Kermit’s Bankers

HONG KONG – Sesame Street’s Kermit the Frog once lamented that “it’s not easy bein’ green.” Today, this sentiment is surprisingly relevant to the global economy – only it is becoming green that is the problem.

Last September, the Intergovernmental Panel for Climate Change warned that if the world sticks with “business as usual,” global temperatures may rise more than 4°C – far beyond the 2°C increase that has been deemed “safe.” This prompted UN Secretary-General Ban Ki-moon to challenge political, economic, and financial leaders in January to intensify their efforts to achieve a new global agreement on climate change by 2015.

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But, as important as high-level deals are, they will amount to little unless they are backed by considerable investment in areas like smart grids, energy storage, and renewables. Indeed, the International Energy Agency estimates that nearly $1 trillion worth of investment will be needed annually between now and 2050 to put the world economy on a more sustainable path.

While that may seem like a lot of money, it is the equivalent of only 1% of global GDP, and less than 0.3% of global financial assets. Moreover, since 2007, major central banks have proved that they can augment their balance sheets by more than $1 trillion annually, without triggering inflation. In other words, the world can afford the transition toward a green economy.

Nonetheless, last year, green investment amounted to only $254 billion – implying an annual shortfall of nearly $750 billion. To bridge the gap, advanced-country governments are leveraging their limited public funds to catalyze private-sector investment. At the same time, developing countries are rapidly increasing their contributions to green finance, with domestic clean-energy financing in non-OECD countries having surpassed OECD-country levels in 2008.

But the problem remains that the current structure of markets impedes their ability to adjust to climate change. What is really needed is not money, but the political will to correct market failure by bringing about fundamental shifts in the metrics, institutions, and policies that govern how investors evaluate economic activities.

A green project is bankable only if it provides a clear view of its real costs and benefits. The return on private capital (profit and loss) plus the return on “social” capital must be positive. The current GDP metric ignores the negative externalities of fossil-fuel-based private activities, leading to overwhelming pollution and gross wastage of non-renewable natural resources. Without full cost accounting, some of the worst activities will continue to be immensely profitable.

A successful transition to a green economy will require a new set of metrics. The good news is that some governments have already moved to establish a shadow cost for CO2 emissions. In the US, the “social cost” of carbon was raised from $24 to $37 per ton emitted. Publicizing fine-particulate (so-called PM2.5) levels was critical to mobilizing widespread Chinese public support for addressing air pollution. Similar metrics are now needed to measure other forms of natural capital destruction, such as deforestation, marine-reef bleaching, wastewater discharge, and soil degradation.

Once these metrics are established, they must be incorporated into international accounting standards for private and public financial statements. Some companies are already releasing annual reports with full details on their activities’ social and environmental impact, and will eventually move toward fully integrated reporting.

But bringing about real change will require more than moral suasion. Policymakers must take advantage of the full range of tools available to them, including legislation, reporting guidelines, taxes, incentives, and public education about the costs of inaction. Financial regulators in emerging economies like Bangladesh and China have already taken a step in the right direction, introducing rules to promote financial inclusion. China’s green credit banking guidelines call upon financial institutions to consider the environmental risks in their loan portfolios.

Finally, there needs to be an honest discussion on the merits – and limits – of current monetary policy and financial regulation. Central-bank subsidies like quantitative easing and near-zero interest rates should have increased the supply of low-cost financing for green projects. Instead, they have boosted the profits of ever-larger financial institutions, leaving credit to small and medium-size enterprises and long-term projects severely constrained.

The irony is that regulations aimed at strengthening financial stability tend to reward short-termism (higher liquidity), adding risk-weights and costs to long-term projects – that is, most green investments. Regulators must recognize that if the real economy is unsustainable, no amount of bank reforms will protect people’s livelihoods, let alone the financial system. Adding a green-investment requirement of just 0.5% would be sufficient to cover the annual financing gap.

The global financial crisis occurred because we ignored externalities – shadow prices and institutions – allowing instability and inequality to proliferate. Building a more stable, sustainable future requires getting policies, prices, and incentives right. It will not be easy, as Kermit said, but the risk is that if we do not act, we get boiled before we become green.