green-finance-embedding-climate-considerations green finance, climate change, climate consideration, sustainable investment

green finance 101

Finance underpins all activities and projects across economies, whether driven by business, the public sector, social enterprises, or households—and whether the policy objectives are purely economic, social, environmental, or a mixture of all three. The financial services sector plays a pivotal role in supporting overall economic development through its intermediary functions and informed risk-taking and management.

The 2015 Paris Agreement turned the spotlight on the need to align financial systems with policies supporting sustainability while reducing environmental risks. The unprecedented volume of capital needed to achieve the agreement's goal of limiting global warming to 1.5°C this century has galvanized the development of green finance, or financial transactions that support the low carbon transition and fight against climate change.

ESG portfolios comprised

IN EUROPE IN 2018

€10.57 Trillion

GREEN FINANCE CAN:

Since 1995, when the Forum first measured the size of the U.S. sustainable investment universe at $639 billion, assets have increased more than 25-fold. And at the start of 2020, the total amount of U.S.-domiciled assets under management using sustainable investing strategies was $17.1 trillion, an increase of 42% since 2018. In Europe, the end of 2019 saw €10.7 trillion in invested assets after an ESG selection strategy, accounting for nearly 45% of total assets under management. These assets included the exclusion of sectors or companies from investment due to unacceptable activities, and integration, or the evaluation of ESG risks and opportunities alongside traditional financial analysis. However, products that specifically target sustainable development objectives were a smaller segment of the EU market, accounting for €2 trillion, or 11% of assets under management. We anticipate further significant growth due to the progressive sustainable finance agenda, including the new EU Taxonomy and Disclosures Regulations. However, current investment level is significantly lower than what is required to meet the Paris Agreement goals and the Sustainable Development Goals.

CHALLENGES TO GREEN FINANCE

The scale of the climate mitigation challenge is unprecedented. Analysis by the Climate Action Tracker shows the scale of change required to achieve the temperature goals set in the Paris Agreement.

Even if we see positive signs from policymakers around the world (e.g., China’s pledge to achieve carbon neutrality before 2060; the European Union’s increase of its 2030 ambition to 55% less GHG emissions; the U.S. re-joining of the Paris Agreement), achieving overall climate neutrality by 2050 still requires a real paradigm shift. This is especially the case since, despite all these good intentions, current pledges and policies would still lead to a warming of up to 3.1°C by 2100.

Support the development

and implementation of sustainable, green activities to address the climate, environmental, and social crises across all sectors of society.

Make a major contribution

to global efforts to create sustainable economies that can reduce emissions and enable growth.

Boost financial flows

to sustainable development projects from banking, insurance, micro-credit, and investment from the public, private, and non-profit sectors.

THE SUSTAINABLE, GREEN FINANCE WE NEED NOW

Current discussions focus on the fact that we not only need finance that ensures better outcomes, we also need finance that leads to substantially better outcomes in line with specific environmental and, potentially, social goals.

The EU Taxonomy for Sustainable Activities is a central piece of the EU Green Finance agenda, as introduced by the EU Taxonomy Regulation in June 2020. The Taxonomy Acts (or Delegated Acts) published recently are supporting its implementation. They include guidance on how to identify activities that substantially contribute to environmental preservation or do no significant harm, and also clarify the disclosure requirements for financial and non-financial companies Currently, the EU Taxonomy focusses on the definition of climate change mitigation and adaptation-related activities. However, in the future, it will cover a total of six key EU environmental objectives (which, for example, also include biodiversity and circular economy objectives). ICF is supporting the European Commission in preparing the future developments of the EU Taxonomy. The Taxonomy Acts currently focusses on a limited sets of activities and on only includes criteria related to substantial contribution to climate change mitigation and adaptation. In the future, it will cover a total of six key EU environmental objectives (which, for example, also include biodiversity and circular economy) and potentially also social dimensions.

Financial market players have already spent the past 10 to 20 years becoming increasingly familiar and comfortable with the risk profile of an array of new energy technologies. As a result, players are now deploying renewable energy and energy efficiency technologies at scale globally. Beyond environmental sustainability, the transition towards sustainable, green finance also covers social sustainability. This coverage reflects the increasing awareness that environmental sustainability cannot be achieved without social and economic sustainability. The European Commission is already assessing the opportunity to expand the current focus of the EU Taxonomy for Sustainable Activities to include social and governance issues. The market is also already moving on this topic. See, for example, the emergence of social and recovery bonds using key reference points, such as the UN Sustainable Development Goals (UN SDGs), to develop new green bond frameworks.

ACCELERATING THE PACE OF GREEN FINANCE

We know that the depth and speed of transformation need to reach the objectives set by the Paris Agreement or the UN SDGs are enormous. Therefore, the question now becomes: How can we foster this transition and drastically accelerate the pace of change of the global financial system?

To achieve this accelerated pace, we need to engender an appreciation of sustainability concepts, issues, and objectives in the minds of all stakeholders. Lucas Simons, in Changing the Food Game, first described the four-phase pattern of transformation toward sustainability. According to this framework, sectors transitioning toward more sustainable models do not follow a linear trajectory. Rather, they follow a dynamic process structured around four main phases of maturity, each of which involves its own dynamic, with different actors supporting or resisting change. In each phase, sectors in transition face new barriers, but also – and crucially – seize new opportunities. The Transformation Curve framework presented below also allows for visibility of the big picture and for constituent stakeholders to leverage their sector’s dynamics to catalyze the transition towards the next phase.

Using such a framework can help the finance sector:

Identify

where it sits in its journey towards greener and more sustainable practices.

Understand

the forces at play in one phase to define the required actions to support development to the next phase.

the transformation curve

We believe the European Union’s green finance system is entering the “critical mass” phase (as described in the above framework), characterized by increased cooperation within the sector and the emergence of multi-stakeholder initiatives to define common practices for key elements such as:

The SWOT analysis across highlights the key elements that will enable the EU’s financial system to continue the journey toward the next phase of its green and sustainable transformation. Click on each key element to learn more.

• EU financial players positioning themselves as first movers and pioneers in the field of green finance • Increased level of awareness of the severity of the potential impacts and the risks to business continuity and societal impacts at large • Increased recognition of underlying opportunities and potential competitive advantages • Strong support from EU policymakers, with high priorities and a clear political agenda • Increased awareness between market players of the need to cooperate rather than compete to achieve common goals

• Low market demand leading to resistance to change from established stakeholders (e.g., acceptance of the EU Taxonomy for Sustainable Activities). • Lack of definition and reference frameworks to support further development of green practices • Low level of technical expertise related to sustainable finance.

• Perception that green products may undermine financial performance. • Multitude of (voluntary) standards and taxonomies emerging across the world, creating risks of confusion and increasing costs. • Loss of momentum if current moves toward more sustainable finance do not translate into tangible impacts. • Difficulty recognizing the critical role played by key sectors while considering their underlying risks.

• Global recognition of the trailblazing role played by the European Union in this area, providing the opportunity to catalyze and shape global standards, and therefore accelerate the overall transition in global financial markets. • Increased recognition of the importance of a comprehensive approach to sustainability (covering all ESG dimensions) among “classic” financial players.

WHAT NEEDS TO HAPPEN NEXT

We believe the financial community recognizes the need to integrate a broader set of environmental challenges than just those related to climate change, and to also look at the interlinkages with social and governance issues. However, these challenges very much depend on the sectors that require such investments. In this context, sectors without clear decarbonization pathways aligned with the Paris Agreement (so-called transitional sectors, such as aviation) still need further support and research to identify possible developments while at the same time limiting the risk of carbon lock-in or stranded assets.

While the European Union is in a prime position to continue leading the way in green finance transition, some important barriers remain to maximizing opportunities and mitigating risks. Based on our analysis, three key priorities should enable green EU financial markets to reach the tipping point towards the institutionalization of the “new normal".

Innovative green financial mechanisms to scale up current investment in clean technologies and new business models, and to support both transitional sectors and the development of a sustained pipeline of bankable projects across sectors such as natural capital.

Harmonized tools and frameworks to assess investment impacts, address risks, and identify new opportunities related to challenges, such as climate change or the loss of biodiversity.

Increased dialogue between financial stakeholders to align on priority actions and identify the required policies to support them.

Sovereign green bond raise of

IN EARLY MARCH 2021

€8.5 Billion

PRIORITY 1: Innovative green finance mechanisms

The development of the green bond market is one of the most important examples of breakthrough innovation in green finance.

However, this development would need to comply with prudential rules and is currently subject to scrutiny by the European Bank Authority and the European Parliament. The European Union has also developed innovative financial instruments to promote investment supporting the transition. InvestEU and EU Emissions Trading System (EU ETS) financing mechanisms, such as the Innovation Fund and Modernization Fund, are all great initiatives helping to support both cutting edge research and development in climate neutral technologies, as well as wider deployment of proven technologies to aid the transition. The opportunities to help sectors to come together to articulate their investment needs, define bankable projects, and crowd-in investors are also now in the hands of investment platforms, such as that created to stimulate investment into the blue economy.

Recent years have seen a rapid increase of green bond issuance globally. We expect this increase to continue to rise in 2021 with the economic rebound effect following the COVID-19 pandemic. Government appetite for issuing sovereign green bonds, in particular, has fueled this momentum with several re-openings and a few inaugural issuances, including Italy, which achieved a record breaking debut sovereign green bond raise of €8.5 billion in Italy inearly March 2021. The market is exploring the opportunity to expand those instruments towards broader environmental and social dimensions, following the trend of looking at overall sustainability (e.g., sovereign nature bonds) rather than focusing on single thematic. Financial markets are also looking at adapting existing tools to get green bonds markets to the next level. Green securitization is a potential solution for corporations and financial institutions to access funding for their green projects.

PRIORITY 3: INCREASE Dialogue between green finance stakeholders

Many financial players understand the need to be part of the growing action-oriented movement and have started to engage with peers through pre-competitive collaborations to bring the green finance to the next level. A need to shield investments from either immediate environmental risks or long-term transition risks offers a powerful incentive.

Initiated by members of the EU Business and Biodiversity Platform, the Finance for Biodiversity Pledge brings together more than 37 banks, asset managers, insurers, and impact funds who collectively commit to collaborating, engaging, assessing their own biodiversity impact, setting targets, and reporting on biodiversity by 2024 at the latest. More globally, the International Platform on Sustainable Finance pursues the ultimate objective of scaling up the mobilization of private capital toward environmentally sustainable investments through the exchange of ideas, initiatives, and best practices, as well as the identification of barriers and opportunities. These groups, though small in size and numbers, provide a vivid illustration that financial players are coalescing around a series of identified challenges with the willingness to speed up the course of change in the financial sector. The objective, however, should be mainstreaming environmental considerations into financial decisions, including by associating developing countries with the United Kingdom’s Partnering for Accelerated Climate Transition’s program and Green Recovery Challenge Fund. This would be in line with the UN Climate Change Conference (COP26)’s stated ambition to “build a private finance system for net zero” a clear necessity if we are to achieve commitments set out by the Paris Agreement.

Against this backdrop, the European Union has accelerated regulatory efforts to bring clarity and develop a level playing field for investors and companies. With the Taxonomy Regulation, for example, the European Commission wants to build a common classification system, establishing a list of environmentally sustainable economic activities helping investors and businesses identify projects that are not only economically rewarding but also environmentally sustainable. The EU Taxonomy for Sustainable Activities is an important enabler to scale-up sustainable investment by driving the consistent development of future legislation within the European Union; the suggestion to link the use-of-proceeds of future EU green bonds to the EU Taxonomy for Sustainable Activities, as set out in the forthcoming EU green bond standard, is a good illustration of that. The Taxonomy’s long-term impacts on the financial transition, however, will only be effective once the technical screening criteria of its next iterations fully reflects all environmental objectives. The private sector has also shown a willingness to embrace change and the capacity to organize itself by initiating the development of frameworks aimed at complementing public sector regulation. A growing number of corporations around the world are using the recommendations of the Task Force on Climate-related Financial Disclosure (TCFD) to report on their climate transition risk management processes. Such private sector endeavors are effective ways to increase the availability and quality of disclosure. Following initial signs of success, other players have come together to mimic the TCFD model on nature to aid the appraisal of nature-related risk and the redirection of global financial flows toward nature-positive outcomes. While supporting disclosure frameworks is necessary as it contributes to market transparency and enhances competition, it is often not enough to drive effective sustainable outcomes beyond climate.

The variety of standards for reporting and disclosing investments labelled as “green”, as well as the lack of frameworks and tools to account for other environmental components such as biodiversity, are major hindrances to the growth of green finance within the European Union and globally.

The rapid development and adoption of financial standards and regulatory frameworks spurred on by the European Union’s leadership in green finance, and the many testimonies of successful collaboration between peers, represent clear signals that the greening of the financial system is firmly on its way. However, many obstacles remain to fully embed environmental considerations into financial considerations.

To make green finance the “new normal,” and to scale up investments, we need to both accelerate the pace and the volume of investments targeting green projects.

Bringing Green Finance to the Next Level

ACCELERATING THE PACE OF GREEN FINANCE

PRIORITY 2: Harmonized TOOLS & frameworks for green finance

Companies and investors also need to better understand how their activities impact and depend on nature in order to make informed decisions. The recently launched Align project is the first of its kind to support financial institutions in developing standardized natural capital accounting practices (including a standardized approach to biodiversity measurement).

In addition, we must recognize the key role currently played by the European Union and its Member States in driving the green and sustainability agenda, with a clear focus on the EU Green Deal and the EU Sustainable Finance Action Plan to transition to a more resilient, sustainable, and just economy and society. As highlighted in the S-curve framework above, the increased scrutiny and transparency make it highly likely that several other challenges will emerge. Moving at an accelerated pace also generates important risks to be recognized and addressed in order to ensure we maintain the right direction of change.

Target setting

(e.g., the Science Based Targets initiative for financial institutions).

Reporting

(e.g., CDP’s financial services questionnaire).

Impact assessment

(e.g., the Partnership for Carbon Accounting Financials initiative or the Align project).

Risk analysis

(e.g., the Task Force on Climate-related Financial Disclosures and the Task Force on Nature-related Financial Disclosures).

2100 warming projection

Emissions and expected warming based on pledges and current policies

Source: Climate Action Tracker

STAGE 1

INCEPTION

STAGE 2

FIRST MOVERS

STAGE 3

CRITICAL MASS

STAGE 4

INSTITUTIONALIZATION

% SECTOR SUSTAINABLE

These same market players should now start preparing for the more complex environmental objectives under the EU Taxonomy, such as how to address the issues of biodiversity loss.