Transition to a Green Economy: Sustainable Private Finance

As the threats of climate change increase, sustainable finance has an important role to play in fostering the transition to a green economy. On 9 December 2021, financial experts from IMF’s Monetary and Capital Markets Department discuss key findings and progress in COP26 agreements and Chapter Three of the Global Financial Stability Report, October 2021. The speakers include Ms Charlotte Gardes, Financial Sector Expert, Global Market Analyst Division, Mr Felix Suntheim, Financial Sector Expert, Global Financial Stability Analysis Division, and Mr Xu Yizhi, Economist, Global Financial Stability Analysis Division, and the session was moderated by Associate Professor (Practice) Yougesh Khatri, Nanyang Business School.

COP26

COP26 saw progress in terms of The Glasgow Climate Pact and the forming of other pledges, such as the Global Methane Pledge and the Glasgow Financial Alliance for Net-Zero. However, Ms Gardes stressed that despite COP26’s impact in spurring momentum for climate action, more work still needs to be done.

Crucial topics such as ambition gap, lagging adaptation finance and the lack of mandatory targets and methodologies for the financial sector remain unsettled. The recent rise in methane emissions in the energy sector justifies actions taken during COP26 for abatement measures. Amit mounting ESG pressure to limit coal emissions, coal mining companies’ stock performances have depreciated. Methane-related emissions need to be substantially reduced worldwide, especially in Asia where the coal mining sector has expanded. Ms Gardes suggested that progress has been made as loans to thermal coal corporates show a substantial decline since the Paris Agreement. However, coal is still not completely phased out in COP26.

Investment funds

Concentrating on the summary of the Global Financial Sustainability Report, Mr Suntheim stressed that the financial sector has a key role in facilitating the transition to more climate friendly business models. As investors make decisions based on risk, opportunities, and sustainability preferences, investment flows into conventional and sustainable funds, which in turn can affect the corporate sector through proxy or a supply of capital. Climate-focused funds account for only a small share of funds but there have been strong inflows in recent years. In fact, the sector has grown much faster than conventional peers in recent years.

In Advanced Economies, transition opportunities have remained stable and the average carbon intensity has declined only slightly outside of emerging markets. However, Mr Suntheim emphasised that these results are based on a relatively small sample size. On average, climate funds have higher levels of transition opportunities but portfolios with higher levels of carbon intensity are more heavily invested in transition-sensitive sectors. They key takeaway here is that climate funds do indeed invest in transition but are small compared to the overall sector.

With regards to the possibility of a green finance bubble, Mr Suntheim cited the example of sin stocks (e.g., alcohol, tobacco, etc.), which require higher rates of return; he noted that the higher cost of funding these products reduces their ability to fund projects. But the upside is if there are flows into the funds and there is more buying (rather than selling) pressure, the cost of capital would go down. While it is possible to call this a bubble, it could also be seen as a persistent change in investor preference.

Findings and implications

Referring to the motivations that drive flows into system, Mr Xu pointed out that funds with a climate label are more likely to attract investment fund inflows. Investors appear to pay more attention to sustainability labels rather than portfolio holdings. However, Mr Xu noted the importance of considering the meaningfulness of the classification so as to avoid greenwashing.

The report found that beyond portfolio scores, labels are useful for identifying funds’ climate stewardship. Flows into sustainable funds increase the likelihood and amount of bond issuance, and the amount of equity issuance by green firms. Price pressure caused by high flow sustainable funds increases equity returns. In general, flows into sustainable funds can help companies adopt more climate-friendly business models through stewardship or by issuance of securities. But additional policies are needed to support flows into sustainable funds.

In terms of policy recommendation, Mr Xu stated that there is a need to strengthen global climate information architecture and ensure regulatory oversight to prevent greenwashing. Policy tools also need to change savings toward transition-enhancing funds could be considered.

On how sustainable funds could profit, Mr Xu suggested that investors may prefer to hold green assets as they function as a hedge for potential transition risks. Due to these preferences, risk premiums associated with green assets may also be smaller. However, when there are shocks related to transition risks, there should be structural shifts in investor preferences, which may increase their preference to buy more investment funds, thus pushing up returns for green assets.

Greenwashing

On the question of greenwashing, Mr Suntheim highlighted climate-themed funds invest in funds with clear transition aims. Chapter Three of the report does not have clear evidence of greenwashing but measuring greenwashing is also tricky. The sector is small and not yet effective in reducing emissions but it does seem to be active in the right direction.

With regards to the effect of The International Sustainability Standards Board (ISSB) on greenwashing, Ms Gardes pointed out that ISSB stems from wide developments in the EU. There has been a strong push for a common level of reporting on an international level amongst all ESG topics. The goal is to extract financial information in order to have common standards and rules for auditing. Although the ISSB has no enforcement power per se, it can put forth the rule and norm, which is the basis of any financial regulation.

The EU context

Responding to a question on the EU taxonomy, Ms Gardes said that one of the great advantages of a taxonomy is to set out run maps for sustainable investing as its role is to provide a format for everyone but also to prevent greenwashing.

With regards to private equity firm, Ms Gardes pointed out that research shows that public companies rely on their subsidiaries to come up with better ESG reporting, which would have impact on private and smaller firms. Also, the relative decrease in IPOs in EU is not due to enhanced reporting requirements but are more about macroeconomic-related issues. Ultimately, Ms Gardes found that it depends on the level of standardisation; standards need to match the specificity of the sectors and companies for better results.

Career in Sustainable Finance

Finally, Associate Professor Khatri asked if sustainable finance is an area of specialty worth pursuing. Mr Xu felt that this is a promising field, particularly in climate change and policy issues while Mr Suntheim thought it most important to work in field that match individuals’ interests. Emphasising her personal bias, Ms Gardes suggested that climate change will remain a topic of interest, even if it is not the flavour of the month.