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Green Investing: the Financial Sector and the New Climate Economy

 7 min read / 

Most people think about eradicating poverty and global inequality when discussing global challenges. However, both objectives are dependent on a more pressing and greater challenge: global climate change.

A turning point in the fight against global warming occurred after 185 countries signed the COP21 Paris Agreement, which was premised on the need of keeping global warming under 2°C through the mobilisation of $100bn annually between 2015 and 2020, for a total of $1trn by 2030.

In this context, the financial sector plays a fundamental role in helping governments to finance their goals. By committing to sustainable projects, the financial sector can be an effective multiplier for the lasting benefits for both clients and the society at large.

Economic Development and Sustainable Finance

Due to the increasing size of the world population, and the consequent urbanisation and expansion of a global middle class, there is a need for a sound financial system that meets the long-term requirements of an inclusive, environmentally sustainable economy.

As World Bank Senior Director John Roome observes, if current population trends continue, there will need to be double the current amount of infrastructure in place in fifty years time, due largely to the growth of emerging economies.

Moreover, consumer goods and everyday luxuries, such as meat, cosmetics and home appliances, will be demanded more than ever, which will increase the carbon footprint. In this context, a World Bank study estimates that developing countries alone will bear a cost of  $520bn due to climate change in the next fifty years, but at a global level, assets worth $158trn – or twice the current output of the global economy – will be at risk.

However, such risks are avoidable mainly due to technological advances, which can be translated into new opportunities for businesses. For example, in private finance, trillions of dollars are invested in liquid assets with a low or negative interest rate, according to an estimate by the International Finance Corporation.

A possible transformation of this status is changing these assets into green bonds, which also have a positive impact on the environment. Furthermore, carbon pricing is, above all, a source of government revenue and should, therefore, be promoted foremost by governments themselves.

However, according to Roome, the main issue with climate-related investment is conveying the various sources of financing in bigger and more effective pools of investments. The key solutions to this problem are long-term commitment and optimal risk allocation.

Proof of this is the viability of the ‘Rewa Ultra Mega Solar’ energy plant in the state of Madhya Pradesh, India, partially funded with loans from the World Bank. As seen in the previous example, it is clear that developing states like India are seen as key markets for future green investments, mainly because with the current situation regarding climate change, a truly effective economic development has to consider the environmental issue.

Risks of Green Energy Investing

Other than physical risks, such as natural catastrophes and market risk, companies and businesses may face liability risk correlated with regulatory and reputational issues that may arise as a consequence of climate change.

Alice Garton of ClientEarth, a non-profit environmental law organisation, pointed out that potential liabilities may arise due to voluntary or involuntary contribution to climate change, or failure to mitigate risks associated with climate change.

Failure to adapt not only to environmental issues, but to regulations related to them, may compromise a company’s reputation, demonstrating a lack of competence, and undermining the trust and loyalty of clients, investors, and regulators.

However, blame should not be put just on companies that fail to adequately disclose risks and potential liabilities, but also on regulators that in many situations do not adequately enforce the regulations and laws created to protect customers and investors.

While it is obvious that technological and environmental disruption creates winners and losers, failure to disclose liabilities means failure to adapt for firms. When laws are not clear or inexistent, according to Garton, companies should always try to apply new business risks to already existing or older laws in order to disclose all regulatory, material and reputational risks to their business from climate change.

In theory, acting in this way should reduce the risk of liability of most firms, thus benefiting both clients and investors.

Green Investment and Emerging Markets

Climate change should become a priority for the private sector, not only for the sake of global welfare per se but also because more than half of pension portfolios are exposed to climate risks, according to an estimate by the International Finance Corporation.

As Alzbeta Klein, Director and Global Head of IFC pointed out, the global economy is always moving forward, but when things become too dangerous and difficult to handle, changing the course becomes increasingly harder.

Moreover, after the Paris Agreement and the commitment of its participants to mobilise $1trn by 2030, taking the green path makes sense for many industries also because it is potentially highly profitable.

Emerging market economies are trying to develop directly in environmentally friendly ways, not only because of the increasing opportunities in the green sector as mentioned before but also because following the usual path of highly polluting industrialisation undertaken by most advanced economies might be too costly and risky for the whole Planet.

In order to attract investment in the green sector, Klein suggested that three broad rules should be followed: safety, scale and simplicity.

While the first, which includes accountability and transparency is a fundamental prerequisite to protect investors and shareholders, the second is designed to cluster together small projects that alone would not interest most investors simply because of their size.

On the other end, simplicity implies the use of plain vanilla instruments, such as bonds convertible into either cash or carbon credit, which are easily understandable by the vast majority of investors.

Moreover, these three principles, are useful to mitigate the risks posed by investing in new markets, historically characterised by volatility and political uncertainties.

What Next?

As stated during the recent FT Climate Finance Summit, green energy projects are quietly disrupting not only the traditional energy industry but also the automotive sector, which has seen a 42% increase in the sale of electric vehicles since 2015.

Traditional business models of many power companies are being disrupted, but this is only the beginning, because, according to Per Lekander, portfolio manager at Lansdowne Partners, the next sector involved will be the oil industry. Evidence of this is the recent issuance of green bonds, and the internal carbon pricing, recently used by oil giants Repsol and ExxonMobil.

Opportunities in the green sector are enormous, with more than $350bn invested in 2016 alone. However, for Meral Ozcicek, head of Financial Institutions at TSKB, a Turkish investment management company, the only issue that prevents many sustainable projects to take off is a lack of an established relationship between lenders and issuers.

As the price of clean energy lowers, due to technological advances in the solar photovoltaic and lithium-ion batteries, the future of green energy seems brighter than ever.

Growing investor interest means that governments should incentivise and facilitate green investment through effective policies. Still, as Mathew Nelson, of EY, points out, markets should be left to partially autoregulate.

This means allowing the increasing demand for clean energy to meet its supply, as is happening currently in Australia, where a new coal plant is simply unthinkable because the economic advantage of renewables is so great.

Moreover, this strategy of market autoregulation thanks to new technological developments may work as well to ease the transition towards a more widespread use of sustainable sources of energy, not to mention the consequent possible fall in greenhouse gas emissions.

The Role of Financial Services

As fundamental actors of the global investment value chain, public and private financial institutions arguably have a fiduciary duty to optimise their response to climate change.

Adapting business models to new environmental and regulatory situations, and including climate-related issues in daily decision making is a good point to start, but more will be needed to make the transition towards a low-carbon economy.

Last but not least, by helping clients and investors to optimise climate-related opportunities and risks, and by directing capital to groundbreaking individual firms, the financial sector will invariably reshape the global economy for the better.

After all, investing in renewables is not only good for the World and its population but, as Roome said, “it also makes good business sense”.

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