A sustainable financial system is one that creates, values and transacts financial assets in ways that shape real wealth to serve the long-term needs of an inclusive, environmentally sustainable economy. Green finance then refers to any financial instruments whose proceeds are used for sustainable development projects and initiatives, environmental products and policies under the single goal of promoting a green economic transformation toward low-carbon, sustainable and inclusive pathways.
Two main goals of green finance are to internalize environmental externalities and to reduce risk perceptions. Promoting green finance on a large and economically viable scale helps ensure that green investments are prioritized over business-as-usual investments that perpetuate unsustainable growth patterns. Green finance encourages transparency and long-term thinking of investments flowing into environmental objectives and includes all sustainable development criteria identified by the UN Sustainable Development Goals (SDGs).
Green finance covers a wide range of financial products and services, which can be divided into investment, banking and insurance products. The predominant financial instruments in green finance are debt and equity. To meet the growing demand, new financial instruments, such as green bonds and carbon market instruments, have been established, along with new financial institutions, such as green banks and green funds. Renewable energy investments, sustainable infrastructure finance and green bonds continue to be areas of most interest within green financing activities.
Green finance is the financing of investment in all financial sectors and asset classes that integrate environmental, social and governance (ESG) criteria into the investment decisions and embed sustainability into risk management for encouraging the development of a more sustainable economy. Various actors in the investment value chain have been increasingly including ESG information in their reporting processes. As ESG reporting shifts from niche to mainstream and begins to have balance sheet implications, investors are raising challenging questions on how ESG performance is assessed, managed, and reported. Indeed, ESG factors are critical in the assessment of the risks to insurer’s assets and liabilities, which are threefold: physical risk, transition risk and liability risk. For banks, ESG risks exert an influence on banks’ creditworthiness. Banks can then provide sustainable lending in incorporating environmental outcomes in risk and pricing assessments. Institutional investors can incorporate ESG factors in portfolio selection and management to identifying risks and opportunities.
The financing gap to achieve the SDGs is estimated to be $2.5 trillion per year in developing countries alone (UNCTAD, 2014). The transition to a low-carbon economy requires substantial investments, which can only be financed through a high level of private sector involvement. The adoption of ESG considerations in private investments is evolving from a risk management practice to a driver of innovation and new opportunities that create long-term value for business and society. However, mobilizing capital for green investments has been limited due to several microeconomic challenges; for example, there are maturity mismatches between long-term green investments and the relatively short-term time horizons of investors. Moreover, financial and environmental policy approaches have often not been coordinated. To scale up and crowd in private sector finance, governments can team up with a range of actors to increase capital flows and develop innovative financial approaches across different asset classes, notably through capacity-building initiatives.
Most importantly, a harmonized definition of “green” and a taxonomy of green activities are needed to help investors and financial institutions efficiently allocate capital and make well-informed decisions. The definition of green finance needs to be more transparent to prevent “greenwashing”. And a common set of minimum standards on green finance is essential to redirect capital flows towards green and sustainable investments as well as for market and risk analysis and benchmark. Standards and rules for disclosure would help developing green finance assets. Voluntary principles and guidelines for green finance, complemented with regulatory incentives, need to be implemented and monitored for all asset classes.
The Green Growth Knowledge Partnership (GGKP) and the United Nations Environment Programme’s (UNEP) Inquiry into the Design of a Sustainable Financial System (“the Inquiry”) have launched the Green Finance Measures Database – a library of policy and regulatory measures across 60 developed and developing countries that support the development of green finance. With an estimated €6.2 trillion of investment required by 2030 to limit global warming to 2 degrees, these measures help clarify the responsibilities of financial institutions with respect to environmental factors within capital markets, such as clarifying the relevance of ESG issues within the context of fiduciary duties of pension funds, and strengthen flows of information relating to environmental factors within the financial system, for instance requirements for public disclosure of climate-related risks to investment portfolios.
According to Climate Policy Initiative’s Updated view on the Global Landscape of Climate Finance 2019, climate finance flows reached a record high of USD 608 billion in 2017, driven particularly by renewable energy capacity additions in China, the U.S., and India, as well as increased public commitments to land use and energy efficiency. This was followed by a 11% drop in 2018 to USD 540 billion.
Based on currently available information, Climate Policy Initiative’s initial estimate suggests 2019 climate finance flows will amount to USD 608 – 622 billion, representing a 6% - 8% increase from 2017/18 averages. Growth was likely driven by development finance institutions such as MDBs and members of the International Development Finance Club (IDFC).
Multilateral development banks: MDBs have deep institutional expertise in providing and catalysing investments in sustainable development and are taking steps to align their activities with the 2030 Agenda, including by scaling up climate finance, designing new SDG-related financial instruments and advancing global public goods in areas such as combatting climate change.
In 2019, climate financing by the world’s largest MDBs accounted for US$ 61,562 million, with US$ 41,467 million or 67 per cent of total MDB commitments for low-income and middle-income economies and US$ 20,095 million or 33 per cent for high-income economies.
Climate Bonds: The analysis of annual green bond and loan issuance that meet internationally accepted definitions of green is estimated to be US$350 bn in 2020, with a 31.8 per cent increase from 2019. At the end October 2020, the yearly global green bond & loans market reached US$194.6bn, a 9% increase on the equivalent period in 2019.
Scaling-up the private sector: According to Climate Policy Initiative, Private corporations remain the actor type responsible for the most finance, accounting for USD 155 billion per year in 2017/18. CPI’s new database adds categories for state-owned enterprises (SOE), state-owned financial institutions (SOFI), and public funds which are now considered as public actors.
However, climate finance flows still appear to be far below the level needed to achieve the Paris goals and there is also uncertainty over the mid to long-term prospects of climate finance due to the COVID-19 pandemic. In fact, over USD 1.6 to 3.8 trillion in new climate investment is required for the supply side of the global energy system until 2050 (IPCC Special Report on Global Warming of 1.5°C). Moreover, the UNEP Adaptation Gap Report 2020 has estimated that USD 70 billion per year are needed to adapt to the ongoing and future impacts of climate change in developing countries alone. This figure is expected to reach USD 140-300 billion in 2030 and USD 280-500 billion in 2050. To reach this target, current investment trends need to significantly shift towards low emissions and carbon resilient development. Ambitious and innovative policies for sustainable COVID-19 recovery and even greater collaboration among public and private actors will be needed to achieve climate goals.