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Greening Financial Reform

SEOUL – Trillions of dollars in “green finance” – that is, low-carbon, resource-efficient investment – are needed annually to prevent climate change and natural constraints from stalling the global economy and threatening the livelihoods of billions of people. But investors remain resolutely brown and dirty, unwilling to bet on a sustainable future. Now, given an increased focus on regulatory reform, policymakers must seize the opportunity to chart a new course.

Given the low cost of capital and the need to stimulate the global economy, now is the ideal time to invest in the infrastructure needed to support sustainable growth. But prolonged economic recession in developed countries, together with the rise of cheap shale gas, has undermined investment in clean technologies.

While investment in renewable energy is higher in emerging economies, it remains inadequate to support a sustainable future. Even in China, where green initiatives have gained significant attention in recent years, investment in renewables – high by international standards – is dwarfed by investment in coal-generated energy.

Moreover, “climate finance” – advanced countries’ contribution to developing countries’ emissions-reduction and climate-adaptation efforts – remains pitifully small, with efforts to persuade investors and advanced-country taxpayers to contribute more having delivered only small returns. As a result, innovative financing mechanisms like the Green Climate Fund are struggling to get off the ground, and have yet to offer a vision for unlocking capital at scale.

Clearly, policymakers need to develop more effective ways to boost green investment – a point that was emphasized at the recent Global Green Growth Summit in South Korea. Efforts to entice investors under “business as usual” conditions, which provide only modest incentives to pursue projects that strengthen economic sustainability, are no longer tenable. Investors need to be motivated to assume responsibility for their investments’ environmental impact and to adopt a longer-term view in their risk assessments.

Given that financial intermediaries’ job is to invest in the future, linking financial-market reform to green growth should be an obvious step. Indeed, in the run-up to last year’s Rio+20 summit, the United Nations Secretary-General’s High-Level Panel on Global Sustainability highlighted the need to “green” financial-market reform. But this far-sighted message was lost amid general disappointment with the panel and a focus among some developing-country leaders on seeking higher contributions from developed-country taxpayers.

Policymakers should embrace the green mission and adjust their reform efforts accordingly.

Several regulatory actions would drive progress in this area:

· Investors should be required to disclose fully the carbon and natural-resource pricing in their asset valuation, so that it is consistent with the principles of material-risk reporting, and intended beneficiaries are informed about how their money is being used. A carbon-price floor could also be established.

· Rating agencies should be required to integrate carbon and natural-resource intensity (emissions per unit of output) into corporate and sovereign credit ratings.

· Given that investment in renewables is effectively guaranteed by government electricity-purchase agreements, the Bank of International Settlements should allow such investment to count against the new global capital-holding requirements established under Basel III.

· Global leaders should launch an inquiry to determine the best way to build long-term environmental considerations into the legal architecture governing fiduciary duties, especially for private institutional investors, but also for policy-directed banks and sovereign wealth funds.

· Financial regulators should extend their macro-prudential mandates to include the impact of financial markets on the broader economic and natural environment within which they operate – and upon which they depend for their long-term performance and survival.

To be sure, implementing such reforms will not be easy. In order to minimize the risk of unintended consequences, regulatory changes should be straightforward and enforceable – tough criteria, given the complexity and dynamism of financial markets. But pursuit of perfection should not be allowed to impede progress, especially in an environment in which American and British regulators, in particular, are already struggling against a fierce headwind of lobbying by financial firms and threats by them to relocate, much like today’s corporate-tax optimizers.

In fact, emerging-economy policymakers could take the lead in advancing financial-market reforms aimed at encouraging green finance. Investor-based assessments, such as the China Banking Regulatory Commission’s Green Credit Guidelines, have proved useful in overcoming policy-enforcement challenges in the real economy.

Developing-country financial regulators have already taken steps to direct investment toward their countries’ most pressing needs. Bangladesh’s central bank, for example, has introduced rules to encourage financial inclusion, including requirements that banks use a percentage of their disbursements to strengthen agricultural and rural credit lines.

Furthermore, incumbent business interests in developing countries, unlike their counterparts in the developed world, tend to lack the power to block innovation. South Africa has adopted the King III Code of Governance Principles, which requires firms to integrate their financial and sustainability reporting, and a revision of the Pension Funds Act establishes guidelines for consideration of environmental and social outcomes in investment decisions. In many developed countries, such measures would have been (and still are) impossible to enact.

Limiting regulatory reform to preventing a repetition of past crises is an incomplete, potentially damaging approach, akin to driving with both eyes focused on the rear-view mirror. Today’s financial-market reform must also look ahead, in order to avoid the potential crises of tomorrow.