There are high hopes associated with “Sustainable Finance”. A sustainable financial system is supposed to steer capital, support the transformation of the economy, and thus help to achieve the Paris Climate Goals.

However, our report shows that the financial system has fundamental deficits that are holding back a positive impact on sustainable economic transformation. Even if significantly stricter financial market rules than those planned so far are implemented, the financial system alone cannot fix it. This is because the sustainable transformation requires active political management and the right framework conditions.

Greenwashing in the financial market

One hope is that the financing conditions for sustainable investments will be improved if the financial market distinguishes between “green” and “dirty” investments. Investments that are harmful to the climate should thus become more expensive and less attractive. But already the definition of “sustainability” poses problems.

The planned classification of natural gas and nuclear power as sustainable economic activities under the EU taxonomy is just one of the latest developments. With this, nuclear power and natural gas can also be financed by “green” investments.

“Greenwashing” makes it difficult for investors to invest their money in a sustainable way. An investigation by Finanzwende Recherche into “sustainable” equity funds available in Germany shows that, on the whole, their investments hardly differ from those of conventional funds.

Reliable information is lacking

Moreover, sustainability reports from companies are often neither meaningful nor comparable. Also, it is unclear to what extent credit rating agencies currently take climate risks into account. Yet their ratings are a widely used basis for decision-making by financial players. Sustainability ratings, which assess the environmental and social performance of companies, are also a mess, as our report explains.

Stricter green financial market rules could partially remedy the situation. A taxonomy free of gas and nuclear, a reliable consumer label, uniform sustainability reports, transparency in credit ratings, and standardized sustainability ratings could significantly improve the situation.

Sustainability vs. abundance of capital

However, green financial market regulation will not address the fundamental deficits of the financial system. Financial market players invest in projects as long as they have the right balance of risk and return. However, too many profitable investments are harmful to the climate because their risks are not sufficiently priced in. That’s why both “green” and “dirty” companies have been able to get cheap financing so far.

One good example is the Saudi Arabian oil company Aramco. Although oil as a fossil fuel is anything but sustainable, the company had the biggest IPO ever. The case shows that, due to the abundance of capital on financial markets, there is not a sufficient shift in favor of climate-friendly investments. Instead, massive investments continue to be made in areas that stand in the way of a sustainable transformation of the economy.

Short-term profit orientation and long-term transformation

Many common financing models and their expected returns on the financial market also make the transformation more difficult. Models such as venture capital or private equity funds are focused on short-term profits and expect very high returns – often a mismatch with the long-term investments that are needed.

Large financial players such as BlackRock are therefore lobbying for the state to take on the risks for them in less profitable and possibly riskier investment objects. The idea is that investors provide the capital and get the profits – virtually risk-free because the main share of risk and therefore potential losses is transferred to the public.

Instead of this, consumer-friendly financing instruments, especially for investments with a long-term impact but limited profitability, could be a way forward. For necessary projects for which private investors are not suitable at all, public financing might make more sense.

The limits of sustainable finance

Ambitious green finance rules that go beyond those currently planned can make a relevant contribution. But that alone will not sufficiently advance the transformation of the economy. Obstacles such as the abundance of capital, extreme return expectations, and the short-term nature of investments stand in the way of restructuring the economy despite green finance rules. Therefore, in addition to a sustainable financial system, the right economic framework conditions are needed. Proposals for this are on the table: a higher price for carbon emissions, climate-appropriate subsidies and a suitable industrial policy.

Only in this way will environmentally and climate-damaging investments no longer be financially rewarding. The state should define a transformation path that ensures the sustainable transformation of the economy and at the same time makes financial actors invest in sustainable investments.