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Financing the Green Transition

Changing the energy-financing models of banks, or developing sustainability-linked loans and green bonds, will simply not be enough to facilitate the transition to a more sustainable economy. A new approach that is effective and scalable must take investors’ expectations fully into account.

PARIS – Four years after world leaders signed the Paris climate agreement and adopted the United Nations’ 2030 Agenda with its 17 Sustainable Development Goals (SDGs), the global environmental crisis shows every sign of worsening. Polar ice and glaciers are melting at an accelerating rate. Greenhouse-gas emissions are increasing. The Amazon and Indonesian rainforests are burning, and climate catastrophes such as typhoons, tornadoes, and floods are intensifying, with dire consequences for entire populations.

Why has the world strayed so far from its collective roadmap toward sustainable growth? Over the past decade, climate action has mainly involved praising businesses and governments that adopt “green” practices while naming and shaming those that maintain “brown” policies. But this is not enough. We must fundamentally rethink how to create a more sustainable world.

The financial sector will need to play a leading role in scaling up green initiatives, de-risking projects for investors, and optimizing funding costs. And, given the integrated nature of sustainable growth, financial institutions must work more closely with national and local governments, regulators, businesses, NGOs, and citizens.

To that end, the banking sector, including central banks, recently established the Principles for Responsible Banking and the Network for Greening the Financial System. These platforms, along with the Principles for Responsible Investment that were adopted in 2006, can be the basis for financial initiatives that make all economic actors more sustainable.

Many financial institutions have already committed to the energy transition by shifting capital allocation away from fossil fuels and investing more in low-carbon and more resource-efficient businesses and infrastructure projects. The volume of sustainability-linked loans, which offer better financing terms to companies that reduce their carbon footprint, increased from zero to €40 billion ($43.8 billion) in Europe between 2016 and 2018. And worldwide issuance of green bonds – which also originated in Europe – is likely to reach $200 billion this year, with China alone accounting for 20% of this amount.

In order to meet the SDGs and the aims of the Paris accord, we need to encourage everyone to become greener – whether they are large polluting businesses, smallholder farmers, or consumers. That means providing concrete financial support for green transitions, rather than shunning and alienating less environmentally friendly actors.

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But changing banks’ energy-financing models, or developing sustainability-linked loans and green bonds, will simply not be enough to facilitate such “transition journeys.” It is therefore time for a new approach that is effective and scalable, and takes investors’ expectations fully into account.

Two possibilities in particular look promising. First, new “transition bonds” can finance projects aimed at helping industries become more sustainable, produce less carbon and waste, and/or improve social wellbeing through fair labor and workplace practices. The cement, mining, steel, gas, and agriculture sectors, for example, are prime candidates for such financing.

Although discussions regarding transition bonds really started only earlier this year, there is already clear interest and demand among investors. They want more data and disclosure, and more diversification in order to include a wider range of sectors. Investors are also strongly committed to engaging with these industries rather than simply divesting from them. Potential issuers, too, are increasingly interested in such bonds: they need to prove to investors that they have embarked on their own transition journeys.

In this regard, the two transition bonds issued so far in 2019 have raised the question of how to define and apply universally accepted standards of “transition.” Currently, there are no “transition principles” through which issuers can factor the Green and Social Bond Principles into their financing needs. As a result, bond proceeds are not necessarily being used in ways that respect these principles.

True, issuing companies are expected to be transparent regarding their transition toward a greener footprint and their use of bond proceeds. But for now, what constitutes a transition for issuers is determined on a case-by-case basis with investors. In the future, therefore, transition bonds must be anchored in the same kind of norms, standards, and disclosure mechanisms that exist in the green-bond market.

The second big transition-financing opportunity is in blended finance, or collaborative schemes that raise private capital for public goods. These initiatives bring together a wide range of public and private stakeholders, including multilateral organizations, to finance projects with deep environmental and social impacts. Moreover, the blended approach helps to scale up and de-risk projects and optimize their funding.

The Tropical Landscapes Financing Facility, developed in Indonesia in cooperation with the UN Environment Programme, is a good example. The initiative combines private, public, and philanthropic funds to maximize environmental and social benefits. Furthermore, it provides full transparency and measurable outcomes without compromising the project’s risk/return-adjusted profitability.

Such projects aim to make an entire ecosystem virtuous, whether at the level of a single forest or an entire region or country. From the outset, these initiatives must bring together the stakeholders that set the standards (in particular governments, NGOs, and regulators) and those that deliver ecological and social projects locally (including businesses, farming communities, investors, and banks).

Transition financing will require discipline, transparency, and accurate measurement of environmental outcomes related to greenhouse-gas emissions, levels of pollution and deforestation, soil and water degradation, and carbon sequestration. In order for such initiatives to withstand scrutiny and overcome skepticism, their proof of impact will need to be more detailed, evident, and convincing than for green-bond issuances.

Big data and digital technologies will play an essential role in ensuring transparency, measuring progress, and making green transitions successful and scalable. Robust, reliable data and methodologies will build credibility, confidence, and trust among all parties and facilitate transition journeys. In that respect, the relationship between digital innovation and “green fintech” has a promising future.

The world is facing a deepening climate crisis, and financial institutions must help to lead and guide the global response. By adopting innovative new approaches, the financial sector can undergo a positive green transition of its own – and help others with theirs.

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