What a difference a year makes. Just twelve months ago, the question of how the world's US$315 trillion financial system should evolve to respond to the pressing challenge of environmental sustainability was still a minority sport. Last week in Washington, as finance ministers and central bank governors gathered to explore once again how to boost the global economy, a new dimension had entered the equation: green finance.
For the People's Bank of China Governor Zhou Xiaochuan, it's clear that "the financial system should play an important role in promoting the green transformation of our economies." Building on early work in the banking sector, establishing a green finance system has become national strategy in China and part of its new 13th Five Year Plan. Across the world in the UK, Bank of England Governor Mark Carney also underscored the need for global cooperation to move green finance from "niche to mainstream." Under China's leadership, the G20 has set up a new 'green finance study group' to take stock of fast-moving developments in global markets and identify practical options to enhance the ability of the financial system to mobilize private capital for green investment.
All this reflects the convergence of a number of powerful forces. The sheer scale of the investment requirements to deliver the world's Sustainable Development Goals and the Paris Agreement on climate change has stimulated a new conversation on how to mobilise private capital. Strong sector policies to channel private capital to sustainability priorities from agriculture through cities to energy and transport are required more than ever. Real pricing of natural resources and pollution is vital to generate attractive risk:return profiles for sustainable solutions. And smart deployment of scarce public finance is essential to pay for things that the market will not provide and to 'crowd in' private capital to critical areas of green infrastructure and clean tech innovation.
The novel dimension is the growing recognition that action within the financial system itself is also required. Voluntary efforts by financial institutions to anticipate disruptive change are mounting. More than US$10 trillion of investment assets are now committed to disclosing the carbon footprint of their portfolios, for example. And beyond transparency, institutions with over US$600bn of investments assets are reducing the carbon intensity of their holdings, driven by the desire to cut exposure to risky assets ahead of tightening climate policy.
There can be real limits to voluntary action, however. Market innovation may not move fast enough to deliver the required reallocation of capital. Financial short-termism can prevent the timely recognition of new threats, such as mounting water stress. And markets may simply not have the data or the skills to make informed decisions on the complex sustainability agenda. Action by policymakers can help overcome coordination problems in financial markets. This is why in his role as the chair of the Financial Stability Board, Carney, launched a new industry-led task force at the Paris climate summit in December 2015 to help drive a more consistent approach to climate disclosure. In its first report released earlier this month, the Task Force stated that better climate information could help to reduce "the likelihood of large, unexpected changes in asset values" and aid regulators "in their efforts to determine potential system-wide vulnerabilities".
With investments in renewables alone needed to quadruple by the early years of the next decade, high on the list of priorities are new mechanisms to channel private capital to green assets. The nascent 'green bond' market has now gone global - with issuance growing to US$42 billion in 2015. This is a new type of financial market that has been co-created through a mix of public, private and social innovation. Development banks such as the EIB and the World Bank first seeded the market with initial green bond issuance. Investment banks then put in place a set of green bond principles to underpin trust - and investors followed by publishing billion dollar commitments to buy green bonds. Together stakeholders are now designing market standards to ensure performance. And regulators in key markets such as China and India have started to put in place country-level frameworks to drive expansion. The impacts are have been quick to see: so far this year, China has accounted for 50% of green bond issuance. So far, green bonds represent less than 1% of the global fixed income market - but the prize that lies ahead is a market measured in the hundreds of billions if not trillions that not just increases access to finance, but also reduces the cost of capital, which can often be the biggest financial burden for critical green infrastructure.
Yet as all dieters know, just eating the greens without cutting out the carbs will fail to deliver the required results. Here, attention is focusing on how to improve the sensitivity of the financial system's antennae to the risks of pollution intensive assets. The world's largest bank, ICBC, has just released the findings of its pioneering stress test of the impact of policies to cut China's chronic air pollution.
Later this year, France is set to lay out how its banks will need to include climate factors in routine stress tests of their resilience to market shocks. And the IMF is also starting to explore how climate factors could exacerbate the fiscal shocks of intensifying natural disasters in developing countries.
Here, new thinking is needed. As financial markets increasingly integrate sustainability factors such as climate risk into routine practice, vulnerable developing countries fear that access to capital could be compromised if their sovereign bond ratings get downgraded without countervailing action to build up their fiscal firepower. Analysis by Standard & Poor's suggests that climate change will exacerbate the negative sovereign rating impact from 1-in-250-year natural catastrophes by 20% on average. Extending insurance can reduce some of the negative impacts, but not all.
Cutting across the challenge of greening capital allocation and risk assessment is the disruptive potential of fintech. Here developing countries have been ahead of the pack in using digital technology to bring not just access to finance via mobile platforms, but also access to energy, for example, through Kenya's M-Kopa initiative. New ways of matching savers with green investments are also opening up via peer to peer platforms such as Abundance in the UK. But the full potential - both negative and positive - of fintech for green finance has yet to undertaken.
Ultimately, green finance is a question of strategy - how financial sector development can be shaped to respond to this new requirement from the real economy. With historically low interest rates and abundant cash sitting in the wings, there is an emerging realisation that green finance could lie at the cutting edge of new growth strategies. In the European Union, finance ministers will meet for the first time on 22 April to explore how to finance the transition to a sustainable economy. In the EU, many of the elements are known - better disclosure, sustainability 'stress testing' and green asset development. A growing number of EU countries are moving ahead with national action, notably France, the Netherlands, Sweden and the UK. What has been missing until now has been a comprehensive approach at the Union level that links these efforts to greening the financial sector with the broader economic recovery agenda.
This sense of the macro-economic potential of green finance comes most strongly from the emerging economies where the environmental challenge is greatest. For K.V. Karnath, president of the New Development Bank of the BRICS group, 'green finance is an economic imperative' and not just a way of tackling environmental threats. Mixing environmental purpose with market efficiency, green finance could be 'an unbeatable combination' in Karnath's words to put in place the investment flows that the world economy so urgently needs.
Putting this all together, a networked approach to mobilize private finance for sustainable development is starting to emerge, one which blends the introduction of long-term policy signals, a refreshed role for public financial institutions and new rules of the game in terms of market standards.
As world leaders look to implement the far-reaching Sustainable Development Goals and Paris climate agreement, more and more attention looks set to be devoted to how to green the financial system.
* Nick Robins and Simon Zadek are co-directors of the UNEP Inquiry into the Design of a Sustainable Financial System. The Inquiry published its first global report, The Financial System We Need in October 2015.