Ethical Foundations and Governance in Sustainable Finance
Finance exists within a broader ecosystem of social norms, environmental constraints, institutional responsibilities, and moral expectations. As financial systems expand their influence into nearly every dimension of modern life, the ethical responsibilities of businesses, investors, and institutions must be clearly defined and rigorously evaluated. Understanding how financial decision-making intersects with ethics and governance is essential for aligning capital with long-term value creation.
Ethical Theories of Business Responsibility
Business ethics is shaped by competing perspectives on who should benefit from economic activity and how responsibility should be distributed. Three foundational theories guide the debate.
- Shareholder Theory
Popularized by Milton Friedman in 1970, shareholder theory maintains that the primary duty of a corporation is to increase its profits for its owners, as long as it operates within legal and ethical boundaries. According to this view, the only responsibility of business is to its shareholders. Profit maximization is seen as both a right and a duty, with social and environmental concerns considered secondary unless they affect financial performance.
- Stakeholder Theory
This view, introduced by Edward Freeman in 1983, holds that companies must account for the interests of all stakeholders, not just shareholders. Stakeholders include employees, customers, suppliers, local communities, and others who are directly or indirectly impacted by the firm’s activities. This theory expands the scope of responsibility but does not inherently define what obligations the firm has toward each group.
- Stakeholder Contract Theory
An extension of stakeholder theory, this view incorporates a moral framework derived from social contract theory. It sees the relationship between a company and its stakeholders as a voluntary exchange in which each party offers something of value and expects fair treatment in return. Employees offer labor in exchange for a living wage. Customers pay for products with the expectation of quality and safety. These exchanges imply mutual obligations, and the legitimacy of a firm rests on its ability to deliver reciprocal value without coercion or exploitation.
Reordering Economic Priorities
Modern economics often places financial value at the center, treating social and environmental outcomes as peripheral. This inversion of priorities fails to reflect the foundational role that ecological systems and social cohesion play in supporting market activity. Environmental stability is the prerequisite for societal functioning. A functioning society enables economic activity. Financial systems are dependent on both, not the other way around.
Reordering these layers of value places ecological thresholds first, social systems second, and financial systems last. This hierarchy acknowledges that economic systems must operate within planetary boundaries and social norms to remain viable. Finance must adapt its frameworks to reflect this reality.
The Tension Between Short-Termism and Long-Term Value
Short-termism dominates much of the financial system. Quarterly reporting, benchmark tracking, and rapid trading discourage long-term thinking. This short-sightedness obscures systemic risks and undervalues investments that generate long-term public benefits.
Several forces are driving change:
- Financial actors are recognizing their exposure to climate risk, stranded assets, and unsustainable resource dependencies. Rising flood risks, extreme weather events, and regulatory shifts directly impact portfolio value.
- Public pressure has increased. Consumers and civil society organizations now hold companies accountable for environmental damage, labor abuse, and unethical practices. Brand reputation is a material asset.
- Third is a generational shift underway within the financial sector. Younger professionals increasingly expect their work to support sustainable outcomes and align with ethical standards.
Aligning Incentives with Long-Term Sustainability
Several strategies can support a transition to long-term thinking.
Treating environmental and social risks as financial risks allows them to be managed within standard frameworks. Companies that rely on vulnerable supply chains, polluting technologies, or exploitative labor practices face legal, operational, and market risks.
Compensation structures can be reformed to reflect long-term performance. Executive pay linked to three-year sustainability performance metrics encourages alignment between strategic decision-making and societal impact.
Loyalty shares reward long-term investors by offering additional voting rights or share bonuses after a holding period. This encourages stable ownership and reduces volatility caused by short-term speculation.
Examples of Alignment in Practice
Pension funds and institutional investors are adopting ESG criteria in asset allocation. Some Dutch pension funds have pledged to halve the carbon footprint of their investment portfolios. This commitment involves shifting capital from fossil fuel assets to lower-carbon alternatives.
Philips received a one billion euro credit facility with interest rates tied to its sustainability performance, verified by third-party evaluations. This structure lowers the cost of capital as sustainability metrics improve, incentivizing better environmental outcomes.
The Limits of Market Solutions
Markets alone cannot solve the problem of externalities. The financial sector remains heavily skewed toward short-term gains, especially in Anglo-American economies. Shareholder primacy continues to dominate boardroom thinking.
Regulation is essential. Carbon taxes, mandatory disclosures, and environmental standards create baseline expectations that force financial institutions to adjust. Without government action, even the most responsible investors lack the tools to price externalities correctly.
Governance Failures and the Role of Hybrid Institutions
Governance failures are evident across all sectors. Private sector actors may prioritize shareholder returns over sustainability. Civil society may lack coordination. Governments may be captured by special interests or fail to implement effective policies.
Each of the three institutional spheres (public, private, and civic) has inherent limitations. However, when these spheres collaborate, they can offset each other’s weaknesses. Hybrid institutions such as universities, cooperatives, public-private partnerships, and state-owned enterprises often play a central role in delivering public goods and managing long-term risk. These institutions represent the majority of economic activity in many countries and are designed to balance multiple objectives beyond profit.
Managing Common Goods
Common goods such as stable climates, biodiversity, and global health are systematically under-provided. The tragedy of the commons arises when individuals or firms deplete shared resources for private gain. Solutions require collective governance, shared responsibility, and transparent metrics of accountability.
Ethical Accountability and Mission Alignment
Corporate mission statements are evolving. Where firms once focused solely on market dominance and profit, many now include social impact goals. Some companies commit to improving global health, eliminating exploitative labor, or addressing food security. However, mission statements without metrics are meaningless.
Measuring non-financial performance is critical. Companies must assess environmental footprints, labor conditions, and governance standards alongside financial results. Investors need to ask whether companies are delivering on their stated social and environmental objectives. Metrics must be tracked, evaluated, and integrated into decision-making processes.
Failure to measure impact leads to misalignment between public promises and actual outcomes. Without non-financial indicators, companies cannot manage the risks or realize the opportunities that sustainability presents.