Overview
Asustainable financial systemis one that creates, values and transacts financial assets in ways that shape real wealth to serve the long-term needs of an inclusive and environmentally sustainable economy. Although sustainable investment categories are not mutually exclusive, a mapping of related definitions found broad agreement in the distinctions between “sustainable”, “green” and “climate” finance (UNEP, 2016). “Sustainable finance” is recognized as being the most inclusive term, encompassing social, environmental and economic aspects. “Green finance” then refers to any financial instruments whose proceeds are used for environmentally sustainable projects and initiatives, environmental products and policies under the single goal of promoting a green economic transformation toward low-carbon, sustainable and inclusive pathways. A simplified schema for understanding the broad terms is displayed below.
Figure. A simplified scheme for understanding broad terms on sustainable finance
Source: Definitions and Concepts: Background Note, UNEP, 2016.
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 thatgreen investmentsare 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 intoinvestment,bankingandinsuranceproducts. The predominant financial instruments in green finance are debt and equity. To meet the growing demand, new financial instruments, such asgreen bondsand carbon market instruments, have been established, along with new financial institutions, such as green banks and green funds. Renewableenergy investments, sustainableinfrastructurefinance and green bonds continue to be areas of most interest within green financing activities.
Sustainable finance is the financing of investment in all financial sectors and asset classes that integrateenvironmental, social and governance(ESG) considerations into the investment decisions and embed sustainability intorisk managementfor 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 insurers' 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 by incorporating environmental outcomes in risk and pricing assessments. Institutional investors can incorporate ESG factors in portfolio selection and management to identify risks and opportunities.
More about perspectives on green finance and investment here.
Challenges 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 COVID-19 pandemic has caused unprecedented events as more and more countries have been facing debt crises and fiscal deficiency. Due to the pandemic, the SDGfinancing gap has magnified by 70% to $4.2 trillion (OECD 2021), calling for collective action to address both the short-term collapse in resources of developing countries as well as long-term strategies.
The transition to a low-carbon economy requires substantial investments, which can only be financed through a high level ofprivate sector involvement. The adoption ofESG considerations in private investmentsis 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 ataxonomyof 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 minimumstandardson 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 develop 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 Finance Platform and the United Nations Environment Programme’s (UNEP) Inquiry into the Design of a Sustainable Financial System (“the Inquiry”) have launched theGreen Finance Measures Database– a global compendium of green finance policies and regulations across over 100 developed and developing countries to support the development of green finance. According to OECD (2017), with an estimated €6.3 trillion of investment in climate infrastructure 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.
Green Finance Market
According to theClimate Policy Initiative’s Global Landscape of Climate Finance 2021, climate finance has steadily increased over the last decade, reaching USD 632 billion in 2019/2020 but flows have slowed in the last few years. This is a concerning trend given that COVID-19’s impact on climate finance is yet to be fully observed. The increase in annual climate finance flows between 2017/2018 and 2019/2020 was relatively low, 10% compared to previous periods when it grew by more than 24%.
Figure. Global climate finance flows between 2011-2020, biennial averages
Source: Global Landscape of Climate Finance 2021, CPI, 2021
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 the2030 Agenda, including by scaling up climate finance, designing new SDG-related financial instruments and advancing global public goods in areas such as combattingclimate change.
In 2020, climate financing by the world’s largest MDBs accounted for US$ 66 million, with US$ 38 billion or 57.6 per cent of total MDB commitments for low-income and middle-income economies.
Source:2020 Joint Report on Multilateral Development Banks’ Climate Finance
Climate Bonds: According to Climate Bonds Market Intelligence, it is observed that the continued acceleration of green issuance drove the green bond market to just over half a trillion (USD517.4bn) in 2021. This represents a 50% increase from USD434.5bn in 2020 when the market saw its largest growth and diversification spurt (and up a huge +343% on the 2019 figure of USD98.2bn), in part driven by pandemic bonds, a subset of the social bond label. Climate Bonds Initiative estimated that the current growth trajectory could land the first annual green trillion in 2022 – a long-held milestone for green finance.
Scaling-up the private sector:According to Climate Policy Initiative, private corporations committed USD 310 billion per year in 2019/2020, and it was a 13% rise compared to 2017/2018. 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. In 2019/2020, public finance actors and intermediaries have become larger actors, accounting for USD 321 billion per year in climate finance.
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. According to Climate Policy Initiative, an increase of at least 590% in annual climate finance is required to meet internationally agreed climate objectives by 2030 and to avoid the most dangerous impacts of climate change. Also, average annual modelled investment requirements for 2020 to 2030 in scenarios that limit warming to 2°C or 1.5°C are a factor of three to six greater than current levels (IPCC Report on Climate Change 2022 Mitigation of Climate Change). Over USD 1.6 to 3.8 trillion in new climate investment is required yearly for the supply side of the global energy system until 2050 (IPCC Special Report on Global Warming of 1.5°C). To reach this target, current investment trends need to significantly shift towards low emissions and carbon resilient development. Ambitious and innovativepoliciesfor sustainableCOVID-19 recovery and even greater collaboration among public and private actors will be needed to achieve climate goals.
Figure: Global tracked climate finance flows and the average estimated annual climate investment through 2050
Source: Global Landscape of Climate Finance 2021, CPI, 2021
