Many people believe that recovery from the pandemic should be focused on long-term environmental sustainability as much as economic and social concerns. Green finance can contribute by promoting sustainable sectors and by diverting funds away from heavy polluters.
Over the past decade, it has become clear that the financial sector can play a pivotal role in creating a more sustainable economy. In recent years, a diverse range of financial institutions and investment organisations has shown increasing awareness of the environmental, social and governance (ESG) issues facing firms, investors and the wider economy. Among these issues is climate change, which has risen quickly up the agenda for both central banks and financial regulators.
Yet the policies of central banks continue to reinforce the fossil-fuel economy (Wdowin, 2021; Matikainen et al, 2017). This is despite support for greater sustainability from key figures such as Christine Lagarde, president of the European Central Bank (ECB), Kristalina Georgieva at the International Monetary Fund and Mark Carney, former governor of the Bank of England. There have also been frequent calls for firms and investors to divest from fossil-fuel assets and deny future financing of additional projects that may contribute to climate change. A key question is whether these calls have had an impact.
What is the link between climate change and finance?
The current rise in global greenhouse gas emissions indicates that the world is likely to experience catastrophic consequences due to climate change (Intergovernmental Panel on Climate Change, 2018). There is wide scientific consensus that achieving a ‘net-zero carbon economy’ by 2050 is essential for stabilising the temperature increase to under 1.5°C (Matthews and Caldeira, 2008). Funding ‘green’ solutions and discouraging the financing of fossil-fuel-intensive activities are critical for addressing this threat.
For this goal to be plausible, researchers have suggested that any new financing of fossil-fuel infrastructure such as oil rigs and power stations needs to cease with immediate effect. Further, up to 20% of existing infrastructure should be abandoned as what are known as ‘stranded assets’ (Pfeiffer et al, 2016).
Stranded assets are capital investments that have been subject to unanticipated or premature changes in their value. This can take the form of a ‘write-down’ – when the listed value of an asset is reduced to reflect the fact that its fair market value has fallen – or a devaluation – adjusted down when it is assumed to be unable to deliver expected future cash flows. Stranded assets can also refer to assets that have been converted to liabilities on a balance sheet. This can occur when investors have to cover costs for clean-ups or damages, or are held liable for dangerous technologies.
Since investment choices can affect overall emissions, the economic decisions made in the Covid-19 recovery strategy must be aligned with society’s environmental and climate goals. Central banks, as well as other financial institutions, can affect emissions levels through their strategic decisions, which influence the allocation of funding within the wider economy.
What is green investing?
Progress in implementing environmental policies such as carbon taxes and emissions trading schemes has been slow. This has placed greater pressure on the financial sector to cut funding for new fossil-fuel infrastructure (Hepburn, 2010; Le Billon and Kristoffersen, 2019). This pressure has been magnified by the recognition that the fossil-fuel sector has a substantial influence on the policy-making process (InfluenceMap, 2020). As a result, several studies have called for the use of diverse financial instruments to accelerate the shift to a net-zero economy (Ascui and Mackenzie, 2009; Flammer, 2021; Barber et al, 2021).
‘Green investing’ has emerged in the past decade and includes different investment strategies that can contribute to the advancement of environmental sustainability (Mazzucato and Semieniuk, 2018; Global Sustainable Investment Alliance, 2018). These include investing in low carbon energy infrastructure and innovations across financial asset classes; investing in only the top environmentally sustainable companies across sectors; designing fossil-fuel-free investment portfolios; and divesting from (and denying further finance to) fossil-fuel-based economic activities.
But what counts as green can be hard to determine (Mathiesen, 2018; Fiedler et al, 2021). This is why the European Commission defines which economic activities are environmentally sustainable across six objectives: climate change mitigation; climate change adaptation; biodiversity and the sustainable use and protection of water and marine resources; the transition to a circular economy; pollution prevention and control; and the protection and restoration of biodiversity and ecosystems.
This emerging ‘EU taxonomy’ is an important science-based classification system, and can be used to guide investors towards funding environmentally sustainable solutions (EUR-Lex, 2021).
How can central banks promote a green recovery?
Countries around the world have deployed a broad range of Covid-19 spending packages in response to the pandemic. Fiscal policies – including increased public spending as well as tax cuts – have become prominent features in green recovery strategies (Hepburn et al, 2020). But what is less well understood is whether monetary policy has a part to play. A crucial question is whether central banks’ decisions protect fossil-fuel industries or whether they can instead promote sustainable growth (Battiston and Monasterolo, 2019).
- Related question: How green are central banks?
Many argue that central bank interventions should be ‘market-neutral’ and not discriminate between sectors (Matikainen et al, 2017). This does not mean, however, that such neutrality is achievable in practice. For example, during the post-2008 ‘quantitative easing’ (QE) programme, assets purchased by the ECB in order to stimulate economic recovery benefitted more than assets not purchased by the bank (Haldane et al, 2016; Matikainen et al, 2017).
Clearly, the choices made within central bank purchasing programmes have an effect on the wider economy and are not always neutral. Indeed, some argue that there can be no such thing as neutrality: either central banks are driving green recovery or they’re holding it back (Agarwala and Zenghelis, 2020).
There is evidence that the ECB’s asset purchasing programme favours the fossil-fuel industry (Battiston and Monasterolo, 2019; Matikainen et al, 2017). Within the ECB’s corporate bond purchases, over €50 billion (out of a possible €82 billion) are currently in emissions-intensive sectors, despite the fact that firms in these sectors make up only 18% of the euro area economy.
In addition, there is evidence suggesting that the ECB’s Pandemic Emergency Purchase Programme (PEPP) portfolio is likely to favour companies with anti-climate lobbying activities and less transparent emissions reporting processes.
One study suggests that a potential solution to the strict market-neutrality principle – which results in central banks buying bonds from emissions-intensive firms – would be to allow for portfolio rebalancing using the ‘emissions compliance verification’ approach (Bressan et al, 2021). The authors suggest rebalancing the central bank’s portfolio to lower its exposure to climate risk, while respecting all other criteria for the portfolio. In the fossil sector, for example, this can be achieved by increasing exposure to companies with a higher share of renewable energy sources relative to coal in their production.
It is also important that the use of fossil fuels within firms’ business models is discouraged (Green and Denniss, 2018; Le Billon and Kristoffersen, 2019). In recent years, the fossil-fuel divestment campaign has gathered momentum. This can be traced back to the advocacy work of 350.org in 2008. By 2013, it was the fastest growing divestment campaign in history; and by early 2020, divestment pledges reached over $14 trillion (Ansar et al, 2013). But given that this movement has grown against a backdrop of increasing investment in fossil fuels, it is uncertain whether the divestment movement has had any effect.
Figure 1 illustrates how the primary sources of financing for the oil and gas sector have evolved in recent years (Cojoianu et al, 2020). The chart shows that financing came primarily from syndicated bank loans (68%), followed by bonds (25%) and equities (7%) as of 2015. While loan financing has dried up in the aftermath of the global financial crisis of 2007-09, it has rebounded as the dominant asset class through which the oil and gas sector finances new operations and refinances existing debt.
Figure 1: Global oil and gas bank loan financing, equity and bond issuance/underwriting amount
Source: Cojoianu et al (2020), Data from Dealogic
Increasing oil and gas divestment pledges is associated with lower investment, or capital flow, to heavily polluting companies. This effect is enhanced in more stringent environmental policy regimes but diminished in countries that heavily subsidise fossil fuels.
But the divestment movement may have an unintended effect. Domestic banks situated in countries with high divestment commitments and stringent environmental policies provide more finance to oil and gas companies abroad. This is known as the ‘pollution haven’ effect.
From a scientific perspective, halting all new fossil-fuel projects would be optimal for ensuring the safe stabilisation of the climate. But this is a tall order. Investment banks and bond investors can play a critical supporting role in meeting society’s environmental goals, and the strategies that they can pursue are diverse (Matthews and Caldeira, 2008; Pfeiffer et al, 2016). These strategies include engaging with companies through their shareholders, promoting divestment from fossil fuels, and denying funding or credit to fossil-fuel companies looking to develop new projects.
The rising prominence of green finance policies is likely to be effective in fostering incentives within the corporate sector, providing crucial support to governments as they seek to address the substantial task of moving towards a more sustainable system.
Where can I find out more?
Will COVID-19 fiscal recovery packages accelerate or retard progress on climate change? The Smith School of Enterprise and the Environment surveyed central bank officials, finance ministry officials and other economic experts from G20 countries on the relative performance of major fiscal recovery archetypes.
Investing in a green recovery: Ulrich Volz at the SOAS Centre for Sustainable Finance elucidates how the pandemic is only a prelude to the looming climate crisis.
Unburnable carbon: are the world’s financial markets carrying a carbon bubble? Carbon Tracker urges the Financial Policy Committee to address the carbon bubble and ensure regulators require greater disclose on reserves and carbon emission in order to assess this material risk to financial stability.
On financial systems and climate change: Mark Carney’s Reith Lectures on how society comes to ‘knowing the price of everything but the value of nothing’.
Green stimulus jobs and post pandemic-green recovery: this research analyses the impact of past green fiscal stimulus on employment by focusing on the American Recovery and Reinvestment Act after the global financial crisis.
Repair and reconstruct recovery initiative: This research places repairing corporate balance sheets and value chains at the heart of a sustainable recovery by advocating investment in common public goods such as research, resilience and the greening of the economy.
A green Covid recovery: getting the prices right: In this video, Estelle Cantillon from the Université Libre de Bruxelles explains how achieving green goals can go hand in hand with rebuilding economies.
The International Institute for Sustainable Development has a section on a sustainable recovery 2020, including simulations, webinars and commentaries:
- The EU’s financing of a resilient recovery
- ESG targets of the March 2020 economic stimulus
- Financing COVID-19 stimulus: Will high levels of public debt come back to haunt us?
- Debt-for-climate swaps can help developing countries make a green recovery
- Sustainability-linked bonds: A new way to finance covid-19 stimulus
- Green Recovery plans can unlock millions more jobs than ‘return to normal’ stimulus
Who are experts on this question?
- Francisco Ascui, University of Edinburgh
- Cameron Hepburn, University of Oxford
- Nick Robins, The Grantham Institute on Climate Change and the Environment