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Rethinking Capital: the Larger Lessons of the Financial Crisis

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Rethinking Capital: the Larger Lessons of the Financial Crisis 14578 FFF Annual report V4 15/6/09 11:55 Page 1 rethinking capital: the larger lessons of the financial crisis june 2009 14578 FFF Annual report V4 15/6/09 11:55 Page 2 Forum for the Future - the not-for-profit sustainable development organisation - works in partnership with more than 120 leading businesses and public sector bodies, helping them devise more sustainable strategies and deliver these in 1 the form of new products and services. Our vision is of business and communities thriving in a future 2 that is environmentally sustainable and socially just. We believe that a sustainable future can be achieved, that it is the only way business and communities will prosper, but that we 3 need bold action now to make it happen. We play our part by 3.1 inspiring and challenging organisations with positive visions of a sustainable future; finding innovative, practical ways to help 3.2 realise those visions; enabling leaders to bring about change; 3.3 and sharing success through our communications. 3.4 3.5 www.forumforthefuture.org Author: Alice Chapple Registered charity number: 1040519 Company limited by guarantee: 2959712 Registered office: Overseas House, 19-23 Ironmonger Row, London, EC1V 3QN Enquiries: 020 7324 3630 or [email protected] Publication of this report has been supported by The Co-operative Group. 14578 FFF Annual report V4 17/6/09 10:08 Page 3 contents executive summary 3 1 introduction 5 2 diagnosing the problem: why capital markets fail 6 3 finding solutions: where to focus attention 10 3.1 rethinking risk assessment and asset valuation techniques 10 3.2 recapitalising – and not just the banks 14 3.3 stimulating investment in low-carbon, resource-efficient assets 17 3.4 re-regulating capital markets 22 3.5 new models of sustainable growth 27 conclusion 30 14578 FFF Annual report V4 15/6/09 11:55 Page 4 executive summary introduction To encourage this dialogue and help create a momentum for change, Forum for the Future will be convening some round This paper is about why capital markets fail, and what might table discussions to refine some of the broad help us emerge from the current financial crisis with more recommendations outlined in this paper. In each of the five resilient, equitable and sustainable systems. Developing some areas we have identified as requiring attention, this paper key themes from Jonathon Porritt’s pamphlet Living within our suggests the people and organisations that could usefully Means (March 2009), it highlights five areas that require collaborate in refining the recommendations. particular attention: diagnosing the problem: why capital 1 rethinking risk assessment and asset valuation techniques markets fail Capital markets fail for a number of interlinked reasons, 2 recapitalising – not just the banks, but social and including: natural capital too • incentives are not aligned with the public good 3 stimulating investment in low-carbon, resource- efficient assets • critical goods and services are not valued or are under-valued 4 re-regulating capital markets – including remuneration • we lack imagination and awareness about new 5 exploring sustainable growth. and systemic risks In each of these areas, it highlights important initiatives and • regulation is inadequate identifies what we need to explore. There is an enormous amount of great work being done, but at present this is not • ‘progress’ is based on unsustainable growth sufficiently joined-up. The public sector, the private sector models fuelled by credit. and the NGO and academic communities can bring their different perspectives to bear on finding solutions. This paper aims to provide a platform for dialogue between them. 3 14578 FFF Annual report V4 17/6/09 10:18 Page 5 finding solutions: where to and private investors to deliver funding aligned with the focus attention public good. We need to explore: ways to engage 4. re-regulating capital markets – including the private sector in the recapitalisation programme; remuneration new financial mechanisms to facilitate partnerships Existing incentive structures promote a preoccupation with between the public and private sectors; and the 1. rethinking risk assessment and asset valuation short-term returns. This results in a mismatch between the potential for such partnerships to deliver funding on techniques interests served by the capital markets and the interests of a sufficient scale. The failure of risk assessment has been an obvious feature society as a whole. Firmer regulation can better align the two, ensuring that systemic risk is accounted for and of the financial crisis. We can learn from this to create a And we need to look at how to demonstrate that managed, and that incentives both for money managers system that is much more effective in managing risks – and up-front investment has benefits that substantially outweigh and for investors are based on longer-term perspectives. has a very different approach to valuing capital, including the costs over the medium-term. social capital, ecosystems and biodiversity. Key elements This, in turn, will lead to improved methods of risk of this could include: assessment and valuation, and shift the emphasis onto sustainable patterns of growth. 3. stimulating investment in low-carbon, • redesigning financial accounting procedures so that resource-efficient assets critical social and environmental issues are embedded in decision-making; The current set of global stimulus packages involve very 5. exploring sustainable growth substantial sums of money. However, we must look Current growth models are unsustainable. Many people • broadening the focus of rating agencies beyond solely critically at how far they combine the goals of generating would question whether economic growth that relies on short-term factors; economic growth and employment with the imperative for a increasing resource use can ever be sustainable. Certainly transition to a low-carbon, resource-efficient and equitable • introducing more effective scenario planning and we need to rethink our focus on GDP growth as a measure economy. Moreover, since this transition will require such a wider stress testing; and of success. But the financial system in particular relies on massive shift in investment, much of it necessarily coming an assumption of continuous growth – to repay credit plus from the private sector, we need to consider whether there • developing partnerships between public and private interest. So we need to examine what fundamental are suitable incentives in place. When current price signals sectors that can close the gap between short-term changes are required in this system, and explore: drivers of shareholder value and longer-term drivers are weak, we need to look at how private sector financial of public good. institutions can act, individually or in sector collaborations, • the extent to which business models to support to shift their portfolios to reflect the long-term interests of sustainable consumption can deliver growth that is their clients. And we need to explore the opportunities 'decoupled' from the depletion of environmental capital; arising from investment in adaptation, as well as 2. recapitalising – not just the banks, models for risk-sharing between the public and • how certain structures are better suited to delivering but social and natural capital too private sectors. sustainable growth; and The depletion of social and natural capital arises largely because we don't value them adequately. Halting and • the mechanisms that will be required for capital to be reversing this trend will require a combined effort by public allocated to activities that create sustainable growth. 4 14578 FFF Annual report V4 15/6/09 11:55 Page 6 1. introduction The dramatic failure of the capital markets over recent months has caused shock and anger. It has brought widespread calls for fundamental reform. It has also initiated a much wider, and at times philosophical, discussion about the systems and values that made such a disaster possible. These themes have been explored in a recent pamphlet by Forum for the Future founding director Jonathon Porritt, Living within our Means.1 This paper takes up some of these themes and outlines some of the relevant work that Forum and others have been doing to identify, explore and address the barriers to sustainable financial markets. As a sustainable development organisation working with business in general, and with the financial markets in particular, Forum for the Future has a unique perspective on the crisis. It is well-positioned to catalyse a discussion about the sustainable solutions. Our expertise in leadership, innovation and futures provides fresh perspectives on how we can deliver these solutions. We hope that this paper will create a platform to bring together private and public sector organisations and NGOs, alighting on pinch points for change. Part of its purpose is to stimulate debate, and to help in gathering ideas on how some of the key issues are being tackled – or how they could be. 1 Porritt, Jonathon, Living within our Means, Forum for the Future, March 2009 5 14578 FFF Annual report V4 17/6/09 10:08 Page 7 2. diagnosing the problem: why capital markets currently fail Left to their own devices, do capital markets act in the there is public outcry over the size and unconditionality of We are going to need a wide range of solutions here, public interest by ensuring the most efficient allocation of remuneration. And in particular it is seen as inappropriate because of the different nature of the incentives built into capital? Before the current financial crisis, voices could be that the individuals who gained so much during the good the system. These are explored in section 3.1. heard arguing that they do, with capital markets moving to years do not see a corresponding clawback during reflect appropriate prices (for example for scarce goods, or the downturn. to provide an appropriate reward for risk) if and when the ii) critical goods and services are not valued, or are need arises.
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