Get the transition to green financing right

The regulatory debate over the nexus between climate and finance is heating up this year, particularly now that the Federal Reserve has joined the global Network for Greening the Financial System.

Unfortunately, much of the international regulatory work to date has focused on identifying business sectors as either good (green, less risky) or bad (high carbon emitters, more risky). In some instances, this dualistic approach has suggested that financing to a “bad” company must be cut off entirely. This could result in companies not receiving the necessary funds to accelerate the transition to more climate-friendly business models, and support their capital investment in greener infrastructure and technology.

The dualistic approach to labeling is also occurring within sectors.

For instance, some are very quick to suggest that all fossil-fuel energy sources should not qualify as “green,” but really, energy sources must be viewed along a spectrum over a multiyear transition pathway. For example, natural gas is a much greener form of energy than coal. Marry that understanding with the likelihood that many countries will be unable to meet their power needs, or provide consumer energy sources using wind or solar power for the foreseeable future, and the conclusion is clear. For a period of time, funding natural gas or even oil development for many countries will be necessary.

Just look at India — the third-largest energy consumer in the world — which gets 45% of its energy from coal, according to a U.S. Energy Information Administration 2019 report. Replacing some of that coal consumption with natural gas should be encouraged, and not seen as a lack of progress.

The Paris agreement also calls for limiting global temperature warming to 1.5 degrees Celsius. To achieve this, it would take an estimated $100-150 trillion climate-aligned financing over the next three decades, or $3-5 trillion annually, according to a study by the Global Financial Markets Association.

While sustainable financing has almost doubled during the last several years, it is far from reaching the scale necessary to transition the economy to a low-carbon model.

Private finance has accounted for the majority of sustainable financing at 56% in 2019, with public financing making up the remaining 44%, according to the Climate Policy Initiative. Within private financing, the majority of sustainable direct investment has been conducted by corporates, but commercial financial institutions are playing an increasing role through the underwriting of green bonds, direct lending and refinancing. Between 2015 and 2018, commercial financial institutions increased their sustainable financing by 51%, the report said.

The scale of transition financing is monumental and will take time to develop. Volume is growing across sustainable asset classes but transition financing has been limited in some cases by way of private initiatives, such as the Climate Bond Standard and the Green Bond Standard, which provide products with a “green” label or stamp of approval.

Overly strict labeling criteria or “use of proceeds” requirements that determine when an asset can be deemed “green” — like requiring 100% of proceeds to be used for “green” projects or excluding financing if a portion is used for working capital — may limit financing for transition-related activities.

Any regulatory or other legislative measures aimed at transitioning to a low-carbon economy must not inhibit the scaling of sustainable financing, but rather incentivize it.

Government policy will need to address lack of clarity on carbon pricing, as well as provide incentives for financing innovative solutions that might not be profitable in the short term, or projects that would otherwise be too risky for commercial lenders. Policies should also address data gaps through consistent, corporate climate disclosure and the establishment of agreed-upon metrics, particularly in the context of what constitutes transition activities.

Jump-starting the transition should not be driven through prudential regulation that might either call into question the soundness of climate-related finance through lower capital requirements for investments that are considered green. Nor should regulation chill transition financing for certain companies or sectors with regulatory “penalties,” which will only serve to widen the financing gap.

If policy is to be effective in creating a large-scale transition to a greener economy, then it needs to focus less on risks and more on recognizing the challenges and the opportunities of such a shift.