Sustainable transformation must go beyond the environment

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The economic implications of the transition for capital markets must also be considered, writes Marcus Pratsch, head of sustainable bonds & finance, DZ BANK AG.

COP28 signalled the beginning of the end for the fossil fuel era. The final document states an intention ‘to transition away from fossil fuels in energy systems, in a just, orderly and equitable manner’. This is important and right. Never before has action on fossil fuels been explicitly part of a COP decision.

However, in the context of the global sustainability agenda and from a capital market perspective, it is important not to view transformation too narrowly. From an environmental perspective, it must go beyond the energy transition to include nature-related issues, such as preserving biodiversity.

The transformation has four interrelated dimensions that influence each other: economic, environmental, social and governance. These dimensions require a socio-economic transformation to create sustainable change, while reducing inequalities and ensuring that the costs and benefits of transition are fairly shared, and that good governance, fundamental labour principles and human rights are respected.

The economic dimension is particularly important in relation to the capital market where an effective transformation is about a more sustainable economy as a whole, not just the growth of the already green economy.

This requires a supportive financial architecture that helps to close gaps in the transition financing architecture. The availability of material and high-quality data, credible disclosures, usable taxonomies as well as ambitious transition plans will help to create this. There is also a need to remove market barriers and facilitate access to the transition finance market.

Why a successful transition is economically important

The conversation in capital markets has matured in recent years. We have moved from talking about investing in climate to investing in transition. When making sustainable financing decisions, care must be taken to ensure that sustainability and economic growth are balanced.

Let's take Germany as one example. The German real economy is undergoing a fundamental transformation in the face of environmental and social challenges, digitalisation and a new era of globalisation. Massive investments are needed to make business models and production methods fit for the future and to benefit from the opportunities of sustainable development.

Germany already has many large, global market leaders as well as smaller ‘hidden champions’ with regard to sustainable products and technologies – not only from an environmental point of view. At the same time, there are many companies in Germany that have great potential for change, but are still at the very beginning of their sustainable transformation. This is quite natural because the transition does not happen overnight. For some corporates, a successful transformation is also key to keeping their licence to operate.

A successful transformation requires substantial changes in the structure of the economy. It will have major implications for the capital stock, capital allocation and the nature of innovation. Making the economy more sustainable would require significant investment in the creation of new physical assets and the transformation of existing ones. Stranded assets are no longer able to generate a return.

While the innovation required to develop sustainable technologies is a major challenge, it could bring significant benefits in terms of knowledge transfer to the rest of the economy. It also offers major economic opportunities for growth and job creation. Workforce requirements would be subject to change as markets are reshaped and organisations adopt new operating practices and processes. While jobs will be lost in some sectors, more will be created in others. The increase in employment and investment will stimulate the output of the economy, leading to a net increase in gross domestic product.

The financial sector plays a key role in this process. It must be a reliable financing partner to support all sectors and industries in their sustainable transformation to maintain and strengthen strategic know-how and value creation in Germany.

A more sustainable world will not be achieved by focusing exclusively on business models that are already ‘dark green’. We can have a much greater positive impact on the global sustainability agenda by helping to make less sustainable economic activities more sustainable rather than making already green economic activities a shade greener. No one should be excluded from sustainable financing. The financial sector must therefore also accompany ‘future champions’ on their way to sustainable market leadership.

This will help to protect the competitive position of large German world market leaders and hidden champions from sectors that are still at the beginning of their transformation path. The new credo needs to be: ‘transform instead of divest’.

In the past, many sustainable and responsible investors focused on strategies such as exclusions or best-in-class approaches. Those who did not fit into the grid were sold. Today, investors look more at the transformation potential of the real economy. Identifying the sustainable companies of tomorrow is becoming increasingly important. The possibility of divestments always remains – but only as a last resort if the company leaves the promised, credible transformation path.

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