By Robin Penfold, partner at UK law firm TLT
Momentum is building around green finance. According to recent UN estimates, the value of sustainable financial products such as green bonds and sustainable funds hit $3.2trn in 2020 – an increase of more than 80% compared to the previous year1UNCTAD
With attention focussing on ramping up more ambitious actions on tackling climate change at the COP26 UN climate summit in Glasgow this month, how to fund the transition to a low carbon economy by mobilising private as well as public capital is high on the agenda. Green finance should have a starring role to play here in the months and years ahead.
Green finance will provide the loans, debt mechanisms and investments that will encourage the development of green projects, but to bridge the gap between rhetoric and action, more effective policy and regulatory frameworks as well as more green financial products must be developed.
So, what is the current state of play and what initiatives and outcomes do we need to see post-COP for green finance to truly start to flourish?
Promoting greater understanding and awareness
As host of the international summit, the UK government has set the tone, raising more than £16bn to fund green projects since the launch of its first green gilts and green savings bonds in September 20212GOV.UK. This was followed by its publication of a Greening Finance paper, which aims to empower well-informed decision-making that factors in climate change and environmental considerations when making investments. Its first two chapters address how to get the right information to the right participants, and how to define what counts as green when it comes to finance.
This matters because for green finance to be successful, people need to understand what it is and, crucially, what it is not. Green finance combines economic growth with environmental protection and the delivery of a net zero economy. The simplest definition is that green finance is any structural financial activity that is created to drive sustainable outcomes. A diverse suite of financial products is emerging under this banner.
Of these, green bonds – which are designed to support climate-related or environmental projects – are relatively well established, with almost $1.5trn issued to date in total3Climate Bonds Initiative . Others are more nascent –for example the green mortgage market, where borrowers with more energy-efficient homes receive preferential rates on their loans. There are green loans where funds can only be used for green purposes, such as retrofitting insultation into buildings, and sustainability-linked loans, where interest rates are linked to defined sustainability goals, such as reducing CO2 emissions in business operations. This is without mentioning products such as green pensions and ESG investments.
Some of these products, such as sustainability-linked loans, offer flexibility but could be difficult to implement in terms of assessing how green customers’ activities really are. They may work well for large corporates for whom appropriate KPIs can be developed, but they are likely to be harder to scale down for smaller business and retail customers. This is a challenge the industry will have to tackle for take up to become more widespread.
Businesses (especially SMEs) and consumers need greater awareness of which products are available to them, how lenders evaluate borrowers, and what the conduits for accessing such products are. Currently the supply of capital far exceeds demand for products, and that has got to change if the green finance sector is to see the material year-on-year growth it is capable of (and that’s desperately needed to tackle the climate emergency).
Implementing a common taxonomy and standards
While more publicity and better education is needed around green finance products, a common taxonomy clarifying what constitutes green finance and what counts as a green loan or a sustainable investment is also urgently required. Few countries have developed one, and where they have, they can be controversial, as demonstrated by the push by some EU member states to include gas in the EU’s green finance taxonomy4EURACTIV.
Such a taxonomy would help to combat greenwashing, as would implementing common reporting and disclosure standards. The G7 leading economies have already agreed to make reporting in line with the standards set out by the Taskforce on Climate-related Financial Disclosures (TCFD) mandatory5Reuters, and more countries must follow suit. Adopting a global baseline for reporting is critical to creating consistent and transparent reporting and makes it harder to make misleading or unsubstantiated green claims.
However, all companies, especially SMEs, will need to be equipped with the proper tools to produce meaningful reports, and investors must be empowered to understand them. Implementation and enforcement are also crucial. Simply hoping that investment pressure alone will lead to compliance may eventually yield improvements, but it might not be enough where time is clearly of the essence.
The UK’s recent Greening Finance paper points to stewardship – or investor engagement – as a way of holding investment managers to account on green investment. While this is certainly a positive step, the lack of transparency in investment generally – particularly for pooled and hedged funds, in which a lot of large pension schemes invest – is notoriously opaque. For stewardship to be effective, the quality of data may need to be monitored, and managers need to be able to clearly identify and articulate what a fund invests in – in real and tangible terms – to enable investors to make informed decisions. This is often easier said than done.
Driving innovation
With many nations now committed to working towards bold decarbonisation targets, there’s a growing role for green finance – and that requires innovation on the part of policymakers as well as financial services providers.
Internationally, preferential capital treatment is being used to incentivise lenders to offer green financial products. For example, in Germany, the government provides concessional funding to banks – in some cases on rates as low as 0% – which is then lent onwards at attractive rates to businesses and households to undertake green activities.
However, it’s important to look at the market as a whole, including the wholesale funding underpinning these products, and not just how the products are structured from a retailer or customer perspective. Everyone needs to be on the same page in terms of what is and is not green for these purposes, and what funding is available for those loans. That includes intermediaries, who may need more comfort from regulators. The extent to which advisers can consider a customer’s preference for certain types of products versus simply the price often presents a major challenge for lenders.
In the US, the well-established practice of attaching mortgage finance to the home rather than the borrower is helping to drive the green mortgage market forwards. Countries like the UK, where mortgages instead attach to the borrower, are starting to take note (with the UK’s Green Finance Institute actively driving this shift).
Expanding the remit of open banking could also help raise awareness of, and improve access to, green financial products. Enabling consumers and businesses to see all types of financial products – and indeed, all aspects of running their property – on one platform would make it easier for them to make green choices.
In addition, subsidies for investing in renewable energy generation and technologies must remain an area of focus. For instance, in the UK, although Contracts for Difference (CfDs) have made an important contribution to the rollout of low-carbon electricity, the existing electricity market needs to be reformed, requiring a holistic approach to send out the right investment signals. When it comes to new technologies such as carbon capture, heat and energy storage, the UK’s new Subsidy Control Bill should play a key role in providing more clarity over revenue streams and closing the viability gap.
These kinds of initiatives could help transform slow-to-grow parts of the green finance market that require strong incentives for price-sensitive customers, and where issuers need more certainty over demand. They could help turbocharge those areas that are already seeing substantial growth. We need to see more lenders entering the market to make it more competitive and more efficient, so that the range of products on offer becomes wider, more affordable and more accessible.
The journey towards making green finance mainstream is likely to be long and challenging, and it will be driven by both in-market and external pressures. But with the UK Committee on Climate Change estimating that reaching net zero by 2050 will cost between 1% to 2% of GDP each year, its role is mission-critical to saving the planet and supporting the global economy. Real opportunity for rapid, steep market growth exists and there will come a point where those lenders that don’t offer green finance products will start to be left behind. Ultimately, green finance as a concept will cease to exist when all finance becomes green. And that is the direction of travel.
