Briefing Paper 23/2016

Green Finance: Actors, Challenges and Policy Recommendations

Summary sources, public budgets will fall far short of the required
funding. For this reason, a large amount of private capital
The year 2015 seems to have been an historic turning is needed.
point in combatting climate change. Not only did the world
agree on the first universal climate agreement, but the However, mobilising capital for green investments has
United Nations established the Agenda 2030 for Sustain- been limited due to several microeconomic challenges
able Development. Implementing the Paris commitment such as problems in internalising environmental externali-
means limiting global warming to below 2°, striving even ties, information asymmetry, inadequate analytical
for 1.5°. In practice, this implies the radical decarbonisation capacity and lack of clarity in the definition of “green”.
of our economies, which entails fundamental changes in There are maturity mismatches between long-term green
the financial world towards what has been termed “green investments and the relatively short-term time horizons
finance”. of savers and – even more important – investors. In
addition, financial and environmental policy approaches
Green finance represents a positive shift in the global eco- have often not been coordinated. Moreover, many
nomy’s transition to sustainability through the financing governments do not clearly signal how and to what
of public and private green investments and public extent they promote the green transition.
policies that support green initiatives. Two main tasks of
green finance are to internalise environmental externali- In order to increase the flow of private capital for green
ties and to reduce risk perceptions in order to encourage investment, the following measures are crucial. First, it is
investments that provide environmental benefits. necessary to design an enabling environment facilitating
green finance, including the business climate, rule of law
The major actors driving the development of green and investment regime. Second, the definition of green
finance include banks, institutional investors and finance needs to be more transparent. Third, standards
international financial institutions as well as central banks and rules for disclosure would promote developing green
and financial regulators. Some of these actors implement finance assets. For all asset classes – bank credits, bonds
policy and regulatory measures for different asset classes and secured assets – voluntary principles and guidelines
to support the greening of the financial system, such as for green finance need to be implemented and
priority-lending requirements, below-market-rate finance monitored. Fourth, because voluntary guidelines may not
via interest-rate subsidies or preferential central bank be sufficient, they need to be complemented by financial
refinancing opportunities. and regulatory incentives. Fifth, financial and
Although estimations of the actual financing needs for environmental policies as well as regulatory policies
green investments vary significantly between different should be better coordinated, as has happened in China.

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Green finance: actors, challenges and policy recommendations

Green finance: what it is and why we need it Moreover, the short-term time horizon of savers and
investors does not match the long-term nature of green
Realising the climate agreement and starting the overdue
investment projects, which often extend over more than a
implementation of transforming our economies requires
decade. In addition to these general challenges, the specific
enormous effort from the financial sector and its actors.
challenges of different actors impede the rise of green
Unfortunately, the current financial system is not providing
finance.
the necessary financing. The main reason for this lies in the
external costs of carbon emissions that are not adequately Important actors and their instruments
considered in prices. Even more, in most countries the use
of fossil fuels is heavily subsidised, which implies that There are a number of crucial financial intermediaries and
investments in new energies and energy efficiency are institutions driving the greening of the financial system,
becoming unattractive. The first best solution to this including banks, institutional investors and international
problem – the correct pricing of carbon emissions through financial institutions (IFIs), as well as regulatory authorities
the abolition of fossil fuel subsidies on the one hand and and central banks. In particular, regulatory authorities and
the introduction of carbon emission trading systems or central banks can have an important impact on the speed
carbon taxes on the other – has only been successful on a at which the greening of the financial system takes place,
limited scale. Even if financing is provided, appropriate as the legal and supervisory regime determines the
green investment projects have often not been available, framework for the financial system.
or financing for green investments is not allocated
appropriately. Hence, in addition to carbon pricing we have Banks
to adapt our financial system. Banking system assets play an important role in the
Green finance comprises the following three aspects. First, international financial system because they represent an
it includes the financing of public and private green important share of global financial assets. In particular,
investments – including preparatory and capital costs – in emerging markets and developing countries have
the following two areas (i) environmental goods and established numerous measures to mobilise finance for
services such as water management or protection of sustainable development and to mainstream green
biodiversity and landscapes; and (ii) prevention, minimisa- finance in the banking system (Alexander, 2014). These
tion of and compensation for damage to the environment measures include priority-lending requirements and
and to the climate, such as dams or measures for increasing below-market-rate finance via interest-rate subsidies.
energy efficiency. Second, green finance covers the However, these measures carry risks because they could
financing of public policies – including operational costs – also bring about misallocation of financial resources. In
that encourage the implementation of environmental and addition, these measures could cause fiscal problems
environmental-damage mitigation or adaptation projects (UNEP, 2015). When designing these measures, these
and initiatives, for example feed-in tariffs for renewable risks have to be taken into account.
energies. Third, it comprises the components of the
Institutional investors
financial system that deal specifically with green invest-
ments, such as the Green Climate Fund or financial instru- It is widely acknowledged that a large share of the trillions
ments for green investments, such as green bonds and of USDs needed to finance green investments have to
structured green funds, including their specific legal, come from institutional investors, including pension
economic and institutional framework conditions. funds, sovereign wealth funds and insurances. However,
this investor group is constrained by a number of hurdles:
General challenges to green finance green investments are generally not included in the
relevant benchmarks of rating agencies as they do not
Even taking into account the wide range of estimates of
have a sufficient track record to be given a rating. In
the financing needs of green investments, public financial
addition, green investments are usually not possible at
sources will be insufficient to finance the green trans-
scale because of an insufficient number of appropriate
formation. Hence, a significant amount of private capital is
green projects. Generally, even if institutional investors
needed. However, private green finance is still scarce due to
would be willing to invest in long-term and sustainable
a range of microeconomic challenges, including problems
projects, the prevailing regulation often prevents them
in internalising environmental externalities, information
from doing this, or allows it only in a very limited way
asymmetry (e.g., between investors and recipients),
inadequate analytical capacity of issuers and investors, a because this regulation requires cautious and
lack of generally accepted green definitions and maturity conservative investment strategies.
mismatches (G20, 2016). The unclear definition of green
International financial institutions
finance leaves room for “green-washing”, with issuers of
“green assets”, for example, making misleading claims In order for investments in green products and projects to
about the environmentally friendly nature of their assets. be significantly up-scaled, pioneering work is necessary.

Electronic copy available at: https://ssrn.com/abstract=2881922

 Kathrin Berensmann / Nannette Lindenberg

IFIs can support the green transformation in three specific Box 1: Green Bonds
ways. First, they have a pioneering role in testing new ways
of financing sustainable development: voluntary commit- Various financial market actors have identified green bonds as a
ments to take climate risks and the carbon footprint of key instrument of climate finance. The bond market, which
potential investments into account when making includes longer-term debt instruments delivered by
investment decisions by using the notional “shadow governments, regions, municipalities and enterprises, is mainly
prices” of carbon. Second, IFIs have an important role to used to change illiquid assets into tradeable assets, backed by
play in the mobilisation and rechannelling of private and securities. Since bonds make up the largest single asset class in
the financial system, it is possible to issue many green bonds.
institutional capital for green investments by the provision
According to estimations of the Climate Bonds Initiative, a
of innovative instruments such as green bonds. Finally, IFIs
non-governmental organisation that supports the growth of
are predestined to build a coalition of green financiers with
green bond markets, issuance could rise to USD 100 billion in
the aim of reforming global financial governance to
2016.
become supportive of sustainable development
(Lindenberg, 2016). Since the IFIs often have different On the one hand, green bonds have several benefits for green
objectives and instruments, one main challenge is to apply projects and investors because they represent an additional
the same definition for green finance in order to prevent source of financing for green investments. Moreover, green
“greenwashing”. bonds provide long-term financing for green projects and
investors. On the other hand, green bonds are associated with
Central banks and regulatory authorities some difficulties. Labelling a bond “green” incurs costs related
to administrative certification, verification and monitoring,
Apart from IFIs, central banks and other regulatory which gives rise to “greenwashing”. To avoid “greenwashing”,
authorities could push financial markets towards more investors need more information than green labels provide.
sustainability by establishing adequate policies and Third-party verification must include “second-opinion”
regulations. They are particularly called upon to support providers and more detailed green bond ratings. Green bond
the green transformation (Alexander, 2014). The current valuations by rating agencies are in an embryonic stage:
financial system is driven mainly by short-term yields and, agencies should ensure ongoing monitoring (Berensmann /
consequently, a chronic investment deficit for long-term Dafe / Lindenberg, 2017).
and sustainable projects is one of the most urgent
problems financial regulators could help to tackle. In addition to financial sector regulators and central
Banking stress tests and standards of due diligence for banks, the Financial Stability Board (FSB) represents a
banks and financial institutions could give greater crucial multilateral actor in regulating environmental
consideration to climate risks in order to impact the risks. This institution assumes the task of promoting
common investment behaviour. What is more, green global financial stability by coordinating the development
financial guidelines and regulations can avoid competi- of regulatory, supervisory and other financial sector
tive distortions due to the higher costs related to green policies. As regards green finance, the G20 Finance
financial activities. Ministers and Central Bank Governors mandated the FSB
to assemble public and private sector participants to
While green prudential regulation represents an effective
assess the role of the financial sector in green trans-
lever to green investments, there are many more
formation and to analyse financial stability against the
examples of green policies and regulations. For instance,
background of the green transformation.
in many countries – including Australia, Brazil, Canada,
Denmark, France, Netherlands, New Zealand, Norway,
Sweden and the UK – regulators require investors to
What needs to be done?
include information on environmental, social and gover- In order to enhance private capital for green investment,
nance aspects in their financial disclosures (UNEP, 2015). it is necessary to design an enabling environment
facilitating green finance. Among other factors, the
One main problem with green regulation in the financial
business climate, as well as rule of law and investment
sector has been that financial and environmental policy
regime, are important aspects that support the increase
approaches have often not been coordinated. Finance
of green investment activities. Above all, a coordinated
ministries have frequently not yet given bank supervisors
approach of all public and private actors of the financial
the mandate to require banks and financial institutions to
system at all levels is needed.
report and disclose their environmental risks. In this
regard, China and Peru represent exceptions and some Several general measures could contribute to increase
kind of path leaders because these countries have private capital for green investment. Country authorities
coordinated their environmental and finance ministries as should support green finance by backing the strategic
well as their banking regulators by, for instance, framework for green finance, notably the Sustainable
exchanging information and data, and have assessed the Development Goals (SDGs) and the Paris Agreement
adoption of environmental laws (Alexander, 2014). (G20, 2016). By providing clear policy signals, this could

Electronic copy available at: https://ssrn.com/abstract=2881922

 Green finance: actors, challenges and policy recommendations

be an incentive for actors of the international financial  Banks should accelerate their green finance instru-
markets to pursue the SDGs and to fulfil the Paris ments, notably priority-lending requirements and
Agreement. capital adjustments. Banks and financial institutions
should report and disclose their systemic environ-
With the start of its G20-presidency on 1 December 2016,
mental risks (Alexander, 2014). In this regard, the
Germany has the opportunity to carry on China’s efforts at
G20 countries should serve as good examples.
establishing a clearly defined green finance agenda on the
 All institutional investors should state in their annual
list of G20 concerns. The world needs to pursue its green
report in which way their investment policy considers
transformation, and ensuring that the world’s 20 most
environmental, social and governance factors and
influential nations keep discussing the green agenda
disclose their carbon footprint.
could be decisive at this point in time. Financial and
 For mobilising private capital for green investments,
environmental policies, as well as regulatory policies,
IFIs assume a crucial task because they can alleviate
should be better coordinated, as in the case of China. The
the environmental risks by offering risk-mitigating
ministries of finance should give bank regulators the
instruments and guarantees. In the same vein, IFIs are
mandate to supervise the financial sector’s environ-
able to accumulate green projects for appropriate
mental risks. green financial products. In addition, IFIs, notably
In the same way, it would be necessary to increase multilateral development banks, take on an important
transparency about the definition of green finance to role in promoting the market development for green
prevent “greenwashing”. Voluntary principles and financial products (Lindenberg, 2016).
guidelines for green finance need to be established and  In order to ensure financial stability, central banks
monitored for all asset classes: bank credits, bonds and should assess the potential effects of environmental
secured assets for institutional investors. However, degradation, climate change impacts and resource
voluntary guidelines alone will not bring about a “green scarcities on price and financial stability. In addition,
transformation of finance” if not complemented by they should incorporate environmental effects in their
financial and regulatory incentives. central bank reporting. Moreover, central banks could
acknowledge high-rated (AAA) asset-backed
Moreover, country authorities, together with IFIs and the securities as collateral for central bank loans to banks
private sector, should enlarge capacity-building platforms, (Alexander, 2014).
for example to discuss the effects of the green trans-  Similarly, regulatory authorities should take into
formation on credit risks and to elaborate adequate risk account environmental risks. Financial regulation
modelling and trainings. The Sustainable Banking Network such as Basel III and Solvency II should include
and the Principles for Responsible Investment represent exceptions with regard to capital and liquidity
good examples of capacity-building platforms (G20, requirements for green investments.
2016).
Whether the ambitious climate and sustainability goals
In addition to these general policy recommendations, all can be achieved, will depend significantly on the determi-
important actors for green finance should contribute to the nation with which these actors drive the development of
further development of green finance: green finance forward.
References
Alexander, K. (2014). Stability and sustainability in banking reform. Are environmental risks missing in Basel III? Cambridge: University of
Cambridge, Institute for Sustainability Leadership.
Berensmann K., Dafe, F., & Lindenberg, N. (2017). Demystifying green bonds. In S. Boubaker, D. Cummings, & D. Nguyen (Eds.) Sustainable
investing and financial markets. Edward Elgar, forthcoming.
G20, Green Finance Study Group. (2016). G20 Green Finance Synthesis Report.
Lindenberg, N. (2016): Coordinating the willing. D+C Development and Cooperation e-Paper, 7/2016, 38-39.
UNEP (2015). The financial system we need: Aligning the financial system with Sustainable Development. Geneva: Author.
Published with financial support from the Federal Ministry for Economic Cooperation and Development (BMZ)

Dr Kathrin Berensmann and Dr Nannette Lindenberg

Senior Researchers
Department “World Economy and Development Financing“
German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE)

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Electronic copy available at: https://ssrn.com/abstract=2881922