Finance

The financial sector needs to be driving the green transformation

Financing the green transformation

The financial sector needs to be driving the green transformation

Many Asian countries have set ambitious targets for climate change mitigation. Governments all over the region are devising green growth strategies, aiming to reconcile economic growth with low carbon emissions as well as trying to limit other forms of environmental degradation such as soil, water, and air pollution. What is needed is no less than a “green transformation” to put green growth at the heart of development (OECD 2013). To achieve such a green transformation, large investments will be needed in renewable energy generation, energy efficiency, smart transportation networks, and many other areas that will help the shift toward sustainable patterns of production and consumption. Public finance alone will certainly not suffice to make this change. Even though public finance will be crucial in supporting the green transformation, a large chunk of the necessary financial resources must come from private investors. And the financial sector will have to play a key role in allocating green finance for sustainable investment and development (Volz et al., forthcoming).

The financial sector—or at least parts of it—is responding to the challenge. Financial firms, including banks, mutual funds, pension funds, and insurance companies, are showing a growing interest in sustainable finance. According to the latest Asia Sustainable Investment Review (ASrIA 2014), assets worth $45 billion were managed using sustainable investment strategies in Asia (excluding Japan) in 2013. According to the Review, sustainable investment assets managed in the region grew by 22% per year during 2011–2013. This is impressive, but it cannot gloss over the fact that sustainable investments still account for only a tiny fraction of the total market. To date, the vast majority of Asian investors still do not consider environmental, social, and governance (ESG) factors in their investment decisions. Moreover, most banks do not take developing effective and sustainable risk cultures seriously—even if their corporate social responsibility departments tell us otherwise.

The role of financial authorities

To make headway with the green transformation, environmental and social risk screening needs to become an integral part of financial firms’ core business. The aim should be bold: mainstreaming sustainability in financing and investment, and not just nurturing a niche market for do-gooders. There are important reasons why financial authorities should care about environmental risk (Volz 2014).

First, even though few central bankers and regulators will think of environmental risk when considering forms of systemic risk, there should be little doubt that environmental risk—and risk arising from climate change in particular—constitutes a significant systemic risk for the financial sector. As Leaton et al. (2013: 23) point out: “[t]he rules that guide and govern the operation of financial markets need to evolve to address this systemic risk.”

Second, the provision of finance for socially undesirable activities—such as carbon-intensive businesses—can be characterized as a market failure. Of course, environmental regulation and carbon pricing should be the preferred policy tools to correct this market failure and prevent or discourage such investments, but as long as carbon pricing markets are not functioning and environmental policies are neither in place nor effective, there is a case for financial authorities to make use of their powers to affect credit creation and allocation.

And thirdly, the case for an environmental role for financial authorities can be made for developing countries, where these institutions typically have a strong institutional standing in the policy framework, while environmental regulation is often ignored, or weakly or not implemented because environmental authorities lack clout.

From theory to practice

All this may sound very theoretical, but the threats of climate change and environmental degradation are real, and they are too serious to easily dismiss the thought that financial authorities may have a role to play in this story. Indeed, a number of Asian central banks and financial regulatory authorities are the vanguard that has already stood up to this challenge. Already in 2011, Bangladesh Bank, the central bank of Bangladesh, introduced a comprehensive green banking framework. In 2012, the China Banking Regulatory Commission of the People’s Republic of China (PRC) issued Green Credit Guidelines “for the purpose of encouraging banking institutions to, by focusing on green credit, actively adjust credit structure, effectively fend off environmental and social risks, better serve the real economy, and boost the transformation of economic growth mode and adjustment of economic structure” (CBRC 2012). Also, in 2014, the People’s Bank of China, the PRC’s central bank, launched a large research program to analyze whether and how environmental risk should be included in its macroprudential analysis. And in December 2014, the Indonesian Financial Services Authority (OJK) published a Roadmap for Sustainable Finance in Indonesia (OJK 2014) while the Bank of Mongolia, the central bank of Mongolia, launched the Mongolian Sustainable Finance Principles and Sector Guidelines, a voluntary framework to support local banks integrate environmental and social considerations into lending decisions and product design.

For sure, all of these frameworks, guidelines, and roadmaps have their shortcomings, and the effects they have had on financial market outcomes are negligible to date. But we are just seeing the beginning of a greater trend, where more and more central banks and financial authorities are starting to respond to the challenges posed by climate change by requiring adequate management and disclosure of climate and other environmental risks from financial firms. As the impact of climate change on business is increasingly felt across Asia and the associated risks are rising, financial firms need to strengthen their capacity for environmental and social risk analysis and integrate ESG into the investment and lending process. At the same time, governments need to remove barriers to green investments, such as energy subsidies and ambiguous, unsteady regulation, and create an environment conducive to sustainable investment. For financial firms, it is better to actively embrace the opportunities that sustainable investment and lending offer and be ahead of the curve, rather than waiting for prospective green financial regulation to bite.
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References:

ASrIA. 2014. 2014 Asia Sustainable Investment Review. Hong Kong, China: Association for Sustainable and Responsible Investment in Asia.
CBRC. 2012. Notice of the CBRC on Issuing the Green Credit Guidelines. 24 February.China Banking Regulatory Commission.
Leaton, J., N. Ranger, B. Ward, L. Sussams, and M. Brown. 2013. Unburnable Carbon 2013: Wasted Capital and Stranded Assets. London: Carbon Tracker and Grantham Research Institute, London School of Economics and Political Science.
OECD. 2013. Putting Green Growth at the Heart of Development. Paris: Organisation for Economic Co-operation and Development.
OJK. 2014. Roadmap for Sustainable Finance in Indonesia. Jakarta: Otoritas Jasa Keuangan.
Volz, U. 2014. On the Role of Central Banks in Enhancing Green Finance. Paper prepared for the UNEP Inquiry–CIGI Research Convening on Design Options for a Sustainable Financial System, 1–3 December 2014 in Waterloo, Ontario.
Volz, U., J. Böhnke, V. Eidt, L. Knierim, K. Richert, and G.-M. Roeber. Forthcoming. Financing the Green Transformation – How to Make Green Finance Work in Indonesia. Houndmills, Basingstoke: Palgrave Macmillan.

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Ulrich Volz

About the Author

Ulrich Volz is a senior lecturer (associate professor) in the Department of Economics at SOAS, University of London. He is also a senior research fellow at the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE) and an honorary professor of East Asian Economics at the University of Leipzig. His areas of expertise include international financial markets, green finance, financial market development and stability, and open economy macroeconomics. His latest book, Financing the Green Transformation – How to Make Green Finance Work in Indonesia, will be published in spring 2015.

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