Dr Paul Fisher looks at the challenges of financing a sustainable economy. He asks whether the focus should be on shifting the supply of finance or the demand to borrow.
Green finance is now firmly centre stage in financial markets and policy circles.
Complicated definitions of green finance do exist. But basically it can be any finance that supports the transition to a greener, more sustainable economy or the adaption of society to a warmer climate.
Either way, it is defined by the use to which it is directed, not by the investors nor the financial technology involved.
Defining what is green – or brown – is certainly a priority and is being formally addressed by a Technical Expert Group of the European Commission. This is drawing up a new ‘green taxonomy’. Initial work was published in June 2019.
That work is important, not least because if one wants to introduce rules and regulations – as the EU undoubtedly does – or even voluntary standards, one has to have formal definitions to which rules and standards can apply.
Challenges of green finance
Leaving aside the thorny issue of different shades of green, it is not surprising that many of the other challenges of green finance are those that have dogged the industry for many years, such as how to:
- finance small to medium enterprises (SMEs), infrastructure projects, and projects which produce social returns but insufficient private returns to be investable
- fund public investment when there are so many competing needs
- address the many frictions and inefficiencies which, on close inspection, abound in supposedly efficient financial markets.
A sustainable economy
Many campaigners talk about the need to divert finance towards creating a sustainable economy. One estimate suggests that $90trn is needed for new infrastructure by 2030.
But focusing on changing the flow of finance could be looking in the wrong direction – for both the problem and the solutions.
The financial sector has always financed changes in the economy. In doing so, savers and investors all take some degree of risk to generate returns.
And the highest returns often accrue from the biggest risks – new ideas and technologies that have the potential to grow the real economy.
Green finance will achieve scale as long as the risk-adjusted return from green assets is sufficiently positive.
As it stands today, I would argue that the biggest challenge lies not with insufficient supply of green finance but with insufficient demand. There is a shortage of green assets.
The only significant ‘green asset class’ currently is green bonds. These are usually over-subscribed and often increased in size during syndication.
There are arguments about how green some bonds really are. But the underlying problem is that big investors, in particular, cannot get their hands on enough to satisfy the demand for new green funds.
At the same time, ‘brown’ assets – particularly fossil fuels – are plentiful and they can still depend on a ready supply of cheap capital. And these industries represent vested interests which will not shrink unless they have to.
Brown industries can be discouraged in part by financial regulators insisting that the financial risks from investing in fossil fuels are properly accounted for.
But, more broadly, we should expect financial flows to follow and support changes in the real economy, not to lead them.
How to increase sustainable investment
To shift the dial, we shouldn’t be focusing just on persuading investors to invest in green. We need policies to help bring more investable green projects to market – whether for equity or debt, large or small, public or private.
The most effective policy for governments would be to intervene directly in the real economy to encourage green investment. For example, subsidies and taxes, or state guarantees should be applied to borrowers – not lenders. The prospective profitability of a business is the key to it raising capital.
Sadly, government interventions in the real economy are often perverse in terms of green objectives.
We can’t expect all private lenders to pull away from financing high carbon emissions if those emissions reflect government policy, for example, on energy infrastructure or roads.
I am optimistic on the support of the financial sector meeting the demands of the transition.
I am pessimistic that enough appropriate interventions are happening in the real economy to shrink brown industries or to encourage the rapid development of new green goods and services.
Dr Paul Fisher is a Fellow at the Cambridge Institute for Sustainability Leadership. He was previously a senior official and macroeconomist at the Bank of England for 26 years, including five years as a member of the Monetary Policy Committee and Executive Director for Markets and two years as Deputy Head of the PRA. He is a member of the European Commission’s High Level Experts Group on Sustainable Finance and was a member of the UK Green Finance Task Force. He holds a portfolio of other roles in finance and academia.
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