Earlier this year, we wrote about ESG goals and how they can impact businesses’ success (Suggested Reading: ESG Goals, Social Innovation, and Startup Trends That are Here to Stay!). Since then, we have received several queries about sustainable and green finance.
It is a fairly new practice but crucial in today’s world, where we have a looming threat of global warming and climate change. Businesses worldwide have started to embrace climate risk assessments and management, considering the disastrous effect of climate change on our economies.
For more details, consider reading our previous story, The Disastrous Effects of Climate Change on Your Business.
Among this chaos, there has been a new term trending among the world leaders: green finance. That’s why today we decided to write about the meaning of sustainable & green financing, its status in India, and why it is significant.
This part will break down the evolution of sustainable and green finance.
Before we understand green finance, we first need to understand sustainable finance. And if you don’t understand what financing is, keep reading, or feel free to jump to the next section.
Financing is a complicated subject. However, if we put it in simple terms, financing is when people put their money in banks as deposits or savings. After which, banks take our money and lend it to businesses and companies to pursue their various ventures. Banks earn from the interests from these loans and make a profit. And that’s pretty much how the entire financing system works and keeps the market running.
Now, if you have noticed, the entire goal of these banks is to maximize their profit. But, in the last few years, we have noticed a difference in how traditional banking works.
Today, banks have started to focus less on maximizing their profits and instead actively invest in sustainability projects. Such investments are what we call sustainable financing. It is also worth mentioning that the notion of sustainable finance covers a wide range of green projects (1).
Level of Sustainable Financing
If you look at level one financing, it involves environmental, social, and governance, ESG, for short risk management. At this level, financial institutes avoid lending or investing their money into businesses that can potentially lead to negative outcomes for society. It can include businesses that produce tobacco, are involved in human rights violations, gambling, cause harm to animals or the environment, etc.
In the case of sustainable impact investing, banks primarily decide to finance a business based on both sustainability and profit (a win-win!). It includes investments in sectors like carbon reduction and other renewable energy projects, poverty reduction, waste reduction, and so on.
In level three, we have impact-first investments in which banks start prioritizing social and environmental interests over profit. In other words, it is a step ahead of simply avoiding harm and managing risks.
However, the most important of all is level four, in which financial generosity is to the next level. In sustainable philanthropy, profit not only takes a back seat but is completely disregarded for social and environmental good.
It isn’t very easy to determine on which level our financial institutes are at right now. After all, while banks make investments in an alternative energy source, at the same time, it also invests in fossil fuel. This means, banks often make investment decisions that have a positive or negative impact. It makes determining the position of an individual bank on the spectrum quite challenging.
The Status of Sustainable Finance Worldwide
We can use the UN’s sustainable development goals as a benchmark to determine the status of sustainable or green finance around the world (2).
The UN has estimated a gap of 2.5 trillion USD/year to achieve the SDG. But, these goals are far from being met. We are not saying that there has been no progress made so far. The investment in renewable energy has been increasing over the past few decades.
Clean energy investments peaked at 331 billion USD in 2017 after starting at under 37 billion USD in 2004. The large increase in investment capital suggests that the industry has reached a significant level of maturity (3).
The steady rise in green power investment has been fueled by policy support for renewables, a growing sector, and the creation of publicly traded firms that control clean energy resources (also known as yieldcos).
Biomass and waste-to-energy and geothermal and marine energy are all viable alternative energy sources these days. However, solar and wind energy investments have been the highest so far. Since 2004, worldwide investment in solar energy has surged from just over 10 billion USD to more than 140 billion USD (4, 5).
While these developments are necessary, at the same time, this news doesn’t sound very good when you realize that between 2016 to 2020, private banks have invested more than 3.8 trillion USD in fossil fuel projects (6, 7).
In a statement released with the report, Lorne Stockman, a Senior Research Analyst at OCI, Oil Change International (8), one of the paper’s authors, stated,
“This report offers a reality check for banks that think that nebulous ‘net-zero’ goals are adequate to stop the climate catastrophe. The flow of money determines our destiny, and by 2020, these banks have already invested billions which lock us into even more climatic instability.”
We analyzed several reports and publications to give you more data about how much the world still leans towards fossil fuels. And we found that between 2013 to 2019, G20 countries invested about 180.2 billion USD to finance energy projects in Africa and the Middle East.
Of the total 180.2 billion USD, clean energy initiatives received 29.9 billion USD, whereas fossil fuels received 122.5 billion USD. Another 27.8 billion USD was spent primarily on infrastructure development and was not immediately recognizable as supporting fossil fuels or sustainable energy (9).
The data sends a clear message: while sustainable and green finance has tremendous potential, it is still in a nascent phase and has a long way to go.
Green Finance and ESG Investing
So far, we have understood financing and sustainable finance.
Now many of you wonder how traditional banks started focusing on sustainable investments. As far as we know, the changes started happening in the 1960s.
The history of banking and finances started in the 15th century. At that time, financing and sustainability were pretty much the same as these banks followed strict ethical guidelines.
However, they were differentiated during the 16th, and 17th centuries when banks started expanding and getting bigger, they started adopting new financial practices. Banks started promoting industrialization, which accelerated economic growth.
By the industrial revolution in the 18th century, big banks started to move away from local financing to international markets. Consequently, there was a gap in the regional market, which led to the emergence of cooperative banks and credit unions by the half of the 18th century.
In short, traditional banks started becoming multinational banks embracing international trades to maximize their profit. In contrast, corporate banks and credit unions started supporting local developments and practicing sustainability in the form of socially responsible investment.
But, we started seeing a shift among these multinational banks in the 1960s when people criticized these big banks for investing in companies that supported wars and caused environmental damage.
By the 1980s, these multinational banks finally started focusing on sustainable finances under the pressure of regulations to ensure that banks do not make any investments that may harm the environment.
In other words, banks needed to do an environmental risk assessment before making any investments. It led sustainable financing to become mainstream among the major banks (10).
The movement was further cemented by the UN’s report on sustainable development in 1987. It led to the creation of the United Nations Environmental Program (UNEP) Finance Initiative in 1992 (11).
The UNEP program aimed to link sustainability and financial performance. Their biggest contribution was its report on a legal framework for integrating ESG issues with institutional investment published in October 2005. After that, sustainability became a business case in the financial sector.
It came in the form of various frameworks and initiatives, including but not limited to:
- The Equators Principle (2003)
- The Principles of Responsible Investment (2006)
- The Global Reporting Initiative Financial Services Sector Supplement (2006)
- Global Impact Investing Network (2007)
- Global Alliance for Banking on Values (2009)
Why are Banks Focusing on ESG Goals and Green Finance?
Banks primarily focus on sustainability to avoid governments’ environmental and social regulatory interventions. After all, these interventions can put 50 to 60% of banks’ profits at risk. Hence, banks have started focusing on sustainability and green finance out of self-interest.
On top, there is always money they can make out of it. According to a Business and Sustainable Development report (12, 13), sustainability offers at least 12 trillion USD opportunity to businesses. And banks can start investing in these companies looking to leverage recent developments in sustainability and green financing.
Furthermore, investing proactively in sustainability also increases banks’ reputation and value. Several reports suggest that it will also help banks retain quality employees and attract more customers.
At present, banks are focusing on the below ESG criteria to screen potential investment opportunities (14):
- Energy use
- Waste management
- Treatment of animals
- Employee’s working conditions
- Relationship with suppliers, customers & local communities
- Accounting transparency
- Risk management
- Shareholder rights
Often, companies may not meet all these criteria. In that case, banks decide which criteria are most important and set their own ESG standards.
We know so far, we have only discussed sustainable financing. But what about green financing? We explained sustainable financing first because green financing is a subset of sustainable finance.
Diving Deeper into Green Finance
UNEP gives the broadly accepted definition of green finance (15):
“Green financing increases financial flows, from banking, insurance, investment, and microcredit, from private, public, and non-profit sectors to environmentally-friendly development priorities.”
Green finance aims to manage environmental risks, take up opportunities that offer environmental benefits and a decent financial return. Examples of green finance include:
- Green bonds
- Green banks
- Carbon financing
- Community-based green funds
However, we have not seen green finance becoming mainstream even though the benefit it offers. It is primarily because green projects come with several technological risks.
For example, solar panels have uncertainties regarding their energy storage, which is also weather dependent. These factors make it difficult for financial institutes to assess the financial risks of such green projects.
In addition, there are also risks of insufficient information since many governments and businesses are not openly sharing their environmental performance and progress.
In other words, there is limited information available on the success or failure of green projects. Again, it makes it challenging for FIs to identify, price, and manage their financial and environmental risks.
There is also an issue of maturity mismatch. It is worth highlighting that most green projects pay off in the long term, whereas the financial system is dominated by short and mid-term investments, leading to a maturity mismatch.
It is especially a complication for banks as most of their resources come from deposits, and people usually deposit their money in the short or mid-term (one to five years).
The lack of a reliable green finance policy framework also plays a crucial factor in why we don’t see many FIs embracing green finance.
Most policy frameworks do not offer any incentives for FIs to invest in green projects. At the same time, several policies still offer subsidies on fossil fuel investments. So, there are a lot of complications for green finance to become mainstream.
Solutions to Overcome These Challenges
The simple solution is to invest more resources into researching, improving, and developing green technologies.
Another solution is to focus more on funding small and medium-scale green projects. It would help banks reduce risks of individual failures and help test green projects at higher frequencies.
We can also overcome the challenge of insufficient information if businesses and governments disclose more information or become transparent about the success and failures of their green projects. It will help reduce financial risks, chances of repeating the same mistakes, and wasting resources on reinventing the wheel.
There are portals like Green Finance Platform with a worldwide network of experts, organizations, and countries that work to address green finance’s knowledge gap.
Researchers also suggest that with pension funds and insurance companies, we can scale up our green projects and overcome the challenges of maturity mismatch.
Unlike bank deposits, these institutes prefer long-term investments. People who invest in pension fund schemes do not look for a financial return for a few decades. In addition, every single dollar spent on a green project today can make at least three dollars in the future.
Finally, there is the issue of policy frameworks. In this case, central banks and governments need to work together to create reliable green financial policy frameworks.
Central banks have regulatory oversights on money, credit, and the financial system. Hence, they can easily identify risks associated with different green investment projects and models. Central banks can use this data to support governments and create a green financial policy framework as per their needs.
This is where we conclude our part of green finance. In the next part, we will discuss ESG goals, green finance status in India, and its significance.
Continue reading: Explained: Green Finance and ESG Goals in India Part – 2