggregate resource use in the economy within biosphere limits. (9)

      Even critics who ignore the ecological weaknesses of financial markets acknowledge a telling distinction between the "real" economy and "real" investment on the one hand and the "financial" economy and its often ephemeral investments on the other. (10) The real economy involves investments in functional goods and services, such as manufactured products, buildings and transportation, as well as investment in services such as health care and education. By contrast, the financial economy, managed by banks and investors, emphasizes securities trading...