The Stern review of 2008 called climate change the greatest market failure. In this working paper the World Bank looks at the role of the green financial sector and how it could be used to accelerate the global low carbon transition.
- Lack of scale, continuing exposure to climate risk and market conditions are slowing green finance.
- The WB’s theory of change could drive green financial sector initiatives in climate mitigation.
- Integration an understanding of climate risk and effective financial change within the low-carbon transition could drive the developing sustainable finance market.
The paper examines the efficacy of green financial sector initiatives with focus on low income and developing countries. It explores the role and understanding of climate risk and how much work needs to be done to integrate it into wider thinking.
What underlying factors have prohibited the transition to low-carbon economy?
Capital formation is not yet occurring at the scale needed to achieve countries’ climate mitigation ambitions. On a global scale, high carbon or carbon-intensive goods do not yet reflect their negative externalities, that is, the impact they have on the environment and on climate change.
At the same time, while there is increased discussion and awareness of the potential impact of climate risk, banks have not wound down their exposure to climate-related risks. This is in part failure to understand their exposure on a portfolio across debt, equity and financial services but also in the disconnect between investment time horizons and climate impact.
In emerging markets and developing economies (EMDEs), it is difficult for low carbon investments to break through pre-existing market conditions. Enabling environments from legal frameworks, effective regulation, implementation of carbon rules and accounting etc can be a challenge.
Low-carbon solutions are already competitive in sectors representing around 25% of global emissions. This is expected to increase to sectors covering 70% of global emissions by 2030, according to research from Systemic. However, according to the same research, here is not an effective enabling environment; regulatory frameworks are weak, institutional capacity limited. Capital markets are not so developed and debt and equity costs are higher than in the United States or European Union.
Regulation is one approach that could overcome the investment gap
Climate policies, particularly a carbon tax, would trigger a shift but that has not yet been introduced and where a carbon price has been introduced it varies wildly from less than $1/ tonne in Poland up to $137/tonne in Sweden in 2020.
The price corridor recommended by the World Bank’s 2017 High Level Commission specified $40 – $80/tonne of CO2 in 2020 rising to $50 – $100/ tonne by 2030.
In several EMDE’s, the countries rely on the oil and gas sector for fiscal revenue, GDP, and employment and despite some recent evidence showing positive benefits for the economies and people (Heine and Black 2019), climate policies may seem invasive and disruptive.
For each green financial sector initiative, the paper identifies its entry point in the economy and its direct and indirect impacts. Resulting from this, the paper develops a theory of change about the role of green financial sector initiatives in climate mitigation and in the low-carbon transition, identifying the criteria for applicability and conditions to maximize impact.
Climate risk needs proper assessment
Lack of certainty about the risk characteristics of the borrower’s investment projects is likely to lead to the investor rationing credit. (Greenwald and Stiglitz 1990). “In contrast, if investors would properly assess climate-related financial risks for firms, they would revise the cost of capital for high carbon investments, thereby making low-carbon investments more attractive.”
The Paris Agreement has spurred a movement among financial supervisors, including central banks and financial regulators, to join the Network for Greening the Financial System (NGFS).
The NGFS has co-developed climate mitigation scenarios, in collaboration with the process-based Integrated Assessment Models (IAM) community (NGFS 2020, Bertram et al. 2021). Several central banks have already applied the NGFS scenarios in their climate stress tests. Others recommended investors to disclose climate risks on their balance sheets.
However for financial institutions in the euro area, these efforts still fall short of meeting the European Central Bank’s (ECB’s) expectations (ECB 2021, Arnold 2022). The ECB recently assessed the climate-related and environmental risk management approaches of 112 European commercial banks.
Monetary opportunities for GSFIs
Green and sustainable financial institutions (GSFIs) can take many forms such as the greening of monetary, e.g., via the preferential purchase of green bonds, or by factoring in climate transition risk (Bressan et al. 2021).
Financial institutions’ lending portfolios could granting green portfolio rewards (TCAF 2021). Green national development banks could be capitalised (Griffith-Jones and Gallagher 2021), and synergies exploited between central banks and state-investment banks. This latter initiative has taken place in the euro zone with the European Investment Bank. All these avenues are explored in the report.
Adjusting capital levers for green ends
GFSI could foster the demand for green investment in low-income countries by adjusting the availability and the price of capital for low- and high-carbon activities.
With design and implementation that moderates the effects of carbon pricing on macroeconomic and financial stability, GFSI could support the introduction of fiscal policies for an orderly low-carbon transition.
The most debated GFSI include central banks and financial regulators’ intervention, e.g., via a greening of asset purchases and macroprudential regulations (Dikau and Volz 2021).
To address this, the European Commission (EC) has proposed the revision of the micro-prudential banking framework, i.e., the introduction of a Green Supporting Factor (GSF) aimed to lower capital requirements for banks’ lending to green investments (Dombrovskis 2018).
There were however significant criticisms around the introduction of lower capital requirements due to the potential implications on financial stability. Lessons learned from the 2008 financial crisis are hard to forget. Penalisation for environmentally damaging activities is more widely accepted. (Thoma and Hilke 2018, Dafermos et al. 2021, Dunz et al. 2021a).
Design of GSFIs is needed in EMDEs and the paper provides a number of different options, as well as the different approaches that are already in play or in planning.
Among the schemes being released is a sustainability linked sovereign debt hub that the World Bank has advised on with the European Bank for Reconstruction and Development, Asian Infrastructure Investment Bank, Climate Bond Initiative, Nature Conservancy, Institute of International Finance and International Capital Markets Association. It will be launched in November when COP27 is taking place.