|Leverage for the Environment - A Guide to the Private Financial Services Industry (WRI, 1998, 108 pages)|
This guide is designed to acquaint members of the public interest community with the inner-workings of the private financial services industry so that they will be able to communicate to financiers the importance of environmental issues and promote environmentally sustainable development paths in developing and transition economies. The materials assume that readers have no prior knowledge of the industry and attempt to provide the nonspecialist with the minimum level of information and understanding necessary to participate in a strategic planning discussion. As noted by one reviewer, these materials look with binoculars at institutions and transactions that are usually studied under a microscope. This guide is intended to help readers generate the right questions about designing a strategy for influencing the private financial services industry rather than supplying the right answers or selecting particular tactics.
Scope of This Guide
This guide focuses on the activities of the private financial services industry, which is only one part of the global finance landscape. It does not address public international financial institutions such as multilateral development banks or bilateral export credit agencies, except where operations of these public entities intersect with private financial transactions. This guide focuses on financial flows that enter capital markets, and thus does not treat foreign direct investment by operating companies, which currently represents the most significant component of total private transboundary financial flows to developing and transition economies. Similarly, this guide does not cover private transfers, such as investments made by "angels," wealthy individuals who invest significant sums directly in private enterprises. Rather, the focus is on mainstream financial institutions and instruments and not on so-called "socially responsible investment" (SRI) vehicles, although SRI trends are discussed where appropriate. In the context of strategic planning, the reader should consider the potential impact of leverage points within the private financial services industry relative to opportunities for influence in these other public and private investment arenas. Finally, this guide is not intended to be comprehensive, nor to serve as a "how-to" guide for advocacy directed at the financial community.
Variations Across Countries
Because international capital markets are concentrated in industrialized countries and there is only limited information on such activities in non-industrialized countries, this guide is based on how the financial services industry operates in the United States. Accordingly, readers must keep in mind the huge variations across countries in terms of opportunities to influence the behavior of private investors, creditors, and underwriters. In emerging market economies, regulatory frameworks, information disclosure requirements, and enforcement capacity are likely to be less well developed in both the financial and environmental spheres than is the case in industrialized countries. For example, the threat of being held legally liable for environmental damage has been a critical factor in getting the U.S. commercial banking and insurance sectors to pay attention to environmental issues. However, in countries where environmental standards and judiciary systems are weak, the financial industry faces a different set of incentives.
Segments of the Industry
This guide introduces readers to eight segments of the private financial services industry: commercial banks, investment banks, mutual funds, pension funds, property and casualty insurance, life insurance, venture capital, and foundations. The first six capture the largest financial services industry segments or vehicles in terms of the magnitude of assets that they control or manage. They are presented in order of relative size. Bonds, which are an increasingly important source of finance for developing country governments, are discussed briefly in the investment banking segment. The venture capital industry is presented because it is a rapidly growing and evolving area in developing and transition economies, it is linked to international financial institutions such as the World Bank Group's International Finance Corporation, and it is highly flexible due to lack of regulation and high tolerance for risk. Foundations - which make both programmatic and endowment-related investments - are presented as an example of institutional investors of particular interest to the public interest community.
Some of the eight segments are defined by type of institution (e.g., commercial bank); others are defined by type of vehicle (e.g., mutual fund). Note that the lines separating these various types of financial institutions have become increasingly blurred, and therefore their definition should be understood at the functional level of an operating business unit. The eight segments include principal examples of financial institutions that provide the three types of financial service functions: credit extension, equity investment, and underwriting activity. Extenders of credit, such as commercial banks, provide debt financing by making loans to enterprises; investors, such as pension funds, provide equity to enterprises by purchasing stock in companies; risk underwriters, such as property and casualty insurers, help enterprises manage risk by receiving premiums in exchange for compensation of loss. Note, however, that many of the segments are in at least two businesses. For example, the property and casualty insurance industry is in the risk underwriting business, but this industry is also a significant investor in capital markets.
HOW TO USE THIS GUIDE
This guide contains one chapter for each of the eight industry segments with the following information available on each type of financial institution:
· Introduction: What is the industry?
What services does it provide? How does it make money?
· Size and Leaders: What is the relative size of the industry globally, and which are the most prominent firms?
· Key Features: What else is important to know about the industry? What is the industry's risk tolerance and time horizon? What are significant variations and trends in the industry?
· Regulation: How is the industry regulated, and what information disclosure is required?
· Attention to Environmental Issues: To what extent does the industry currently integrate environmental factors into its decisionmaking?
· Relevance to Developing and Transition Economies: What activities of the global industry influence industry operations or capital flows to nonindustrialized countries? To what extent is a domestic financial industry developed in these countries?
Each sector profile also includes a bar chart depicting that segment's regulation, time horizon, risk aversion, and availability of information. We assume that a higher degree of regulation and information availability provide external actors with more opportunities for influence, and that more risk aversion and longer time horizons increase the relevance of environmental considerations to financial decisionmaking.
For each industry segment, this guide presents a diagram that shows flows of capital and information between the industry segment and external actors. The diagrams use a common set of symbols, as illustrated in Figure 1.1:
· Cross-hatch shading represents the
diagrams starting point, or where demand for the financial service originates.
· Blue boxes represent the financial entity. Within the blue box, there is a central decisionmaker and the entity's main operational units.
· Orange boxes represent the corporate client.
· Black boxes represent entities external to the firm or vehicle.
· Yellow boxes represent activities.
· Green circles represent sources or uses of capital.
· Green arrows represent flows of money.
· Black arrows represent flows of information or influence.
· Dashed arrows represent optional flows of information.
· Red circles with a letter "L" represent potential leverage points.
The diagrams provide a visual "map" of the relationships among various actors internal and external to the industry segment. Each diagram is accompanied by an explanation that guides the reader through the diagram's various elements and discusses the activities and roles played by the various functional participants in a transaction.
For each industry segment, we have identified a preliminary list of potential "leverage points" for influencing various actors to integrate environmental considerations into decisionmaking. The identified leverage points are intended to serve as a starting point for discussion by the public interest community in the context of strategic planning, and are not intended to be comprehensive or prioritized.
The guide focuses on leverage that external actors can exert on the private financial services industry. In some cases, however, we have also noted opportunities in which the financial services industry itself can exercise leverage over capital markets or over other corporate entities. For example, the proxy power held by pension funds and foundations is identified as a leverage point to influence the operating companies in which these institutions hold shares. Leverage points are described in this guide in terms of four types: bottom-line leverage, policy leverage, reputational leverage, and values-based leverage.
Bottom-line leverage uses information or analysis to demonstrate to financial decisionmakers that taking environmental performance into account will directly result in improved financial performance. Bottom-line leverage appeals to a decisionmaker's desire to avoid environmental risk and identify new profitmaking activities. It is important to stress that most professionals in the mainstream financial services industry - including fund managers, analysts, financial advisors, and ratings agencies - are interested in environmental considerations only to the extent that they can be translated into financial gains or losses. Unfortunately, empirical data and analysis conclusively linking environmental and financial performance remain limited and are inadequately disseminated throughout the financial community.
Policy leverage exploits the sensitivity of financial decisionmakers to changes in regulations or to taxation consequences related to environmental performance. Legislators, courts, and government agencies set the "rules of the game" for standards to be achieved, for information to be disclosed, and for remedies for noncompliance. Tax policies provide incentives or disincentives for certain kinds of investing, lending, and underwriting behavior. Some types of policy leverage - such as banning certain pollutants or imposing a carbon tax - affect the financial services industry indirectly through their impact on corporate valuation. This guide focuses on regulatory or tax-related leverage points specific to the financial services industry.
Reputational leverage exploits the sensitivity of financial decisionmakers to information or analysis that demonstrates that taking environmental performance into account - or failing to do so - will have an impact on a financial institution's public image (and thus perhaps indirectly on the bottom line). Actions that generate positive or adverse media attention are examples of reputational leverage. Firms that have a high level of brand name recognition - such as a commercial bank with a significant consumer base - are more susceptible to reputational leverage.
Values-based leverage exploits the willingness of individual and institutional investors to promote environmental values even at the possible expense of financial value. The socially responsible investment (SRI) movement has utilized this leverage to deny funds to corporations that cannot pass various social and environmental "screens," and to attract funds for socially or environmentally friendly companies.
Each chapter in this guide includes a case study that illustrates how leverage was applied to or by the financial services industry in the interest of environmental change. Each case study presents the background to the case, the action taken to effect change, the resultant outcome, and an analysis of the type of leverage exercised and its effectiveness.
Available Information and Bibliography
For each industry segment, we suggest places to find additional information - particularly on the Internet - and list the sources we found most useful in compiling the industry-specific information.
This guide is designed to be accessible to a relatively sophisticated lay-person, such as the average reader of The Economist. Set out below are definitions of a few key concepts to ensure a common understanding of terms.
Debt versus equity. There is an important distinction in capital market transactions between debt and equity. A debt transaction involves a loan, mortgage, bond, or other instrument that requires the borrower to repay the lender in full plus interest. In a public equity transaction, the investor purchases a share of a company, for example in the form of stock, the value of which will vary over time. Possession of equity in a public company usually implies a degree of shareholder control, which can be exercised through shareholder resolutions and voting of proxies. Large companies or projects in developing or transition economies often utilize a mixture of debt and equity to finance their activities. In general, companies in Asian countries have tended to rely heavily on debt finance, while Latin American companies have tended to seek equity investment from capital markets.
Bonds. A bond is a security issued by a corporation or a government, and purchased by an investor. The bond-issuer is obligated to pay the bondholder interest on the principal at a specified rate and to repay the principal at a specified point in time. For this reason, bonds are often referred to as "fixed-income" investments. Bonds are an important means by which corporation and governments raise long capital. On the investor side, because bonds provide predictable income they are the preferred investment vehicle of the life insurance industry, property and casualty insurance industry, and most pension funds.
Underwriting. The term "underwriting" has two distinct meanings in the financial services community, one associated with investments and one with insurance. From an investment perspective, underwriting is the role played by investment banks when they agree to arrange for and guarantee to buy at a set price a new debt or equity security issued by a corporation or a government entity with the intention of selling the security via a private placement or in the public market. Profit is realized by underwriters based on their ability to sell the security at a price higher than the guaranteed purchase price. From an insurance perspective, underwriting is the role played by insurance companies when they assume the financial risk of paying claims for loss or damage suffered by a client in exchange for the client's payment of premiums to the insurance underwriter. The profit realized by insurance underwriters is a function of their ability to estimate accurately the frequency and magnitude of claims that will need to be paid and adjust the price of coverage accordingly.
Risk management. Risk is the perceived chance for a measured increase or decrease in the value of an asset over time. With greater risk, the rational investor demands a greater rate of return. For example, a venture capitalist takes enormous risks by investing in new companies and expects a return of up to ten times or more on the initial investment. In contrast, individuals who put their savings in U.S. commercial banks face virtually no risk and thus earn only a nominal interest rate. Investors often try to diversify their asset holdings to spread risk and usually seek to reduce risk through acquiring additional information about their assets. The mainstream financial services industry tends to perceive environmental considerations in terms of increased risk - for example, potential liability for clean-up costs or negative public relations from an environmental disaster - rather than in terms of the potential for improved environmental performance to generate increased returns.
Intermediation. The private financial services industry is based on the concept of intermediation, that is, an institution serving as a go-between on behalf of parties seeking financing and others seeking a return on capital. Financial intermediation involves making decisions about how to manage large volumes of other people's money. Typically, institutional investors such as pension funds or foundations delegate investment discretion to an asset manager or team. Mainstream asset managers understand their role to be maximizing financial return, and thus do not take environmental considerations into account unless they understand that those considerations will affect financial return or they are specifically directed otherwise.
Securitization. Securitization is the repackaging of multiple individual assets that are too small or risky to attract investors if sold one by one. The assets, such as mortgages, are bundled as bonds or other financial instruments for resale in the secondary market. Some observers see the trend toward increased Securitization as an important opportunity to package small, environmentally friendly investments (such as those in energy efficiency) in ways that are more likely to attract financing from international capital markets. Others are concerned that Securitization severs the direct link between investors and enterprises, rendering asset holders less likely to know or care about the environmental and social impacts of their investments.
The glossary provides additional definitions of a select number of commonly used terms. It was compiled from Barron's Dictionary of Finance and Investment Terms.