The future is green finance

Green finance Green finance is created to ensure a better environmental outcome (Photo by Wall Street International)

Source: Wall Street International Magazine

Date: 5 April 2021

Environmentally friendly developments cannot be achieved unless appropriate funding is made available, and several elements of green finance have been introduced already some two decades ago. It was a logical response to the basic awareness that socially responsible and therefore also sustainable investment should be more systematically and effectively encouraged and supported by distinctly favourable access to and conditions of funding.

As profit margins and risk management remain the key criteria for both investors, as well as fund providers, societies are concerned that those who respect the environmental profile and impact of a project should be fully recognised and supported – in proportion to the environmental excellence criteria.

With the recommendations from the multilateral, actually also the global UN level, many countries have started to develop some instruments and schemes – now labelled as "green finance". Several governments encourage various types of financial institutions to offer favourably differentiated conditions for investors who are respecting all the recommended environmental concerns – in terms of minimizing pollution, energy consumption and contributing to the circular economy.

It is estimated that the total volume of needed green investment – just to comply with the Sustainable Development Goals Strategy – range annually between 5-7 trillion USD. Currently, we are still far from these figures, and the key question is, what should be done to come closer, because – obviously – unless the necessary funding is made available, the Strategy will remain a dead letter on the paper!

What is green finance?

Green finance is any structured financial activity created to ensure a better environmental outcome. It includes an array of loans, debt mechanisms and investments that are used to encourage the development of green projects or minimize the impact on the climate of more regular projects. Typical projects that fall under the green finance umbrella include:

  • renewable energy and energy efficiency;
  • pollution prevention and control;
  • biodiversity conservation;
  • circular economy initiatives;
  • sustainable use of natural resources and land

As mentioned, large amounts of finance are needed to allow for sustainable development and to achieve climate and environmental objectives. Particularly private financial markets are to be mobilised, with public finance serving to leverage such private capital. The G20 Green Finance Study Group (2016) defines green finance as "financing of investments that provide environmental benefits in the broader context of environmentally sustainable development. […] Beyond the financing of green investments, green finance also involves efforts to internalize environmental externalities and adjust risk perceptions in order to boost environmentally-friendly investments and reduce environmentally harmful ones […]". Yet, this is only one of several definitions of green finance available globally and, moreover, such a definition provides little guidance on selecting investments that actually have the potential to provide such environmental benefits.

Green finance encompasses all the initiatives taken by private and public agents (e.g. businesses, banks, governments, international organizations, etc.) in developing, promoting, implementing and supporting projects with sustainable impacts through financial instruments. It should be recalled also that for these changes to take place and produce the desired outcomes, in the long run, the active involvement of public, private and international organisms is normally required. The term "green finance" is closely associated with related concepts, such as climate finance and sustainable finance.

According to Landberg et al.: "The growth of green finance seems certain to continue as most governments worldwide focus on how to cut pollution and greenhouse gasses, and more regulators require companies to disclose climate-related risks — leading to more data showing which companies are most exposed and better insight about how to make money while saving the planet." This is the ultimate Win-Win!

Why is green finance important?

Green finance promotes and supports the flow of financial instruments and related services towards the development and implementation of sustainable business models, investments, trade, economic, environmental and social projects and policies. As the financial sector plays a key role through its intermediary functions and risk management in advancing sustainable economic development while directing investment to the real economy, the intertwinement of these two aspects is crucial. Moreover, based on the lessons learned from the global financial crisis in 2006-2009, the availing of global warming and the need for more sustainable business practices, green finance initiatives have also been addressing the 2030 Sustainable Development Goals (SDG's) Agenda by emphasizing the shift of focus from shareholders' value creation (economic) to the generation of stakeholders' value (economic, environmental and social).

Green finance provides linkage between the financial industry, protection of the environment and economic growth. Green finance, which has grown by leaps and bounds in recent years, provides public well-being and social equity while reducing environmental risks and improving ecological integrity. For example, global interest in green energy finance is increasing at a rapid pace – in 2019, investments in green energy reached the figure of US$ 282.2 billion, which underscores the significance of green finance.

During the past few years, green finance (also known as climate finance) has gained increasing relevance mainly due to the urgency of financing climate change mitigation and adaptation efforts, and the scale of sustainable development projects around the world. The impetus has been provided by three major agreements adopted in 2015 – the Paris Agreement on climate change, a new set of 17 sustainable development goals (SDGs) and the 'financing for development' package. The implementation of these agreements is strongly dependent on finance and realizing its importance the G20 nations established the Green Finance Study Group (GFSG) in February 2016, co-chaired by China and the UK, with UNEP serving as its secretariat.

According to Sustainable Energy for All, a global initiative launched by the UN Secretary-General Ban-Ki Moon, annual global investments in energy will need to increase from roughly US$400 billion at present to US$1-1.25 trillion out of which US$40-100 billion annually is needed just to achieve universal access to electricity. Such a massive investment is a big handicap for developing countries as they will face an annual investment gap of US$2.5 trillion in infrastructure, clean energy, water, sanitation, and agriculture projects. Green finance is expected to at least partly fill this gap by aligning financial systems with the financing needs of a sustainable or low-carbon economy.

Many developing countries experience hurdles in raising capital for green investment due to a lack of awareness and inadequate technical capacities of financial institutions. Many banks, for instance, are not familiar with the earnings and risk structure of green investments, which makes them reluctant to grant the necessary loans or to offer suitable financing products. With the rising popularity of green finance, it is expected that financial institutions will more quickly adapt to funding requirements of environment-friendly projects.

The green bonds

One common green finance instrument is the green bond. There is a code of conduct that defines what constitutes a green bond. To qualify it, a bond must adhere to criteria on the use of proceeds, have a process for project evaluation and selection, ensure proper management of any proceeds, and offer detailed reporting. The US, China and France are the three biggest issuers of green bonds. Presently, the European Central Bank holds around 20% of all euro-denominated green debt, even though it only started buying corporate bonds as recently as 2016, which indicates that the Bank sees this as a way to further its own green agenda. An emerging way to raise debt capital for green projects is through green bonds, which fixed income, liquid financial instruments dedicated exclusively to climate change mitigation and adaption projects, and other environment-friendly activities. The prime beneficiaries of green bonds are renewable energy, energy efficiency, clean transport, forest management, water management, sustainable land use and other low-carbon projects.

Most of the bonds labelled as "green" is in line with the broad and general list of eligible project categories 1 outlined in the Green Bond Principles (GBP). Often, the green character of green bonds is verified by external reviewers through second opinions. External reviewers do not usually apply their own definitions of "green", but rather assess whether the bond is aligned with the GBP and whether the expected environmental impacts of green projects are realistic. Financial service providers for green bonds, for the most part, build their definitions of "green" on the guidance provided in the GBP and by the CBI.

The analysis of annual green bond and loan issuance that meet internationally accepted definitions of green is estimated to be US$ 350 bn in 2020, with a 31.8 % increase from 2019. At the end of October 2020, the yearly global green bond & loans market reached US$ 194.6 bn, a 9% increase on the equivalent period in 2019.

Many green bond issuers develop green bond frameworks in order to illustrate their general understanding of "green". For example, the Nordic Investment Bank, in its 2014 Green Bonds Framework, roughly describes the sectors into which eligible categories must fall (energy efficiency, renewable energy, public transport solutions, transmission and distribution systems, waste management systems, wastewater treatment, green buildings) and determines that a long-term lock-in in high carbon infrastructure should be prevented. Moreover, Renovate America Inc., a provider of consumer financing options for home improvements in the U.S., developed a green bond framework under which it intends to issue green bonds and other green notes through its ABS platform called Home Energy Renovation Opportunity Funding. The framework entails a detailed taxonomy of eligible projects and determines specific eligibility criteria for each product. The frameworks by other issuers from the list provide only very general information on eligibility. The Asian Development Bank (ADB), for example, defines broad categories of eligibility, divided into mitigation and adaptation. The green bond framework of the International Finance Corporation (IFC) states that projects eligible for green bond financing are selected from IFC's climate-related loan portfolio. The Colombian Bank Bancóldex describes five categories of eligible projects. The German KfW's Green Bond Framework document contains a list of eligible renewable energy project categories that promote the transition to low-carbon and climate-resilient growth.

Let us also mention green lending and green equity investments. Banks are increasingly involved in green loan origination. Eligibility for credit under specific green credit lines is usually tied to compliance with detailed technical eligibility criteria. Such eligibility criteria can be accompanied by lists of technologies or products that can be considered green without further assessment. Several Multilateral Development Banks together with the International Development Finance Club (IDFC) developed the MDB-IDFC Common Principles for Climate Mitigation Finance Tracking. These principles include a taxonomy of eligible sectors for climate mitigation finance. Beyond this initiative, joint action is relatively limited.

Moreover, investors use a range of strategies for making sustainable investments. Green equity investments are mostly made via index investing or equity funds. In recent years, many indexes have been developed to identify and track the performance of specifically green industries, firms and investments. While index providers are relatively transparent about the methodologies for identifying green companies for their indexes, the methods for delimiting "green" used by green equity funds are often complex and contested. Thus, labels and certification schemes to certify the greenness of funds have been developed. Overall, methodologies used to delimit "green" are highly heterogeneous in the green listed equity segment. Efforts to harmonise such definitions have yet to be taken.

In the end, according to the Green Finance Platform, climate finance flows still appear to be far below the level needed to achieve the Paris goals and there is also uncertainty over the mid to long-term prospects of climate finance – now additionally due to the Covid-19 pandemic. In fact, over USD 1.6 to 3.8 trillion in new climate investment is required for the supply side of the global energy system until 2050 (IPCC Special Report on Global Warming of 1.5 °C). Moreover, the UNEP Adaptation Gap Report 2020 has estimated that USD 70 billion per year are needed to adapt to the ongoing and future impacts of climate change in developing countries alone. This figure is expected to reach USD 140-300 billion in 2030 and USD 280-500 billion in 2050. To reach this target, current investment trends need to significantly shift towards low emissions and carbon resilient development. Ambitious and innovative policies for sustainable Covid-19 recovery and even greater collaboration among public and private actors will be needed to achieve climate goals.

Closing thoughts

After about a decade of practical achievements in green finance one could be cautiously optimistic. Though still far from the volumes required to support the implementation of the Paris Treaty and the SDG Strategy (investments needs to be estimated at about 60 trillion USD till 2030), experience is showing that interest to develop this new, socially responsible project funding is rising among the banking community, private investors, and the public authorities.

The rapid development of the range of instruments, from bank loans, to green, social and sustainability bonds, and finally to the green banks, confirms that the responses to this new niche of funding is quite encouraging. For example, the green banks in the US and Australia are focussing on green energy projects and have demonstrated some interesting innovations (for example the Connecticut Green Bank offering zero-interest pre-development loans, and Australian Clean Energy Finance Corporation supports projects like the country's largest utility-scale battery storage programme).

Of course, there are still challenges to scaling green finance: instruments to address the time horizon differences (investors are interested in quick return – which is in conflict with the nature of most green projects), lack of clarity and standards about what is a green project, lack of experience in quantifying environmental risks, as well as lack of policies and tax incentives. Besides, there is always some skeptics about any innovation, but there are plenty of arguments speaking in favour of green finance.

It is now the governments who have to create regulatory and financial conditions guiding and encouraging sustainable development through green finance - in line with OECD recommendations. Interesting to note that Mexico and Indonesia have recently adopted such policies. Are they the only ones to understand that green investment will pay off at the level of 300% by 2050?

The fact is also that there is sufficient money sitting in banks and pension funds – waiting for good investment opportunities. Currently, it is estimated that only in OECD member countries there is over 80 trillion USD, available for good, reliable investment. So, what is needed is to create conditions that more resources will be mobilised to invest through green finance, for the benefit of a healthier and nicer environment, and for a happier society.

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