Investment in climate action—Governments and the private sector must work together

It has been clear for some time that the cost of investment needed in climate action is too great for the official sector alone to bear—and indeed it should not try to, given the profit opportunities for the private sector to invest in new areas. However, the financing landscape is complex, and rapidly evolving; likewise, the rules and boundaries of climate financing are just emerging and continue to shift.

This blog reports on the third session of a virtual conference, European Climate Action: Political Economy Challenges, hosted by the European Studies Centre of St. Antony’s College Oxford, on January 21, 2021, which considered the needs of the various financing players and their appropriate roles.

The panel included Josué Tanaka, Visiting Professor, Grantham Research Institute on Climate Change; Olaf Sleijpen, Executive Director of Dutch National Bank responsible for Climate Change; Isabelle Mateos y Lago, Managing Director, Blackrock; it was chaired by Professor Kalypso Nicolaidis, St. Antony’s College. Click here for the podcast of session 3.

Josué Tanaka              Olaf Sleijpen                       Isabelle Mateos y Lago      Kalypso Nicolaidis

Background: new profit opportunities for the financial sector, but with new risks to financial stability

After a tentative start, the financial sector, both public and private, has begun to mobilize financing for climate projects fast and creatively. The sector is currently in ferment. To ensure that adventurous green financing efforts (and the risks associated with climate change itself) do not imperil financial stability, central banks and prudential regulators are increasingly engaging in assessing risks attached to climate change and mitigation measures, supported by the establishment of new standards/guidelines.

• For the official sector, the complex landscape of climate financing raises the question of where European financial agencies like the EBRD and EIB should be concentrating their efforts. At the global level, climate financing for developing countries remains messy and inadequate.

• For the private financial sector, there are both upside and downside challenges.

• As regards new profit opportunities, private firms are responding to public demand for ESG investment (investments with good environmental, social, and/or governance characteristics) by issuing ‘green bonds’. The challenge, however, is to make sure these finance genuine, additional green reforms, rather than merely ‘green-washing’ pre-existing investment plans. Climate Action 100+, a large organization of investors (now with 545 members with over $52 trillion under management), has committed to requiring ‘green behaviour’ for the corporations they invest in.

• On the downside, the private financial sector may be more risky than currently assessed, since banks, hedge funds, insurance companies, etc. are only now beginning to calculate the impact of climate change on their existing portfolios (e.g., will oil-sector investments lose value as renewable energy replaces oil?). Mark Carney, when governor of the Bank of England, led an international taskforce which developed reporting guidelines for private financial institutions to disclose their climate risks (TCFD guidelines)—with extensions also for large corporations. These guidelines remain voluntary, and their effectiveness is disputed. Other competing guidelines re muddying the waters, though with less influence.

• Although it would have been unheard of in the past, there is much discussion on whether central banks should also help finance climate change. The international Network on Greening the Financial System has grown from 8 central banks to 83 members now, including the US Federal Reserve. Importantly, the ECB has announced that it will include certain ESG bonds in its asset-purchase schemes in 2021. This announcement has shifted the debate somewhat, from whether central banks should get involved, to where to draw the line—what they should and should not do as regards climate financing.
  

Josue Tanaka opened the session by giving an overview of the magnitude of the investment challenge, and the complexity of the climate investment landscape, with its broad array of players. Despite its current spurt, green financing remains deeply inadequate. Investment in key sectors will have to be scaled up sixfold or more between now and 2050. (For instance, one estimate of the cost of transitioning global energy systems to low carbon is US$ 3.8 trillion, while Bloomberg estimated total green investment in 2014-18 to have amounted only to around $300 billion—though with significant acceleration since then.)

Both the official and private sector are responding, and institutions are proliferating.

• In the official sector, for instance, the EBRD’s climate finance has risen by 65 percent since 2015. Other multilateral financial institutions, regional and national development finance agencies, and the concessional climate funds (such as the Global Environment Facility and the Green Climate Fund) are all providing financing, but each with their own rules. Cities and other subnational governments have joined national governments and the EU as important players.

• The European Green Deal is playing a special and vital role in the official sector, by combining both policies and financing. Tanaka believes Europe has done well to integrate green financing with the Recovery Plan—not least because it is difficult to look at climate investment alone (and indeed there is no single definition of climate financing).

• Private-sector players include commercial banks, investment banks and private equity. The green bond market has been growing, though it is still too small (an estimated US$ 250 billion in 2019). Products are becoming more diversified—for instance, the EBRD has developed a resilience bond.
  

Despite the relatively promising institutional developments, shortcomings in the design and delivery of financing will need to be resolved before climate financing can achieve its global goals. These include:

• ‘Aggregation issues’. Delivering adequate finance to the right users is an unresolved challenge: climate projects are often very small, and many separate projects are needed to reach a critical mass of impact. Ironically, this is less of a problem in lower-income countries, where governments play a bigger role in investment; in these countries, however, financing has to be sufficiently concessional to become affordable to governments.

• The need to shift from exclusive focus on financing mitigation to mobilizing also financing for adaptation projects (with demands becoming more urgent as the impacts of global warming hit closer to home).

• Better design of government investment to catalyse private investment (as recommended by Iakova in session 2).

• Clarity about policies (as emphasized by all speakers). Notably, a strong commitment to a predictable path of carbon price increases would be a phenomenal instrument for eliciting climate finance, since investors would have a far clearer picture of expected returns and losses.
  

Olaf Sleijpen acknowledged a tectonic shift since five years ago, when it would have been inconceivable to involve central banks in climate action. This is because the business case for involving central banks has become so much clearer. Namely: climate change poses significant threats to financial systems and economies, and central banks (along with supervisors and governments) are responsible for preserving financial stability. Moreover, given the huge investments to be mobilized, the official sector has an important role to play in ensuring enabling conditions are in place.

‘Ensuring enabling conditions’ mainly means ensuring that the private sector can make adequate returns and can manage its risks properly. As regards returns, a key problem is that carbon prices are usually still not high enough to make investment in ‘green’ sectors more profitable than investments in fossil fuels. As regards risks, a key problem is that new technologies are intrinsically uncertain and often have long gestation periods. The uncertainty is worsened by lack of clarity on what government regulation will look like in future. There are also other lacks of clarity: for instance, a serious uncertainty about what is truly ‘green’, and the inability of investors to compare across projects, since reporting about climate risks and assessment of returns is not uniform. These uncertainties impose additional costs that makes climate investment more expensive.

Applying this framework, Sleijpen pointed to key policy messages, first for governments in general, and then for central banks more specifically:

• A first priority must be to increase returns to private investment—and policies that increase the carbon price are key here (meaning that the Green Deal’s commitment to higher carbon prices is welcome).

• A second priority is for governments to offer clear plans. Doing so will reduce risk for the private sector, which needs to understand and respond appropriately both to the present and future regulatory framework, and to the government’s catalytic investments.
  

Central banks can, and usually should, play several roles based on their responsibilities and capacity:

• They should help governments make informed decisions – for instance, research can show the economic impact of delaying climate action. Central banks are usually exceptionally well-equipped to do this type of scenario analysis, but can help also by engaging non-traditional partners with new expertise. (For instance, in the Netherlands, the central bank works with the National Environment Agency to strengthen the legitimacy of their joint analysis.)

• As supervisors, central banks can push financial institutions into taking account of climate risks in their portfolio choices. For this to be effective, improvements are needed urgently in the quality and consistency of corporate reporting.

• Central banks can play a catalytic role by demonstrating that they are taking climate risks on board in their own portfolios—for instance, by requiring climate risks be disclosed as part of asset-purchase eligibility. For this to have systemic impact, central banks will need to work with credit-rating agencies, to ensure that they take climate risks into account in their investor evaluations.
  

• All financial institutions, including central banks, have a social responsibility to the rest of the economy, to reduce their own carbon footprints!

• Finally, to the extent that climate change will impact the economy and in particular price stability, central banks should take account of this in their monetary policy decisions. How to do so is of course a difficult question, currently under assessment as part of the ECB’s ongoing Policy Strategy Review.
  

Isabelle Mateos y Lago described the current position and expectations of private investors. She reminded the audience of the role of the private financial sector, which does not itself create emissions, but is tasked with accurately pricing returns and risks to investments. Uncertainties about climate change have made this drastically more difficult. For instance, should investors expect big carbon price changes or not? Will climate action avert rising sea-levels or should investors begin to factor in the cost of flooding? This is why the emphasis on clarity and predictability of government policies is vital.

Fortunately, the last 18 months or so have seen a game-changing ability of the financial sector to allocate risk. Commitments such as the Green Deal clarify the outlines of policy action (though the need for specified plans remains paramount). There has also been progress in the private sector, with an explosion of data from corporates and other capital-users in response to calls to disclose the risks they face and how they are managing them.

In turn, this has enabled a significant acceleration (about 80 percent) in flows of capital for green purposes in 2020—despite the pandemic. Institutional investors expect to double their allocation of capital to sustainable strategies over the next five years. Relatedly, the case for ESG investing has become much stronger: sustainable investments markedly outperformed others throughout 2020—suggesting that the financial sector is on the right path. And further, the nature of the ESG market is evolving rapidly. Until recently, classes of investment were undefined or inappropriately defined; now, many more products are being developed (by Blackrock and others) to meet the needs of corporates.

Looking forward, a key role for the official sector, as a regulator, should be to pressure firms to disclose their risk exposure, with as much standardization as possible. That said, given the dynamism and flux in the sector, it will be important to avoid adopting taxonomies or labels (for categories of eligible investments and risks) that will be out of date in a year and need to be changed.

Mateos y Lago agreed with Sleijpen that central banks can play an important role, while staying within their mandate. In particular, she considered that, as huge asset-owners themselves, central banks and sovereign wealth funds should send clear signals to society by greening their own balance sheets (she mentioned the Dutch central bank as a trailblazer in this area). And as large borrowers, if sovereigns were to issue green bonds they would importantly help to develop the still embryonic green bond market. Since the Recovery Fund will quadruple the size of the European sovereign bond market, it could play a big role in developing green bonds.

The offline discussion noted that, despite the current virtuous cycle of cooperation and growth across all financial-sector actors, the needed scaling-up will require fixing many problems—of imbalances in where the money is going and of better risk identification. There was consideration of whether greenwashing can be addressed effectively by fixed classifications for climate-eligible investment. While all supported movement toward standardization, some participants felt that too-rigid a classification risked being overkill, given the need for innovation and uncertainties about the ‘right’ investments.

The discussion also considered whether central banks could become unduly politicized by engaging in climate action. Panelists reemphasized the value of non-value-judgmental exercises such as scenario analysis for informing policies; it was also noted that many central banks have secondary objectives that could justify their buying green bonds.