Credit Substitution in Sustainable Finance: An Achilles Heel?

Abstract Sustainable finance has become mainstream, with governments and stakeholders relying on financial players/channels to prod real economy firms into addressing environmental and social issues. An overlooked, yet significant problem with this idea is credit substitution—where firms replace their ‘exiting’ creditors or investors. This significantly weakens the effect of ‘exit’ and results in the migration of problems or risks associated with lending and investment to new entrants. This article examines credit substitution in theory and practice, focusing on its implications for sustainable finance. It argues that the current regulatory framework and broader ecosystem for financial institutions worldwide create conditions highly conducive to credit substitution. Key factors include substantial cross-jurisdictional differences in approaches towards sustainable finance among major financial centres and cross-sectoral differences within jurisdictions—particularly in the EU—where sustainable finance regulations vary between bank-based and market-based financing. These conditions undermine the effectiveness of sustainable finance policies. If the aim is to address environmental and social impacts in the real economy, such policies are diluted; alternatively, if focused on managing financial risks associated with lending to and investing in firms causing these impacts, the result is only migration, rather than mitigation, of risks. The article concludes with policy implications.