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Green Finance: The Road Ahead

 4 min read / 

The green finance market is expanding tremendously, and financial institutions seek to leverage the new opportunities from the transition to a carbon-neutral economy. Climate change is altering the environment in which companies operate, but also offers great investment opportunities. In addition, there are two main categories of risk that have been recently considered: (1) physical risks such as flooding and storms; and (2) transition risks such as climate policy measures and carbon-neutral technologies. Green finance has emerged and gained in popularity especially after the Paris Agreement. Despite the positive impact that such a development entails, there is a wide range of risks associated with green investment products.

Trends

Total new investment in renewable energy grew from $72.7bn in 2005 to $241.6bn in 2016. Only China and India alone are a $4trn opportunity for the (sustainable) energy sector. The current expansion in the green finance market seems to be driven by profitable investment opportunities. Furthermore, environment, social and corporate governance factors became a very important part of the business plan and marketing strategies of major companies and institutions. Asset management entities are openly willing to contribute to the Paris Agreement 2015 climate goals by closely tracking decarburization of their portfolios and disclosing their climate impact.

Risks

Technological developments and innovations in financial products have proved to cause bubbles – tulipmania, the dotcom bubble, ‘Railway Mania’ and the 2007-8  financial crisis, just to name a few. The internet revolution in the 1990s drove the prices of the US stock market index to unimaginable heights. The NASDAQ Composite index peaked in 2000 and fell almost 80% in the upcoming 30 months.

More surprisingly, small companies changed their names to “dotcom” between 1998 and 1999, which produced 74% cumulative average return (CAR) for the 10 days surrounding the announcement day. The crash wiped out the savings of many individual investors, who bought equities during the run-up and the collapse of the bubble. Some researchers document that sophisticated asset management companies actively bought internet stocks during the run-up, but reversed their investment strategies at the beginning of 2000, which drove the collapse (Griffin, Harris, Shu and Topaloglu, 2011).

The energy transition may cause a similar bubble. As investors allocate their capital to new technologies and (un)labelled green bonds, financial instruments may become overvalued. The competition among green bond investors increased exponentially during the last 2 years. At the moment, investors who have a mandate to invest in green bonds and want to gain exposure to certain parts of the world have to pay more than a similar conventional bond. However, such a relationship does not hold for all green bonds, so active management adds value without a doubt.

Reputation Damage

To date, the Green Bond Principles (GBP) remain vague and unclear in certain cases. The financial markets have observed several cases of controversial allocation of resources to “green” projects – a kind of behaviour also known as ‘greenwashing’. Although the term is not new, it became more popular in the recent f years due to the increased demand for environmentally friendly (financial) products.

For instance, a European oil company issued a bond to finance energy-efficiency upgrades of its refineries. As a response, major bond index providers such as Bloomberg Barclays MSCI excluded the oil company’s green bond from Bloomberg listings. Another good example is a European Union Member State that openly opposed the implementation of EU Climate and Energy policies has issued a green bond. Allocating resources to small green projects, while continuing to increase investments in large fossil fuel projects is something both issuers and investors should be careful of.

Conclusion

It is important that climate risks are identified and mitigated appropriately by encouraging investors to allocate resources to green financial products. Financial institutions and individual investors should be careful and consider all available data, as either group may end up with a set of asset bubbles.

One could remember overpriced assets could trigger a crisis that impacts various industries. More importantly, considering the (green) label of an asset (for example, the Climate Bond Initiative certification) and second party opinion could prevent one from ending up with “greenwashing” assets and risk their reputation. Nevertheless, green investments – especially green bonds – would remain a powerful tool in the hands of investors to help mitigate climate change risks.

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