Challenges In Formulating A Policy Framework For Green Finance
Author: LawSphereX
Category: Banking & Finance
Published:
Updated:
CHALLENGES
IN FORMULATING A POLICY FRAMEWORK FOR GREEN FINANCE
Komal Priya, Lawyer Practicing in Delhi
ABSTRACT
Environmentally sustainable financing and its interaction with the political economy and the legal policy framework of a country is an emerging but nascent field of study. In this article we discuss the various challenges policy makers, investors and other stakeholders face in taking definite positions with respect to sustainable finance. This ambiguity results in sub optimal allocation of financial resources to environmentally sustainable economic activities. We first discuss the challenges in defining green finance. We then try to contextualise the role of green finance within the wider framework of financial institutions and its interaction with actors within the financial system. The article also discusses the challenges that are specific to framing green financial policies.
Central Banks are one of the most important actors in the financial system, this is because they control the financial regulatory framework. Through this article we discuss how Central Banks can facilitate sustainable financing through a mix of regulation and incentivisation. Finally, we discuss how green finance has grown in India despite apparent legal ambiguity and suggest a broad direction that our policymakers, as well as financial actors, need to explore to ensure optimal growth of Environmentally Sustainable Financing. Keywords: Green finance, Political economy, UNEP, Sustainable financing.
Introduction
The United Nations Environment Programme (UNEP) defines Green Financing as “.... is to increase the level of financial flows (from banking, micro-credit, insurance and investment) from the public, private and not-for-profit sectors to sustainable development priorities. A key part of this is to better manage environmental and social risks, take up opportunities that bring both a decent rate of return and environmental benefit and deliver greater accountability”. 1 Green financing is a set of sustainable financing methods that are aimed at directing investments to projects and processes that are climate friendly. This however is much easier said than done since fossil fuels are currently the backbone of industries like energy and transport. Green finance is predicted to be one of the solutions to the problems related to global warming & climate change.
However, according to an estimate by Global Environment Facility (“GEF”), less than 15% of total required finance is currently being used in the conservation of the environment, & the main source for this is public & philanthropic entities. The latest account of Climate finance therefore reflects a financial gap of $70 billion. 2 According to UNEP, key contributions of green finance are financial instruments such as green bonds, green loans, PPP contracts, micro credit & instruments that support the public sector in promoting a sustainable environment. 3 Challenges In Defining Green Finance Currently we don’t have any precise or universally accepted definition of green finance as different countries face environmental problems to a varying degree & are differently endowed with resources to combat the problem.
For instance, the definition of clean coal in India is different from that in the EU as both are located in different geographical realities & have different types of coal with differing carbon content. There are two separate aspects that need to be considered in defining Green Finance: the first deals with the industry or sectors that can be funded through green finance; the second deals
1 UN Environment, ‘Green Financing’ (UNEP - UN Environment Programme, 23 January 2018)
2 ‘Intro to Green Finance.Pdf’ (Global Environment Facility).
3 Environment (n 1).
with the operational standards that need to be considered while marking a security or a product or a service as green. 4 The first aspect is not limited to climate change adaptation & mitigation but also includes effects of each sector and industry on the environment. Financing in some sectors such as renewable energy, clean energy, energy efficiency, etc that can be considered as green financing. However, financing in sectors such e-vehicles are not considered a part of green finance by critics who believe that charging these vehicles has a high carbon footprint. For securities, many methodologies have been proposed by the industry but all of them consider the evaluation & selection process of projects that needs to be financed in classification. 5 As of now the core component of green financial markets includes labelled green financial securities.
However, if we widen our interpretation a little, green finance can also include unlabelled financial securities. 6 One of the issues in defining green finance is also related to the unpredictable future of the market. There are three main reasons that can be considered as playing an important & critical role in defining green finance: first, is the identification of what can be considered as green which means sectors or industries that contribute to achieving environmental goals. The only beneficiaries of this definition will be the green sectors and industries & rest of the sectors will miss out. Second, building on the first definition, specific policy measures can be taken to encourage investments in the environmentally friendly sectors. However, this will again benefit only some sectors or activities leaving out the rest.
Third, uncertainty in the definition of what is green, can harm market sentiments of new investors who will not invest unless they are sure that their investment decisions are in line with predictable policy. Thus, defining green finance is very crucial for the financial sector to invest optimally in green projects. The definition of green finance is currently dependent on the underlying motivations of the defining institution or governmental body or international organisations. 7 There is a need of global governance for coordinating with different stakeholders across different jurisdictions in defining the term ‘Green Finance’ keeping in mind all related aspects as well as the future of financial markets.
4 Romain Berrou, Nicola Ciampoli and Vladimiro Marini, ‘Defining Green Finance: Existing Standards and Main Challenges’ in Marco Migliorelli and Philippe Dessertine (eds), The Rise of Green Finance in Europe: Opportunities and Challenges for Issuers, Investors and Marketplaces.
5 Ibid.
6 Ibid.
7 Ibid.
The Political Economic Context of Green Finance The Political Economic context of green financing is further complicated by varying levels of development needs and uneven economic status of countries. While the developed economies like the OECD economies have already achieved a minimum level of living for their citizens, developing economies like much of Asia and Africa are yet to achieve a minimum living standard for all their citizens. It is predicted that the impact of Global Warming and Climate Change will be felt disproportionately by citizens of developing countries however developed economies are better placed in adopting green financing methodologies. This is one of the central political economic problems of green financing and its regulation.
The central goal of green financing is to minimize environmental risk and encourage projects that promote sustainability along with ensuring adequate return on investments. Green bonds, green banks, carbon financing and community based green funds are some examples of green finance instruments. Some political economic challenges to the regulation of green financing include:
1 Lack of transparency and adequate disclosures
Governments and firms alike have not yet started openly and adequately sharing their environmental performance. In India sharing financial and accounting performance is mandatory and has backing of statutes like the Companies Act however no laws or regulations exist for mandatory sharing of environmental performance this creates information asymmetry and prohibits the development of deep and liquid markets for green financing. 8 This problem can be remedied by bringing in adequate regulatory frameworks for mandatory disclosures. G20’s Task Force on Climate Related Disclosures (TFCD) had earlier recommended mandatory disclosures close to 60% of the world’s largest public corporations have shown commitment to the recommendations of the TFCD. 9 However these recommendations have not been given the force of law in most countries hence lack adequate teeth.
Awareness related to disclosures is also not high leading to challenges for regulators and consumers alike. Some countries like China, Brazil and Lebanon 8 Sebastian Steuer and Tobias H Tröger, ‘The Role of Disclosure in Green Finance’ (2022) 8 Journal of Financial Regulation 1 accessed 1December 2022. 9 Saurabh Ghosh, Siddhartha Nath and Abhishek Ranjan, ‘Green Finance in India: Progress & Challenges’ (2021) accessed 7 December 2022. have also introduced credit restrictions, capital adequacy norms and policies of differential reserve requirements based on compliances on environmental performance. Although in the right direction these steps are not sufficient by themselves in fostering and enabling a green financial policy framework with sufficient enforcement power.
We must enforce green accounting procedures and voluntary disclosures of environmental performance for all commercial entities.
2 Technical problems like maturity mismatch
Most sustainable projects have medium to long term maturities. This in part is also because many green projects depend on technological breakthroughs in becoming financially viable examples include cost reduction in solar panels etc. 10 In the financial sector banks handle most short to medium term deposits hence the problem of maturity mismatch is more pronounced for banks. Many countries have tried establishing dedicated specialist green financial institutions like the UK Green Investment Bank plc in 2012,this investment bank was owned completely by the UK Government. 11 Some Nordic countries have also come up with specialist green financing institutions. Most such institutions are in a nascent stage but are a step in the right direction.
The problem of maturity mismatch especially in the case of banks can be solved by focusing on term-appropriate projects so that risk can be better managed. Insurance and pension funds can also help amplify the scope of green finance.
3 Lack of a well-developed policy framework
Policy framework relating to green finance is not very well developed as of now. Central banks and fiscal authorities world over can contribute towards the development of a policy framework. Central banks are key regulators of money, credit as well as the overall financial system, this places them in a unique position to influence the policy framework related to green finance.12 They can use this position to develop a risk appropriate regulatory framework. Some central banks like the Bangladesh Central Bank have stated explicitly that they consider ‘greening’ the financial system a part of their legal mandate. However in most jurisdictions ‘green finance’ has not yet become a part of banks’ legal mandate. The international policy framework should not only promote sustainable financing but also
10 Sima Kammourieh and Shahin Vallée, ‘The Political Economy of Green Regulation’.
11 ‘Our Mission’ (Green Investment Group) accessed 28 December 2022.
12 Simon Dikau and Ulrich Volz, ‘Central Banking, Climate Change, and Green Finance’ 23.
ensure that environmentally harmful activities are disincentive for they might lead to market failures. Many central banks have ‘sustainability’ built in their legal mandates but overstretching sustainability to mean all types of green finance also pose challenges therefore it is necessary that we have clear legal mandates for central banks as well as fiscal institutions regarding environmentally sustainable financing.
4 International system risks
The International system of nation-states does not lend itself well to the idea of a common legal framework however when issues as grave as climate change and global warming are involved the international system has no option other than to cooperate and coordinate towards a common objective. We have in the past seen the inability of nation-states to arrive at common ground on climate related issues during past editions of the United Nations Climate Change Conferences. Lack of common definition for sustainable as well as environmentally harmful activities, insufficient feedback loop and disincentive mechanisms, lack of common international standards, different historical contexts, global inequality and different developmental challenges are some problems that when left unaddressed have the potential to derail our sustainable financing efforts.
There have also been concerns that green financing will exacerbate global inequality hence advanced economies like OECD should take responsibility for their historical actions and take steps towards mitigating the downside risks of adopting green finance. Erection of green barriers could slow down flow of investments into developing economies and thus inhibit their growth. Advanced economies must step in to address this issue through appropriate relaxations for developing economies. Challenges in Framing Policies for Green Finance Internalising environmental externalities & reduction of risk perception in order to bolster investments that will help in achieving environmental goals, are the two main tasks of green finance.
13 There have been many programmes at the international level that promote green finance such as creation of UNEP FI framework which includes programmes like Principles for Responsible Investment (PRI), Principles for Responsible Banking (PRB), Principles for Sustainable Insurance (PSI), Equator Principles (EP) for financial institutions, etc. Several
13 Kathrin Berensmann and Nannette Lindenberg, ‘Green Finance
Actors, Challenges and Policy Recommendations’ 5. countries are signatories to these including India. However, there are many challenges in framing policies for funding green projects. One of the challenges for policy makers other than the challenge in defining green finance, is understanding the long-term role of green finance in contributing towards the sustainable environment in the global financial system. 14 It is important for policy makers to understand the incentives of the issuers of green securities, as they are complex instruments with often subjective assessments of risks and reward. Currently there are three recognised incentives: reputational gain, realisation of specific business opportunities & corporate social responsibility acknowledgement. One business opportunity is the lower cost of green labelled debt in the market.
However, a lot of research is needed by investors, policy makers and other stakeholders to accurately assess the benefits of issuing green securities for financial gains. 15 Another challenge in framing policy is bringing green finance into the mainstream by making it transaction based for calculating its impact on the environment. This can be done through structured & effective policy framework with a focus on fostering demand & supply of green securities & also including investor’s environmental risk in their decision-making process. 16 “Lack of reliable & usable information on the effective impact of environmental risks on financial & economic activities” is one of the obstacles in inclusion of environmental risks in the decision-making process.
17 The political commitment both at the national & international level is sporadic which hampers progress towards environmental goals particularly underscored by the Paris Agreement & Sustainable Development Goals (“SDG”). International commitments towards climate change are very important for the strategic policy framework of green finance. However, the announcement that the USA is opting out of the Paris Agreement has weakened advocacy of Green Finance at the international level, even though countries like India & EU constituents
14 Marco Migliorelli and Philippe Dessertine, ‘From Transaction-Based to Mainstream Green Finance
Mainstream Green Finance’ in Marco Migliorelli and Philippe Dessertine (eds), The Rise of Green Finance in Europe: Opportunities and Challenges for Issuers, Investors and Marketplaces.
15 Romain Berrou, Philippe Dessertine and Marco Migliorelli, ‘An Overview of Green Finance’ in Marco
Migliorelli and Philippe Dessertine (eds), The Rise of Green Finance in Europe: Opportunities and Challenges for Issuers, Investors and Marketplaces.
16 Ibid.
17 Migliorelli (n 14).
are strongly committed towards it. 18 Geographic constraint in developing a global legal framework is another challenge as different countries are situated in different tropics & have different advantages & disadvantages; no uniform one size fits all global policy can be framed. International community before framing a legal framework must understand the economics of renewable energy in different tropics. Methodology for lending money for financing green projects must be different from regular banking processes, considering the climate risk along with management & liquidity risks. There is a need for coordination between financial & environmental policy approaches by mandating banks & financial institutions to report & disclose their environmental risks.
China & Peru have already done this as their environment & finance ministries as well as banking regulators have exchanged information & data with each other to assess them within the context of environmental laws. The Financial Stability Board (“FSB”) is also regulating environmental risk at the international level. 19 How Can Central Banks Contribute Towards Regulation of Green Finance Central Banks across the world possess various tools that they can employ in the service of Green Finance. In the area of micro prudential regulation central banks can mandate environmental performance disclosures. Banks can also formulate rules regarding environmental risk assessment and management standards. Central banks can also link reserve requirements with exposure to ‘green assets’ similarly they can mandate higher reserve requirements for exposure to environmentally harmful projects.
Central banks can also influence green financing through macro prudential regulation. 20 Some tools that can be used include: first, environmental stress testing can be done for banks and other financial institutions. Second, central banks can also place restrictions on exposure to high environmental risk projects. Third, central banks can help reduce climate risk for systemically important financial institutions through mechanisms like surcharges. Central banks can also help the development of overall Green markets by issuing green bond guidelines detailing criteria for financing green projects, qualifications and disclosure standards. Central banks can also relax refinancing guidelines for environmentally sustainable projects and include them in
18 Ibid.
19 Berensmann and Lindenberg (n 13).
20 Dikau and Volz (n 12).
the list of priority or preferred sectors. Central banks can also help global green financing efforts through interbank coordination. 21 Banks can also come together to develop norms like the Basel norms for capital adequacy to ensure environmental sustainability of projects. Central banks can also influence fiscal institutions to adopt a similar approach towards environmental sustainability. 22 Developments in Public Policy of Green Finance in India India started focusing on green finance as early as 2007. RBI issued a notification on “Corporate Social Responsibility, Sustainable Development & Non-Financial Reporting- Role of Banks in December 2007, mentioning the importance of sustainable development. For mitigating the effect of climate change & global warming, the National Action Plan on Climate Change (NAPCC) was also formulated.
For coordination between different institutions, Climate Change Finance Unit (CCFU) was formed within the ministry of finance. Implementation of the sustainability disclosure requirements is another move towards India’s commitment towards mitigation of global warming. 23 Publication of Annual Business Responsibility Reporting (ABRR) by the top 100 listed companies since 2012 has also been mandated by SEBI. The SEBI has also issued guidelines for the issuance of green bonds in India in 2016. 24 This will help in expansion of green bonds market in India. In 2016, Hero Future Energies issued the first certified green bond to fund wind energy.
25 Moreover, it was proposed by the Report of the committee on Corporate Governance in 2017 that “the board of directors shall meet at least once a year to specifically discuss strategy, budgets, board evaluation, risk management, ESG and succession planning”. 26 India has brought many initiatives to fulfil its commitment under different international initiatives including the 2015 Paris Agreement. One such initiative is the ‘Green Car loans’ scheme introduced by SBI to counter the high upfront cost of e-vehicles. 27 Keeping in mind the importance of contribution of central banks towards green finance, RBI has also taken many policy measures such as Priority Sector Lending (PSL) for renewable
21 Ibid.
22 Ibid.
23 Ghosh, Nath & Ranjan (n 9).
24 Ibid.
25 Ulrich Volz, ‘Fostering Green Finance for Sustainable Development in Asia’ 30.
26 Ghosh, Nath & Ranjan (n 9).
27 Ibid.
energy projects to support green financing. 28 ‘Credit Enhancement Scheme’ was launched by India Infrastructure Finance Corporation Limited (IIFCL) to fund infrastructure projects. For green projects to be able to raise money across the borders the External Commercial Borrowings (ECB) guideline has also been liberalised. Several countries in Asia such as China, Bangladesh, Indonesia and Vietnam have introduced sustainable finance regulation such as a Sustainable Banking Network (SBN) that supports & manages environmental & social risk and promotes green financing. India is also in dialogue with partners for developing the same. This will make India move a step forward towards sustainable financing. 29 Green Finance in India is growing fast & there have been many initiatives & regulations to promote it.
Reduction in asymmetric information regarding green projects & increased coordination among policy makers, regulators & other stakeholders will help in long term development of green finance in India. Conclusion Through our discussion on green finance we can conclude that green finance has a long way to go before it becomes a stable financial tool for combating climate change. There are many challenges that need to be considered, from mainstreaming of green finance to taking into account climate risk by banks around the globe. It has been globally accepted that climate risk can have a great impact on the financial & macroeconomic stability of the global system, & many central banks have developed frameworks that take into account climate risks along with the traditional banking risks.
However, the future of green finance is greatly dependent on the political commitment at global platforms & also seriousness at the national level towards achieving environmental goals. In order to make mitigation & adaptation measures successful for fighting climate change, there is a need for sustainable financing of projects which should be the core responsibility of the government & central banks of all countries especially so in developing countries like India that are most at risk of damage due to climate change and related environmental problems. There is a need for coordination between environmental & financial regulators through disclosure requirements, along with framing of policies that take
28 Ibid.
29 Volz (n 25).
into account preferences of investors & other stakeholders, and enhance demand for green securities.