Handbook of Green Finance [1 ed.] 9789811302268, 9789811302275

Citation preview

Sustainable Development Series Editors: Parkash Chander · Euston Quah

Jeffrey D. Sachs · Wing Thye Woo Naoyuki Yoshino Farhad Taghizadeh-Hesary  Editors

Handbook of Green Finance Energy Security and Sustainable Development

Sustainable Development Series Editors Parkash Chander Jindal School of Government and Policy New Delhi, India Euston Quah Nanyang Technological University Singapore, Singapore

The MRW Series on Sustainable Development explores and examines a range of key sustainability questions, right from the abstract concepts, definition, criteria, and approaches around the subject of Sustainable Development to the examination of more concrete issues from policies and practices. Through various volumes looking at the global scenario in general and Asia Pacific in particular, the series introduces economic tools in sustainability, including cost-benefit analysis, environmental impact assessment, economic appraisal techniques, methods to deal with uncertainty and risks, and other methods to evaluate the impacts of policy instruments applied by governments to sustainability issues. Finally, the series advocates best practices on the part of produces, consumers, and governments, while charting the future for sustainability. More information about this series at http://www.springer.com/series/15042

Jeffrey D. Sachs • Wing Thye Woo Naoyuki Yoshino Farhad Taghizadeh-Hesary Editors

Handbook of Green Finance Energy Security and Sustainable Development

With 143 Figures and 133 Tables

Editors Jeffrey D. Sachs Columbia University New York, NY, USA Naoyuki Yoshino Asian Development Bank Institute (ADBI) Keio University Tokyo, Japan

Wing Thye Woo Department of Economics University of California at Davis Davis, CA, USA Farhad Taghizadeh-Hesary Faculty of Political Science and Economics Waseda University Tokyo, Japan

ISBN 978-981-13-0226-8 ISBN 978-981-13-0227-5 (eBook) ISBN 978-981-13-0228-2 (print and electronic bundle) https://doi.org/10.1007/978-981-13-0227-5 © Asian Development Bank Institute 2019 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

Series Preface

The term “sustainable development” – first coined by former Norwegian Prime Minister Harlem Brundtland in 1987 in the World Commission on Environment and Development report – has been used and misused over the years to justify many actions or causes. Sustainability, in the context of that report, is defined as “development that meets the needs of the present without compromising the ability of the future to meet their own.” This concept, while noble and caring for the environment and that for the future generation, has however come to mean different things to different people. To some, it implies a greater awareness of environmental issues, while to others it means a coordinated, organized, and systematic evaluative theory for economic and public policy. Much intellectual debate on sustainability also stems from whether society allows for substitution between natural capital (green areas, fossil fuels, and forests) and man-made capital (buildings and other infrastructure) in the course of economic growth and development. Still others would be happy with efforts to measure sustainability by way of human progress, welfare, and income growth. For much of environmental management, one clear focus is to achieve environmental quality by reducing man-made pollution to a level that is acceptable to society. In all, sustainability is a nebulous but attractive concept with an important guiding principle and essentially asks the basic question for any activity: “Can this activity continue?” There exists many works on sustainability, most of which are related to global sustainability, as well as sustainability in the Western world. In contrast, many Asian countries are still prioritizing strong, yet possibly unsustainable, economic growth. Majority of these developing Asian countries are economically far behind the developed world. Some of these countries are experiencing pockets of abject poverty, struggling to meet the needs of the present in areas such as sanitation and education. It is evident that strong economic growth remains paramount to improving living standards in many Asian regions, but we cannot overlook the fact that growth carries its own costs to the natural environment and to peoples’ health. The true success of growth thus hinges on whether “sustainable development” has been achieved and whether Asian countries are able to balance the twin goals of economic growth and environmental protection.

v

vi

Series Preface

The MRW series on Sustainable Development explores and examines a range of sustainability questions as follows, with each book dealing with a particular topic. 1. The origins and definitions/meanings of the term “sustainable development”; the relationship between sustainability and economic efficiency/growth; sustainability theories and models; sustainability criteria including concepts of weak and strong sustainability; other key conditions required to achieve sustainable development; approaches to measuring sustainability. 2. The roles of various economic agents in sustainable development. What can and what should producers, consumers, and governments do? 3. How has sustainability policies and measures been implemented in developed economies? What are the lessons for Asia? 4. How does sustainability feature in the Asian environment? How is sustainability perceived and understood by Asian countries? What has the region achieved thus far? What are the strengths or weaknesses/limitations of currently adopted policies and approaches? 5. Economic tools in sustainability, including cost-benefit analysis, environmental impact assessment, economic appraisal techniques, methods to deal with uncertainty and risks, and other methods to evaluate the impacts of policy instruments applied by governments to sustainability issues. 6. International policies and sustainability, including international institutions to resolve sustainability related issues, and the history of international negotiations, agreements, and actions. 7. Charting the future for sustainability: What lies ahead? What are the future challenges, new solutions, and technological innovations? 8. Sustainability in megacities. 9. Balancing environment and economic growth, including the complexity of sustainable development in the Asian context. 10. Climate change and international agreements to tackle it. 11. The problem of Southeast Asia haze and its possible solutions. 12. Economic instruments and mechanisms for achieving sustainability and related goals. Audience Practitioners; government policy makers; industry specialists; university students, researchers, and faculty members taking courses on environment, resource management, ecology, economics, environmental science, urban and resource planning, etc.; NGOs; and others.

Jindal School of Government and Public Policy, NCR Sonipat, Haryana, India Department of Economics Nanyang Technological University Singapore, Singapore

Parkash Chander

Euston Quah

Preface

Given the current trajectory of global fossil fuel use, the projected increase in the temperature of the planet will be catastrophic for food production, human health, and biodiversity. Indeed, in many parts of the world it will threaten the survival of communities. Governments have already agreed to keep global warming below 2  C but have yet to take decisive action toward creating a low-carbon energy system. The world needs massive investments in green energy systems, and phasing out of coal-fired power plants. In addition, it needs considerable investments in electric vehicles together with a sharp reduction in internal combustion engine vehicles. However, new investments in green energy projects and energy efficiency have slowed down. The private sector is not showing sufficient interest in green projects because of their higher risks and lower rates of return when compared with fossil fuel projects. This means that achieving the Sustainable Development Goals (SDGs) will require the establishment of new financial schemes for green projects. For “Green Finance” to succeed, governments will have to introduce policies to increase rates of return of green projects in order to incentivize private investors to invest in them. The Handbook of Green Finance: Energy Security and Sustainable Development brings together leading scholars, policy-makers, and practitioners to discuss options in strategies and policy instruments in a policy-oriented approach on green finance. The handbook consists of 12 parts. Part 1 is for the introduction, which shows the importance of Green Finance for achieving sustainable development goals and energy security. Parts 2-11 are for financial barriers for the development of green projects, green energy transition (strategies and financial governance), credit risk and credit rating of green projects, green bonds, carbon capture and carbon pricing, role of banks and non-bank financial institutions, fintech and financial innovation, green technology financing, community-based green finance, and the role of fiscal policy. These 10 parts provide 19 thematic works that show practical methods (financial and nonfinancial) for promoting private sector investments in green projects. Part 12 contains country case studies to identify the barriers and solutions to green finance. The countries covered are Australia and New Zealand, Bangladesh, India, Indonesia, Malaysia, Pakistan, the Republic of Korea, Singapore, and Viet Nam. The comparison of vii

viii

Preface

country experiences provides valuable lessons on how to utilize green finance to accelerate the move to a carbon-free world. This handbook is an essential source for researchers, government officials, students, and professionals working in the financial market and energy sector. Jeffrey D. Sachs Wing Thye Woo Naoyuki Yoshino Farhad Taghizadeh-Hesary

Acknowledgments

We are grateful to Peter J. Morgan and Bihong Huang for their help in this research project from the ADBI side, Ainslie Smith for coordinating the copyediting of the chapters, Muriel S. Ordoñez and Jera Lego for publication management, Grant Stillman for legal affairs management, and Masae Ikeda for secretarial support. We also thank Juno Kawakami, Krithika Radhakrishnan, and Tina Shelton of Springer Nature for their help and efforts in the book publishing process. We are grateful to all contributors to this book. Without their valuable contributions, we would have not been able to finalize this book.

ix

Contents

Part I 1

.......................................

Importance of Green Finance for Achieving Sustainable Development Goals and Energy Security . . . . . . . . . . . . . . . . . . . . Jeffrey D. Sachs, Wing Thye Woo, Naoyuki Yoshino, and Farhad Taghizadeh-Hesary

Part II 2

Introduction

1

3

Financial Barriers for Development of Green Projects . . . . .

13

Financial Barriers for Development of Renewable and Green Energy Projects in Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hooman Peimani

15

Part III Green Energy Transition: Strategies and Financial Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

35

3

Financial Strategies to Accelerate Green Growth Hee Jin Noh

.............

37

4

A “Cap and Invest” Strategy for Managing the Intergenerational Burdens of Financing Energy Transitions . . . . . Jatin Nathwani and Artie W. Ng

63

5

Central Banking, Climate Change, and Green Finance . . . . . . . . . Simon Dikau and Ulrich Volz

Part IV 6

Credit Risk and Credit Rating of Green Projects . . . . . . . .

Managing Credit Risk and Improving Access to Finance in Green Energy Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dhruba Purkayastha

81

103

105 xi

xii

Contents

Part V 7

Green Bond

......................................

Differences Between Green Bonds Versus Conventional Bonds . . . Suk Hyun, Donghyun Park, and Shu Tian

Part VI

Carbon Capture and Carbon Pricing . . . . . . . . . . . . . . . . . .

8

Carbon Pricing to Promote Green Energy Projects . . . . . . . . . . . . Takashi Hongo

9

Financial Barriers and Strategies for Promoting Carbon Capture and Storage Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Akira Ogihara

Part VII 10

Banks and Non-bank Financial Institutions

...........

Stimulating Non-bank Financial Institutions’ Participation in Green Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gianfranco Gianfrate and Gianni Lorenzato

11

Role of Bank Lending in Financing Green Projects . . . . . . . . . . . . Maria Teresa Punzi

12

A Comparative Study on the Role of Public–Private Partnerships and Green Investment Banks in Boosting Low-Carbon Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dharish David and Anbumozhi Venkatachalam

Part VIII

Fintech and Financial Innovation . . . . . . . . . . . . . . . . . . .

125 127

155 157

183

211

213

237

261

289

13

Energy Efficiency Finance Program . . . . . . . . . . . . . . . . . . . . . . . . Simon Retallack, Andrew Johnson, Joshua Brunert, Ehsan Rasoulinezhad, and Farhad Taghizadeh-Hesary

291

14

The Role of Fintech in Unlocking Green Finance . . . . . . . . . . . . . . Darius Nassiry

315

Part IX 15

Green Technology Financing . . . . . . . . . . . . . . . . . . . . . . . .

Use of Innovative Public Policy Instruments to Establish and Enhance the Linkage Between Green Technology and Finance . . . KyungJin Hyung and Prajwal Baral

337

339

Contents

Part X 16

17

18

xiii

Community-Based Green Finance

....................

Role of Hometown Investment Trust Funds and Spillover Taxes in Unlocking Private-Sector Investment into Green Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Naoyuki Yoshino and Farhad Taghizadeh-Hesary Energy Market Liberalization for Unlocking Community-Based Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Aki Suwa and Magali Dreyfus Financing Solar Photovoltaic Transitions . . . . . . . . . . . . . . . . . . . . Ranaporn Tantiwechwuttikul and Masaru Yarime

Part XI Role of Fiscal Policy in Unlocking Green Finance and Green Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

20

Implications of Fiscal and Financial Policies on Unlocking Green Finance and Green Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dina Azhgaliyeva, Zhanna Kapsalyamova, and Linda Low Impact of Fiscal Policy on Green Technologies Transfer . . . . . . . . Ambiyah Abdullah

Part XII Barriers and Solutions to Green Finance in Selected Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

363

365

383 405

425

427 459

483

21

Green Finance in Australia and New Zealand . . . . . . . . . . . . . . . . Ivan Diaz-Rainey and Greg Sise

485

22

Green Finance in Bangladesh . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Monzur Hossain

513

23

Green Finance in India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gopal K. Sarangi

539

24

Green Finance in Indonesia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ariel Liebman, Aisha Reynolds, Dani Robertson, Sharna Nolan, Megan Argyriou, and Beth Sargent

557

25

Green Finance in Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Behnaz Saboori, Azlinda Azman, and Maryam Moradbeigi

587

26

Green Finance in Pakistan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sadia Malik, Maha Qasim, and Hasan Saeed

611

xiv

Contents

27

Green Finance in the Republic of Korea Deokkyo Oh and Sang-Hyup Kim

....................

629

28

Green Finance in Singapore . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Youngho Chang

659

29

Green Finance in Viet Nam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trong Co Nguyen, Anh Tu Chuc, and Le Ngoc Dang

675

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

707

Series Editors Biographies

Parkash Chander is Professor of Economics and Executive Director, Center for Environmental Economics and Climate Change at Jindal School of Government and Public Policy, is a Fellow of the Econometric Society, an Associate Editor of Journal of Public Economic Theory, a member of the Advisory Board of Journal of Economic Surveys, and a member of the International Advisory Board of Singapore Economic Review. He has previously held professorial positions at Indian Statistical Institute, Delhi, and National University of Singapore (in reverse order). He was formerly Head of Indian Statistical Institute, Delhi, and Head of Department of Economics, National University of Singapore. He has researched primarily in the areas of public economics, environmental economics, and game theory and its applications to climate change. His publications include articles in Econometrica, Review of Economic Studies, Journal of Economic Theory, and other leading journals in economics. He has recently completed a book on climate change, to be published in 2017. He has also written on policy matters in national newspapers and magazines. Professor Chander has held visiting appointments at Johns Hopkins University, California Institute of Technology, University of Pennsylvania, Vanderbilt University, CORE (Louvain-la-Neuve), and Nanyang Technological University, among other institutions.

xv

xvi

Series Editors Biographies

Euston Quah Professor Euston Quah is Head, Department of Economics at the Nanyang Technological University (NTU), Singapore, and an Adjunct Principal Research Fellow of the Institute of Policy Studies at the National University of Singapore (NUS). He was formerly Chair, School of Humanities and Social Sciences at NTU; Vice-Dean, Faculty of Arts and Social Sciences; Deputy Director of the Public Policy Program (now called the Lee Kuan Yew School of Public Policy); and headed the economics department at NUS. A prolific writer, Professor Quah had published over 100 papers in major internationally refereed journals and opinion pieces. His most recent works are a paper in an international publication on cost-benefit analysis for Oxford University Press, 2013, and a lead journal article in The World Economy in 2015. Two books on cost-benefit analysis were published by Routledge, UK, in 2007 and 2012, respectively. His work on cost-benefit analysis (with E.J. Mishan) was recommended for reference by the US White House, Office of Management and Budget for use by government agencies applying for project grants. He was coauthor of an Asian edition of the best selling Principles of Economics text with Gregory Mankiw of Harvard University, now a second edition in 2013. Professor Quah advises the Singapore government in various ministries and was a member of the recent Prime Minister’s Economic Strategies Sub-Committee on Energy and the Environment. He had served on the Boards of Energy Market Authority, Fare Review Mechanism Committee of the Ministry of Transport, and presently sits on the Boards of the Energy Studies Institute at NUS and the Energy Market Company. In 2016, Professor Quah was appointed a member of the Social Sciences Research Council of Singapore. He is also a review panel member for the Bill and Melinda Gates Foundation project hosted by the Overseas Development Institute, London; and in 2015 was inducted as a Fellow Member of the prestigious learned society, European Academy of Science and Arts. Professor Quah is Editor of the Singapore Economic Review (since 2002) and the President of the Economic Society of Singapore since 2009. He has been invited by Stanford University, Princeton University, the USA Inter-Pacific Bar Association, WWF

Series Editors Biographies

xvii

for Asia, UNESCAP, Earth Institute of Columbia University (Asian Meetings), and ADBI and ADB to speak at their functions and conferences, and he is one of the most highly cited and influential university economists in Singapore.

About the Editors

Jeffrey D. Sachs is a world-renowned economics professor, bestselling author, innovative educator, and global leader in sustainable development. He is widely recognized for bold and effective strategies to address complex challenges, including debt crises, hyperinflations, the transition from central planning to market economies, the control of AIDS, malaria, and other diseases, the escape from extreme poverty, and the battle against human-induced climate change. He is Director of the UN Sustainable Development Solutions Network, a commissioner of the UN Broadband Commission for Development, and an SDG Advocate for UN Secretary General Antonio Guterres. From 2001 to 2018, Sachs served as Special Advisor to the UN Secretary General, for Kofi Annan (2001–2007), Ban Ki-moon (2008–2016), and Antonio Guterres (2017–2018). Professor Sachs was the co-recipient of the 2015 Blue Planet Prize, the leading global prize for environmental leadership. He was twice named among Time magazine’s 100 most influential world leaders and has received 28 honorary degrees. The New York Times called Sachs “probably the most important economist in the world,” and Time magazine called Sachs “the world’s best-known economist.” A survey by The Economist ranked Sachs as among the three most influential living economists. Professor Sachs serves as the Director of the Center for Sustainable Development at Columbia University. He is University Professor at Columbia University, the university’s highest academic rank. Sachs was Director of the Earth Institute from 2002 to 2016. Sachs has authored and edited numerous books, including three New York Times bestsellers, The End of xix

xx

About the Editors

Poverty (2005), Common Wealth: Economics for a Crowded Planet (2008), and The Price of Civilization (2011). Other books include To Move the World: JFK’s Quest for Peace (2013), The Age of Sustainable Development (2015), Building the New American Economy: Smart, Fair & Sustainable (2017), and most recently A New Foreign Policy: Beyond American Exceptionalism (2018). Prior to joining Columbia, Sachs spent over 20 years as a Professor at Harvard University, most recently as the Galen L. Stone Professor of International Trade. A native of Detroit, Michigan, Sachs received his B.A., M.A., and Ph.D. at Harvard. Wing Thye Woo (胡永泰) is Professor of Economics at University of California in Davis, and Director of Jeffrey Sachs Center on Sustainable Development at Sunway University in Kuala Lumpur. He also holds academic appointments at Fudan University in Shanghai, Columbia University in New York City, Penang Institute in George Town, and Chinese Academy of Social Sciences in Beijing. His current research focuses on designing efficient, equitable pathways to achieving the Sustainable Development Goals, with projects in Malaysia, Indonesia, China, and USA on Green Finance, De-Carbonization of Energy Systems, Preservation of Bio-Diversity, Middle Income Trap, Indigenous Innovation Capability, and Global Economic Architecture in the Multi-Polar World. Wing’s article “The Monetary Approach to Exchange Rate Determination Under Rational Expectations: The Dollar-Deutschemark Case,” Journal of International Economics (JIE), February 1985, was identified by JIE in 2000 to be one of the 25 most cited articles in its 30 years of history. His article “China Meets the MiddleIncome Trap: The Large Potholes in the Road to Catching-Up,” Journal of Chinese Economic and Business Studies (JCEBS), November 2012, was awarded the Best Paper Prize at the 30th Anniversary Conference of the Chinese Economist Association (UK/Europe) in 2018. Wing Woo has worked with several governments on the design of growth-oriented adjustment programs and written several books on these problems afterward. In the early 1990s, he advised several centrally planned

About the Editors

xxi

economies on their transition strategies to market economy (Economies in Transition: Comparing Asia and Europe, MIT Press, 1997), and Indonesia’s central bank on exchange rate system reform (Macroeconomic Crisis and Long-Term Growth: The Case of Indonesia, 1965–1990, World Bank Press, 1994). He advised China’s Ministry of Finance on the comprehensive tax and exchange rate reforms implemented in January 1994 (Fiscal Management and Economic Reform in the People’s Republic of China, Oxford University Press, 1995), and the US Treasury in 1997–1998 on the Asian Financial Crisis (The Asian Financial Crisis: Lessons for a Resilient Asia, MIT Press, 2000). From 2002 to 2005, Wing was the Special Advisor for East Asian Economies in the Millennium Project of the United Nations; in July 2005, he was appointed to the International Advisory Panel to Prime Minister Abdullah Badawi of Malaysia; and in 2008, he became the economic advisor to Chief Minister Lim Guan Eng of Penang State. Wing Woo is a leader in the study of Asian economies. He has been the convener of the Asian Economic Panel (AEP) since 2001, a forum of 100 specialists on Asian economies which meets tri-annually to discuss important Asian economic issues and publishes the Asian Economic Papers, MIT Press (of which he is the Editor-in-Chief). Wing is founding President of the Jeffrey Cheah Institute on Southeast Asia (2014) and founding Director of the Jeffrey Sachs Center on Sustainable Development (2017). He was President of the Chinese Economists Association of North America (CEANA) in 2002, and President of the Chinese Economists Society (CES) in 2016. Wing is active in the East Asia Economic Association, serving as Director since 2015, and the Chinese Economist Association (UK/Europe), serving as Editor of Journal of Chinese Economic and Business Studies since its founding in 2003. In 2004, the University of California at Davis awarded him its Distinguished Scholarly Public Service Award; in 2006, he was appointed a Chang Jiang Professor by the Ministry of Education of China; in 2009, the Governor of Penang conferred on him the title Dato; and in 2016, he was appointed a National Distinguished Expert under the Thousand Talents Program (Qian Ren Jihua) of China.

xxii

About the Editors

Wing was born in 1954 in George Town, Penang, Malaysia. He graduated from Swarthmore College in 1976 with a B.A. (High Honors) in Economics, and a B.S. in Engineering; and received an M.A. in Economics from Yale in 1978, and an M.A. and a Ph.D. in Economics from Harvard in 1982. Dr. Naoyuki Yoshino is Dean and CEO of the Asian Development Bank Institute (ADBI) and Professor Emeritus at Keio University, Tokyo, Japan. He obtained his Ph.D. from Johns Hopkins University (United States) in 1979 where his thesis supervisor was Sir Alan Walters, economic adviser to former British Prime Minister Margaret Thatcher. Dr. Yoshino has been a visiting scholar at the Massachusetts Institute of Technology (United States) and a Visiting Professor at various other universities, including the University of New South Wales (Australia), Fondation Nationale des Sciences Politiques (France), and University of Gothenburg (Sweden). He has also been an Assistant Professor at the State University of New York at Buffalo and an Economics Professor at Keio University. Dr. Yoshino’s professional career includes membership in numerous government committees. He was named Director of the Japan Financial Services Agency’s (FSA) Financial Research Center (FSA Institute) in 2004 and is now Chief Advisor. He was appointed as Chair of the Financial Planning Standards Board in 2007. He has served as Chairperson of the Japanese Ministry of Finance’s Council on Foreign Exchange as well as its Fiscal System Council. Additionally, he has been a Board Member of the Deposit Insurance Corporation of Japan and President of the Financial System Council of the Government of Japan. He was nominated for inclusion in Who’s Who in the World for 2009 and 2013, and was named one of the Top 100 Educators in 2009. He obtained honorary doctorates from the University of Gothenburg (Sweden) in 2004 and Martin Luther University of Halle-Wittenberg (Germany) in 2013. He also received the Fukuzawa Award in 2013 for his contribution to research on economic policy.

About the Editors

xxiii

Dr. Farhad Taghizadeh-Hesary is a faculty member and an Assistant Professor of Economics at the School of Political Science and Economics, Waseda University, Tokyo, Japan, and Visiting Professor at Keio University in Tokyo. He completed his master’s degree in Energy Economics from Tehran University, Iran, in 2011 and subsequently obtained a Ph.D. in Energy Economics from Keio University in 2015 with a scholarship from the government of Japan. He taught as Assistant Professor until March 2018 at Keio University following the completion of his Ph.D. He was also a visiting scholar and Visiting Professor at several institutions and universities such as the Institute of Energy Economics of Japan (IEEJ) (2013–2015), the Credit Risk Database (CRD) association of Japan (2014–2015), and the Graduate School of Economics of the University of Tokyo (2016–2017). Dr. Taghizadeh-Hesary has published on a wide range of topics, including energy economics, green finance, small and medium-sized enterprises finance, monetary policy, and banking. His credits include authoring more than 50 academic journal papers and book chapters and the editing of six books including: Monetary Policy and the Oil Market (Springer: 2016), Japan’s Lost Decade: Lessons for Asian Economies (Springer: 2017), Unlocking SME Finance in Asia (Routledge: 2019), and Achieving Energy Security in Asia (World Scientific: 2019).

Contributors

Ambiyah Abdullah National Institute for Environmental Studies, Tsukuba, Japan Megan Argyriou ClimateWorks Australia, Monash Sustainable Development Institute (MSDI), Monash University, Melbourne, VIC, Australia Dina Azhgaliyeva Energy Studies Institute, National University of Singapore, Singapore, Singapore Azlinda Azman School of Social Sciences, Universiti Sains, Penang, Malaysia Prajwal Baral Hornfels Group Ltd., Moscow, Russian Federation Joshua Brunert Carbon Trust, London, UK Youngho Chang School of Business, Singapore University of Social Sciences, Singapore, Singapore Anh Tu Chuc Academy of Finance, Ministry of Finance, Ha Noi, Vietnam Le Ngoc Dang International Finance Department, Academy of Finance, Ministry of Finance, Ha Noi, Vietnam Dharish David Singapore University of Social Sciences (SUSS), Singapore, Singapore Ivan Diaz-Rainey Otago Energy Research Centre (OERC) and Climate and Energy Finance Group (CEFGroup), Department of Accountancy and Finance, University of Otago, Dunedin, New Zealand Simon Dikau Department of Economics, SOAS University of London, London, UK Magali Dreyfus CNRS- Lille University, Lille, France Gianfranco Gianfrate Harvard University, Cambridge, MA, USA Takashi Hongo Global Economic and Political Studies Div., Mitsui & Co. Global Strategic Studies Institute, Tokyo, Japan xxv

xxvi

Contributors

Monzur Hossain Bangladesh Institute of Development Studies (BIDS), Dhaka, Bangladesh Suk Hyun East Asia International College, Yonsei University, Wonju, Republic of Korea KyungJin Hyung Korea Technology Finance Corporation (KOTEC), Busan, Republic of Korea Andrew Johnson Carbon Trust, London, UK Zhanna Kapsalyamova School of Humanities and Social Sciences, Environment and Resource Efficiency Cluster, Nazarbayev University, Astana, Kazakhstan Sang-Hyup Kim Korea Institute for Advanced Science and Technology, Seoul, Korea Ariel Liebman Monash Energy Materials and Systems Institute (MEMSI) Monash University, Melbourne, VIC, Australia Gianni Lorenzato Independent Development Advisor, New York, NY, USA Linda Low Singapore University of Social Sciences, Singapore, Singapore Sadia Malik JS Energy Limited, Karachi, Pakistan Maryam Moradbeigi Taylor’s Business School, Taylor’s University, Selangor, Malaysia Darius Nassiry Overseas Development Institute (ODI), London, UK Jatin Nathwani Ontario Research Chair in Public Policy for Sustainable Energy, Waterloo Institute for Sustainable Energy, University of Waterloo, Waterloo, ON, Canada Artie W. Ng School of Professional Education and Executive Development, The Hong Kong Polytechnic University, Hong Kong, China Trong Co Nguyen Academy of Finance, Ministry of Finance, Ha Noi, Vietnam Hee Jin Noh Koscom, Seoul, Republic of Korea Sharna Nolan ClimateWorks Australia, Monash Sustainable Development Institute (MSDI), Monash University, Melbourne, VIC, Australia Akira Ogihara Global Environment Department, Oriental Consultants Global Co., Ltd., Nishi-shinjuku, Tokyo, Japan Deokkyo Oh Korea Corporate Governance Service, Seoul, Korea Donghyun Park Economic Research and Regional Cooperation Department, Asian Development Bank, Manila, Philippines Hooman Peimani School of Management and Economics, Beijing Institute of Technology, Beijing, China

Contributors

xxvii

Maria Teresa Punzi Webster Private University Vienna, Vienna, Austria Dhruba Purkayastha Climate Policy Initiative, New Delhi, India Maha Qasim Independent Consultant, Karachi, Pakistan Ehsan Rasoulinezhad Faculty of World Studies, University of Tehran, Tehran, Iran Simon Retallack Carbon Trust, London, UK Aisha Reynolds ClimateWorks Australia, Monash Sustainable Development Institute (MSDI), Monash University, Melbourne, VIC, Australia Dani Robertson ClimateWorks Australia, Monash Sustainable Development Institute (MSDI), Monash University, Melbourne, VIC, Australia Behnaz Saboori Department of Economics and Accounting, South Tehran Branch, Islamic Azad University, Tehran, Iran Jeffrey D. Sachs Columbia University, New York, NY, USA Hasan Saeed Independent Consultant, Karachi, Pakistan Gopal K. Sarangi TERI School of Advanced Studies, New Delhi, India Beth Sargent ClimateWorks Australia, Monash Sustainable Development Institute (MSDI), Monash University, Melbourne, VIC, Australia Greg Sise Energy Link Ltd, Dunedin, New Zealand Aki Suwa Department for the Study of Contemporary Society, Kyoto Women’s University, Kyoto, Japan Farhad Taghizadeh-Hesary Faculty of Political Science and Economics, Waseda University, Tokyo, Japan Ranaporn Tantiwechwuttikul Graduate Program in Sustainability Science – Global Leadership Initiative (GPSS-GLI), Graduate School of Frontier Sciences, The University of Tokyo, Tokyo, Japan Shu Tian Economic Research and Regional Cooperation Department, Asian Development Bank, Manila, Philippines Anbumozhi Venkatachalam Economic Research Institute for ASEAN and East Asia (ERIA), Jakarta, Indonesia Ulrich Volz Department of Economics, SOAS University of London, London, UK German Development Institute, Bonn, Germany Wing Thye Woo Department of Economics, University of California at Davis, Davis, CA, USA

xxviii

Contributors

Masaru Yarime Division of Public Policy, Hong Kong University of Science and Technology, Hong Kong SAR, China Department of Science, Technology, Engineering and Public Policy, University College London, London, UK Graduate School of Public Policy, The University of Tokyo, Tokyo, Japan Naoyuki Yoshino Asian Development Bank Institute (ADBI), Keio University, Tokyo, Japan

List of Abbreviations

2DS ABS ACCC ADB ADBI AHP APEC ASEAN BAU BCCTF BCR BNEF BNP AM BP CAGR CAPM CCS CCST CCT CCUS CDL CDM CDP CER CGC CNR COP CPI CPP CPPA-G CPPIB CTBCM CTF

2  C scenario Association of Banks in Singapore Australian Competition and Consumer Commission Asian Development Bank Asian Development Bank Institute Analytic hierarchy process Asia-Pacific Economic Cooperation Association of Southeast Asian Nations Business as usual Bangladesh Climate Change Trust Fund Benefit–cost ratio Bloomberg New Energy Finance BNP Paribas Asset Management British Petroleum Compound annual growth rate Capital asset pricing model Carbon capture and storage Carbon capture and storage technologies Clean coal technologies Carbon capture, use, and storage City Development Limited Clean Development Mechanism Carbon Disclosure Project Certified emission reduction Credit Guarantee Corporation Compagnie Nationale du Rhône Conference of Parties Climate Policy Initiative Canada Pension Plan Central Power Purchasing Agency Canada Pension Plan Investment Board Competitive Trading Bilateral Contract Market Clean Technology Fund xxix

xxx

DBS DFI DG DPV E-DSGE E&S EBRD ECBM EDF EERF EESL EIA EIRR EOR EPC EPI ESCO ESG ETF ETF ETS EU EV EVN FCV FDI FIRR FIT FMDV G8 GBN GBPs GCF GEEREF GET GFO GHG GIB GITA GITE GOP GPFN GTBC

List of Abbreviations

Development Bank of Singapore Development finance institution Distributed generation Distributed photovoltaic Environmental dynamic stochastic general equilibrium Environmental & social European Bank for Reconstruction and Development Enhanced coal bed methane Electricité de France Energy Efficiency Revolving Fund Energy Efficiency Services Limited Energy Information Administration Estimated economic rate of return Enhanced oil recovery Engineering, procurement, and construction Environmental Performance Index Energy Service Company Environmental, social, and governance Environmental Trust Fund Exchange-traded funds Emissions Trading Scheme European Union Electric vehicle Viet Nam Electricity Fuel cell vehicle Foreign direct investment Financial rate of return Feed-in-tariff Fonds Mondial pour le Développement des Villes (Global Fund for Cities Development) Group of Eight Green Bank Network Green Bond Principles Green Climate Fund Global Energy Efficiency and Renewable Energy Fund General Environmental Tax Green Finance Organisation Greenhouse gas Green Investment Bank Green Investment Tax Incentive Green Income Tax Exemption Government of Pakistan Government Pension Fund of Norway Green Technology Business Certificate

List of Abbreviations

GTFS GW GW-p GWEC HIT ICAO ICIO ICMA ICP IDB IDCOL IDF IDFC IEA IISD IMF IoT IPCC IPP IREDA IRENA JBIC KAU KEITI KIAT KOTEC LCOE LGX LNG LULUCF MAS MDB MEIH MEPS MIGA Mtoe NBFI NCEEF NDC NEM NEPRA NGO NPS NZETS

Green Technology Financing Scheme Gigawatt Gigawatt-peak Global Wind Energy Council Hometown Investment Trust International Civil Aviation Organization Inter-country input–output International Capital Market Association Installation control point Inter-American Development Bank Infrastructure Development Company Limited Infrastructure debt fund Infrastructure Development Finance Company International Energy Agency International Institute for Sustainable Development International Monetary Fund Internet of things Intergovernmental Panel on Climate Change Independent power producer Indian Renewable Energy Development Agency International Renewable Energy Agency Japan Bank for International Cooperation Korean Allowance Unit Korea Environmental Industry & Technology Institute Korea Institute for Advancement of Technology Korea Technology Finance Corporation Levelized cost of electricity Luxembourg Green Exchange Liquid natural gas Land-use, land-use change, and forestry Monetary Authority of Singapore Multilateral development bank Malaysia Energy Information Hub Minimum energy performance standard Multilateral Investment Guarantee Agency Million tons of oil equivalent Non-bank financial institution National Clean Energy and Environment Fund Nationally determined contribution National Electricity Market National Electric Power Regulatory Authority Nongovernment organization New policy scenario New Zealand Emissions Trading Scheme

xxxi

xxxii

OECD OGRA PACE PCB PCF PFA PFI PO PPA PPI PPP PPS PRC PRE PSF PSU PV R&D RAM RBI RE REC RET RPO RPS RVO SBFM SBP SBV SDB SDGs SDS SEDA SEFF SHS SIFI SMEs SOE SPV SREDA T&D TCB TFCD TPES TPO

List of Abbreviations

Organisation for Economic Co-operation and Development Oil and Gas Regulatory Authority Property Assessed Clean Energy Private commercial banks Private climate finance Pooled financing agency Private Finance Initiative Partner organization Power purchase agreement Private participation in infrastructure Public–private partnership Power producer suppliers People’s Republic of China Projects to reduce emissions Private sector facility Public sector undertaking Photovoltaic Research and development Rating Agency of Malaysia Reserve Bank of India Renewable energy Renewable energy certificate Renewable energy target Renewable portfolio obligation Renewables portfolio standard Netherlands Enterprise Agency Subnational pooled financing mechanism State Bank of Pakistan State Bank of Viet Nam State-owned development bank Sustainable Development Goals Sustainable Development Scenario Sustainable Energy Development Authority Sustainable Energy Finance Facilities Solar home system Systemically Important Financial Institution Small and medium-sized enterprises State-owned enterprise Special purpose vehicle Sustainable and Renewable Energy Development Authority Transmission and distribution Technology Credit Bureau Task Force on Climate-related Financial Disclosures Total primary energy supply Third-party ownership

List of Abbreviations

Ttoe TWh UK UNFCCC UNIDO UNPRI US VAT VC VGF WTP

Thousand tons of oil equivalent Terawatt hours United Kingdom United Nations Framework Convention on Climate Change United Nation Industrial Organization United Nations-sponsored Principles for Responsible Investment United States Value-added tax Venture capital Viability gap funding Willingness to pay

xxxiii

Part I Introduction

1

Importance of Green Finance for Achieving Sustainable Development Goals and Energy Security Jeffrey D. Sachs, Wing Thye Woo, Naoyuki Yoshino, and Farhad Taghizadeh-Hesary

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Green Finance, Energy Security, and Sustainable Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 How to Fill the Green Finance Gap? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Abstract

In 2017, global investment in renewable energy and energy efficiency declined by 3% and there is a risk that it will slow further. Clearly, fossil fuels still dominate energy investments. This could threaten the expansion of green energy needed to meet energy security, climate, and clean-air goals. Several developed and developing economies are still following pro-coal energy policies. The extra CO2 generated from new coal-fired power plants could more than wipe out any reductions in emissions made by other nations. Finance is the engine of development of infrastructure projects including energy projects. Generally, financial institutions show more interest in fossil fuel projects rather than in green projects, mainly due to risks associated with these new technologies and their relatively J. D. Sachs Columbia University, New York, NY, USA e-mail: [email protected] W. T. Woo Department of Economics, University of California at Davis, Davis, CA, USA e-mail: [email protected] N. Yoshino Asian Development Bank Institute (ADBI), Keio University, Tokyo, Japan e-mail: [email protected] F. Taghizadeh-Hesary (*) Faculty of Political Science and Economics, Waseda University, Tokyo, Japan e-mail: [email protected]; [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_13

3

4

J. D. Sachs et al.

lower rate of return. If we plan to achieve the Sustainable Development Goals (SDGs), we need to open a new file for green projects and scale up the financing of investments that provide environmental benefits through new financial instruments and new policies, such as green bonds, green banks, carbon market instruments, fiscal policy, green central banking, fintech, community-based green funds, among others. These instruments are known as “green finance.” Keywords

Green finance · Renewable energy · CO2 emissions · Paris agreement · Sustainable development goals · SDGs JEL Classification

G21 · G23 · Q28 · Q48 · Q58

Introduction The global economy, despite all the huge bumps in the road, is delivering aggregate annual growth of 3–4%, leading to a doubling of output every generation. Yet the global economy is not delivering sustainable growth in two basic senses. In many parts of the world, growth has been deeply skewed in favor of the rich; and it has been environmentally destructive – indeed, life-threatening when viewed on a century-long timescale, rather than according to quarterly reports or 2-year election cycles. Climate change is the greatest environmental threat (though not the only one). Given the current trajectory of global fossil-fuel use, the planet’s temperature is likely to rise by 4  C to 6  C above pre-industrial levels, an increase that would be catastrophic for food production, human health, and biodiversity; indeed, in many parts of the world, it would threaten communities’ survival. Governments have already agreed to keep global warming below 2  C but have yet to take decisive action toward creating a low-carbon energy system (Sachs and Du Toit 2015). The climate change and global warming that are mainly caused by greenhouse gas (GHG) emissions are beyond the “point of no return” that merit government intervention and the Sustainable Development Goals (SDGs) and the Paris Climate Agreement guide governments. The big disappointment in the world economy today is the low rate of investment. In the years leading up to the 2008 global financial crisis, growth in high-income countries was propelled by spending on housing and private consumption. When the crisis hit, both kinds of spending plummeted, and the investments that should have picked up the slack never materialized. This must change. After the crisis, the world’s major central banks attempted to revive spending and employment by slashing interest rates. The strategy worked, to some extent. By flooding capital markets with liquidity and holding down market interest rates, policy makers encouraged investors to bid up stock and bond prices that created financial wealth through capital gains. Yet this policy has reached its limits and imposed undeniable costs. With interest rates at or below zero, investors borrow for highly speculative purposes. As a result, the overall quality of

1

Importance of Green Finance for Achieving Sustainable Development. . .

5

investments has dropped, while leverage has risen. When central banks finally tighten credit, there is a real risk of significant asset-price declines (Sachs 2016). However, as monetary policy was being pushed to its limits, what went missing was an increase in long-term investments and financing infrastructure, especially in green energy projects. The public sector in most countries, especially in developing countries, cannot afford this huge investment gap; while on the other hand the private sector does not show enough interest. The main reason that the private sector is not interested in entering long-term financing of infrastructure projects, including green energy projects, is the low rate of return and the associated risks (Yoshino and Taghizadeh-Hesary 2018: 335–357). In the aforementioned conditions, if we plan to achieve SDGs, we need to scale up the financing of investments that provide environmental benefits, through new financial instruments and new policies, such as green bonds, green banks, carbon market instruments, fiscal policy, green central banking, fintech, community-based green funds and etc. known as “green finance.”

Meanwhile, there are three challenges facing such a strategy: identifying the right projects, developing complex plans that involve both the public and private sectors (and often more than one country), and structuring the financing. To succeed, governments must be capable of effective long-term planning, budgeting, and project implementation. The world needs massive investments in green energy systems, and an end to the construction of new coal-fired power plants. In addition, it needs considerable investments in electric vehicles (and advanced batteries), together with a sharp reduction in internal combustion engine vehicles. The developing world, in particular, also needs major investments in water and sanitation projects in fast-growing urban areas, while low-income countries, in particular, need to scale up health and education systems. In the developing world, the largest infrastructure investment demand is in developing Asia. Developing Asia will need to invest $26 trillion from 2016 to 2030, or $1.7 trillion per year, if the region is to maintain its growth momentum, eradicate poverty, and respond to climate change (climate-adjusted estimate). Without climate change mitigation and adaptation costs, $22.6 trillion will be needed, or $1.5 trillion per year (baseline estimate). Of the total climate-adjusted investment needs over 2016–2030, $14.7 trillion will be for power and $8.4 trillion for transport. Investments in telecommunications will reach $2.3 trillion, with water and sanitation costs at $800 billion over the period. Figure 1 shows the climate-adjusted estimated infrastructure needs by sector and region between 2016 to 2030. Developing Asia relies heavily on coal for power generation. Statistics from the World Bank’s World Development Indicators database show that in 2013, 66% of electricity was generated from coal-fired power plants in the region, compared to 14% in non-Asian developing countries and 32% in Organisation for Economic Cooperation and Development (OECD) countries. Large economies in the region explain most of the high percentage, such as the People’s Republic of China (75%), India (73%), Indonesia (51%), the Republic of Korea (41%), and Malaysia (39%). This poses significant local and global environmental challenges. While

6

J. D. Sachs et al. By region ($ billion) By sector (percentage)

Telecommunications 9%

16,062

Water and Sanitation 3%

6,347 Transport 32%

3,147

Power 56%

565 Central Asia

46 East Asia

South Asia*

Southeast The Pacific Asia

Figure 1: Climate-Adjusted Estimated Infrastructure Investment Needs by Sector and Region in Developing Asia and Pacific (2016–2030). (Percentage and $ Billion in 2015 Prices). (Source: Made by authors based on data from ADB (2017). Note: Asia and Pacific stands for ADB’s 45 developing member countries. *Pakistan and Afghanistan are included in South Asia. Climate change adjusted figures include climate mitigation and climate proofing costs, but do not include other adaptation costs, especially those associated with sea level rise)

some countries have undertaken actions, considerable investment will be needed in the short to medium term to make the power sector greener through reducing emissions and switching to renewable energy (RE) (ADB 2017). To help finance such programs in Asia and other regions, the multilateral development banks – such as the World Bank, the Asian Development Bank, and the African Development Bank – should raise vastly more long-term debt from the capital markets at prevailing low interest rates. They should then lend those funds to governments and public–private investment entities. Governments should gradually raise levies on carbon taxes, using the revenues to finance low-carbon energy systems. Also, the egregious loopholes in the global corporate tax system should be closed, thereby boosting global corporate taxation by some $200 billion annually, if not more. The added revenues should be allocated to new public investment spending. Sustainable development is not just a wish and a slogan; it offers the only realistic path to global green growth and high employment. It is time to give it the attention – and investment – it deserves.

Green Finance, Energy Security, and Sustainable Development Since the Industrial Revolution, finance has been a powerful enabler of human progress. The purpose of the global financial system is to allocate the world’s savings to their most productive use. When the system works properly, these savings are

1

Importance of Green Finance for Achieving Sustainable Development. . .

7

channeled into investments that raise living standards; when it malfunctions, as in recent years, savings are channeled into real-estate bubbles and environmentally harmful projects, including those that exacerbate human-induced climate change (Sachs 2014). Effective financial markets should also channel more global savings from highincome countries with relatively weak long-term growth prospects to low-income regions with relatively strong growth prospects, owing to new opportunities to leapfrog development with smart, information-based infrastructure. Just a decade ago, hundreds of millions of rural Africans lived outside the flow of global information. Now, with the rapid spread of broadband, once-isolated villages benefit from online banking, transport services, and ICT-enabled agribusiness and health and education programs. To seize the benefits of these new technologies at scale and to avoid investments that aggravate cascading environmental crises, the finance industry will need to understand how the SDGs will reshape the investment landscape. The time has come to embrace the concept of true long-term investing, which requires marshalling the capacity of institutionally mobilized capital to support investment opportunities that will secure a sustainable future for all. We know that enormous public and private investment is required for the transition toward a low-carbon and green economy, to win the global fight against poverty and disease, and to provide high-quality education and physical infrastructure worldwide. Today’s savvy investors, and the financial industry as a whole, need to look beyond today’s market prices and policies to the market prices and policies of the future. For example, today there is no global price on carbon to shift energy investment from fossil fuels to RE; but we know that, in order to keep global warming below the 2  C limit, such a price is coming soon. As stewards of long-term capital, today’s investors cannot ignore the coming carbon price and the shift toward green and RE sources. That means devising practical ways to finance and encourage the required shift. We believe that financial leaders want their industry to play a vital role in sustainable development, and we urge them to contribute actively to the unique opportunity that the current situation represents. Apart from the role of RE projects in reducing the carbon emissions level in line with SDGs, another reason for the development of RE projects is raising energy selfsufficiency (domestic production of primary energy [including nuclear]/domestic supply of primary energy  100) (Yoshino et al. 2017)) and energy security by diversification of energy resources. Too much reliance on limited resources of energy (coal, oil, or gas) will reduce the resiliency of the economy and make it more prone to energy price fluctuations. Several studies (see, inter alia, Hamilton 1983; Barsky and Kilian 2004; Taghizadeh-Hesary et al. 2013, 2016; Taghizadeh-Hesary and Yoshino 2016) have evaluated the impacts of oil price fluctuations on various macroeconomic indicators and generally found that increases in oil prices are disruptive to economic growth and create inflation for most oil-importing countries. In a more recent study, Taghizadeh-Hesary et al. (2017) showed that after the Fukushima nuclear disaster in Japan in March 2011, which resulted in the shutting

8

J. D. Sachs et al.

down of nuclear plants and substituting nuclear power with fossil fuels, energy security in Japan suffered. Their findings revealed that the absolute value of elasticities of oil consumption in some economic sectors decreased after the disaster because of an increased dependency on oil, which endangered the country’s energy security. They suggested that to raise energy self-dependency and energy security, Japan needs to diversify its energy supplies. As a result of eliminating nuclear power generation and substituting it with fossil fuels, energy self-sufficiency fell from 19.6% in fiscal year 2000 to 8.6% in fiscal year 2013 (MIAC 2015). Before the 2011 disaster, Japan was the third largest consumer of nuclear power in the world, after the United States (US) and France. In 2010, nuclear power accounted for about 13% of Japan’s total energy supply (Taghizadeh-Hesary et al. 2016). In 2012, the nuclear energy share fell to 1% of total energy supply (and contributed at a similar level to primary energy consumption in 2013 as only two reactors were operating for a little more than half of the year) (Taghizadeh-Hesary and Yoshino 2015). A large body of literature estimates the effect of energy security drivers on RE deployment using import dependence as a proxy for energy security, which is an approach that ignores the potential effect of other energy security strategies, such as the diversification of energy sources. Using a panel data for the energy sector across 21 European Union (EU) member states, Lucas et al. (2016) investigated the effect of different energy security concepts on the development of RE. Their primary findings confirmed that (i) RE deployment is a consequence of a combination of energy security strategies including environmental concerns rather than being solely caused by a shift toward more sustainable energy policies; and (ii) among the different energy security strategies, the diversification of energy sources through RE deployment is a more coherent strategy than using RE to reduce dependency. Hence, increasing the share of green energy resources in the energy basket not only reduces the emissions in line with the SDGs and the Paris Agreement but also increases the energy security level.

How to Fill the Green Finance Gap? In recent years, several new methods for financing green projects have been developed, including green bonds, green banks, and village funds. Green banks and green bonds partially have the potential to help clean energy financing. The advantages of green banks include improved credit conditions for clean energy projects, aggregation of small projects to reach a commercially attractive scale, creation of innovative financial products, and market expansion through dissemination of information about the benefits of clean energy. Supporters of green bonds believe that it can provide long-term and reasonably priced capital to refinance a project once it has passed through the construction phase and is operating successfully (NRDC 2016). Although the aforementioned methods were somehow helpful for development of low-carbon/green projects, the data suggests they are inadequate. Global energy investment totaled $1.8 trillion in 2017, a 2% decline in real terms from the previous year, according to the World Energy Investment 2018 report (IEA 2018a). More than

1

Importance of Green Finance for Achieving Sustainable Development. . .

9

$750 billion went to the electricity sector while $715 billion was spent on oil and gas supply globally. Global energy investment in 2017 failed to keep up with energy security and sustainability goals. After several years of growth, combined global investment in renewables and energy efficiency declined by 3% in 2017 and there is a risk that it will slow further this year. This could threaten the expansion of green energy needed to meet energy security, climate and clean-air goals. For instance, investment in renewable power, which accounted for two-thirds of power generation spending, dropped 7% in 2017 (IEA 2018b). Clearly, fossil fuels still dominate energy investments. A major concern in the transition to low-carbon energy provision, therefore, is how to obtain sufficient finance to steer investments toward RE (Mazzucatoa and Semieniuk 2017). Due to the limitations of the Basel capital requirements on lending by financial institutions, and because banks consider most RE projects to be risky, banks are reluctant to finance them. On the other hand, banks resources are coming from deposits and deposits are usually short to medium term. Allocating bank resources to green infrastructure projects that require long-term finance will make maturity mismatch for banks. Hence, relying on banking finance is not a solution for financing green projects; we need to look for new channels of financing this sector to fill the financing gap for such projects. Bank lending should be allocated to safer sectors and businesses. One possible solution is to stimulate non-bank financial institutions’ investments in green projects (See ▶ Chap. 10, “Stimulating Non-bank Financial Institutions’ Participation in Green Investments” by Gianfrate and Lorenzato of this Handbook). These institutions, including pension funds and insurance companies are keeping long-term financial resources that are suitable for green infrastructure investments. Institutional investors are (the largest) suppliers of capital to listed companies, managing almost $100 trillion asset in OECD countries alone (World Bank 2015). Because of their size and their role as a conduit of savers’ climate concerns to the capital markets, institutional investors are ideally positioned to steer corporate capital allocation toward more sustainable uses. As for emissions trading and carbon pricing schemes, according to recent estimates (World Bank 2017), as of 2016, 40 countries have a carbon pricing system in place, and that number is expected to increase significantly over the next few years following the climate change agreement reached in Paris in 2015. From the current systems of carbon prices in place, “carbon price risk” emerges as a new form of political risk for both companies and investors. Such risk is related to the probability of the emergence of future international climate agreements and of national policies. The timing and extent of carbon-related policies will dramatically determine when and which real and financial assets will be affected. The risk is not merely political, but technological as well, as there is uncertainty about possible future technologies that might affect the speed and scope of the transition toward a lowcarbon economy. This aspect further influences investors’ ability to form long-term expectations about assets to be invested in (▶ Chap. 10, “Stimulating Non-bank Financial Institutions’ Participation in Green Investments” by Gianfrate and Lorenzato). Another important factor that needs to be considered for filling the green financing gap is the role of green central banking. The responsibility for financial and

10

J. D. Sachs et al.

macroeconomic stability implicitly or explicitly lies with central banks, which therefore ought to address climate-related and other environmental risks on a systemic level. Furthermore, central banks, through their regulatory oversight over money, credit, and the financial system, are in a powerful position to support the development of green finance models and enforce an adequate pricing of environmental and carbon risk by financial institutions. It is important to consider how financial governance policies through central banks, as well as other relevant financial regulatory agencies, can address environmental risk and promote sustainable finance (Dikau and Volz 2018). The role of fiscal policies in increasing the rate of return of green projects for elevating the share of the private sector’s investment in these projects is crucial. Countries can widely use tax relief or tax credit to promote renewable energy deployment. The US uses production tax credit extensively for the promotion of wind energy and investment tax credit for solar energy. A company could use these tax credits to reduce the deductions from income taxes or corporate taxes in exchange for investment in renewable energy. The US has extended its production tax and investment tax credit policies until 2020 (See ▶ Chap. 19, “Implications of Fiscal and Financial Policies on Unlocking Green Finance and Green Investment” by Dina Azhgaliyeva, Zhanna Kapsalyamova, and Linda Low). Another incentive and support for renewable energy deployment through fiscal policies could be returning the tax revenue originated from the spillover effect of private investments in green energy projects. Several studies discuss the spillover effects of green energy projects to other sectors and the gross domestic product of the region. The spillover effect can increase the tax revenue of local or central governments from that region, which countries could further refund partially or entirely to the private-sector investors in order to increase the rate of return of these projects (Yoshino and Taghizadeh-Hesary 2018). For small and medium-sized green projects, community-based funds and village funds could be a suitable solution. The Hometown Investment Trust (HIT) funds is a new source of community-based trust funds created to support solar and wind power. The basic objective of the HIT funds is to connect local investors with projects in their own locality, where they have personal knowledge and interests. Individual investors choose their preferred projects and make investments via the internet (Yoshino and Kaji 2013). One of the major applications of HITs in Japan relates to wind and solar power projects, which have raised money from individuals (about $100 to $5,000 per investor) interested in promoting green energy. Through these funds, many Japanese people invest small amounts of money in the construction of wind power and solar power. Advertisements of each wind and solar power project on the internet play an important role in pushing people to invest in these projects. Internet marketing companies provide the platform for investment in these projects and are able to market these projects. Local banks have started to use the information provided by HIT funds. If these projects are done properly and are received well by individual investors, banks can then start to grant loans for those projects. In this way, renewable projects (wind and solar), most of which are considered risky, can be supported by HIT funds until they are able to borrow from banks. The use of

1

Importance of Green Finance for Achieving Sustainable Development. . .

11

alternative financing vehicles, such as HIT funds, has therefore assisted the growth of solar and wind projects in Japan, where the finance sector is still dominated by banks (Yoshino and Kaji 2013; Yoshino and Taghizadeh-Hesary 2014). HIT funds have expanded from Japan to Cambodia, Viet Nam, and Peru. They are also attracting attention from Thailand’s government, Malaysia’s central bank, and Mongolia. Venture capital markets are generally not well developed in many countries including in many Asian economies, and the financial systems of many developing countries are still dominated by banks. However, internet sales are gradually expanding and the use of alternative financing vehicles such as HIT funds will help risky sectors to grow (Yoshino et al. 2019). An example for community-based green finance is the Hokkaido Green Fund, that was established in 2000 to finance wind power projects in northern Japan, and funded by individual investors and donations. As it was difficult to raise money from banks, only 20% of total investment was financed by banks and the other 80% was obtained from individual investors and through donations. A community wind power corporation runs wind power and sells electricity to the company that supplies power to the region. In many cases, the price of power produced by wind is 5% higher than that of other forms of electricity, but users are willing to pay the extra to save the environment. More than 19 wind power projects have been constructed in northern Japan using a similar method. There are also examples of solar power projects in Japan where local governments put money (seed money) into the community fund as an incentive for private investors. Last but not least, new financial technologies (“fintech”) can offer the potential to unlock green finance technologies, such as blockchain, the Internet of Things, and big data, developed over the same timeframe as the Paris Agreement and the SDGs. According to Nassiry (▶ Chap. 14, “The Role of Fintech in Unlocking Green Finance” of this Handbook), three broad areas for the possible application of fintech to green finance are: blockchain applications for sustainable development; blockchain use-cases for renewable energy, decentralized electricity market, carbon credits, and climate finance; and innovation in financial instruments, including green bonds.

References Asian Development Bank (ADB) (2017) Meeting Asia’s infrastructure needs. Asian Development Bank, Manila Barsky RB, Kilian L (2004) Oil and the macroeconomy since the 1970s. J Econ Perspect 18(4):115–134 Dikau S, Volz U (2018) Central banking, climate change, and green finance. ADBI working paper 867. Asian Development Bank Institute, Tokyo Hamilton JD (1983) Oil and the macroeconomy since World War II. J Polit Econ 91(2):228–248 International Energy Agency (IEA) (2018a) World energy investment 2018. International Energy Agency, Paris International Energy Agency (IEA) (2018b) Global energy investment in 2017 fails to keep up with energy security and sustainability goals, 18 July. https://www.iea.org/newsroom/news/2018/ july/global-energy-investment-in-2017-.html. Accessed 13 Nov 2018

12

J. D. Sachs et al.

Lucas JNV, Francés GE, González ESM (2016) Energy security and renewable energy deployment in the EU: Liaisons dangereuses or virtuous circle? Renew Sust Energ Rev 62(C):1032–1046 Mazzucatoa M, Semieniuk G (2017) Financing renewable energy: who is financing what and why it matters. Tech Forecasting Soc Chang. https://doi.org/10.1016/j.techfore.2017.05.021 Ministry of Internal Affairs and Communication (MIAC) (2015) Statistical handbook of Japan 2015. Statistics Bureau, Ministry of Internal Affairs and Communication, Tokyo NRDC (2016) Clean energy finance outlook: opportunities for green banks and green bonds in Chile. Natural Resources Defense Council, New York Sachs JD (2014) Financing climate safety. https://www.project-syndicate.org/commentary/fossilfuels-carbon-pricing-tax-by-jeffrey-d-sachs-2014-12?barrier=accesspaylog. Accessed 12 Nov 2018 Sachs JD (2016) Investment for sustainable growth. https://www.project-syndicate.org/commentary/ investment-for-sustainable-growth-by-jeffrey-d-sachs-2016-10?barrier=accesspaylog. Accessed 10 Nov 2018 Sachs JD, Du Toit HJ (2015) Earth Calling the financial sector. https://www.project-syndicate.org/ commentary/sustainability-finance-leaders-by-jeffrey-d-sachs-and-hendrik-j%2D%2Ddu-toit-201502?barrier=accesspaylog. Accessed 8 Nov 2018 Taghizadeh-Hesary F, Yoshino N (2015) Macroeconomic effects of oil price fluctuations on emerging and developed economies in a model incorporating monetary variables. Econ Policy Energy Environ 2:51–75 Taghizadeh-Hesary F, Yoshino N (2016) Monetary policy, oil prices and the real macroeconomic variables: an empirical survey on China, Japan and the United States. China: Int J 14(4):46–69 Taghizadeh-Hesary F, Yoshino N, Abdoli G, Farzinvash A (2013) An estimation of the impact of oil shocks on crude oil exporting economies and their trade partners. Front Econ China 8:571–591 Taghizadeh-Hesary F, Yoshino N, Mohammadi Hossein Abadi M, Farboudmanesh R (2016) Response of macro variables of emerging and developed oil importers to oil price movements. J Asia Pac Econ 21(1):91–102. https://doi.org/10.1080/13547860.2015.1057955 Taghizadeh-Hesary F, Yoshino N, Rasoulinezhad E (2017) Impact of the Fukushima nuclear disaster on the oil-consuming sectors of Japan. J Comp Asian Dev 16(2):113–134. https://doi. org/10.1080/15339114.2017.1298457 World Bank (2015) Institutional investors: the unfulfilled $100 trillion promise, 18 June. http:// www.worldbank.org/en/news/feature/2015/06/18/institutional-investors-the-unfulfilled-100-tril lion-promise. Accessed 13 Nov 2018 World Bank (2017) Carbon pricing watch 2017. World Bank, Washington, DC. https:// openknowledge.worldbank.org/handle/10986/26565 Yoshino N, Kaji S (eds) (2013) Hometown investment trust funds. Springer, Tokyo Yoshino N, Taghizadeh-Hesary F (2014) Hometown investment trust funds: an analysis of credit risk. ADBI Working Paper 505. Asian Development Bank Institute, Tokyo Yoshino N, Taghizadeh-Hesary F (2018) Alternatives to private finance: role of fiscal policy reforms and energy taxation in development of renewable energy projects. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, Tokyo Yoshino N, Taghizadeh-Hesary F, Tawk N (2017) Decline of oil prices and the negative interest rate policy in Japan. Econ Polit Stud 5(2):233–250. https://doi.org/10.1080/20954816.2017.1310798 Yoshino N, Taghizadeh-Hesary F, Nakahigashi M (2019) Modelling the social funding and spillover tax for addressing the green energy financing gap. Econ Model. 77:34–41. https://doi.org/ 10.1016/j.econmod.2018.11.018

Part II Financial Barriers for Development of Green Projects

2

Financial Barriers for Development of Renewable and Green Energy Projects in Asia Hooman Peimani

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Asian Regions’ Overall Situations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Technology Availability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional Financial Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of Not Switching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Feasible Measures to Overcome Financial Barriers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Developing Local Appropriate Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16 17 21 26 27 29 31 32 32 33

Abstract

The expansion of green renewable energy has been very limited in all the Asian countries despite their various differences. The contributing factors are numerous, but the financial factor has been the major single one determining whether or not they opt for such energy. This is notwithstanding their awareness about the unsustainability of their fossil energy-dominated energy mixes both for environmental and economic reasons. The main culprit is Asia’s bank-dominated financial system with its underdeveloped capital market, which leaves Asian banks as the major source of funding for green renewable energy projects. Considering these projects as very risky with low rate of return on their invested capital, their reluctance to finance them has been the major barrier to the expansion of green renewable energy in Asia. Addressing the financing challenge is both possible and necessary to remove the barrier to green energy expansion in Asia.

H. Peimani (*) School of Management and Economics, Beijing Institute of Technology, Beijing, China e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_14

15

16

H. Peimani

Keywords

Renewable energy financing · Sustainable development · Sustainable energy JEL Classification

Q01

Introduction Despite a prevailing belief, renewable energy is not a synonym for green or environmentally-clean energy, as it consists of non-pollutive (e.g., wind, solar and geothermal) and pollutive (e.g., biomass and biofuel) types. Hence, the sheer increase in their consumption is not necessarily good news for addressing global warming and other environmental challenges, unless their bulk is non-pollutive. Asia is the world’s largest economy with the highest growth rate to last in the foreseeable future. Added to its rapidly expanding economy, its large and growing population with improving living standards, by and large, ensures an increasing demand for energy to secure Asia’s first global rank as the largest energy consumer (6,602.2 million tons of oil equivalent, hereafter Mtoe, in 2016) in the foreseeable future (BP 2017). As is the case in other continents, the Asian energy mix is dominated by fossil energy whose unsustainable nature is not a matter of disagreement among the continental governments, thanks to the growing environmental and also economic and health damages of their heavy consumption of oil, gas and coal. Thus, they acknowledge the need for moving away from such pollutive energy in favor of environmentally clean types of energy to prompt their efforts for adding to their countries’ energy mixes green energy, especially renewable ones, but also non-renewable nuclear energy in cases, or expanding its share. Needless to say, their progress in this regard has differed from one Asian country to another to put some of them in the forefront of the global efforts to tackle global warming through reducing their greenhouse gas (GHG) emissions (e.g., the People’s Republic of China, [PRC]) and some others on the list of the countries lagged behind (e.g., Indonesia). Despite such significant differences, Asia as a whole is far behind where it should be in the field of green energy, mirroring the unfortunate global reality in this regard. This is evident in the insignificant share of non-fossil energy (nuclear and renewable) of the global energy mix in 2016 (14.47%) equal to 1,922 Mtoe of which the total share of renewables, including the pollutive ones such as biomass, is even smaller (10.01%) equal to 1,329.9 Mtoe (BP 2017). In that year, the total shares of non-fossil energy and renewables of the Asian energy mix were 9.58% (642.9 Mtoe) and 8.11% (535.6 Mtoe), respectively (BP 2017). This dissatisfactory result cannot be attributed to only one single factor regardless of its importance, but a combination of factors. Nevertheless, the financial factor seems to be the most influential one. In fact, the comparative cheapness of fossil energy, including the availability of funds for realizing its projects, has been the single most important determinant in the Asian countries’ limited success in expanding their green renewable energy sectors, although an increasing number of Asian countries such as the PRC and India are taking major steps to change this reality.

2

Financial Barriers for Development of Renewable and Green Energy. . .

17

Despite this positive Asian trend, the financial barriers are the main obstacles to the development of environmentally-clean renewable and thus green energy (hereafter environmentally-clean renewable energy, green renewable energy or green energy) projects in Asia. Chief among them is the issue of financing of such projects, which are, by and large, capital intensive and thus require large borrowings. Given capital market, including venture capital, is not well-developed in many Asian countries and the Asian financial system is bank-dominated, the continental banks are the main source of funding for these projects. However, many Asian banks are reluctant to finance them for mainly two inter-related reasons: high risks and low rate of return on invested capital compared to fossil energy projects. As a result, the difficulty of securing adequate funding for green renewable energy projects has detracted from their attractiveness as viable and profit-making investments to serve as a major disincentive for energy developers interested in such projects. The scarcity or limited availability of adequate financial means has made the continuity of the status quo or making limited changes to it a more economically “realistic” option for many Asian countries compared to switching to green energy, which requires a huge amount of initial investment. This factor has postponed or delayed a major switch to environmentally-clean energy to an unspecified time in the future, notwithstanding the apparent negative consequences of large-scale consumption of pollutive fossil energy, not only on the Asian countries’ environment, but also economy and public health. Yet, despite their significance, financial barriers could be overcome through various measures. Examples include a host of new ways of non-bank financial solutions and tools such as green bonds, green credit rating and community-based financing as discussed in detail in other chapters as well an additional measure to be briefly discussed in this chapter. The latter avails to the low-income Asian countries affordable green energy technologies such as small hydro generators and vertical wind turbines or encouraging their domestic production.

Asian Regions’ Overall Situations Asia is not a homogenous continent and consists of regions (e.g., Asia-Pacific) and within them subregions (e.g., South Asia, Southeast Asia, and East Asia) with varying degrees of infrastructure development, industrial and scientific advancements, trained human resources, and financial means necessary for embarking on projects. Despite variations in the mentioned areas between and within these regions, by and large, these factors determine the Asian countries’ ability to embark on major projects, including green-energy ones. Hence, barriers to such projects are not confined only to the financial ones, although, as will be discussed, the financial barriers are the single most important ones. The existence of the mentioned factors plays the major role in prioritizing projects. This reality has decreased the urgency of switching to green energy and/or expanding its share of the Asian countries’ energy mixes while negatively affecting, and therefore limiting, its scale and scope when efforts to that effect are made. This is

18

H. Peimani

reflected in the Asian energy mix, which is dominated by fossil energy as per Table 1 covering the entire continent from the world’s single largest fossil energy-producing and exporting region (Middle East) and much smaller but still significant oil and gasexporting ones (Central Asia and Caucasus) to the world’s largest energy-consuming region (Asia-Pacific). The small share of renewables, both pollutive (e.g., biomass) and non-pollutive (e.g., hydro), of the total energy consumption is true regardless of the continental countries’ characteristics in terms of land, population, income and level of economic development and technological advancement (Table 2). This is evident in the case of the developing Asian countries such as large and low-income India (6.29%) and Pakistan (9.7%), large and middle-income Indonesia (3.3%) and Turkey (14.79%), small high-income Singapore (0.23%), and large and high-income Iran (1.10%) and Saudi Arabia (0%), demonstrating a spectrum of industrial and technological capabilities. As relatively small and large Asian countries, affluent and highly-developed Republic of Korea (1.71%) and Japan (8.28%), respectively, indicate the same energy pattern. Despite its heavy investment in its renewable energy sector and the sector’s impressive rapid expansion, this is also true in the case of the PRC (11.43%). Of course, comparatively, some Asian countries have a much larger renewable energy share, such as Vietnam (21.29%), but still, such energy accounts for a fraction of their energy mix dominated by fossil energy. The regional breakdown of Asia mirrors the same pattern of energy consumption as evident in Table 3 covering the major Asian regions in terms of population, economic activities and energy consumption. The mentioned energy pattern is notwithstanding the major efforts to promote non-fossil energy, both nuclear and renewable, in many Asian countries as part of their individual efforts and/or commitments to that effect because of their membership in regional organizations such as Association of South East Asian Nations (ASEAN) and Asia-Pacific Economic Cooperation (APEC). For example, as set in the 2014 APEC Economic Leaders Declaration, APEC has a declared objective of doubling by 2030 the share of renewables in the APEC energy mix, including in power generation, through the efforts of its 21 member countries of which 16 are in Asia, including Eurasian Russia (APEC 2017). However, by and large, the overall impact of such policy will be insignificant because of the small share of renewable energy of the APEC region’s energy mix, which was 9.61% in 2013, the most recent year on which such data are available for all APEC members (APERC 2016). Additionally, the share consists of green and non-green renewables and includes that of five non-Asian APEC members, i.e., Canada, Chile, Mexico, Peru, and the United States, to detract from its real positive impact on Asia. Thanks to their own initiatives, certain Asian countries such as India and the PRC have made more significant achievements in expanding the share of green renewable energy of their energy mixes as apparent in the PRC’s turning itself into the world’s largest producer of wind turbines and solar panels over a short period of time. In 2017, it produced about two thirds of the world’s solar panels and half of its wind turbines (Pham and Rivers 2017). The PRC overtook the United States in 2016 to become the world’s largest renewable power producer (BP 2017).

499.0 1192.9

459.0 1987.2

47.7 2792.9

Coal 2708.6 36.6 1.4 107.3

Nuclear 105.9 0 19.9 382.9

Hydroelectricity 358.2 4.8 5.9 142.7

Renewables 136.7 0.1 35.8 535.6

Total Renewable Energya 494.9 4.9 1033.0 6602.0

Total Consumption 5420.3 148.9

3.46 8.11

Percentage of Renewable Energya 9.13 3.2

b

Total renewable energy and percentage of renewable energy are calculated by this author. Australia and New Zealand are excluded by this author as two countries of Oceania. As part of Asia-Pacific, South Asia covers the three largest regional countries, i.e., Bangladesh, India, and Pakistan. Relevant data on the smaller South Asian countries (Bhutan, Maldives, Nepal, and Sri Lanka) are unavailable. c Central Asia excludes Kyrgyz Republic and Tajikistan. The Caucasus excludes Armenia and Georgia as data on them are unavailable. d Including Turkey added by this author. Source: Author’s creation based on the data provided in: BP (2017) The BP Statistical Review of World Energy, p. 9. https://www.bp.com/content/dam/bp/en/ corporate/pdf/energy-economics/statistical-review-2017/bp-statistical-review-of-world-energy-2017-full-report.pdf.

a

Asia Pacificb Central Asia and Caucasusc Middle Eastd Total Asia

Gas 609.1 84.8

Oil 1501.8 22.7

Table 1: Primary Energy Consumption in Asia 2016 (Mtoe)

2 Financial Barriers for Development of Renewable and Green Energy. . . 19

37.9 9.6

41.2 20.1

38.4 21.3

Coal 1887.6 411.9 62.7 1.7 119.9 5.4 0.1 0.4 81.6

Hydroelectricity 263.1 29.1 3.3 2.9 18.1 7.7 – – 0.6 15.2 13.7

Nuclear 48.2 8.6 – 1.4 4.0 1.3 – – 36.7 – – 5.2 0.1

Renewables 86.1 16.5 2.6 0.1 18.8 0.4 † 0.2 4.3 20.4 13.8

Total Renewable Energya 349.2 45.6 5.9 3.0 36.9 8.1 – 0.2 4.9 137.9 64.8

Total Consumption 3053.0 723.9 175.0 270.7 445.3 83.2 266.5 84.1 286.2 14.79 21.29

Percentage of Renewable Energya 11.43 6.29 3.3 1.10 8.28 9.7 0.0 0.23 1.71

Total Renewable Energy and Percentage of Renewable Energy are calculated by this author. Source: Author’s creation based on the data provided in: BP (2017) The BP Statistical Review of World Energy, p. 9. https://www.bp.com/content/dam/bp/en/ corporate/pdf/energy-economics/statistical-review-2017/bp-statistical-review-of-world-energy-2017-full-report.pdf.

a

PRC India Indonesia Iran Japan Pakistan Saudi Arabia Singapore Republic of Korea Turkey Vietnam

Gas 189.3 45.1 33.9 180.7 100.1 40.9 98.4 11.3 40.9

Oil 578.7 212.7 72.6 83.8 184.3 27.5 167.9 72.7 122.1

Table 2: Primary Energy Consumption in Selected Asian Countries (2016) (Mtoe)

20 H. Peimani

2

Financial Barriers for Development of Renewable and Green Energy. . .

21

Table 3: Share of Renewable Energy of the Largest Asian Regions (2016)

West Asiab Central Asia & Caucasusc South Asiad Southeast Asiae East Asiaf

Primary Energy Consumption 1033 163.4

Renewable Energya 25,8 5,3

Percentage of Renewable Energy 2.49 3,24

839.5 589.3 3925.2

53.9 33,2 393.5

6.42 5,60 10.02

a

Renewables include hydro-electricity. West Asia consists of the Middle East and Turkey. c Central Asia excludes the Kyrgyz Republic and Tajikistan and the Caucasus excludes Armenia and Georgia as data on them are unavailable. d South Asia includes Bangladesh, India and Pakistan as data on the remaining smaller countries (Bhutan, Maldives, Nepal and Sri Lanka) is unavailable. e Southeast Asia includes Malaysia, Indonesia, Philippines, Singapore, Thailand and Vietnam as data on the smaller regional countries (Brunei Darussalam, Cambodia, Lao PDR, and Myanmar) are unavailable. f East Asia consists of the PRC; Hong Kong, China; Taipei, China; Japan, and the Republic of Korea. Source: Author’s creation based on the data provided in: BP (2017) The BP Statistical Review of World Energy, p. 9. https://www.bp.com/content/dam/bp/en/corporate/pdf/energy-economics/statis tical-review-2017/bp-statistical-review-of-world-energy-2017-full-report.pdf. b

In short, Asia is the main scene of long-term growth of renewables and green energy should the current trend continue. In particular, the Asia-Pacific region has been the leading region in this field as reflected in its share of 60% of the global growth in renewable energy in power generation (not including hydro) of 14.1% in 2016 (BP 2017).

Financial Barriers The financial barriers are the single major barrier to the expansion of green renewable energy, although they are not the only barriers. While these barriers may vary from country to country, by and large, they stem from the Asian bank-dominated financial system. Given this system lacks a well-developed capital market and thus the availability of venture capital is limited in many Asian countries, banks are the main source of funding for major projects, including green renewable energy ones. Yoshino and Taghizadeh-Hesary have discussed this major characteristic of the Asian financial market in detail in their recent works; thus a comprehensive account of it in this chapter is redundant. Suffice to state that their following figure (Figure 1) on the size and forming components of this market illustrates this characteristic by demonstrating that bank loans account for the bulk of the available financing for such projects (Yoshino and Taghizadeh-Hesary 2014). Accordingly, despite variations in the degree of dominance of the banking system in the five covered Asian countries, this characteristic is clearly apparent in the

22

H. Peimani

Figure 1: Size of Financial Markets in Asia

financial system of the two largest and fast-growing Asian countries, namely the PRC and India, as well as the expanding medium-sized Asian economy (Malaysia) to reveal the dominant continental reality in terms of available source of funding for major projects. Needless to say, the most economically-advanced Asian countries, namely Japan and the Republic of Korea, have more developed financial systems with a comparatively smaller role for banks reflecting a more developed capital market, which is not mainly limited to banks. Yet, despite differences between the capital markers of these Asian countries and those of the remaining ones, the mentioned characteristic is evident all over the continent, of course, to a varying extent and in different forms. Hence, in a sense, it is the case even in Japan with its large developed capital market where “the share of cash and deposits is much larger than that of securities and stock” to limit relatively the size, and thus the role, of its capital market compared to the European one, while the less-developed financial systems of the other Asian economies are similar, though not identical, in this regard. As a result, these economies’ banks “dominate the financial system, pension funds and insurance companies provide a second level, and the share of the capital market is small” (Yoshino and Taghizadeh-Hesary 2017). In this case, “banks, insurance companies, and pension funds will be the main source of finance for projects and businesses” in the overwhelming majority of the Asian countries (Yoshino and Taghizadeh-Hesary 2017), including green renewable energy projects. This reality has a major implication for such projects’ growth because of its impact on the availability of funds for their financing while determining what projects could be financed with the available funds. In this regard, the following elaboration of Yoshino and Taghizadeh-Hesary (2017) is noteworthy:

2

Financial Barriers for Development of Renewable and Green Energy. . .

23

Banks [sic] loans are suitable for financing short- to medium-term projects because the resources of banks are bank deposits, which typically are short-term or medium-term resources—usually 1 year, 2 years, and at most 5 years (deposits longer than 5 years are very rare). Hence if banks allocate their resources to long-term infrastructural projects (bridges, highways, ports, airports, etc.) and mega energy projects (such as large hydropower projects), there would be a maturity mismatch. Therefore, because banks’ liabilities (deposits) are short- to medium-term, their assets (loans) also need to be allocated to short- to medium-term projects rather than to long-term projects. Insurance and pensions are an alternative for long-term investments (10, 20, 40 years). Large projects, such as big hydropower, gas-, or coal-based power plants can be financed by insurance companies or pension funds, as they are long-term (10–20 year) projects.

Briefly, the bank-dominated Asian financial market whose main source of financing for green renewable energy projects is its banks determines as the single major factor the growth, the extent, and the type of green renewable energy projects, i.e., those whose required funds are short- to medium-term projects accounting for the bulk of these projects such as wind farms. In such a market, the financial realities of Asia’s market economy as set by its banks, but not the purposeful decisions out of environmental necessities with direct implications on economic growth made by the Asian government, dictates what kind of energy can be developed, instead of what is needed for environmental and energy reasons and, by default, sustainable economic development. Within this restricted financial market, the availability of funds for green renewable projects is further limited, given the risk-aversion characteristic of the main potential funders: Asian banks. Restricting the availability of venture capital, this characteristic is a consequence of much larger problems affecting all the small and medium-sized enterprises (SMEs) in which the majority of these projects fall. Yoshino’s following account on the latter sheds light on this restrictive factor (Yoshino and Taghizadeh-Hesary 2014): Asian economies are often characterized as having bank-dominated financial systems and capital markets that are not well developed, particularly in the area of venture capital. Consequently, banks are the main source of financing. Although the soundness of the banking system has improved significantly since the 1996 Asian financial crisis, banks have been cautious about lending to SMEs, even though such enterprises account for a large share of economic activity. Start-up companies, in particular, are finding it increasingly difficult to borrow money from banks because of strict Basel capital requirements. Riskier SMEs also face difficulty in borrowing money from banks. (Yoshino and Taghizadeh-Hesary 2014)

“Riskier SMEs” include green renewable energy projects for a host of reasons. They include the risk of their technologies, which are still new in many cases, and thus untested as reliable investment as far as Asian banks are concerned. This is notwithstanding the fact that the existence of a large number of successful projects of such technologies in many parts of the world weakens the validity of this argument. As well, the intermittent nature of most of green renewable technologies further increases the risk, given that their input of energy is not secured due to their natural nature, which makes them beyond human control. This factor turns their technologies

24

H. Peimani

unreliable as a grid-connected source of electricity, while increasing the cost of green energy projects even when the cost of their technologies themselves could be affordable. The fact that adequate wind and sunshine is not available all the time, whether during a given day, month or season, make the electricity generation of wind turbine, solar panel and concentrated solar projects intermittent. This shortcoming makes them unsuitable for baseload generation, which requires the availability of specific amounts of electricity 24 hours a day. To address this shortcoming, backup fossil-fueled generators are added to grid-connected wind and solar projects to cover the known daily electricity generation gaps. Excluding exceptional cases (e.g., hydropower in New Zealand), greenhouse gases-emitting coal-fired or diesel-fired generators are usually used for gap-filling as the cheapest options, although more expensive gasfired could also be used. This non-green requirement adds a high cost to wind and solar energy projects. Consequently, for financial reasons, wind and solar electricity generators are not the best options on their own as grid-connected ones to meet baseload electricity demand, although they are used by a growing number of Asian countries for environmental reasons. Other reasons include lower rate of return of green renewable energy projects compared to fossil fuel ones for various reasons. Examples include the mentioned additional cost of realizing green renewable energy projects, higher prices of their generated electricity than the fossil-fueled ones to challenge their competitiveness, and the much smaller amount of available governmental subsidies for these projects compared to those of fossil energy. However, as reported by the International Energy Agency (IEA), the impressive global growth of wind and solar energy in 2016 suggests that this assumption is losing ground. Accordingly, “renewables accounted for almost two-thirds of net new power capacity around the world in 2016, with almost 165 gigawatts (GW) coming online” (IEA 2017). IEA also reports the growing competitiveness of wind and solar-generated electricity in many countries, including the Asian ones such as the PRC, India, and the United Arab Emirates (IEA 2017). Asian banks’ risk-aversion characteristic has been reinforced by the tightening regulations on credit lending, including credit risk measurement, by the Basel Committee on Banking Supervision to make them further reluctant to lend to green renewable projects. This reality and its implications are well summarized by Yoshino and Taghizadeh-Hesary as follows: Due to the limitations of the Basel capital requirements on lending by financial institutions, and because banks consider most renewable energy projects to be risky, banks are reluctant to finance them. Hence, relying on banking finance is not a solution for financing green energy projects and we need to look for new channels of financing this sector to fill the financing gap for such projects. Bank lending has to be allocated to safer sectors and businesses. (Yoshino and Taghizadeh-Hesary 2017)

In short, Asian banks’ categorizing green renewable energy projects as risky with lower rate of return compared to fossil fuels ones make them reluctant to fund such projects. Hence, the resulting difficulties in securing funds for these projects make them unaffordable for potential investors, thus making affordability the single major factor in slowing down the expansion of green renewable energy in Asia. This is

2

Financial Barriers for Development of Renewable and Green Energy. . .

25

notwithstanding the fact that availability, accessibility, and plausibility of other energy options are also major contributors to such an outcome. It should be pointed out that affordability, and thus financial factor, is not the single major barrier to all types of renewables, as traditional bioenergy (biomass) such as wood, charcoal, and animal waste have been extensively used for thousands of years in every continent as the widely-available fuels. In modern times, traditional bioenergy has been used especially in rural parts of many developing Asian countries, particularly for cooking, as the available inexpensive fuel. In the ASEAN region, for example, its 10 forming Southeast Asian countries consumed 49.25 Mtoe of traditional bioenergy in 2015, the most recent year for which such data exist (ACE 2017). It accounted for 7.83% of their total primary energy supply of 628.45 Mtoe. Even modern bioenergy sources are increasingly being consumed in some Asian countries as a cheaper alternative to liquid fossil fuels. Examples include most of the Southeast Asian countries, such as Thailand where biofuel consumption has been increasing on a steady basis, from 647,000 tons of oil equivalent (toe) in 2010 (Sustainable Technology Forum 2012) to 1,610,000 toe in 2016 (Statista 2017a). In fact, the major growth of renewables not just in Asia, but globally, has been in pollutive and thus non-green bioenergy. This type of energy is being promoted as a less pollutive and more sustainable alternative to fossil fuel for a wide-range of applications from household needs (e.g., biogas) to transportation (bioethanol and biodiesel). This is due to its ease and low cost of production especially when it is done without regard to environmental considerations (e.g., clear-cutting of forests for wood and charcoal production, palm oil production for producing biofuel, and exhausting fresh water resources for biofuel production). Consequently, as reported by the International Renewable Energy Agency (IRENA): About three-quarters of the world’s renewable energy use involves bioenergy, with more than half of that consisting of traditional biomass use. Bioenergy accounted for about 10% of total final energy consumption and 1.4% of global power generation in 2015. (IRENA 2017)

Various recent reports indicate a growing expansion of bioenergy globally in both developed and developing countries, including in Asia, such as World Energy Resources: Bioenergy 2016 (World Energy Council 2016). Against this background, the financial factor acts as a major barrier to the expansion of renewable energy in cases when switching to this type of energy involves environmentally clean and thus green energy such as solar (both solar panels and concentrated solar), wind, and geothermal. In such cases, the switch is a deviation from the entrenched energy practice, which is using various derivates of oil, gas and coal, and also traditional and modern bioenergy to which given countries are accustomed. Switching demands significant investments in the required new technology and/or adaptation of their economies and societies to new types of energy, which are capital intensive to require financing. In other words, the financial factor is effective as the single major barrier mainly when the cost of switching is simply unaffordable for potential investors to make their embarking on large-scale renewable energy projects on their own out of the

26

H. Peimani

question. This happens in the case of opting for non-pollutive green renewables, which require advanced technologies unavailable locally, or available at unaffordable prices, to demand a significant amount of funding. In absence of nonbank financers, lack of large financing only permits the realization of affordable small-scale projects with no major impact on any given Asian country’s energy consumption pattern for being too limited in scale and scope to address energycaused environmental degradation, first and foremost global warming, while meeting their respective societies’ energy requirements.

Technology Availability The contributing factors to such comparatively high costs vary from one country to another. Above all, this is due to the availability of locally-made required technologies only in a small number of technologically-advanced Asian countries such as Japan, the Republic of Korea, Taipei, China, and the PRC, at a varying extent. However, other Asian countries, including those with extensive industrial capabilities and a degree of achievement in developing indigenous green renewable technologies at home (e.g., India and Iran), have to rely on imports for such technologies in all, most, or some areas, depending on the case, from the mentioned Asian suppliers or the Western ones. India, for example, has a thriving domestic wind and solar manufacturing sector, but it still needs to import such technologies for various reasons, including the current inability of the sector to catch up with the growing demand, thanks to the country’s many wind and solar projects. As a result, a recent KPMG report predicted that India would need to import “$42 billion of solar equipment by 2030, corresponding to 100 GW of installed capacity” (Quartz 2016). This reliance of various extents on imported technologies increases the cost of realizing green energy projects and adds an import burden on their economies to make green energy projects unaffordable for some Asian countries and restrict them for others, especially in the case of large-scale projects. The Asian technologically-advanced countries with locally available clean renewable energy technologies may also find the cost of a large-scale switch to green energy too high when they have the option of comparatively cheaper fossilfueled alternatives. For them, the latter is more economically sensible for large-scale consumption due to, generally speaking, the low yield of clean renewable technologies compared to fossil fuel ones, notwithstanding the pollutive and environmentally unsustainable nature of oil, gas, and coal. The PRC is a good example of an Asian country with a growing use of clean renewables, particularly solar and wind. In its efforts to curb its GHG emissions, the PRC has turned itself into the world’s largest producer of wind turbines and solar panels as mentioned earlier. With this large-scale production to meet the growing domestic demand, with an eye on becoming a world major technology giver and thus exporter, it has significantly decreased the cost of production of green energy technologies to make them affordable at home and competitive abroad. As a result, in December 2016, the PRC’s National Development and Reform Commission

2

Financial Barriers for Development of Renewable and Green Energy. . .

27

announced decreasing “tariffs paid to solar farms by as much as 19% in 2017 from this year’s levels, and by as much as 15% for wind mills in 2018 from current prices” to reflect declines in construction costs of solar and wind projects (Shen 2016). Despite this major achievement, the PRC’s continued use and large-scale construction of fossil-fueled power generators (mainly coal- and gas-fired) reflects the comparatively high cost of total replacement of its power generators with clean ones. Their scale is evident in the PRC’s ongoing building of 272,940 MW of coalfired generator capacity (Shearer et al. 2017). In consequence, total replacement of the PRC’s fossil energy demand with green renewable energy is not the objective of the PRC government in the near and even predictable distant future, as the under-construction power generators, and those built over the last 20 years, have a life span of around 50 years. Needless to say, cost is not the only contributing factor to the continued large-scale consumption of fossil energy. Apart from electricity, which can be generated with green energy, the PRC’s huge and expanding demand for liquid fuel for its rapidly-expanding vehicle fleet thanks to its growing middle class, has justified using oil and gas for transportation, for example. The number of vehicles in use on roads in the PRC jumped from 90.86 million in 2010 to 194 million in 2016 (Statista 2017b). Drawing on the current global practices, the highly water- and energy-intensive and pollutive process of biofuel production as detailed in many reports such as Biofuel and sustainability challenge: A global assessment of sustainability issues, trends and policies for biofuels and related feedstocks (Elbehri et al. 2013) removes biofuels as an environmentally and economically sensible option for a large-scale replacement of the PRC’s huge demand in liquid fuel. Nevertheless, for various reasons such as fuel diversification, lessening reliance on oil and curbing CO2 emissions, the PRC has increased its biofuel production from 925 thousand tons of oil equivalent (ttoe) in 2006 to 2,053 ttoe in 2016 (BP 2017). The pollutive and energy/water-intensive nature of biofuel production is, of course, the case in all Asian and non-Asian countries to serve as an example why renewables are not rapidly replacing non-renewable fossil energy even when no major barrier exists.

Additional Financial Concerns Apart from the discussed financial factor serving as the main barrier to the expansion of green energy in Asia, certain additional financial concerns negatively affect decisions on such energy, not just in Asia’s low-income regions and countries, but also in the affluent ones, although to differing extents. They include the real or perceived high cost of switching to green energy to replace the existing fossil-fueled power generators, namely oil (diesel and furnace fuel), gas and coal-fired, in order to end or significantly reduce the consumption of fossil energy in fueling their major sectors, industrial, commercial, agricultural, service, transportation, and household. In this regard, the main concern is the required initial cost, which is usually the cheapest for fossil-fueled generators. This is a major preventive factor for all of the Asian countries, for its pushing up or possibly pushing up the production cost of

28

H. Peimani

goods and services in their countries, using the energy generated by green energy to affect their domestic markets, and/or detract from the competitiveness of their exports, depending on the case. In consequence, the issue of cost is not only a barrier to the switch and/or its extent in low-income technology-taker Asian countries with small or non-developed industrial sectors and its affiliated educational and research capability, but also in the developed and major trading Asian countries with advanced technological capabilities. Thus, the Republic of Korea and Japan, with indigenous capabilities for developing and producing green renewable technologies, are also mindful of this cost, as reflected in their fossil-energy dominated energy mixes. It is also evident in the low pace and small scale of the expansion of their renewable energy’s share of their energy mixes as demonstrated in Table 4. The Fukushima accident of March 2011 revealed this concern in the case of Japan. Corrected for a significant drop of around 11.5% in Japan’s energy consumption from 503.0 Mtoe in 2010 to 445.3 Mtoe in 2016 due to its declining energy consumption caused by the demographic factors (negative birth rates and shrinking and aging population) and lowering economic activities because of a global economic slowdown, the shutting down of the Japanese nuclear energy reactors generating about 30% of the country’s electricity demand prior to the accident led to a major increase in Japan’s fossil energy consumption. However, as demonstrated in Table 5, it did not prompt a major increase in renewable energy consumption, despite the plan to that effect. This result is notwithstanding Japan’s capability to produce solar panels and wind turbines, for instance.

Table 4: Growth of Renewable Energy in Japan, The Republic of Korea and Taipei, China from 2006 to 2016 (in Mtoe) 2006 Percentage of Renewable Total Energy of Renewable Total Energy Total Energy Energy Consumption Consumptiona Japan 21.5 520.3 4.13 Republic 1.2 225.8 0.53 of Korea Taipei, 1.8 113.6 1.58 China a

2016

Total Renewable Energy 36.9 4.9

Percentage of Renewable Energy of Total Energy Total Energy Consumption Consumptiona 445.3 8.28 286.2 1.71

2.5

112.1

2.23

Total Renewable Energy consists of hydro-electricity and renewables added together by this author. Source: Author’s creation based on the data provided in: BP (2007) The BP Statistical Review of World Energy, p. 41. https://www.bp.com/content/dam/bp-country/en_ru/documents/publications_ PDF_eng/Statistical_review_2007.pdf. BP (2017) The BP Statistical Review of World Energy, p. 9. https://www.bp.com/content/dam/bp/ en/corporate/pdf/energy-economics/statistical-review-2017/bp-statistical-review-of-world-energy2017-full-report.pdf.

2

Financial Barriers for Development of Renewable and Green Energy. . .

29

Table 5: Energy Consumption in Japan in 2010 and 2016 (in Mtoe) Year 2010 2016

Oil 200.3 184.3

Gas 85.1 100.1

Coal 123.7 119.9

Nuclear 66.2 4.0

Hydroelectricity 20.6 18.1

Renewables 7.2 18.8

Total Energy Consumption 503.0 445.3

Sources: Author’s creation based on the data provided in: BP (2012) The BP Statistical Review of World Energy, p. 41. https://www.bp.com/content/dam/bp-country/de_at/pdfs/20120620_statisti cal_review_of_world_energy_full_report_2012.pdf; BP (2017) The BP Statistical Review of World Energy, p. 9. https://www.bp.com/content/dam/bp/ en/corporate/pdf/energy-economics/statistical-review-2017/bp-statistical-review-of-world-energy2017-full-report.pdf.

Given the Japanese experience, this cost factor raises questions about the government of the Republic of Korea’s June 2017 decision to replace its nuclear energy and coal with LNG and renewables over a few decades (World Nuclear News 2017). While it is technically possible and, in fact, good news for its aim of ending the consumption of the most pollutive type of fossil energy (coal), the share of renewables of such replacement will likely be small, although potentially much larger than its current share, to put the burden on LNG as the cheaper alternative. As Table 6 demonstrates, the current small share of renewable energy, including hydro, of the Republic of Korean energy mix and its low-paced expansion over time supports this doubt as nuclear energy, not renewables, has accounted for the bulk of its non-fossil energy for the last 2 decades. The low-income and less affluent Asian countries may have additional financial concerns. The main one could be the lack of adequate domestic financial means or their limited availability to put a barrier to any major project, including energy ones. In such case, unless they can secure foreign funding, switching to environmentally-clean renewable energy would be out of the question apart from small-scale projects, which could be locally funded or funded through regional and international funding agencies with development mandates such as the ADB. In this regard, recent examples include ADB’s approving “a loan of $200 million with sovereign guarantee for Ceylon Electricity Board to develop Sri Lanka’s first 100-megawatt wind park” (ADB 2017).

Cost of Not Switching Expanding the share of renewable energy and, particularly, the green one is surely an option for the Asian countries today, to be decided by each individual country. However, preserving the status quo, that is the domination of their energy mixes by fossil energy with or without a share for green renewables, certainly does involve a huge cost for them. This could be an immediate one or one in the short, medium or long term. Global warming is a blatant example of the environmental damage of GHG whose main contributor is about two centuries of large-scale consumption of CO2-emitting fossil energy all over the world with an upward direction to worsen the situation in all continents, including Asia. Despite a prevailing view justifying

Total Energy Consumption 225.8

Share of Renewable Energy of Total Consumption 0.53% Renewable Energy 1.7

2011

Total Energy Consumption 267.8

Share of Renewable Energy of Total Consumption 0.63% Renewable Energy 4.9

2016

Total Energy Consumption 286.2

Share of Renewable Energy of Total Consumption 1.71%

Renewable Energy consists of hydro-electricity and renewables added together by this author. Source: Author’s creation based on the data provided in: BP (2007) The BP Statistical Review of World Energy, p. 41. https://www.bp.com/content/dam/bpcountry/en_ru/documents/publications_PDF_eng/Statistical_review_2007.pdf. BP (2013) The BP Statistical Review of World Energy, p. 41. https://www.bp.com/content/dam/bp-country/fr_fr/Documents/Rapportsetpublications/statistical_ review_of_world_energy_2013.pdf. BP (2017) The BP Statistical Review of World Energy, p. 9. https://www.bp.com/content/dam/bp/en/corporate/pdf/energy-economics/statistical-review-2017/ bp-statistical-review-of-world-energy-2017-full-report.pdf.

a

Renewable Energy 1.2

2006

Table 6: Share of Renewable Energy, Including Hydro-Electricity, of the Republic of Korea’s Energy Mix 2006, 2011, 2016 (in Mtoe)a

30 H. Peimani

2

Financial Barriers for Development of Renewable and Green Energy. . .

31

the continued status quo on the ground of the importance of economic considerations over the environmental ones. viewing economy and environment as two separate and unrelated realms, global warming does have an economic cost, which is growing unless a major reduction in GHG, and particularly CO2 emissions, is achieved. Many well-researched and fully-documented reports on various aspects of the direct and indirect negative economic impact of this phenomenon have been published, including a major recent one by the Intergovernmental Panel on Climate Change (IPCC 2014). This reality makes a thorough elaboration on this topic in this chapter repetitious and unnecessary. Hence, a few examples should suffice to make this point. As an example, global warming is damaging agriculture in many ways. Depleting fresh water resources through rapid vaporization, which then causes water scarcity and pushes up the cost of irrigation, as well as triggering or worsening droughts to totally destroy farming in some cases, is one way. Another is prolonging the life cycle of insects damaging crops. These two developments result in increasing the cost of agrarian activities and products used for daily consumption as food and as raw material for a range of industrial activities to affect the lot of consumers and uplift the production cost of their respective industrial products, with the effect of reducing their competitiveness. Rising sea levels damaging the coastal areas of countries with coastal lines on open seas is yet another blatant example negatively affecting their respective residents, infrastructure, and commercial and industrial premises. Unless serious efforts are made to contain and reverse global warming, the coastal areas of Asia will be severely damaged as a result of this phenomenon by 2050, to put at risk 40 million Indians, 25 million Bangladeshi, over 20 million Chinese, and about 15 million Filipinos according to a 2016 United Nations Environment Programme report (UNEP 2016). In short, financial barriers have surely prevented the expansion of green energy to prolong the energy status quo, which is certainly putting a huge financial burden on the Asian countries. Its extent will increase over time, as the environmental damages caused by extensive use of fossil energy will expand. Consequently, there is a positive correlation between environmental damages and financial burdens on the Asian countries.

Feasible Measures to Overcome Financial Barriers Despite their significance, financial barriers could be overcome through various measures. In fact, such measures are discussed in length in other chapters to include new ways of non-bank financial solutions such as carbon pricing (▶ Chap. 25, “Green Finance in Malaysia”), green technology financing (▶ Chap. 4, “A “Cap and Invest” Strategy for Managing the Intergenerational Burdens of Financing Energy Transitions”), and community-based financing (▶ Chap. 3, “Financial Strategies to Accelerate Green Growth”), to name a few. As a result, this chapter only briefly suggests an additional measure.

32

H. Peimani

Developing Local Appropriate Technologies Given the majority of the Asian countries are developing ones, it makes sense to integrate green energy projects into their development plans. These projects could therefore be categorized not just as energy ones, but as part of these countries’ sustainable development plans to address their energy needs, while expanding their technological and industrial sectors, and generating employment and income for their populations. Within this framework, the concerned Asian governments, instead of the Asian banking system, will be the source of funding for green energy projects, drawing on their available funds for economic development, and not those for green energy projects per se. In this case, developing green energy projects could consist of developing locally their required technologies and building green energy facilities with such indigenous technologies. As an economic incentive, the return on the government-provided capital will be in the form of renewable green energy to decrease the beneficiary countries’ dependency on locally-produced or imported pollutive energy to sustain their economic development, while enlarging their industrial activities and generating sustainable and constructive employment. Depending on their countries’ specifics, including industrial and technological development, the interested Asian governments could focus on certain green energy projects whose respective technologies are locally available or could be developed locally. In particular, this is a way forward for the Asian countries, which are not currently technology-givers and thus lack the advanced scientific and industrial sectors to embark on their own on renewable energy projects requiring alreadyrealized advanced technologies. The focus should be on small-scale production of certain green energy technologies, which are more suitable for these countries both technologically and financially, given their specific situations, while helping them advance themselves technologically and industrially. Briefly, they are much easier to build, install, maintain, and repair locally at a much lower comparative cost than the ones produced in green energy technology-supplying countries. Examples include small and medium-sized wind turbines with vertical blades, which can operate with much weaker wind speed than the large, expensive horizontal turbines. Other examples include small hydro generators (run-off hydro generators), which do not require diverting rivers with its certain negative environmental consequences and phenomenal cost. As well, solar water boilers for household, commercial, and industrial use do not require the sophisticated technology of converting sunbeams into electricity as done in solar panels and concentrated solar facilities, and thus could easily be built in many Asian countries. These boilers reduce the demand for energy in liquid, gaseous, and electric forms for boiling water, which is in large demand in all the Asian countries.

Conclusion As is the case in all other phenomena, many factors have prevented development of green renewable energy projects in Asia. Yet, among them, the financial factor has played the single major role by making embarking on such projects more difficult and

2

Financial Barriers for Development of Renewable and Green Energy. . .

33

challenging than those on non-renewable energy, if not impossible in many cases by denying the required funds. In particular, the bank-dominated nature of the Asian financial system is the root cause. The underdevelopment of its capital market with a few exceptions (mainly Japan and Republic of Korea) has left the Asian banks as the main source of funding for these projects, which are reluctant to fund them for the mentioned reasons. In absence of venture capital or its inadequacy, and limited governmental-provided funds, funding the capital-intensive green energy projects has become very difficult. This difficulty has served as a disincentive for those interested in undertaking these projects with the result of a limited expansion of green renewable energy in Asia, in general. Needless to say, many Asian countries are mindful of this unsustainable reality and are taking impressive measures to expand their green energy sectors significantly, although they are still far from drastically decreasing the share of fossil energy from their energy mixes. The PRC and India are the major players in this regard, while many other countries are making an effort to catch up. This reality has prolonged the domination of environmentally-unfriendly fossil energy over the Asian countries’ energy mixes. Apart from their non-renewable nature to make their resources finite, their pollutive nature has made them an unsustainable source of energy, as evident in expanding environmental problems caused by CO2 emissions, in particular. Consequently, global warming as the most blatant manifestation of this unsustainability is not only worsening the environmental damages, but also negatively affecting the Asian economies, as is the case in other continents. Of course, these damages happen to a varying degree as determined by the extent of their own fossilenergy consumption and the effect of other countries’ consumption affecting them, in addition to the effectiveness of their measures to deal with global warming and, in general, climate change. Given this reality, it is necessary to remove the financial barriers to the development of green renewable energy. Needless to say, the specifics of any given Asian country determine the best course of action towards this end. Within this context, as mentioned earlier, the detailed suggested solutions in other chapters cover a wide range of means to tackle the financial challenge, which the Asian countries can employ to meet their specific circumstances and needs. In particular, this chapter’s suggested local development of certain types of green energy technologies is suitable for all the Asian countries, especially those aiming at addressing their development challenges and achieving sustainable development. In conclusion, financial barriers to the development of green renewable energy projects in Asia are certainly formidable obstacles to realizing such projects, but not the nonremovable ones. They can be removed at least by the ways mentioned in this book, in addition to others to be suggested by all the interested parties in sustainable development and environmental health.

References ASEAN Centre for Energy (ACE) (2017) Total primary energy supply ASEAN 2011–2016. Available at: http://aeds.aseanenergy.org/total_energy_supply/. Accessed 10 Dec 2017 Asian Development Bank (ADB) (2017) ADB boosting renewable energy in Sri Lanka with 100 MW wind park. In: ADB focus on energy. https://www.adb.org/sectors/energy/main

34

H. Peimani

Asia Pacific Energy Research Centre (APERC) (2016) APEC energy demand and supply outlook, vol I, 6th edn. Asia Pacific Energy Research Centre, Tokyo Asia-Pacific Economic Cooperation (APEC) (2017) Energy working group. https://apec.org/Groups/ SOM-Steering-Committee-on-Economic-and-Technical-Cooperation/Working-Groups/Energy BP (2007) The BP statistical review of world energy. https://www.bp.com/content/dam/bp-country/ en_ru/documents/publications_PDF_eng/Statistical_review_2007.pdf BP (2012) The BP statistical review of world energy June 2012. https://www.bp.com/content/dam/ bp-country/de_at/pdfs/20120620_statistical_review_of_world_energy_full_report_2012.pdf BP (2013) The BP statistical review of world energy. https://www.bp.com/content/dam/bp-country/ fr_fr/Documents/Rapportsetpublications/statistical_review_of_world_energy_2013.pdf BP (2017) The BP statistical review of world energy June 2017. https://www.bp.com/content/dam/bp/ en/corporate/pdf/energy-economics/statistical-review-2017/bp-statistical-review-of-world-energy2017-full-report.pdf Elbehri A, Segerstedt A, Liu P (2013) Biofuel and sustainability challenge: a global assessment of sustainability issues, trends and policies for biofuels and related feedstocks. Food and Agriculture Organization of the United Nations, Rome. http://www.fao.org/docrep/017/i3126e/i3126e. pdf. Accessed 10 Dec 2017 International Energy Agency (IEA) Renewables (2017.) https://www.iea.org/renewables/ Intergovernmental Panel on Climate Change (IPCC) (2014) Climate change 2014: impacts, adaptation, and vulnerability, from working group II of the IPCC International Renewable Energy Agency (IRENA) (2017) Bioenergy. IRENA. http://www.irena. org/bioenergy. Accessed 1 Nov 2017 Pham S, Rivers M (2017) China is crushing the US in renewable energy. In: CNN tech. http:// money.cnn.com/2017/07/18/technology/china-us-clean-energy-solar-farm/index.html Quartz (2016) India’s solar dreams, too, are made in China. https://qz.com/760079/indias-solardreams-too-are-made-in-china/ Shearer C, Ghio N, Myllyvirta L, Yu A, Nace T (2017) Boom and bust 2017. Tracking the global coal plant pipeline. Retrieved from http://endcoal.org/wp-content/uploads/2017/03/ BoomBust2017-English-Final.pdf Shen F (2016) China to cut solar, wind power prices as project posts fall. Bloomberg. https://www. bloomberg.com/news/articles/2016-12-26/china-to-cut-solar-wind-power-prices-as-project-costs-fall Sustainable Technology Forum (2012) Which countries produce the most biofuels? https://www. sustainabletechnologyforum.com/which-countries-produce-the-most-biofuels_21729.html#. Accessed 8 Dec 2017 Statista (2017a) Leading countries based on biofuel production in 2016 (in 1,000 metric tons of oil equivalent). https://www.statista.com/statistics/274168/biofuel-production-in-leading-countries-inoil-equivalent/. Accessed 8 Dec 2017 Statista (2017b) Vehicle population in China from 2007 to 2016 (in millions). https://www.statista. com/statistics/285306/number-of-car-owners-in-china/. Accessed 14 Dec 2017 United Nations Environment Programme (UNEP) (2016) Global environment outlook GEO-6: regional assessment for Asia and the Pacific. http://web.unep.org/geo/assessments/regionalassessments/regional-assessment-asia-and-pacific. Accessed 10 Dec 2017 World Energy Council (2016) World energy resources: bioenergy 2016. Retrieved from https:// www.worldenergy.org/wp-content/uploads/2017/03/WEResources_Bioenergy_2016.pdf World Nuclear News (2017) Korea’s nuclear phase-out policy takes shape. World Nuclear News. http:// www.world-nuclear-news.org/NP-Koreas-nuclear-phase-out-policy-takes-shape-1906174.html Yoshino N, Taghizadeh-Hesary F (2014) Analytical framework on credit risks for financing small and medium-sized enterprises in Asia. Asia-Pacific Dev J 21(2):1–21 Yoshino N, Taghizadeh-Hesary F (2017) Alternatives to bank finance: role of carbon tax and hometown investment trust funds in development of green energy projects in Asia. ADBI working paper 761. Asian Development Bank Institute, Tokyo Zheng S (2017) China flips the switch on world’s biggest floating solar farm. South China Morning Post (SCMP). http://www.scmp.com/news/china/society/article/2096667/china-flips-switchworlds-biggest-floating-solar-farm

Part III Green Energy Transition: Strategies and Financial Governance

3

Financial Strategies to Accelerate Green Growth Hee Jin Noh

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concept and Needs of Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concept of Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Concepts Related to Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Funding and Investment Mechanisms of Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rationale of Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Funding Mechanisms of Green Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Revised Capital Asset Pricing Model for Green Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Global Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Financial Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Climate Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Strategies to Stimulate Green Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Improve Rules and Regulations of Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Establish Green Investment Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilize the Green Climate Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Design a Code of Conduct in Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Develop New Green Financial Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Integrate a Global Cooperative System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Set Up Infrastructure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

38 40 40 41 42 42 43 44 47 47 50 52 53 53 54 55 56 57 58 58 60 61

Abstract

Green growth brings about economic development and environmental enhancement simultaneously. In order to support green growth financially, the green finance sector needs to be developed. H. J. Noh (*) Koscom, Seoul, Republic of Korea e-mail: [email protected]; [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_16

37

38

H. J. Noh

Funding and investment mechanisms of green finance differ from those of non-green finance because green finance needs to consider environmental value in the financial activities. Public finance plays an important but limited role in supporting green growth because a huge amount of money is needed. Therefore, the role of private finance is essential. However, under the current private financial mechanisms, the green field is difficult to invest in because the risk and return profile is different from those of traditional industries. Therefore, green finance is needed. This chapter suggests strategies for developing green finance. These strategies include improving rules and regulations of green finance to encourage green growth, establishing green financial institutions, utilizing the Green Climate Fund, designing a code of conduct in green finance, developing new green financial products, integrating a global cooperative system, and setting up infrastructure.

Keywords

Green growth · Green finance · Green CAPM · Public-private partnership · Emission trading system JEL Classification

G2

Introduction Green growth brings about economic development and environmental enhancement simultaneously. In order to support green growth financially, the green finance sector needs to be developed. Continuous research by the (Intergovernmental Panel on Climate Change (IPCC) examining the relationship between human activities and climate change proves that, we can, without a doubt, conclude that the current and potential climate change is the result of anthropogenic activities. The main drivers of climate change are greenhouse gases (GHGs) such as carbon and methane. We can predict a variety of economic losses from climate change (see Table 1). Therefore, green growth policy needs to focus on how economic development can be achieved by reducing carbon emissions. We will review the details of Stern (2006) in order to understand the impact of climate change and the guidelines of the United Nations Principles for Responsible Investing (UN PRI) to better understand general investment principles considering environmental, social, and governance factors. Stern (2006) has shed light on green climate economics and finance. His work opened a new field of climate change economics and urged policy makers worldwide to act right now. According to his extensive and intensive research, it is projected that without proactive actions to mitigate GHGs and adapt to climate change, it will cost us more than 5% of gross domestic product (GDP) and within 20 years the global economy could shrink by 5–20%.

3

Financial Strategies to Accelerate Green Growth

39

Table 1: Estimates of Global and Domestic Climate Change and Economic Loss by Scenarios World Degree of greenhouse gas emissions

Projections

Temperature

Sea level

Precipitation

Economic losses

If the current trend continues, Will go up 3.7
C on average in the late 21st century (2081–2100) Will rise 63 cm by the end of the 21st century

If significant reductions are achieved, Will go up 1.8
C on average in the late 21st century (2081–2100) Will rise 47 cm by the end of the 21st century

Will see widening difference in the amount of seasonal rainfall between arid and humid regions Is likely to increase in the high latitudes and the equatorial Pacific Ocean Economic losses caused by global warming are expected to be 5% to 20% of the world’s GDP.

Republic of Korea If the current If significant trend continues, reductions are achieved, Will be 5.7
C warmer in later part of the 21st century

Will rise 65 cm in the south and west coast of the country, and 99 cm in the east coast Will increase 17.6% in the later part of the 21 century

Will be 3.0
C warmer in later part of the 21st century Will rise 53 cm in the south and west coast, and 74 cm in the east coast Will rise 16.0% in the 2nd half of the 21st century

If temperature rises more than 4
C in 2100, economic losses will reach about 3% of Republic of Korea’s GDP the same year By 2100, the accumulated losses are estimated to be KRW 2,800 trillion in total

GDP gross domestic product, KRW won. Sources: IPCC (2013), Stern (2006), KEI (2012), KMA (2012).

With a proper response, the cost involved with mitigation actions can be confined to 1% of total global GDP, which shows an asymmetry between proactive and reactive actions. Early actions to mitigate GHGs can make a big difference according to Stern (2006). The UN PRI initiative is an international network of investors working together to put six principles for responsible investment into practice. Its goal is to understand the implications of sustainability for investors and support signatories to incorporate these issues into their investment decision making and ownership practices. In order to facilitate ecology of green firms and industry, which hopefully would be our next generation growth engine, financing green technology and industry with abundant funds would be the most important and critical factor. However, due to high uncertainty within the green field and a lack of a track record of historical high returns on investment related to direct investment in green projects or green funds, investors are still somewhat reluctant to invest aggressively in green industry and firms.

40

H. J. Noh

It is natural that investors—both institutional and individual—seek to maximize their financial gains from their investment. For private investors so far, going green is difficult in that it is associated with high risks and low returns at the initial research and development stage. Once a green market is formed and developed with positive market expectations within the next 10 years, the overall market view will be totally changed. But only well-prepared market players can survive after the green market is formed. Those who dominate the new market in advance will take it all, as history has always proved. Although investing money in the green field at the moment seems like a bottomless pit, it is an inevitable process to form and boost the market. Taking a long-term view is therefore essential in green finance. Policy makers themselves already know that they cannot force the private sector to invest in green without a concrete belief and assurance that the market will be formed. That is why the Green Climate Fund, headquartered in the Republic of Korea, was established. The role of this public institution is internalizing uncertainties and externalities, which means hedging the risks involved with green investment. Green growth policy can be attractive to developing countries, which seek economic growth by developing green technologies and green projects. Based on the Durban Platform of the United Nations Framework Convention on Climate Change, not only developed but also developing countries must participate in the global efforts to reduce carbon emissions. However, developing countries’ policy priorities will be put on economic development. As a result, green growth policy will be needed in developing counties. In order to implement green growth policy, financial support is needed, which can be named as green finance. Through this chapter, financial strategies to accelerate green growth are suggested.

Concept and Needs of Green Finance There is no single agreed-upon definition that can clearly explain what green finance is. There is not only the term “green finance;” other similar terms also appear these days as the importance of green finance increases. In this chapter, we will define green finance as it relates to green growth and clarify relevant concepts: sustainable finance, environmental finance, carbon finance, and climate finance.

Concept of Green Finance Green finance is a type of future-oriented finance that simultaneously pursues the development of financial industry, improvement of the environment, and economic growth. Green finance should incorporate new technologies, financial products, industries, and services that consider environment, energy efficiency, and reduction of pollutant emissions, according to Rakić and Mitić (2012), to support low-carbon green growth (see Figure 1).

3

Financial Strategies to Accelerate Green Growth

41

Development of financial industry - Developing new financial commodities - Activation of financial support for industry and technology development -Improving risk management techniques -Efficient operation of CER transaction market

Economic growth - Development of technology as new growth engine - Nurturing of pro-environmental industry for economic growth -Loosening the burden of industry through efficient CER transaction system

Improvement of environment - Environmental improvement through fostering of green enterprise - Environmental improvement through development of green technology - Enacting legislation for environmental improvement - Activation of CER transaction market

Figure 1: Definition of Green Finance. The Overlapping Area is Green Finance, Which is Financial Support for Green Companies, Development of Green Technology, Development of Green Financial Products, and Efficient Operation of Carbon Markets. CER Certified Emission Reduction. (Adapted with permission from Noh (2010))

Financial Concepts Related to Green Finance There are several concepts related to green finance: sustainable finance, environmental finance, carbon finance, and climate finance. The relationship of these concepts is illustrated in Figure 2. Sustainable finance. Sustainable finance is the practice of creating economic and social value through financial models, products, and markets that are sustainable over time (University of California, Berkeley 2017). It takes into account investments that are more expansive, comprehensive, and inclusive, considering not only the environmental aspect but also the social aspect and governance issues. Environmental finance. Environmental finance is finance and investment targeting the ecological environment (air, water, soil, etc.) Environmental finance regards environmental damage as financial risk. Under environmental finance, projects that harm or potentially damage the environment are prohibited from being funded or financed. This concept is broader than green finance in that it focuses on environmental protection, which may not contribute to economic growth. Carbon finance. Carbon finance provides resources to projects that aim to reduce emissions of carbon dioxide and other GHGs. Through the emissions trading market,

42

H. J. Noh

Sustainable finance Climate finance

Carbon finance

Green finance

Environmental finance

Figure 2: Relationships Between Green Finance and Other Related Finances. (Reproduced with permission from Noh (2014))

carbon finance can be designed in versatile ways in spot and derivative markets. Additionally, through a carbon fund, investment for the emission trading market can be made. Climate finance. Climate finance supports the activities of climate change adaptation and mitigation to achieve a low-carbon economy and implement climate resilient development. Climate finance also supports projects for adaptation that are not included in carbon finance.

Funding and Investment Mechanisms of Green Finance Rationale of Green Finance Green finance can be considered in two approaches. First, it can play a role to mitigate environmental damage, especially the impact of climate change on the economic system and human society. According to IPCC, climate change will amplify existing risks and create new risks for both nature and the human habitat. As the magnitude of the climate change problem is emphasized by several scientific analyses and forecasts, specific plans including financial support have been discussed to solve this matter. Second, green finance can play a role as targeted financing that supports green growth. Since green growth is a new paradigm of economic growth, which combines environmental sustainability and economic growth, a financial role that meets capital funding requirements from industries is necessary to facilitate it. Noh (2012) points out the reasons why the importance of green finance is growing recently. First, risks are increasing from environmental destruction and depletion of natural resources. Firms have to be prepared for handling those risks to avoid potential economic losses. Second, stakeholders require firms and financial

3

Financial Strategies to Accelerate Green Growth

43

agencies to be socially responsible. Third, the seriousness of the problem has been magnified recently. In other words, there was a change in social awareness of crises such as climate change, lack of natural resources, and environmental destruction. Fourth, international agreements and regulations on the environment are being reinforced gradually. Global Reporting Initiative, ISO 26000, and Principles for Responsible Investment (PRI) are good examples. Fifth, the management paradigm of firms is shifting to emphasize sustainability. However, according to Noh (2014b), there are some difficulties to smoothly fund green industries. First, investing in green industries has a high level of uncertainty. This is because most green industries have intangible assets rather than tangible assets. Second, investing in green industries is based on future growth potential in a long-term perspective. Third, there is information asymmetry between investors and green industry companies, which may cause an imbalance of power in transactions and capital market failures. Therefore, a new approach that is different from traditional finance is required to support green growth.

Funding Mechanisms of Green Investment The role of government is very important. Government should financially support green industry at the initial stage of business. Nonetheless, governments have budget constraints and inefficient working systems (red tape), so continuous and efficient funding from governments is hardly feasible. In this respect, Noh (2014a) claims that government should introduce and encourage private fund investments in green industries. Moreover, from the perspective of private financing, debt-financing from banks is not an appropriate form of private investment. This is because banks are responsible to guarantee principals of deposits, which means they cannot invest in highly risky investment vehicles. Therefore, green finance requires various kinds of financial instruments, and governments should create capital market environments and systems to support green finance. There exist two approaches to induce private investment (Figure 3). The first approach is to set up an investable market through private investment. At the initial stage, public investment is needed because at this stage, private investment is not feasible due to high risks. After green market formation and commercialization, private investment can be natural in the market. Fund scale

Public investment Private investment R&D

Setup

Commercialization

Market formation

Growth

Mature

Market growth

Figure 3: Green Investment Mechanisms. R&D Research and Development

44

H. J. Noh

The second is to seek for public-private partnership. There exist several models of this partnership such as the fund of funds model (Republic of Korea) and the Yozma model (Israel). Applying these models to green finance and attracting more private investors, the public side needs to initiate development of green projects and to provide strong incentives to private investors.

Revised Capital Asset Pricing Model for Green Investment Investor Types The spectrum of potential investors in green investment is diverse (Figure 4). The capital asset pricing model (CAPM) with traditional economic return based on CAPM theory can be revised by the consideration of green value. A new investment approach can be made if economic return is the same but the green value is different; green investors pursue both economic return and green value. Expected Rate of Return for Green Investment The rate of return from green investment is the sum of economic return [R] plus green return [GR] that derives from green value, which can also be expressed as total return [TR] of green investment. Economic return is price [P] change of the investment object plus dividend [D]. Green return is the enhanced green value. For example, if a green project reduces carbon emissions, the reduced volume of emissions will be green return.
T~Rtþ1 P~tþ1  P t þ D~tþ1 =P t þ GRtþ1 Green return [GRt + 1] is considered as a non-probability variable assuming green value is recognized in advance. The expected total green rate of return can be written as follows.

 ~ tþ1 ¼ E P~tþ1  P t þ D~tþ1 =P t þ GRtþ1 E TR

Philanthropist

Mixed value investor

Socially responsible investor

Commercial investor

Social return

Social return + Good use of capital

Economic return with social impact consideration

Economic return

Figure 4: Investor Types. (Reproduced with permission from Noh (2015))

3

Financial Strategies to Accelerate Green Growth

45

Utility Function and Utility Indifference Surface Including Green Value Green utility function can be suggested as
U T~R ¼ a þ bR~ þ cR~2 þ dGR: Utility of green investor depends on total rate of return and volatility risk


   þ c σ 2 R~ þ R 2 þ dGR: E U T~R ¼ E a þ bR Green investors’ indifference surface can be depicted by combining financial and green value. Points that utility gained from green and financial values can be connected to draw the indifference surface. Green investors that have financialoriented values will place importance on economic return utility, whereas those with green-oriented values will place emphasis on green return utility gains (Figure 5).

Revised Capital Asset Pricing Model for Green Investment Our basic assumptions are that green investors pursue utility maximization both from financial and green values, green investors recognize green value in advance at the time of investments, and other assumptions similar to those in CAPM theory. Green security market line. Green security market line (GSML) expresses the linear relationship between the expected total green rate of returns and its covariance with the market returns (Figure 6a). Supposing green value can be measured and quantified, the GSML can be expressed as EðTRi Þ ¼ GRi þ EðRi Þ ¼ GRi þ ½Rf þ βi ðEðRm Þ  Rf Þ: Green investors’ investment decision depends on where the investment object lies. When the investment object is above GSML: buy. When the investment object is below GSML: sell. Total utility

Indifference surface

Financial value

Green value

Figure 5: Utility of Green Investor

46

H. J. Noh

Figure 6a: Green Security Market Line (1)

a *60/ 60/

Figure 6b: Green Security Market Line (2)

b

*60/

60/

When green values cannot be measured and quantifiable, forming a green value evaluation committee and rating green value grades for each respective company, and assuming green value created is proportional to that of financial value, we can make the following calculation (Figure 6b). EðTRi Þ ¼ EðRi Þ þ Ri  EðRi Þ ¼ ð1 þ GRi Þ  EðRi Þ ¼ ð1 þ GRi Þ  ½Rf þ βi ½EðRm Þ  Rf Þ ¼ ð1 þ GRi Þ  Rf þ ð1 þ GRi  βi ½EðRm Þ  Rf Þ Efficient frontier of revised CAPM for green investment. Supposing the same risk level, an efficient frontier can be drawn by first sorting out securities with high financial value, then the one that has a high green value amongst them (Figure 6c). Determination of optimal green portfolio. An optimal green portfolio is determined at the point where the utility indifference surface and efficient frontier meet (Figure 7). Unlike traditional investors, green investors gain utility from green value.

3

Financial Strategies to Accelerate Green Growth

Figure 6c: Efficient Frontier of Revised Capital Asset Pricing Model for Green Investment

c

47

Financial value

Efficient frontier

Risk Green value

Financial value

Indifferent surface Efficient frontier

Risk

Green value Figure 7: Determination of Optimal Green Portfolio

The most financing opportunities exist for the firms that create green value. Also, utility of green investors is increased more by green value than in traditional investments. Thus, in order to vitalize green investment activities, related policy efforts, including incubation of green investors, should be undertaken.

Global Green Finance Green Financial Products Introduction Green financial products are becoming more and more diverse and can become an opportunity for financial institutions to increase their market share, to increase profit, to create customer loyalty with new products, to improve employee satisfaction and

48

H. J. Noh

retention, to enhance their brand image, to catch positive media attention, to improve licenses to operate delivered by governments, and to strengthen relationships and partnerships with external eco-friendly stakeholders. Customers seem to be more aware of the impact of their actions on the environment after understanding the imminent effect it will have on nature. Also, countries have been concluding a rising number of agreements. As a result, the demand for green products has seen a significant increase, including financial products and services. We can divide the drivers of this trend into three categories: 1. Environmental knowledge and media coverage: A better understanding of the sources and implications of environmental challenges, enabled by easy access to information and high levels of media coverage. 2. Environmental awareness and public opinion: A rising level of government support for environmental sustainability and awareness about environmental issues. 3. Environmental regulation and legislation: Legislative actions to prohibit unsustainable practices or provide more price certainty in environmental markets.

Green Financial Products Due to this trend and the rise in demand for these products, banks have started to expand their offerings to include them. These can be divided into four banking categories: retail banking, corporate and investment banking, asset management, and insurance. Table 2 details the green offerings in these four categories. Table 2: Green Bank Offerings Retail banking Green mortgages

Green home equity loans

Green commercial building loans

Green car loans

Green cards

These mortgages offer retail customers lower interest rates than those on the market for clients that purchase new energy efficient homes and/or invest in retrofits, energy efficient appliances, or green power. Banks can also offer coverage of the cost of switching a house from conventional to green power, as well as allowing the inclusion of this benefit when marketing the product. These loans also provide clients with a lower rate that can motivate households to install residential renewable energy technologies. In order to do so, banks have partnered with technology providers and environmental NGOs. Arrangements are given to green commercial buildings that have lower energy consumption, reduced waste, and less pollution than traditional buildings. Some appraisers are now identifying reduced operating expenses, improved performance, and longer lifetimes. These loans encourage customers to purchase cars with high fuel efficiency by offering low interest rates. Most green car loans are being offered by credit unions. Credit cards companies offer to make NGO donations equal to approximately one-half percent of every purchase, balance transfer, or cash advance made by the card owner. (continued)

3

Financial Strategies to Accelerate Green Growth

49

Table 2: (continued) Corporate and investment banking Green project finance Banks have started to create service divisions or teams devoted to large-scale renewable energy finance projects. They have also started to employ groundbreaking financing measures for largescale clean fuel and renewable energy projects. Green securitization Different environmental securitization techniques have begun to appear. Example: Forest bonds Green venture capital and More importance is being given to environmental issues when private equity financing companies through the capital market. Banks can be a profitable assistant with IPOs for clean technology providers, carbon credit developers, and firms promoting environmental products and services. Banks can also establish a capital base for environmental projects through specialized private equity units. Green indices Banks have developed indices that take into account future environmental opportunities and threats. Example: Merrill Lynch has developed an energy efficiency index that focuses solely on energy conservation and demand side management. Carbon commodities Thanks to the EU Emissions Trading Scheme, an arrangement has put over 12,000 European industrial sites under a carbon constraint. In order to serve their clients’ compliance needs, or to supply a tradable product to the banks’ desks, most banks obtain carbon credits. Asset management Green fiscal funds Dutch banks benefit from an initiative launched in 1995: By purchasing shares in a green fund, or investing money in a green bank, citizens are exempted from paying capital gains tax and receive a discount on income tax. As a result, investors can accept a lower interest rate on their investment and banks can offer green loans at a lower cost. Green investment funds Investment funds have evolved through 3 levels: 1. Funds solely employ exclusionary social and/or environmental criteria; 2. Funds use positive criteria that concentrate on progressive social and/or environmental policies and practices; 3. Funds apply both exclusionary and positive criteria to assess and select potential investments. Carbon funds A carbon fund receives money from investors to purchase CO2 emission reduction credits from existing emission reduction projects, or invest in new projects that will generate a stream of CO2 emission reduction credits. As for countries that have carbon funds driven by Kyoto objectives, private carbon funds offer companies a cost-effective compliance instrument, and also provide investors with the possibility of profit returns, marketing, and CSR opportunities. (continued)

50

H. J. Noh

Table 2: (continued) Insurance Green insurance

Carbon insurance

Weather derivatives Weather derivatives

This type of insurance covers two areas: 1. Insurance products that differentiate insurance premiums according to their environmental characteristics; 2. Insurance tailored for clean technology and emission reducing activities. Example: Green home insurance where attractive rates are provided for energy efficient buildings This insurance aims to reduce the risk in emission reduction transactions and low-carbon project assessments, and to manage carbon credit price volatility. A range of derivative products have also been created to help companies whose activities are highly dependent on weather related conditions to cope with variability in their revenues. Weather derivatives, currently offered by Goldman Sachs, are financial instruments that can be used to reduce risk associated with adverse or unpredictable weather conditions. Wind power derivatives are similar instruments, which enable wind power producers to hedge against unfavorable wind conditions. Payments are eventually made to either the wind producer if revenues fall below a pre-determined level or the derivative providers if performance exceeds expectations. ABN AMRO, Rabobank, and Goldman Sachs are all active in these markets.

CSR corporate social responsibility, IPO initial public offering, NGO nongovernment organization.

Implications Due to the newness of these products, it is still early to tell whether they are successful. On the other hand, this can be seen as an opportunity as there are many unserved areas and countries that are still skeptical about the efficiency and profitability of these products and services. It is then left to closely observe how they evolve throughout the years. In this sense, we make our utmost efforts to make it into an opportunity with a bright future.

Green Financial Institutions The Role of Financial Institutions in Promoting a Green Economy Overseas financial institutions are beginning to be aware of the moneymaking reality of delivering sustainability to corporate and retail clients. With a remarkable eco-friendly way to appeal to the public and corporate imagination worldwide, financial institutions want to enter the market with new or repackaged products and service offerings from green auto insurance to innovative eco-friendly mortgages and new sustainabilitybacking investment funds. Taking into account their intermediary role in the economy and far-reaching customer base, global financial institutions are well-positioned to benefit from the design and marketing of new green products and services. It is also a way for them to contribute to sustainable development.

3

Financial Strategies to Accelerate Green Growth

51

These green financial offerings are breaking into many regions and banking sectors. New products are being launched very rapidly and have a range of different designs and features. Owing to this, the quick evolution within financial institutions has made it challenging for stakeholders. The growth of green products is mainly due to better environmental regulation and legislation in Western countries. Regulatory actions, especially those that provide price certainty in environmental markets and those that prohibit unsustainable practices, can boost demand for green products and services among bank clients. In Europe, proactive governmental policies, such as the European Union Emissions Trading Scheme, German feed-in tariffs for renewable energy, and the Dutch Green Funds Scheme, have helped to trigger demand and development of greener consumer options. There are two categories of green financial institutions. First are traditional financial institutions that try to enter a green financial field. Second are the green only financial institutions such as the Green Investment Bank (GIB).

“Green Only” Financial Institution The GIB was established by the UK in order to activate the green part of the UK government investment and solve the investment constraints of the green field. A goal of the GIB is to increase the efficiency of the public and private investment model and minimize the burden on market failures, energy consumers, and tax payers. Vitalization of green investments, efficient operation of the fund, support for government policy, and global cooperation have been the main goals. As for the investment strategies, the GIB prepared a plan to invite venture capital funds by reducing the uncertainty of the future profit through assurance for the technology risk and commercialization. Also, the GIB sought joint investment in the green projects with the private capital market. The GIB tried to support small and medium business, projects to improve energy efficiency of existing houses, and technology development. In particular, investment was planned in the field of development of wind power generation technology by £60 million each year, and to attract private investors’ funds. The GIB started with an initial capital of £3 billion. Raising capital for the establishment of the GIB utilized the existing tax system and state-owned asset sales, auction revenue of carbon credits, student loan debt, radio frequency licenses, and service charges for accounts receivable. These are the support plans of the GIB for green projects. First, subsidies are given for green projects. Second, joint investment with private capital investment is made in the green area. Third, a funding plan through loans and structured products is made. Fourth, the GIB entered into a partnership with private banks. Fifth, support is provided for renewable energy generation projects through mezzanine financing. Recently, the GIB was sold to Macquarie of Australia. Implications Many existing financial firms are entering the green field. However, they are reluctant to invest in a field of high uncertainty. New “green only” financial firms will more easily invest in green industry. Therefore, more “green only” financial firms need to be established.

52

H. J. Noh

Green Climate Fund Characteristics of the Green Climate Fund Climate change threatens the sustainability of the earth and causes huge economic losses, and given the urgency and seriousness of climate change, the purpose of the Green Climate Fund (GCF) is to make a significant and ambitious contribution to the global efforts towards attaining the goals set by the international community to cope with climate change. Compared to other climate finance schemes, GCF has the potential to develop into a mechanism that can operate the largest climate change fund comprehensively and systematically. (If successful, the size of the fund will be significant.) Climate change requires the joint efforts of developed and developing countries, but it is prone to conflicts of interest between the two sides because of the one-way financing flow from developed to developing countries. If the conflicts of interest are effectively controlled, GCF could advance to a body that adjusts various environment-related issues between developed and developing countries. GCF pursues two goals—mitigation and adaptation of climate change— while keeping its operation focus on recipient countries. Hence, it can help recipient countries devise national development strategies for economic growth as they deal with climate change. Especially, GCF is currently discussing the need to expand funding pools beyond public funds. In order to boost private investments, it set up a private sector facility (PSF) that acts as a conduit for initial funding to climate change mitigation and adaptation, encourages private participation especially from local small and medium enterprises (SMEs) and financial institutions, and enables small island nations and the poorest nations to participate in the fund. The PSF will operate within the boundaries of each nation’s policies. If the PSF boosts private participation in developing countries’ projects, this will contribute significantly to GCF’s fund raising. Currently, GCF is broadening its investment targets to diverse projects that pursue greenhouse gas emission cuts, climate change mitigation, and sustainable growth. Going beyond assistance or concessional loans, GCF will use investment incentives to tap into various financial tools. This approach is expected to expand market participant pools, help create an ideal business environment for market making, and eventually enlarge the market size. In summary, GCF is characterized by its important feature of using public funds to promote private participation. Resource Mobilization and Reshaping GCF is a comprehensive and systematic financial mechanism when compared to existing climate funds, so this feature should also be incorporated into criteria for sharing the burden of funding among developed countries. However, developed countries are likely to have different views because of the high correlation between the size of national GDP and the volume of emissions. Thus, adjusting the proportion of the funding should be considered for countries with clear willingness to reduce GHG emissions through reduction targets after the base year.

3

Financial Strategies to Accelerate Green Growth

53

The GCF board has ongoing discussions about the functions and structure of the PSF and promoting private sector participation by defining the role of the PSF that will act as a bridge for cooperation with private capital. And it needs to build the PSF structure that attracts private sources as much as possible. There are many potential areas in which GCF can collaborate with the PSF. For example, investment in projects through matching funds, establishment of infrastructure, guarantees of financial support, and investment in emission allowances. We can refer to the investment model involving private capital that a PSF structure can be based on the investment model for private capital.

Implications GCF was inaugurated to support the green field in developing countries. It needs to collect sufficient money to help developing countries. Additionally, recipient countries need to develop a wise strategy to utilize GCF.

Financial Strategies to Stimulate Green Growth Improve Rules and Regulations of Green Finance As a way of contributing to individual firms or economic growth, green finance can support development of green technology, growth of related firms, and so forth. Therefore, an emission trading system and related system with green finance derived from the law should be designed to be able to perform a reasonable function. There are four ways to improve the Republic of Korea’s current regulation of green finance, which can also be applicable to some other countries’ regulation. The first way is the improvement of the cap-and-trade system. In the Republic of Korea, the cap-and-trade system started officially in 2015. The most important consideration is that it must be designed to run allocations and transactions efficiently and transparently in the system and to help green growth of the firms. For this, trade emission rights should be allocated to economic players fairly and rationally. We can suggest several ways to improve the cap-and-trade system. Initially, by strengthening capital allocation, which is a process of how businesses divide their financial resources and other sources of capital to different processes, people, and projects, we should make policy utilizing those resources. To design the free allocation rate and criteria that can help the effectiveness of reducing greenhouse gas and contribute to individual firms or economic growth, we should reinforce the allocation of allowances. Additionally, Korea Exchange, which is the actual operator of the cap-and-trade system, should work more actively to develop new carbon financial products including carbon derivative products. Subsequently, we need to increase the number of trading participants, which means we should allow the participation of private financial institutions as soon as possible. Or, we can induce them to participate by conducting the trading of carbon emission derivatives quickly. Finally, we should plan to support the participating firms. For example, we can give financial or tax support incentives to firms to develop green technologies.

54

H. J. Noh

The second way is the improvement of the traditional green finance supporting system. Through this, we need to boost the inflow of funds from the private financial sector. In other words, we should expand the range of green certifications and tax support. Examples include a prime rate for green loans, relaxed regulation, and tax exemption. The third is the improvement of accounting and the credit assessment system. The firms that get the emission rights should be recognized in the assets and the firms that have a duty of paying emission rights should be recognized in the liability. But there are several problems with this accounting system. Legal definitions of emission rights are unclear. Therefore, we should revise existing provisions and create new ones. Additionally, when we evaluate the credit of firms, we should consider the carbon emissions of the firms. Lastly, we must improve of the disclosure policy of carbon emissions. If we mandate the disclosure of carbon emissions, market players will get higher levels of information quantitatively and qualitatively. Through this, the firms can be motivated to invest more than ever in the green industry. In conclusion, to improve the regulation of green finance, we should revise the cap-and-trade system, traditional green finance supporting system, accounting and credit assessment system, and the disclosure of carbon emissions. With these efforts, we can revitalize the ecosystem of green industry.

Establish Green Investment Corporations The Need for Green Investment Corporations There are some special features of the green industry compared to traditional industry. That’s why specialized financial corporations that reflect the characteristics of the green industry are needed. In order to cooperate with GCF more actively, a green financial institution is required. Due to the lack of supporting green growth, the participation of private financial corporations is low. When investment is made in the green industry, there is a long payback period and high uncertainties. In addition, due to the lack of standards for green financial and green business, private financial corporations find it difficult to recognize the new business area. Besides, business conduct standards based on the profitability, with respect to green finance, are insufficient. Some financial corporations are reducing the loan to deposit margin of green finance, giving higher interest rates for deposits on green projects, and giving lower loan rates for green loans. This makes long-term sustainable green finance difficult. How to Establish? Green investment corporations provide a comprehensive one-stop service for green finance, and their facilities are equipped with personnel specialized in this field. An insufficient analysis system for low-carbon technologies exists, and there is a limit to supporting smooth funding for green industries, due to the lack of skilled workers to

3

Financial Strategies to Accelerate Green Growth

55

link environment and finance. So the institution of a public character to support the sector is needed. The commercial bank needs to protect depositors. Therefore, a financial investment type like the GIB is desirable. Green specialized financial corporations basically develop and support best available technology, the commercialization of low-carbon technologies, and financial support for SMEs with green technology. But it is necessary to integrate management for existing government green funds in the efficiency levels of investment. The government’s role in establishing green specialized financial corporations is important. Financial, energy, and environmental departments should cooperate to achieve the goal of green growth. Green finance is a concept to pursue economic growth and improve the environment. Thus, green financial institutions should be designed to perform these functions.

Utilize the Green Climate Fund The fact that the Republic of Korea was selected as a host to GCF has a very important meaning to the Republic of Korea. First, GCF is the first international climate financial organization that was set up in Asia. Second, the government can promote the Korean workforce through the green industry. For example, the government expects that they can not only achieve positive economic effects, but also largely promote the meetings, incentives, conventions, and exhibitions industry. Third, through the foundation of GCF, the status of the Republic of Korea in international society was significantly raised. In the situation of severe conflict between developed and developing countries, as a host country of GCF, the Republic of Korea is expected to be empowered by the international community. In order to utilize GCF, we need to take a creative approach. First, each country’s business industry can create new opportunities for financial institutions and the financial services industry. Through efficient utilization of GCF, domestic financial institutions can find opportunities to enter the markets of developing countries and find new business opportunities. They can explore new areas of business for domestic financial institutions by paying attention to privately financed social overhead capital investment or public-private partnership projects in the field of climate change project development for developing countries. And they can take advantage of participating in profitable or economically viable projects supported by GCF’s guarantee of risk sharing. Second, we can also build an industrial cluster for low-carbon technologies in the Republic of Korea. Through working with GCF, we can deliver developed technologies to developing countries. Also, GCF will provide financial support for pursuing zero pollutant emissions by recycling byproducts, resources, and energies from wastes in the industrial cluster. Other factories and companies may use recycled wastes as raw materials or energy sources. Third, through the link to GCF with carbon trading regimes, we can vitalize the carbon trading market. A given portion of cap-and-trade auction proceeds may be contributed to international funds and a proportion of certified emission reduction

56

H. J. Noh

(CER) sales proceeds also may be contributed to global funds upon international approval of clean development mechanism projects. Under an international agreement, incentives may be provided to countries that create and operate a carbon trading market, thereby voluntarily reducing carbon emissions. Finally, we can find ways of providing assistance to the Democratic People’s Republic of Korea using GCF funds. It is possible to seek investment opportunities in mitigation and adaptation projects in the Democratic People’s Republic of Korea. As an international fund, GCF can find a way to provide financial support to the Democratic People’s Republic of Korea, and alternative energy plants and adaptation projects may be targeted in the investment process. However, it will be necessary to take international political situations into consideration.

Design a Code of Conduct in Green Finance To describe in detail, the basic principles of business conduct standards related to the green banking sector will have to be set in the direction that contributes to green growth. The design of green financial products needs to be in accordance with the principles.

Fundamental Principle The fundamental principle of green finance is to contribute to green growth, and it complies with purpose and principles of green growth policy. In compliance with this fundamental principle of green finance, we need to suggest an appropriate code of conduct in green finance such as green deposits, green lending, and green investment. Purpose As the Republic of Korea already enacted basic laws to promote green growth, other countries can get some meaningful implications from the effects of these laws in the Republic of Korea. The purpose of the laws is to build the green growth foundation, and the government considers green business and green technology as a new growth engine. Fundamental Principles Government should design and drive the national development strategy. Government should stimulate market function. Government should build a new economic system to create and expand the green job market. Government should invest in and support green technology and the business field. Government should increase energy efficiency. Government should reorganize social overhead capital infrastructure to pursue green growth. Government should reorganize the tax and finance system to pursue green growth. Government should cooperate with local government, companies, civic organizations, etc. to adopt green growth.

3

Financial Strategies to Accelerate Green Growth

57

Government should survey the global green growth trend and adopt national policy appropriately.

Fairness of Code of Conduct in Green Finance The code of conduct in green finance should be designed to benefit all parties fairly, which can lead to the smooth introduction of green finance. Depositor Aspect Depositors should receive higher net interest benefits from tax benefits, even though depositors receive low interest rates from financial instruments. If the net interest benefits of green finance are lower than traditional finance, depositors will have no motivation to invest in green finance. In order to bolster the growth of green finance, we should suggest diverse benefits to depositors. Financial Institution Aspect The financial institution should receive a higher margin between green deposits and green loans. And we need autonomous guidelines to enable a standard of conduct in green finance. Beneficiary Aspect Most of the beneficiaries are green companies and entrepreneurs. Most green businesses need subsidies and finance support due to uncertainty and low profitability, so beneficiaries should receive interest rates on favorable terms and financial institutions should ease loan conditions.

Develop New Green Financial Products Unprecedented awareness has been growing worldwide of the severity and sources of various environmental challenges, such as climate change, air pollution, water scarcity, and soil erosion. Consumer demand for eco-friendly products and services based on government support is on the rise especially in European countries. Legislative and regulatory actions and some constraints on unsustainable practices and operations have also become widespread in developed countries. Developing diverse green financial products will be indispensable to provide money to the green field. Green financial products, such as CER funds, a carbon related index and exchange traded funds, CERs futures, and guarantee insurance, will be needed. Especially, green financial products to support energy efficiency and companies involved in developing alternative energies are recommended. New financial products related to the weather also need to be introduced to adapt financially to climate change. Weather derivative products are a contract promising to receive money at a fixed time among traders by quantifying the date relevant with weather phenomena such as temperature, rainfall, amount of snowfall, frost, and typhoons. Based on this, such financial instruments can be introduced according to capital market law.

58

H. J. Noh

Yoshino and Taghizadeh-Hesary (2017) explain that recently in Japan, the hometown investment trust fund became a national strategy as successful community based financing for risky sectors including the green field. Community based private financing products such as hometown investment trust funds can be developed, especially for small and medium sized green energy projects.

Integrate a Global Cooperative System Generally, businesses object to emissions trading schemes (ETSs) because of cost concerns whereas environmental groups welcome these schemes. Nevertheless, an emissions trading bill became law recently in the Republic of Korea with strong bipartisan support. This will form the legal basis for policy consistency and include active participation from various industries. And it will help the Republic of Korea to enhance its global presence and become a carbon trading hub in Asia. It will be important for the Republic of Korea to have its ETS well in place and for economic players to prepare for global trends before the introduction of a single international regime for climate change, involving some 190 countries in 2020. The more time the Republic of Korea has to prepare, the better it can adapt to changes in the low-carbon era. Regardless of whether a new exchange is established or a current exchange is selected for carbon trading, the selected operator’s ability is critical for future carbon market development. Trading intermediaries must be chosen according to rational and objective criteria that rule out the interests of individual organizations or political considerations. Selection criteria should include liquidity (to facilitate trades), soundness (to prevent unfair trading), stability (to ensure settlement security), convenience (to provide participants with easy access to the market), and international connections (to grow the Korean ETS into an Asian ETS). Support for ETSs in Asia’s major developing countries is needed. Development of the relevant policy, arrangement of the laws and system, design of a trading mechanism, and establishment of a trading system can be structured based on the experience of the Republic of Korea. If an Asian ETS is established, there is some possibility to make a global ETS together with the EU and US carbon markets. Additionally, a hub of green finance in Asia can be established by providing not only CER trading, but also relevant financial services such as investment and mediation of green financial products.

Set Up Infrastructure Set Up a Statutory Infrastructure Environmental requirements need to be reflected in statutes for investment, lending, credit rating, and accounting. Financial institutions must be required to address

3

Financial Strategies to Accelerate Green Growth

59

environmental concerns that are fiduciary and involve the lender’s environmental liability. Also, environmental factors must be integrated into credit rating and accounting procedures. Corporate disclosure of carbon information is required. Environmental information needs to be obligatory for listing and disclosure. Shifting from voluntary to mandatory disclosure gradually will be required. Financial institutions in developed countries are already required to disclose comprehensive environmental information pursuant to voluntary guidelines, e.g., the Global Reporting Initiative. Certification of green technology, enterprises, and industry to guide investment and lending will be needed.

Develop a Government-Backed Credit Guarantee Scheme Green projects are considered risky from the point of view of many financial institutions. Therefore, development of a government-backed credit guarantee scheme can ease the flow of funds from the private sector to the green field. Yoshino and Taghizadeh-Hesary (2016) explain the credit guarantee scheme. This is for the SME and venture business sector; however, it is applicable to the green field. Globally, the Multilateral Investment Guarantee Agency (MIGA) promotes foreign direct investment by providing political risk insurance and credit enhancement to investors and lenders against losses caused by non-commercial risks. If government takes the role of MIGA for green investment risk and a credit guarantee is provided to green investors, private investors can invest more easily in green projects. Establish a Technical Infrastructure Carbon indices can be created. Developing a green enterprise index to promote green investment will be needed and designing a green (carbon) risk index to promote investment in green bonds is recommended. JP Morgan and Innovest co-developed the JENI Carbon Beta Index, the world’s first bond index that reflects the climate change risk of businesses. The system for providing carbon information needs to be restructured. Building a mechanism to access carbon information will be helpful for investment banks’ credit and investment decisions. License and approvals by ministries of the environment and other authorities, regulatory compliance, green enterprise designation, and participation in voluntary agreements are necessary. Updates of online information on carbon financial products are recommended. Additionally, a green enterprise rating agency can promote green ratings. There are three major rating agencies that specialize in corporate environmental performance: Innovest (US), EIRIS (UK), and SAM (Switzerland). Information on green companies needs to be shared between public organizations and private rating agencies involved in green growth or green finance. Educate People Carbon financial professionals need to be nurtured. Training professionals on how to research, review, and invest to provide carbon financial services is essential.

60

H. J. Noh

Introduction of professional training programs and promotion of expertise is recommended for strengthening green finance education. Green financial consumer education is also needed. Through public and consumer education, raising awareness of green growth can prevent a green bubble, environmental risk, and other key risks in green finance. Conducting an annual conference on carbon finance in Asia similar to SRI in the Rockies in North America is recommended.

Conclusion The role of public finance is important, but limited, to support green projects because a huge amount of money is needed. Therefore, the role of private finance is indispensible. However, under the current private financial mechanisms, the green field is difficult to invest in because its risk and return profile are different from those of traditional industries. Therefore, green finance is necessary. We need to design strategies for developing green finance. They include improving rules and regulations of green finance to promote green growth, establishing green financial institutions, utilizing GCF, designing a code of conduct in green finance, developing new green financial products, integrating a global cooperative system, and setting up infrastructure. By improving carbon trading regulation, we can provide financial or tax support incentives to firms to develop green technologies, which will contribute to the development of new green technology. Through expansion of green certifications and tax support, the inflow of funds from the private finance sector can be boosted. Including green factors in accounting and credit assessment systems and improving the disclosure policy of green factors can let private investors participate more easily in green projects. By establishing green financial institutions, long-term sustainable finance can be provided and cooperation with GCF can be done more actively. GCF is the largest fund supplier to the green field in developing countries. Asian countries need to develop a wise strategy to utilize GCF. In order to provide money to the green field continuously, the basic principles of business conduct standards related to the green financial sector must comply with the purpose and principles of the green growth approach. An appropriate code of conduct in green finance such as green deposits, green lending, and green investment needs to be designed. Developing diverse green financial products in the fields of banking, investment, and insurance will be needed. For example, community based private financing such as a hometown trust fund can be developed for small and medium sized green energy projects. Support for ETSs in Asia will be needed. Development of the relevant policy, arrangement of laws and systems, and design of a trading system can be structured for the establishment of an Asian ETS. If an Asian ETS is established, there is some possibility to make a global ETS together with the EU and US carbon markets. A

3

Financial Strategies to Accelerate Green Growth

61

hub of green finance in Asia can also be established by providing not only CER trading, but also relevant financial services such as investment and mediation of green financial products. Infrastructure of green finance is also important to develop green finance. Setting up a statutory infrastructure to reflect fiduciary obligations and the lender’s environmental liability will be required. Also, development of a government-backed credit guarantee scheme can ease the flow of funds from the private sector to the green field. Finally, technical infrastructure such as developing a green enterprise index and educating people on green topics will be important to develop green finance.

References IPCC (2013) The fifth assessment report. Cambridge University Press, Cambridge KEI (2012) The economics of climate change in Korea. Korea Environment Institute (KEI), Seoul KIF (2005) SME policy financial system in major Western countries (I): US. Korea Institute of Finance (KIF), Seoul KMA (2012) Projections of future climate change on the Korean peninsula. Korea Meteorological Administration (KMA), Seoul Noh HJ (2010) Strategies of developing green finance. Korea Capital Market Institute (KCMI), Seoul Noh HJ (2012) Green finance. Park Young Sa, Seoul Noh HJ (2014a) Financial strategies to activate green company eco system. KCMI, Seoul Noh HJ (2014b) Climate finance. Park Young Sa, Seoul Noh HJ (2015) Social finance. Park Young Sa, Seoul Rakić S, Mitić P (2012) Green banking: green financial products with special emphasis on retail banking products. Educons University, Sremska Kamenica Stern N (2006) Stern review: the economics of climate change. Cambridge University Press, Cambridge University of California, Berkeley (2017) Berkeley sustainable business and investment forum. https://responsiblebusiness.haas.berkeley.edu/events/bsbif.html. Accessed 12 Dec 2017 Yoshino N, Taghizadeh-Hesary F (2016) Optimal credit guarantee ratio for Asia. ADBI working paper 586. Asian Development Bank Institute, Tokyo. http://www.adb.org/publicationsoptimalcredit-guarantee-ratio-asia Yoshino N, Taghizadeh-Hesary F (2017) Alternatives to bank finance: role of carbon tax and hometown investment trust funds in developing green energy projects in Asia. ADBI working paper 761. Asian Development Bank Institute, Tokyo. http://www.adb.org/publications/alterna tives-bank-finance-role-carbon-tax-and-hometowninvestment-trust-funds

A “Cap and Invest” Strategy for Managing the Intergenerational Burdens of Financing Energy Transitions

4

Jatin Nathwani and Artie W. Ng

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Managing the Global Energy Transitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Limitations of a Carbon Cap and-Trade Regime or a Carbon Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Development of Cap-and-Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Problem of Leakage: What Actually Happened . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Jurisdictional Difficulties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Carbon Tax Efficacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cap and Invest through an Integrated Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principles of Cap and Invest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Taxation Regime on Economy-Wide Consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Innovation in Institutional Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concluding Remarks and Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

64 65 66 66 67 68 69 71 71 73 74 76 78

Abstract

The investment required to meet the climate change commitments of the United Nations Framework Convention on Climate Change’s 2015 Paris Accord is on the order of $100 trillion over the next two decades. Reducing greenhouse gas emissions requires a strategy for managing risk that constitutes an intergenerational burden. This chapter proposes a “cap- and-invest” strategy for the build-up of necessary infrastructure to reduce greenhouse gas emissions consistent with national J. Nathwani (*) Ontario Research Chair in Public Policy for Sustainable Energy, Waterloo Institute for Sustainable Energy, University of Waterloo, Waterloo, ON, Canada e-mail: [email protected] A. W. Ng School of Professional Education and Executive Development, The Hong Kong Polytechnic University, Hong Kong, China e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_15

63

64

J. Nathwani and A. W. Ng

commitments. Cap-and-invest is in sharp contrast with cap-and-trade. An economywide general environmental tax on consumption creates a large pool of capital to derisk investment in emerging low-carbon solutions to the threat of climate change. Innovation in governance is an integral part of the policy to leverage the capital markets through public-private partnerships in green financing. Keywords

Cap-and-invest · Environmental trust fund · Financing intergenerational burdens · General environmental tax · Global energy transitions JEL Classification

Q4 · Q5

Introduction There is an urgent need for action to reduce the world’s greenhouse gas (GHG) emissions (Ng and Nathwani 2018). Climate change is an intergenerational burden and requires a strategy for managing future liability. Several factors conspire to undermine progress: demographics drive the demand for energy in concert with income shifts of the global demographic profile. The global energy demand will increase from 20 TW-y in 2020 to 25 TW-y by 2040 and nearly double by 2060 from current levels (IEA 2017). The share of fossil fuels within the current global energy mix at 85% is too high and must be reduced consistent with GHG emissions targets equivalent to a global temperature rise of less than 2  C. Meaningful actions to decarbonize the global energy system have been delayed because of local and regional pressures within political jurisdictions. Target setting and compliance all too often run up against the harsh realities of financing. The core of the global effort to cut emissions will have to be built from the bottom up through ambitious national action (Levi 2009). With the United Nations Framework Convention on Climate Change’s 2015 Paris Accord and voluntary commitments of nations, there is some movement toward tangible actions. Now, there is urgency to deal with the climate change threat; in our view, robust financing is critical for solutions at scale. We propose a fresh approach to reinforce and advance the voluntary target-based approach embedded within the United Nations Framework Convention on Climate Change. Here we focus on tackling a global problem, but with a specific focus on how any country can create a large pool of capital for financing the investments to decarbonize the economy over the long term. For “Managing the Global Energy Transitions”, we briefly describe the climate change challenge as it is influenced by the heavily fossil-based attributes of the current global energy system. Under “Limitations of a Carbon Cap and-Trade Regime or a Carbon Tax”, we identify and explain the limitations of current policy instruments: cap-and-trade versus a carbon tax regime. In the section “Carbon Tax Efficacy”, we investigate the efficacy of a carbon tax, as well as its limitations.

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

65

We propose a ‘cap-and-invest’ strategy for achieving a low-carbon, climateresilient energy infrastructure. An alternative economy-wide tax on consumption combined with a coherent framework for innovation in governance is a key requirement to advance the dialogue on this complex public policy issue. This tax on consumption is similar to a carbon tax but its principal difference is in its allocation of the burden to the end consumers rather than producers. Since carbon is embedded in the final consumption of all goods and services and supply chains are intricately linked across production processes, a limited focus on only producers does not address the fundamental issue of economy-wide consumption. Thus, we move away from the laborious process of identifying the “carbon-heavy” or “carbonlight” content of a product or a service for tax purposes to reduce lobbying pressures for exemptions for one sector (i.e., steel) vs another (i.e., cement or aluminum). This General Environmental Tax (GET) is meant to be a simple, transparent, and effective method for raising the necessary capital for decarbonization. Further, we explain the aspects of institutional governance required to manage the large pool of capital that becomes available for investment through a GET. The proceeds must be “ring-fenced” within an Environmental Trust Fund (ETF) dedicated to support investment for long-term infrastructure sustainability. We highlight the requirements to ensure that the ETF can gain public acceptance of the tax and further catalyze public-private collaboration to enhance the national financing capacity. Our unique contribution is to provide a sound basis for the reallocation of tax revenues from consumption to support long-term investments in a low-carbon, climate-resilient infrastructure. A stable and increasing pool of capital is a prerequisite to help de-risk new technology solutions. Redirecting scarce societal resources from consumption to investment to support decarbonization has not been identified in the literature on green financing strategies.

Managing the Global Energy Transitions Climate diplomacy, as practiced over 25 years, has consumed an enormous amount of political capital and goodwill. Using voluntary national targets and timelines, the Paris Accord has helped reset the framework for achieving meaningful change, but it needs a credible source of financing. At its core, the climate change challenge is an energy-technology policy problem. Breaking down the global challenge into a rightsize approach for positive outcomes at a national level would exemplify best practices leading the way. Achieving meaningful reductions in carbon emissions need not conflict with our wish to improve the standard of living for all people. By 2050, the world population will exceed 9 billion. Without a significant change in the global development profile, an additional 2 to 3 billion would be impoverished. A move from the status quo to a “low poverty” world (implying relatively low energy use) would still be a neardoubling of global primary energy demand from 17 TW-y (terawatts) in 2015 to 30–35 (TW-y) in the 2050–2060 timeframe. (1 TW-y [terawatt-year] = 8,760 TWh

66

J. Nathwani and A. W. Ng

[terawatt-hours] = 31.5EJ [exajoules of energy]) (IEA World Energy Outlook 2017, British Petroleum 2017). Given the existing supply mix of the energy system, this would translate into a doubling of GHG emissions, a pathway entirely inconsistent with the Paris Accord. If no action is taken, continued expansion and operation of fossil fuel infrastructure will lead to global warming of 2.4  C to 4.6  C by 2100, due to high atmospheric CO2 concentration. The resulting environmental stress will create ripple effects that have the potential to undermine the economic livelihood, food supply, and security of millions of people (IPCC 2018; WGSI 2012). The focus of our efforts globally should be to develop an energy system that does not undermine the essential functioning of the environmental ecosystem, but delivers non-carbon energy supplies at scale. This calls for a massive level of investment, on the order of USD69 trillion over the next 2 to 3 decades. This is the estimate of the total cost of the International Energy Agency’s Sustainable Development Scenario (IEA World Energy Outlook 2017). As a counterpoint to provide a perspective, according to the US government estimates, CIA Handbook, $99 trillion was the amount of money in global cash and bank accounts on 31 December 2017. What then can we do to make a significant impact on climate change, and at the same time take into full account the need for energy and investments to reshape the profile of the energy infrastructure?

Limitations of a Carbon Cap and-Trade Regime or a Carbon Tax To date, the cap-and-trade regime has revealed significant limitations, and carbon taxes as a policy instrument have seen mounting challenges from a skeptical public. Neither approach appears capable of delivering coherent international actions that would stabilize GHG concentration. If we are to rely strictly on a carbon price, the ability to achieve significant reductions in global emissions is in doubt (Ball 2018). A combination of pricing, regulations and innovation in governance for stable financing will be necessary.

Development of Cap-and-Trade Cap-and-trade has emerged as one response to climate change over the last two decades. Currently, 27 European countries have had an emissions trading scheme in place since 2005. Twenty-three US states and four Canadian provinces also participate in regional trading schemes, such as the Regional Greenhouse Gas Initiative, which was adopted in 2009 by several northeastern US states and Eastern Canadian provinces (RGGI 2012) with Ontario withdrawing in 2018. In 2012, California’s cap-and-trade program took effect, with an allowance budget established out to 2020, with Quebec and Ontario participating in this system as of 2017 (CEPA 2018). Australia’s carbon regime will shift from a flat-charge approach to a floating-price market beginning in 2015 (Bloomberg 2013). In June 2013, the People’s

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

67

Republic of China (PRC) began testing out its own carbon emissions trading scheme in the city of Shenzhen (Economist 2013a, b). In theory, cap-and-trade offers strong appeal to various groups. Environmental groups support an overall cap that provides a high degree of certainty. Industrial groups respond to the possibility of a new market in carbon, and therefore potential profits, especially when the allowances are grandfathered. It also obscures the passing on of costs to consumers. In addition, it attracts some economists because it minimizes the role of government and the cost of abatement is internalized. The scheme also appeals to some politicians because it allows them to avoid the subject of a tax increase. In practice, the benefits and certainties of a cap-and-trade regime have proved to be illusory. A ‘cap-and-trade’ regime imposes an overall cap on emissions. By limiting the quantity of emission permits, it sets a price for GHGs. The European Union’s Emissions Trading Scheme (EU ETS) provides a good example. When launched in 2005, the EU ETS was considered a major step forward in the fight against climate change by setting a continent-wide limit on carbon emissions with CO2 allowances to be apportioned to member states. In 2005, the EU set a target of reducing CO2 emissions to 20% below 1990 levels by 2020. With generous allowances, companies received 7% more credits than they needed, allowing some to generate significant windfall profits and minimal reduction of emissions. In response, during the second phase from 2008 to 2012, the EU set a cap of 6% lower than the 2005 level. The misallocation of emission allowances and the failure of the first phase of the EU ETS has been attributed to an oversupply of permits by the regulatory authorities (Andrew et al. 2010; Tan et al. 2008) unable to achieve any worthwhile reductions in carbon emissions, and 2008 emissions exceeded the cap by 145 million tons (Andrew et al. 2010). However, the problem of overallocation continued and, because of lower emissions caused by the economic downturn, resulted in a surplus of allowances and hence depressed carbon prices, thus reducing incentives for companies to invest in clean technologies. Moreover, the lack of an effective and consistent carbon pricing system from a cap-and-trade regime is a serious drag on investor confidence. The weaknesses of the approach adopted by the EU and US economies so far are critiqued and noted in a recent study (Ball 2018).

Problem of Leakage: What Actually Happened The overall cap on GHG emissions under the Kyoto Protocol was meant to establish the benchmark for a global cap. However, more than a decade since its adoption, the Protocol had only produced low emissions reductions, falling far short of targets needed to avert the threatening increase of atmospheric concentrations. Also under the Kyoto Protocol, countries could exceed their emission quotas by contributing to emissions-reducing projects in non-Annex B countries, through the Clean Development Mechanism (CDM).The CDM then becomes part of a broader market, subsequently affecting the overall carbon price levels.

68

J. Nathwani and A. W. Ng

Legitimately, the CDM and associated emissions reductions are only admissible as “additional to any that would occur in the absence of the certified project” (Kyoto Protocol Article 12.5). Even with a validation process, the counterfactual is impossible to observe and clearly open to strategic manipulations, since both the buyer and the seller of emissions reductions have an incentive to inflate the baseline (Lecocq and Ambrosi 2007). Entrants into the CDM market poured massive capital into purchasing Certified Emission Reductions (CERs). These included banks and speculators with no need for CERs, aiming to trade them on the secondary market, such as the EU ETS. Hoarding of assets resulted, as well as an increase in demand for CERs from firms under the EU ETS, and from speculators who saw opportunities for arbitrage, in addition to the increased demand for CERs triggered by the entry into force of the Kyoto Protocol (Lecocq and Ambrosi 2007). In its Directive 2009/29/EC, the European Commission recognized that the increased use of CDM credits in the absence of an international agreement could undermine the EU renewables target, as well as the incentives for energy efficiency, innovation, and technological development (den Elzen and Höhne 2008; Vasa and Neuhoff 2011). Whereas CDM exacerbated the misappropriation of emission allowances, the evidence of failure of the first phase of the ETS has been attributed primaraily to an oversupply of permits by the regualtory authorities (Andrew 2010, and Tan 2008). The EU ETS, in its first phase failed to achieve any worthwhile reductions in carbon emissions, and the 2008 emissions exceeded the cap by 145 million tons (Andrew 2010; Matisoff 2010). While Phase III of the EU ETS will purportedly have auctioned allowances, it is unclear whether the regulatory and administrative environment would be robust enough to prevent leakage. A major shortcoming of the cap-and-trade regime is the inability to induce a high level of confidence and certainty for investment in lowcarbon technologies with long lead times and high capital costs (Sandbag 2013). The EU Parliament initially voted to reject the “back-loading” proposal, which aimed to restrict a surplus of carbon allowances that sent prices to below €5 a ton from €20 a ton in 2011 (with the caveat that the allowances would be reintroduced later) (Economist 2013a). After months of negotiation, the EU Parliament voted in support of the plan. According to a study by Sandbag (2013), the EU ETS is now delivering negative tons of abatement, and is set to cancel out over 700 million tons of emissions, much lower than the 2.8 billion tons originally expected.

Jurisdictional Difficulties The cap-and-trade instrument not only has significant regulatory and accounting weaknesses, but also has jurisdictional taxation challenges, including the need to harmonize overlapping international, national, and subnational programs and distributional conflicts (Kossoy and Ambrosi 2010). For example, in the US, interactions between federal climate policy and state and regional programs are determined by the extent to which the state and federal programs cover the same sources, and their relative stringency is in question (McGuinness and Ellerman 2008). Depending on

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

69

the division of the two factors between a state or regional program and its federal counterpart, the outcome could be futile, or generate additional emissions and costs (Jenkins 2009). Distributional impacts, additional cost burdens, and subsequent loss of economic efficiency are felt locally. A nationwide cap-and-trade without federal preemption to improve a more demanding state program would impose punitive burdens on a local or regional economy with limited capacity to adjust to deep reductions. Moreover, in the context of a global cap-and-trade regime, there could be a potential arbitrage opportunity. Importing too many cheap foreign emission rights would both depress domestic carbon prices and create greater demand for offsets if they exist in the foreign system. Without harmonization across jurisdictions, large trading-competition imbalances can arise. Fraud becomes a larger problem in a global setting, where the provision for offsets in one jurisdiction may not follow the same rigorous screening process as it would in another. Experience with the CDM mechanism also reveals the drawbacks and management issues when it comes to cross-border CER validation and verification. Various studies have concluded that a large share of registered CDM projects were not valid. Between 20% and 66% of CERs in the EU ETS in the period 2008–2009 did not meet the requirements and effectively increased global emissions between 30 and 106 million tons of CO2eq (Michaelowa and Purohit 2007; Schneider 2009; Vasa and Neuhoff 2011; Wara and Victor 2008). Europe’s carbon-market efficiency was revealed to be invalid in a prior study by Daskalakis (2013). The People’s Republic of China (PRC), the world’s second-largest economy, has encountered similar issues (Ren and Lo 2017; Zhao et al. 2017). The cap-andtrade mechanism may not increase the capacity of sustainable infrastructure in an effective, timely manner, despite the ongoing climate change threats. It is important to note that there exists an inherent difficulty in identifying a precise point in the energy transformation chain for introducing a tax on GHG emissions. The profile of the global energy system is a complex web of interactions and emissions that occur at different points in the supply chain (GEA 2012). Introducing a cap only on some producers at one point in the chain invariably leads to a plea for exemption and an unyielding process for settling grievances. Thus, we believe our approach to an economy-wide tax at the level of final consumption avoids needless complexity. GET is a practical, transparent, prudent and a fair approach to taxing GHG emissions.

Carbon Tax Efficacy Compared to cap-and-trade, a carbon tax is a straightforward instrument. A tax is imposed at a price per ton of carbon content on the upstream sources of emissions, such as coal, oil, natural gas, and mining entities that are heavy emitters. In theory, a tax on fossil fuels would pass costs on to users (Rabe and Borick 2012). Consequently, as users avoid higher costs, emissions would decline, making the impact

70

J. Nathwani and A. W. Ng

highest where it is most needed, producing an efficient outcome (Lippke and PerezGarcia 2008). A carbon tax provides several advantages over cap-and-trade. As a revenuegenerating instrument (as opposed to non-revenue-generating in the form of a freeallowance cap-and-trade), a carbon tax yields a double dividend of economic as well as environmental benefits (Harrison 2010). A carbon tax is also simple to set up, because extensive experience exists in most jurisdictions on value added or sales taxes on consumption and their collection and enforcement. A carbon tax also ensures certainty for business, since the external cost cannot rise above the rate. It further offers greater transparency with respect to costs and their distribution, which can make it easier to redress impacts on those with low incomes. However, a carbon tax has clear limitations from the perspective of political acceptability. As with any revenue-raising instrument, the mere act of levying duty (even if not implying an actuarial or budgetary increase) is bound to arouse some electoral opposition. In the case of a carbon tax, the more direct and visible nature of costs to consumers may not be politically palatable, due to “a combination of rational ignorance and loss aversion” (Harrison 2010). Much of the opposition to a carbon tax is likely to come from organized groups that stand to benefit from cap-and-trade (Avi-Yonah and Uhlmann 2009), especially when allowances are grandfathered in or permitted to powerful industry lobby groups that are disadvantaged by the carbon intensity of their product. To the extent that industry (energy product and service providers) can adjust to a new cost structure, competition is set to emerge in vying for fiscal privileges, such as exemptions for particular energy-intensive entities, rebates from carbon and energy taxes, and reduced tax rates. More aware of their interests and better organized to invest in their appropriation, business has time and again won out over consumers, as observed in Denmark, Finland, and Germany (Harrison 2010). Along this line, a carbon tax might appear relatively transparent, but discrimination against certain types of emitters, especially in the face of strong anti-carbon taxation lobbying powers, will generate tension over its equity aspect. In terms of international competitiveness, a carbon tax has negative political connotations. Although several academic studies suggest there is “little evidence to support the hypothesis that environmental regulations have had a large adverse effect on competitiveness,” politicians remain highly risk-averse when confronted with threats of capital mobility (Harrison 2010; Jaffe et al. 1995). The political tradeoff is concessions granted to powerful groups that represent large industrial or major emitters. Finally, while segregating the revenues generated from a carbon-tax regime can reduce the uncertainty of environmental and social benefits, voters remain suspicious that, under government management, the tax generated revenues will be primarily directed to address politically appealing pet projects with high voter satisfaction. For example, a proposal, dubbed 40/40 by Alberta’s Minister of Environment to reduce intensity-based emissions and raise the noncompliance penalty, drew national attention in Canada. The plan required large emitters in Alberta to reduce per-barrel emissions by 40% and pay $40 per exceeded ton into a technology fund (thus the 40/40 moniker).

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

71

This marks a significant jump on both ends, compared to the regulation in effect since 2007, which set the emissions-intensity reduction target at 12% and the noncompliance penalty at $15 per ton. Note that the proposed measure is not technically a carbon tax, but rather a performance regulation. The Pembina Institute pointed out that the $40 carbon price still falls short of keeping Canada’s 2020 target, as agreed in Copenhagen (http://www.pembina.org/blog/707). A carbon tax remains a very difficult political proposition at high or increasing levels of taxation for it to be most effective. If it is not clearly linked with a plausible explanation of how the revenues would improve the environment through investments in a transparent and equitable process, then its political acceptability becomes a challenge.

Cap and Invest through an Integrated Approach We propose an approach that integrates three components for effective policy stability in support of decarbonization in any jurisdiction: (i) Cap and Invest (ii) Tax on Final Consumption, economy-wide, as General Environmental Tax (GET) (iii) Innovation in Governance These three complementary components are inter-linked and form an integrtaed framework that enables substantial public funding for investment in the next generation infrastructure as illustrated in Figure 1. Innovation in governance is a key part of the framework to allow “arm’s length” institutions to take initiatives and drive a global transition for a sustainable energy future.

Principles of Cap and Invest The concept of cap-and-invest is to enable the maximum net reduction in emissions on a life-cycle basis from the base year being established to future planned reductions under aspirational targets. The goal is to reduce total national emissions from the current level, such as 50% before 2050, and 80% by 2100. All solutions subject to a list of technical and economic criteria, with no preconceived bias for or against specific technologies, would be eligible for funding from the ETF. The primary test of efficacy is net reduction of GHG emissions at the least cost for maximum net benefit. The governing board of the ETF is guided in its investment decisions by objective technical and financial criteria and established due diligence processes. The ETF is an “arm’s length” independent agency not subject to direct interventions of the government of the day in its normal decision-making process. Commercially available technologies would have the edge in the near term for early deployment. However, what is costly today will become less so over time

72

J. Nathwani and A. W. Ng

Figure 1: An Integrated Approach to Financing a Sustainable Energy Future. (Source: Authors’ compilation)

Principles for “Cap and Invest”

Tax on Economy-wide Consumption

Innovation in Governance of Institutions

Public-Private Partnerships for Financing A Sustainable Energy Future

(Source: Author Compilaon)

through innovation and applications at scale. Initiatives new or old, however, would be subject to a simple test for acceptable investment: What is the largest quantifiable and verifiable reduction in greenhouse gas emissions to be delivered when considered on a life-cycle basis, and at what cost?

An important criterion for allocating investment would be expert judgment on deliverability of measurable results, with validation and verification by the ETF governing board. The enticement for industry is a nudge to invest in clean technologies now; the ETF, depending on project qualification, either matches dollar-for-dollar costs of capital or provides loan guarantees as a source of risk-tolerant capital. This provides an incentive to industry to become a willing partner and leverage the availability of its own technical and financial resources. The obligation on industry is imposition of “deep and steep targets” to be met under firm timelines and all compliance costs to businesses and industry. Over time, most businesses that subscribe to corporate social responsibility would identify the threat posed by a more profitably creative competitor and act to ensure their survival. In the new carbon-constrained world, not only do penalties imposed for non-compliance become important, but also reputations suffer. The virtue of hypothecation—redirecting investment in cleantech and sectoral innovation—is a crucial feature of decarbonizing the global economy (Prins et al. 2010).

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

73

The goal is to create a drive for innovation and a framework for a credible set of local, regional, and national solutions that are cost-effective and technologically feasible. These can then be integrated with a more coherent long-term system view and implementation on a large scale where national and regional priorities converge. Yoshino and Taghizadeh-Hesary (2017, 2018) proposed a similar scheme, where a carbon tax is utilized as seed money in green hometown investment trust funds, in order to increase the rate of return and reduce the risk of private sector investment into renewable energy projects. This scheme is designed as a community-based fund for collecting hometown investors’ money for risky projects. This scheme was initiated in Japan after the Fukushima nuclear disaster in March 2011 and successfully collected investments for small and medium-sized renewable energy projects.

Taxation Regime on Economy-Wide Consumption A tax on consumption—an increase of one or two percentage points to the existing sales tax, designated as a GET—provides a robust basis for financing new lowemissions projects. Furthermore, if the revenues are leveraged with additional private sector financing, the scale of deployment can be accelerated to help achieve national targets for GHG reductions. We note that there is little enthusiasm among both the public and politicians for increased taxes at any time in any jurisdiction. If the public narrative is framed as an investment in our own future to address a compelling global environmental threat, then a tax on consumption that spreads the burden fairly across all individuals has the potential to be widely accepted. The cap-and-invest approach limits large impacts on a narrow group of industries, sectors, or communities. Any reduction of emissions arising from reduced consumption—due to the marginal elasticity effect of a tax—is a positive effect, but only a small part of the benefit. The larger benefit is that this approach relies on a “ring-fencing” of the revenues from the consumption tax to be redirected for investments to deliver a low-carbon energy future. The GET is for a designated purpose to reduce the national carbon footprint. The premise of a functioning democracy is the tacit agreement of citizens who willingly pay taxes in exchange for government services (Tanzi and Schuknecht 2000). For government, its capacity to tax is its only source of revenues implied in the social contract. In essence, citizen consent through taxation provides accountability between public officials and the expectations of their constituents (Beland and Lecours 2012). The impact on the climate, arising from our actions through use of fossil fuels, is a case of an intergenerational burden that requires a broad base of consent. The levy is the mechanism of accountability that will dictate action by public officials. The additional revenue from a 1 or 2 percentage point increase, explicitly identified as the GET, is dedicated solely to investment in solutions required for a clean environment. For the disadvantaged in our society, there are already several

74

J. Nathwani and A. W. Ng

effective compensating measures of tax relief in place, e.g., exemptions on food, textbooks, and rebates to low-income individuals. The proposed GET is somewhat closer to a carbon tax, but with a fundamental difference—it does not seek to identify the carbon-heavy or carbon-light content of the product or service. It reflects on our consumption: whatever we consume to support our lifestyle contains an embedded carbon energy component. Thus, collectively, we are part of the emissions problem that our consumption engenders. The need to devise complicated tax schemes to punish one sector over another or pointing solely to industry as the problem is largely mitigated. It is perverse to punish truckers for bringing our food supplies to our local grocery stores by increasing fuel taxes, just as it is to blame airlines for flying us to destinations we desire. A small levy, no more than 2% of gross consumption, is reasonable at the individual level, but at the national level it adds up to a substantial resource. If the resources can be directed to solving a problem that has emerged as an existential threat globally and with the possibility of large cost impacts on the national infrastructure, it is not a huge sacrifice to put in place the capacity to mitigate emissions and adaptation for a climate-resilient future. One reason that a carbon tax is likely to meet political difficulty is that it entails concentrated costs and diffused benefits, as opposed to the more politically palatable cap-and-trade promises (Harrison 2012). The GET approach, in conjunction with an ETF, not only has the politically palatable feature of concentrated benefits and diffused costs, but also maintains the transparency of a tax-based regime.

Innovation in Institutional Governance The most serious objection to such a bold move is the potential threat of misuse of tax revenues. We believe that rigorous, transparent innovation in governance for institutions managing such a large undertaking would be necessary. A national ETF established through an Act of Parliament with requisite authority and necessary constraints in its operations would manage the proceeds. The ETF, created with a specific mandate by Parliament and recognized as an “arm’s-length” entity separate from government departments, can minimize overt political influence in its decisionmaking. Clarity around the goals and vision for use of these funds would have to be included in the ETF’s enabling legislation.

The Environmental Trust Fund: Institutional Exemplars The concept of a national fund that draws on current contributions to address a future societal liability is well known (Truman 2008). Such funds have been established in several countries, including various Sovereign Wealth Funds, public pension reserve funds, and national funds, such as the Canada Pension Plan (CPP) reserve fund, and the Government Pension Fund of Norway (GPFN). The design of a concept model for the ETF draws upon some of the successful features of these plans. We describe two such designs as illustrations of best practice.

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

75

Canada Pension Plan The CPP is operated and managed by a private-sector entity, the CPP Investment Board (CPPIB). The CPP has undergone drastic reforms since its establishment almost half a century ago, and is presently in good health. Lessons can be drawn from the CPP (Little 2009) to inform the proposed ETF model. The Canadian Pension Plan Investment Board Act created the CPPIB in December 1997 in the form of a Crown Corporation and set out its objectives, holding it accountable to all Canadians. The Act also prohibits the CPPIB from carrying out any business activities inconsistent with the [stated] objectives; any variation would require an amendment to the law (Mendelson 2005; Government of Canada 2007). Regulatory safeguards, including the nomination and appointment processes, protect the CPPIB from political interference, maintain professional standards, and the primary fiduciary goal of maximizing the rate of return. The CPPIB is governed by clear legislation that prescribes a transparent reporting framework. The CPPIB is required to produce quarterly and annual financial statements, in accordance with the accounting principles enshrined in the Handbook of the Canadian Institute of Chartered Accountants (Battle and Tamagno 2007). Along with financial statements, the CPPIB is also required to produce a comprehensive, public annual report that reviews the governance objectives, changes in investment policies and practices, and performance. The CPPIB released its Policy for Responsible Investing, with guidelines for environmental, social, and governance factors that would influence long-term financial results in 2010. Responsible investing principles facilitate engagement with other institutional investors in promoting transparency and performance on environmental, social, and governance factors among the companies in CPP’s investment portfolio (CPPIB 2017). Government Pension Fund of Norway The Government Pension Fund of Norway (GPFN), commonly known as Government Pension Fund Global, was established by an act of te national parliament in 1990 as a long-term policy to offset the curse of resource wealth. It serves as a tool for macroeconomic stabilization against the potential short-term costs of fluctuating revenues (Clark and Monk 2009). In 2001, the Norwegian parliament adopted a fiscal guideline that limits non-oil deficits to 4% of the GPFN to provide spending-level predictability. The Ministry of Finance, as a deposit account with the Norwegian Central Bank, formally owns the GPFN. Thus, the Norges Bank Investment Management administers the assets, which are reported to the Bank’s Governor and the Minister of Finance as a special unit. While the Ministry has the responsibility for key long-term strategic decisions, the Bank’s main responsibility is to maximize expected return relative to the benchmark and variation determined by the Norges Bank Investment Management (Vikøren 2008). Given its transparent nature, democratic processes, and commitment to accountability, intergenerational equity, and obligations to society, GPFN is widely acclaimed for its governance model and has a high Truman score. It has adopted a

76

J. Nathwani and A. W. Ng

mission statement to manage the fund responsibly and to embrace a long-term return that is consistent with sustainable development.

Importance of an Arms-Length Investment Framework The exemplary governance of the GPFN and the CPPIB lends weight to our proposal for an arm’s-length entity such as the ETF with the right governance structure to manage a large pool of investment capital. The ETF serves the purpose of addressing costs and benefits that cut across generations—namely, the intergenerational liability arising from the benefits that accrue to the current generation through use of fossil fuels. The GET is made transparent by ensuring that all receipts are accounted for and deposited to a special ETF, kept at arm’s length from government, and managed by an Investment Board accountable directly to Parliament. The policy stability and governance associated with the management of the investment portfolio will provide confidence in our ability to accomplish the climate reduction targets within a generation or two, in about a 30- to 70-year period. Public-Private Responsible Financing Collaboration The ETF Investment Board would establish a program to foster development of lowcarbon technologies. The pool of investment funds available in the ETF can be further co-invested with business and industry projects that de-risk emerging low-carbon technologies through a collaborative public-private partnership. As the economy grows, the available pool of capital for investments will continue to increase. This approach for financing complements the notion of issuance of large-scale green bonds. Reportedly, $3.8 billion was raised in 2017 alone by both Canadian public and private entities through issuance of green bonds in alignment with the responsible investing principles. The Province of Ontario in Canada released its green bond program in 2014 in support of its infrastructure spending for eligible projects combating climate change. It is worthwhile to note that countries in Asia, including the PRC, have also been active in utilizing green bonds as a financial instrument. In 2017, the PRC allegedly issued $36 billion worth of green bonds (Climate Bonds Initiative 2017). Hong Kong, China, as a global financial center of the PRC, is emerging as a green finance hub in Asia (Ng 2018).

Concluding Remarks and Policy Implications Technology Options and Infrastructure (i) Identification of a viable investment portfolio comprising low-carbon technologies and supporting infrastructure is a key step in achieving a global energy transition. For instance, the Waterloo Global Science Initiative has spearheaded a Low-Carbon Electricity Ecosystem in its document “The Equinox Blueprint: Energy 2030,” which takes into account the scale of and the requirements for de-risking select transformative technologies (WGSI 2012).

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

77

(ii) A Low-Carbon Electricity Ecosystem comprising the core elements of baseload power, smart urbanization, and off-grid electrification, each combining diverse energy technologies in generation, distribution, and storage, has been identified as a pathway for the future energy system. (iii) A transitioning away from fossil fuels will require massive investments for renewal of the energy infrastructure for sustainable economic development.

Cap-and-Invest Strategy for Driving a Global Energy Transition (i) The proposed strategy for decarbonizing a national economy through cap-andinvest in concert with a GET and an ETF is necessary to combat intergenerational burdens. A designated institution such as the ETF for public-private partnerships to foster responsible financing initiatives is proposed as alternative to cap-andtrade. The approach, with modifications by jurisdictions, is particularly relevant in Asia. (ii) Cap and trade and carbon-tax mechanisms have not been sufficient to drive the necessary scale of infrastructure investment for sustainable economic development. (iii) Transformation of the existing global energy system requires patient capital and a stable policy environment to manage intergenerational burdens associated with current GHG emissions. Reallocating the Public Funding for Sustainable Development (i) A small tax, 1% to 2% on economy-wide consumption, with revenues to be “ring-fenced” through an ETF, is a part of a cap-and-invest strategy. (ii) Creation of an arms-length agency would be necessary to manage such a fund, with an explicit mandate to support the national goals of a cap on emissions, and then invest in the development of necessary solutions to effect change at scale. (iii) To gain public trust and to allow the development of an orderly political consensus, it is imperative for government institutions to evolve mechanisms for innovation in governance to complement investment startegies with a long view. (iv) Revenues from the public funding, if complemented by the vast amount of financial resources from the international institutional investors, would reduce the underlying cost of capital and attract the necessary allocation of resources into the development of sustainable energy infrastructure. The recent interest in green bonds around the world, particularly in Asia, suggests the potential for closer alignment and collaboration between the governments or private corporations issuing such financial instruments and the institutional investors seeking responsible investing opportunities. The green bond compliance requirements and third-party assurance imposed on the bond issuers are expected to mitigate the concerns over the effectiveness of the investments in reducing emissions.

78

J. Nathwani and A. W. Ng

In summary, the necessary technological pathways need to be identified while creating the drive for innovation and competitive national advantage. The opportunity exists to create new global markets and the foundational basis of a new economy for solving the global problem of climate change. Governance and technological innovations combined would enhance the national scientific and industrial capacity to catalyze change.

References Andrew J, Kaidonis M, Andrew B (2010) Carbon tax: challenging neoliberal solutions to climate change. Crit Perspect Account 21:611–618 Avi-Yonah RS, Uhlmann DM (2009) Combating global climate change: why a carbon tax is better response to global warming than cap and trade. Stanford Environ Law J 28(3):3–58 Ball J (2018) Why carbon pricing isn’t working- good idea in theory, failing in practice. Foreign Aff 97(4):134–146 Battle K, Tamagno E (2007) Public pension in a development context: the case of Canada. United Nations Research Institute for Social Development. Social Policy and Development Programme Paper Beland D, Lecours A (2012) Equalization at arm’s length. MOWAT Center. Fiscal Transfers Series, Toronto, Canada Bloomberg (2013) Australian factories meet carbon deadline ahead of cap-and-trade, 24 June. https://www.bloomberg.com/news/articles/2013-06-24/australian-factories-meet-carbon-dead line-ahead-of-cap-and-trade British Petroleum (2017) BP Statistical Review of World Energy 2017. http://www.bp.com/statisti calreview. Accessed 7 Mar 2018 California Environmental Protection Agency (2013). http://www.arb.ca.gov/cc/capandtrade/ capandtrade.htm. Accessed 7 Mar 2018 Canadian Public Pension Investment Board (CPPIB) (2017) CPPIB annual report 2017, and ‘Policy on Responsible Investing’, CPPIB (2010), Toronto, Canada Clark GL, Monk AHB (2009) The legitimacy and governance of Norway’s sovereign wealth fund: the ethics of global investment. Environ Plan A42(7):1723–1738 Climate Bonds Initiative (2017) Bonds and climate change 2017: Canada report. https://www. climatebonds.net/ Daskalakis G (2013) On the efficiency of the European carbon market: new evidence from Phase II. Energy Policy 54:369–375 den Elzen M, Höhne N (2008) Reductions of greenhouse gas emissions in Annex I and non- Annex I countries for meeting concentration stabilisation targets. Climate Change 91(3–4):249–274 Economist (2013a) Carbon trading. ETS RIP? The failure to reform Europe’s carbon market will reverberate round the world, 20 April. http://www.economist.com/news/finance-and-economics/ 21576388-failure-reform-europes-carbon-market-will-reverberate-round-world-ets; http://www. theguardian.com/environment/2013/jun/25/eu-emissions-trading-scheme-energy Economist (2013b) Carbon emissions: the cap doesn’t fit, 19 June. https://www.economist.com/ analects/2013/06/19/the-cap-doesnt-fit GEA or Global Energy Assessment (2012) Global energy assessment – toward a sustainable future. International Institute for Applied Systems Analysis/Cambridge University Press, Vienna/Cambridge, UK Government of Canada (2007) Canada Pension Plan Investment Board Act. http://laws-lois.justice. gc.ca/eng/acts/C-8.3/ Accessed 1 June 2017 Harrison K (2010) The comparative politics of carbon taxation. Ann Rev Law Soc Sci 6:507–529 Harrison K (2012) A tale of two taxes: the fate of environmental tax reform in Canada. Rev Pol Res 29:383–407

4

A “Cap and Invest” Strategy for Managing the Intergenerational. . .

79

International Energy Agency (2017) World Energy Outlook 2017. OECD/International Energy Agency. http://www.iea.org/weo2017/ International Panel on Climate Change (IPCC) (2018) Global Warming of 1.5 degrees C, Summary for Policy Makers, October 2018 Jaffe AB, Peterson S, Stavins R (1995) Environmental regulation and the competitiveness of US manufacturing: what does the evidence tell us? J Econ Lit 33:132–163 Kossoy A, Ambrosi P (2010) State and trends of the carbon market 2010. The World Bank, Washington, DC Lecocq F, Ambrosi P (2007) The clean development mechanism: history, status, and prospects. Policy Monitor 1:134–151 Lecocq F, Capoor K (2005) State and trends of the carbon market 2005. The World Bank and International Emissions Trading Association, Washington, DC Levi MA (2009) Copenhagen’s inconvenient truth: how to salvage the climate conference. Foreign Aff 88(5):92–104 Lippke B, Perez-Garcia J (2008) Will either cap and trade or a carbon emissions tax be effective in monetizing carbon as an ecosystem service? Forest Ecol Manage 256:2160–2165 Little B (2009) Fixing the future: how Canada’s usually fractious government worked together to rescue the Canadian pension plan. University of Toronto, Toronto Matisoff DC (2010) Making cap-and-trade work: lessons from the European Union experience. Environment 52(1):10–19 McGuinness M, Ellerman AD (2008) The effects of interactions between federal and state climate policies. Center for Energy and Environmental Policy Research, Cambridge, MA Mendelson M (2005) Financing the Canada and Quebec pension plans. Caledon Institute of Social Policy, Toronto Michaelowa A, Purohit P (2007) Additionality determination of Indian CDM projects – Can Indian CDM project developers outwit the CDM Executive Board? University of Zurich. Climate strategies working paper Ng A (2018) From sustainability accounting to a green financing system: Institutional legitimacy and market heterogeneity in a global financial centre. J Clean Prod 195:585–592 Ng A, Nathwani J (2018) Sustainable energy infrastructure for Asia: policy framework for responsible financing and investment. In: Bhattacharyya SC (ed) Routledge handbook of energy in Asia. Routledge, Abingdon, pp 284–295 Prins G, Galiana I, Green C, Grundmann R, Korhola A, Laird F, Nordhaus T, Pielke R, Rayner S, Sarewitz D, Shellenberger M, Stehr N, Tezuko H (2010) The Hartwell paper. Institute for Science, Innovation and Society, University of Oxford, Oxford, UK Rabe B, Borick C (2012) Carbon taxation and policy labeling: experience from American states and Canadian provinces. Rev Policy Res 29:358–382 Ren C, Lo AY (2017) Emission trading and carbon market performance in Shenzhen, China. Appl Energy 193:414–425 RGGI or Regional Greenhouse Gas Initiative (2012). http://www.rggi.org/. Accessed 21 July 2017 Sandbag Organization (2013) Drifting toward disaster: the EU ETS adrift in Europe’s climate efforts. http://www.sandbag.org.uk/site_media/pdfs/reports/Drifting_Towards_Disaster.pdf. Accessed 21 July 2017 Schneider L (2009) Assessing the additionality of CDM projects: practical experiences and lessons learned. Clim Policy 9(3):242–254 Tan A, Kaidonis M, Moerman L (2008) Balancing the seesaw: how Australia’s carbon pollution reduction scheme can fail. In Proceedings of the 21st Australasian finance and banking conference, Sydney, Australia Tanzi V, Schuknecht L (2000) Public spending in the 20th century: a global perspective. Cambridge University Press, Cambridge, UK Truman E (2008) A blueprint for sovereign wealth fund best practices. Peterson Institute for International Economics. Number PB08-3 Vasa A, Neuhoff K (2011) The role of CDM post-2012. Climate Policy Initiative/DIW, Berlin

80

J. Nathwani and A. W. Ng

Vikøren B (2008) Norges bank’s experiences with the organization of the government pension fund – global. In: Commodities, energy and finance. SUERF: The European Money and Finance Forum, Vienna Wara M, Victor DG (2008) A realistic policy on international carbon offsets. Stanford Law School working paper. http://www.law.stanford.edu/publications/details/4032/. Accessed 21 July 2017 Waterloo Global Science Initiative (WGSI) (2012) Equinox blueprint: energy 2030. Waterloo Global Science Initiative, Waterloo Yoshino N, Taghizadeh-Hesary F (2017) Alternatives to bank finance: role of carbon tax and hometown investment trust funds in developing green energy projects in Asia. Asian Development Bank Institute working paper 761. Asian Development Bank Institute (ADBI), Tokyo Yoshino N, Taghizadeh-Hesary F (2018) Alternatives to private finance: role of fiscal policy reforms and energy taxation in development of renewable energy projects. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, New York, pp 335–357 Zhao X, Li W, Li A (2017) Research on efficiency of carbon trading market in China. Renew Sustain Energy Rev 79:1–8

5

Central Banking, Climate Change, and Green Finance Simon Dikau and Ulrich Volz

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Why Central Banks Should Be Concerned with Aligning Finance with Sustainable Growth and Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 The Importance of Environmental Factors for Conventional Goals of Central Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 Sustainable Development as a Goal of Central Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 Tools and Instruments of Central Banks to Address Environmental Risk and Promote Green Finance and Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 Green Micro-Prudential Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Green Macro-Prudential Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Green Financial Market Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 Green Credit Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Other Supportive Green Central Bank Initiatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Appendix 1: Sustainable Finance Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

Abstract

Responsibility for financial and macroeconomic stability implicitly or explicitly lies with the central bank, which therefore ought to address climate-related and other environmental risks on a systemic level. Furthermore, central banks, through their regulatory oversight over money, credit and the financial system, S. Dikau (*) Department of Economics, SOAS University of London, London, UK e-mail: [email protected] U. Volz Department of Economics, SOAS University of London, London, UK German Development Institute, Bonn, Germany e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_17

81

82

S. Dikau and U. Volz

are in a powerful position to support the development of green finance models and enforce an adequate pricing of environmental and carbon risk by financial institutions. The central topic of this chapter are the public financial governance policies through which central banks, as well as other relevant financial regulatory agencies, can address environmental risk and promote sustainable finance. The chapter first discusses the reasons why central banks should be concerned with aligning finance with sustainable development. Second, the chapter reviews the tools and instruments that can be utilized by central banks and financial regulatory agencies to address environmental risk and promote green finance and sustainable development. Third, the chapter provides a brief review of green public financial governance initiatives. Keywords

Central banks · Green finance · Green transformation JEL Classifications

Q5 · E5

Introduction To achieve the 2030 Agenda for Sustainable Development and the Paris Climate Accord, investment will have to be directed away from carbon- and resourceintensive investments toward sustainable investment. Responsibility for financial and macroeconomic stability implicitly or explicitly rests with the central bank, which therefore ought to address climate-related and other environmental risks on a systemic level. Furthermore, central banks, through their regulatory oversight over money, credit and the financial system, are in a powerful position to support the development of sustainable finance approaches and enforce an adequate pricing of environmental and carbon risk by financial institutions (Volz 2017). Against this backdrop, the chapter discusses the extent to which central banks should incorporate environmental considerations into their operations, and reviews the public financial governance policies through which central banks, as well as other relevant financial regulatory agencies, can promote green finance. The chapter is organized as follows. The section “Why Central Banks Should Be Concerned with Aligning Finance with Sustainable Growth and Development” discusses the reasons why central banks should be concerned with aligning finance with sustainable development. In doing so, it differentiates between the impact of environmental factors on the conventional goals of central banking, and a potential promotional role of central banks with regard to green finance and sustainability. Subsequently, the section “Tools and Instruments of Central Banks to Address Environmental Risk and Promote Green Finance and Investment” reviews the tools and instruments that can be utilized by central banks and financial regulatory agencies to promote green finance and sustainable development. It also provides some examples of public green financial policies in different policy areas. The final section concludes.

5

Central Banking, Climate Change, and Green Finance

83

Why Central Banks Should Be Concerned with Aligning Finance with Sustainable Growth and Development Green central banking can be defined as central banking that takes account of environmental risks, including risks from climate change, which may have a material impact on the short- and long-term stability and development of the financial sector and the macroeconomy. One can distinguish between central banks’ responses to environmental externalities affecting central banks’ traditional core responsibility of safeguarding macroeconomic and financial stability, and an activist role of central banks in “greening” the economy. Green central banking therefore describes, on the one hand, the process of taking environmental risk and other sustainability-related factors, such as climate change mitigation policy, into account in the design of monetary policy and financial regulation in the pursuit of the traditional goals of price and financial stability. This can be described as the passive aspect of green central banking because in pursuing their established goals, central banks may need to incorporate environmental factors into existing frameworks, for instance into macro-prudential frameworks, without pursuing a “sustainability agenda.” On the other hand, central banks may be mandated to actively use the tools at their disposal to promote green investment or discourage brown investment and play a “developmental role” (Dafe and Volz 2015).

The Importance of Environmental Factors for Conventional Goals of Central Banking The core responsibility of most central banks—often specified in the mandate as the singular or primary objective of monetary policy—is safeguarding low and stable inflation. Sometimes embedded in an inflation-targeting framework, this primary focus of central banks on price stability is based on the theoretical and empirical understanding that low and stable inflation is a necessary precondition for growth or development to take place. Apart from maintaining low and stable inflation, safeguarding financial stability has traditionally been the other important concern for central banks, which throughout history have acted as lenders of last resort. Although there was a trend since the 1990s to assign responsibility for financial stability to dedicated financial regulatory authorities, it has received renewed attention as a crucial central baking objective against the background of the global financial crisis. A further (often secondary) goal of central banking is supporting wider economic policy objectives such as sustainable growth or, in some cases, maximum employment. A strong argument for central banks to take environmental factors into account in the conduct of monetary policy in the pursuit of their core objectives can be derived from how these central goals are affected by climate change and other environmental risks.

Impact on Price Stability Prices and price variability, which are at the center of attention of most central banks, could be affected through various channels by anthropogenic climate change and an

84

S. Dikau and U. Volz

associated increase in the frequency and severity of extreme weather events. To start with, climate change may have a significant impact on agricultural production, both domestic and abroad, and hence on food prices, which are an important component of consumer price inflation. For instance, climate change-related droughts and floods may have a significant impact on agricultural production and cause supply shocks and hence rising prices and cost-push inflation. For economies in which agricultural production is a central pillar of the economy—which is often the case in developing economies—climate change effects on the agricultural sector may also have a broader impact on aggregate income and employment. While a first concern is how climate change-related hazards may directly affect prices, a second issue of concern is the potential impact of climate change-mitigation policy on inflation. An important issue in this context is the potential impact that climate change mitigation policies may have on energy production and prices (Volz 2017). McKibbin et al. (2017) discuss how different climate change policy regimes—carbon policies such as a carbon tax, a permit trading system, and other regulatory measures—could theoretically affect different monetary policy regimes. In a scenario where the introduction of a carbon tax causes aggregate output to decline and inflation to spike, no response by the central bank would yield a permanently lower output level and no change in the long-term growth rate. In the case of a strict inflation-targeting regime, the central bank would respond to the spike in inflation by raising interest rates, thereby further slowing the economy, but also causing exchange rate appreciation. While both would have a depreciating effect on inflation, the overall decline in output would be worse than in the case without central bank intervention. McKibbin et al. (2017) also discuss implications for other monetary policy regimes, including flexible inflation targeting and price level targeting, and come to the overall conclusion that solely responding to the inflationary component, without taking rising prices and decreasing output resulting from climate policy into account, may lead to unnecessarily large output losses. Monetary policy therefore has to take climaterelated effects on food or energy prices into account, as well as consider the impact of climate mitigation policies because of potentially important implications for core inflation.

Impact on Financial Stability To the extent that environmental damages and climate-related risks affect the stability of banks, insurance firms and other financial actors, they need to be of concern for central banking. Thus far, only few central banks and financial regulators have been concerned with environmental risk, and even fewer have considered it as part of their systemic risk framework, even though risks arising from climate change can constitute a significant systemic risk for the financial sector and economies at large (Volz 2017). However, a broad consensus is emerging that climate change and related mitigation policies will have substantial repercussions on the functioning of economies, and hence financial systems (Bank of England 2015; Carney 2015). Three different types of risk through which climate change may affect financial systems have been identified: transitional risk, physical risk, and liability risk (Carney 2015). Transitional risk describes the uncertainty associated with policy,

5

Central Banking, Climate Change, and Green Finance

85

price, and valuation changes that may occur in the process of mitigating climate change and reducing carbon emissions. International goals, such as limiting global warming to two degrees, will require powerful policy initiatives, such as the introduction of carbon taxes or extensive environmental regulation, which will affect the valuation of carbon-intensive businesses and may render assets of coal, gas and oil companies less valuable, with potential systemic repercussions in case these policy changes have not been priced in. Volz (2017) also discusses the development of new technologies in the process of climate change mitigation that may render existing technologies redundant, and the associated revaluation of assets, as a potential source of financial instability, which, if not occurring in a gradual manner, may have systemic implications. Physical risk describes the risk of natural hazards, such as floods and storms, which may cause direct damages to an economy, as well as indirectly through the disruption of global supply changes. Climate-related damages and risks are understood to be potentially significant and to not only cause disruptions for individual firms or sectors, but to have systemic repercussions for the economy and, therefore, financial stability. Increasing levels of physical risk can be expected to have particularly large repercussions for the insurance sector. As recognized by the Bank of England (2015), climate change-induced and other vital environmental changes therefore have clear implications for central banks because they may negatively affect the stability of financial institutions and systems. Pricing in physical risks is an essential step in avoiding these negative repercussions for the economy, and seems especially crucial for the valuation of long-term investments. Thirdly, liability risk describes climate or environmental risks that occur from uncertainty surrounding potential financial losses and compensation claims stemming from damages caused by climate change-related natural hazards (Bank of England 2015; Carney 2015). Agents may seek compensation for financial damages from carbon extractors or emitters and environmental polluters, creating repercussions for the insurance sector, and hence for central banks that provide third-party liability insurance (Bank of England 2015). Overall, a consensus has been emerging in the central banking community that climate change-related natural disasters can create and intensify risks to the stability of the financial system, and that potential disruptions from climate change ought to be analyzed and taken into account by central banks, especially if central banks are responsible for safeguarding financial stability (Bank of England 2015; Carney 2015).

Sustainable Development as a Goal of Central Banking The second dimension of green central banking—i.e., an active contribution to a greening of the financial system and the economy as a whole by central banks—has been more contentious. As will be discussed in the next section, central banks have numerous powerful tools at their disposal to affect credit allocation and the investment behavior of financial firms. Whether and to what extent a central bank should

86

S. Dikau and U. Volz

use its powers and actively engage in “greening” the financial system and the economy depends on two factors: its legal mandate, and the extent to which it is best placed to correct certain types of market failures, taking into account the ability and suitability of other policy institutions to steer the green transformation (Volz 2017).

Mandated Responsibility For central banks to assume an active “greening” role requires an explicit legal mandate to pursue environmental and sustainability objectives, given the potentially distributive consequences. In most of today’s advanced economies, central banks have a relatively narrow mandate with a primary objective of pursuing price stability and, in some cases, financial stability. As discussed, such narrow mandates arguably require central banks to explore climate and environmental risks with regard to these core goals, but they do not mandate them to go further and to actively promote sustainability and green finance. In many developing and emerging economies, central bank mandates are more comprehensive and include sustainability, as well as social and economic objectives. This is reflected by the fact that central banks in many developing and emerging economies have been comparatively more active in promoting green finance and sustainable development, as will be discussed below. Dikau and Ryan-Collins (2017) take a closer look at the legal mandates and objectives of those central banks in emerging economies that most actively pursue green central banking policies. The legal mandate of Bangladesh Bank, the central bank of Bangladesh, for example, includes supporting economic growth and development as a secondary objective, based on which Bangladesh Bank has stated that it understands the greening of the financial system and the economy to be within its responsibility (Bangladesh Bank 2011). Furthermore, Banco Central do Brasil, the central bank of Brazil, which serves as financial regulator and supervisor, is tasked with promoting balanced development and to serve the collective interest, implying a sustainability objective for the central bank (Brasil 1988). While the mandate of the People’s Bank of China includes the primary objective of maintaining price stability and thereby promoting economic growth, it also requires the central bank to implement the orders of the State Council, potentially involving the central bank in farreaching policy initiatives, such as the promotion of green finance and sustainability (People’s Republic of China 2003). Nonetheless, there are also risks involved with overstretching the mandates of central banks to include sustainability objectives. Volz (2017) highlights problems associated with potentially conflicting objectives of central banks, and dangers regarding the accountability of central banks. He also points to the prevailing central banking paradigm as limiting the extent to which mandates can or should be extended, and existing ones may be interpreted, to include green sustainability objectives. The Market Failure Argument Achieving the global climate targets will not only require the financial sector to play a central role in financing sustainable and green investment, but also in restricting funding for environmentally harmful activities. In the absence of public intervention,

5

Central Banking, Climate Change, and Green Finance

87

banks and other financial institutions may allocate their resources to environmentally and socially undesirable activities, such as carbon-intensive or polluting ventures, in order to maximize their private returns. This discrepancy between environmental and social returns, and private returns represents a market failure or imperfection that may call for efficiency-enhancing government intervention. That free markets do not necessarily yield Pareto-efficient allocations has been investigated by Greenwald and Stiglitz (1986), based on the understanding that if information is incomplete or asymmetric, or when markets are incomplete, outcomes may not be efficient and can be improved through the intervention of the government. With regard to the allocation of credit, Stiglitz (1994) discusses an efficiency-enhancing role of credit policies based on the assumption that the private returns of commercial bank lending are not necessarily congruent with social returns. He argues that in order to overcome these discrepancies between private and social returns, directed credit, restricted lending to some activities, and promoting investment in others may be justified. With regard to sustainable growth and green finance, externalities that cause an environmentally suboptimal allocation of credit by commercial banks and other market participants may call for a more active, market-correcting role of central banks. Nonetheless, intervention by the central bank conceptually constitutes a secondbest solution to the problem of market imperfection. The preferable first-best solution would be the removal of the market failure. For instance, a carbon pricing mechanism internalizing the social costs of carbon emissions would constitute a preferred, first-best, market failure-correcting policy that may prevent or disincentivize environmentally undesirable investment; the problem, however, is that such first-best policies may not always be politically feasible, or may take a long time to establish (Volz 2017). In the case where the optimality conditions of fixing market failure cannot be satisfied, the intervention of the central bank through environmental financial regulation or the interference into the allocation of resources can be interpreted as a second-best solution based on the theory of the second-best by Lipsey and Lancaster (1956) (Volz 2017). In practice, second-best policies could be implemented by mandating central banks to address such externalities by affecting the creation and allocation of credit. Central banks and other financial regulatory authorities can influence investment decisions and the allocation of resources and credit through a number of different policy implementation instruments, which are discussed in greater detail below. Their regulatory oversight over money, credit, and the financial system puts central banks in a uniquely powerful position that enables them to incentivize or direct resources away from carbon-intensive sectors toward green investment. Especially in developing countries, central banks typically have a strong institutional standing that enables them to shape policy outcomes in ways that other public institutions such as environmental ministries are unlikely to achieve. However, given their power, the points made about central banks’ mandate and accountability discussed above are very important. Historically, credit allocation policies and various other instruments of financial repression have been widely used and have led in many cases to substantial

88

S. Dikau and U. Volz

distortions of financial systems, with often unwanted repercussions for savings and prices; in many cases, the consequence was the underdevelopment of financial markets. While the historic success or failure of credit allocation and financial repression policies is subject to ongoing debate, such instruments stand in strong contrast to the widely accepted notion of the neutrality of monetary policy, and central banks in general, toward different investment classes, sectors, or types of firms. Allocating financial resources toward or away from certain sectors and companies implies favoring certain segments of the economy over others and appears to be incompatible with the modern understanding of central bank independence. Nonetheless, many central banks in emerging and developing economies have resorted to these policies as viable, second-best solutions to promote sustainable development and green investment. The notion of the neutrality of monetary policy has come under intense scrutiny more recently, not least in the context of discussions about the distributional consequences of the negative interest and quantitative easing policies adopted by major central banks. Another kind of market failure involves missing or incomplete financial markets that impede the trading of different forms of credit, assets, or risks (Volz 2017). While central banks most certainly have a role to play in financial market development and in establishing primary and secondary markets for securities, as well as money and exchange market segments where none exist (Gray and Talbot 2007), they may also be in a position to aid development of new green markets by, for instance, creating a regulatory environment that promotes green bonds issuances and trading in secondary markets.

Tools and Instruments of Central Banks to Address Environmental Risk and Promote Green Finance and Investment Central banks and financial regulatory agencies can employ numerous policy instruments to achieve sustainability targets (Volz 2017). This section distinguishes five different policy areas, including micro-prudential regulation, macro-prudential regulation, financial market development, credit allocation, and central bank soft power and guidelines. For each of the five policy areas, a number of different policy implementation tools and instruments are discussed and then illustrated through examples of central banks that have employed the discussed tools. It is apparent that especially central banks in developing and emerging economies, and in Asia in particular, have been at the forefront of using a broad range of instruments to address environmental risk and encourage green investment (Volz 2016, 2018; Dikau and Ryan-Collins 2017). Central banks in advanced economies have only recently begun to address the implications of climate change for monetary and financial stability, with a leading role by the Bank of England, which has played a central role in raising awareness of the implications of climate change risks amongst central banks (Bank of England 2015; Carney 2015). A more comprehensive overview of the steps central banks around the world have taken to align the financial system with sustainability targets is provided in Appendix 1.

5

Central Banking, Climate Change, and Green Finance

89

Green Micro-Prudential Regulation Many instruments of financial regulation can be calibrated to encourage or require financial institutions to consider climate and environmental risks in their operations with regard to the loan origination process or financial stability concerns. Central banks and other financial regulatory authorities can require banks and other financial institutions to adopt Environmental & Social (E&S) risk management standards, to assess and disclose climate-related risks, or to adjust reserve holdings.

Disclosure Requirements Effective disclosure requirements for banks and other financial institutions of climate change-related risks can play a central role in ensuring that the impact of climate change, climate policies, and natural hazards are correctly priced in by financial institutions. The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) discusses disclosure requirements as a central element of forming a response to climate and environmental risk based on the understanding that a lack of information of risk exposure of financial institutions entails consequences for financial stability, because the misallocation or mispricing of assets may cause abrupt price corrections in financial markets at a later stage (TCFD 2016). Mandatory disclosure requirements for all financial institutions could be a regulatory instrument to achieve this goal. Furthermore, Volz (2017) points out that improving transparency with regard to climate-related risks and the appropriate pricing of these risks are pre-conditional for green macro-prudential regulation, which is discussed below. E&S Risk Management Standards Similar to disclosure requirements, financial regulation that endorses mandatory E&S risk management standards requires financial institutions to incorporate E&S risk factors into their governance frameworks. With the aim of enforcing climaterelated risk management beyond disclosure, green E&S risk management standards may also establish environmental and social rules for banks’ lending practices by requiring the assessment of these risks, as well as taking potentially harmful environmental effects of new financial services and products into account. Furthermore, mandatory green risk management standards could oblige banks to include an assessment of E&S risks in the loan origination process as a criterion based on which loans are extended. This is likely to also have allocative consequences by reducing the flow of finance to polluting and energy intensive firms and enhancing the financing of greener projects. Reserve Requirements Reserve requirements determine the minimum amount of reserves that must be held by commercial banks. They could be calibrated to create incentives, leading to the promotion of green assets, or to make brown lending less attractive. Differential reserve requirements that are linked to the compositions of banks’ portfolio allowing lower (higher) required reserve rates for portfolios skewed towards greener, less

90

S. Dikau and U. Volz

carbon-intensive assets (brown, carbon-intensive assets) can potentially influence the allocation of credit and promote green investments. Another approach discussed in the literature is the acceptance of carbon certificates as part of commercial banks’ legal reserves in order to enhance the market for carbon certificates, and by distributing carbon certificates that are exchangeable for loan concessions to low-carbon projects, creating an incentive to further enhance green investment (Rozenberg et al. 2013).

Green Financial Regulation in Practice Green financial regulatory measures have been employed in a number of countries thus far, including Bangladesh, Brazil and the People’s Republic of China (PRC). In the PRC, first environmental regulatory policies by the People’s Bank of China (PBC) date back to the 1980s (Zadek and Chenghui 2014). The Green Credit Policy that was launched jointly by the PBC, the Ministry of Environmental Protection, and the China Banking Regulatory Commission in 2007 has been one of the most comprehensive regulatory green policies to date, addressing the banking system, insurances, and securities markets. Furthermore, in 2006 the PBC created a database for credit consisting of information on credit, fines, and environmental compliance of firms as a source of information on which to base restrictions of credit to blacklisted companies and sectors. Differential reserve requirements have been employed by Banque du Liban, the central bank of Lebanon, with the goal of influencing the allocation of credit in favor of investment in renewable energy and energy efficiency. Commercial banks are incentivized to increase the share of green lending projects of their loan portfolio by allowing “greener” banks to hold lower reserves (Banque du Liban 2010). Commercial banks that extend loans to finance projects that entail energy savings potential are subject to lower reserve requirements. In practice, the Lebanese Centre for Energy Conservation, a governmental agency, verifies whether the underlying investments would contribute to greening the energy sector and declares the bank loans that finance them eligible for receiving the preferential reserve requirement treatment.

Green Macro-Prudential Regulation Macro-prudential regulation aims to mitigate systemic risk that threatens the stability of the financial system as a whole. It is applied to close the gap between macroeconomic policy and micro-prudential regulation and can play a central role in incorporating climate and environmental risks into regulatory frameworks. The application of many macro-prudential policy tools to identify and mitigate environmental risks may also have allocative consequences for credit (Schoenmaker and Tilburg 2016).

Climate-Related Stress Testing Climate-related stress tests can fulfill the task of assessing the potential impact that natural hazards may have on the economy, the health of individual financial

5

Central Banking, Climate Change, and Green Finance

91

institutions, and the financial system as a whole. Apart from enabling the evaluation of the resilience of the financial system to adverse shocks, climate-related stress tests would also be necessary to calibrate green macro-prudential policy instruments and to allow for the incorporation of the identified vulnerabilities into capital buffers, risk weights, and caps.

Counter-Cyclical Capital Buffers Counter-cyclical capital buffers are employed to mitigate the financial cycle, and can be calibrated with regard to environmental risks to ease the potential effect of the pricing-in of a so-called “carbon bubble” that describes the expected sudden repricing of carbon-intensive assets due to stricter emission targets and environmental policy. In practice, higher capital-requirements for carbon-intensive credit growth could be applied (Schoenmaker and Tilburg 2016). Differentiated Capital Requirements Through capital requirements, financial regulators require financial institutions to hold a certain percentage of capital for risk-weighted assets, which is usually expressed in the Capital to Risk (Weighted) Assets Ratio. Capital requirements could theoretically differentiate asset classes based on sustainability criteria and assign higher risk weights to carbon-intensive assets, in anticipation of future negative and sudden price developments. Schoenmaker and Tilburg (2016) stress differential capital requirements as a central policy tool enabling the correct pricing of carbon risks. Furthermore, this instrument may also have important allocative consequences for credit by incentivizing the disinvestment from carbon-intensive assets and dependent sectors. Loan-to-Value and Loan-to-Income Caps Limiting the extension of credit by banks to certain industries and the investment in specified asset classes can also be used as an allocative tool to limit the flow of resources to sectors or companies that exceed specified carbon-emission targets. Large Exposure Restrictions Exposure restrictions by counter-party, sector, or geographic area is a macro-prudential policy tool employed to limit the exposure of financial institutions to assets entailing high risks or, with regard to green finance, a high-carbon intensity. While the primary aim might therefore be to protect financial institutions against a carbon bubble, Schoenmaker and Tilburg (2016) argue that this instrument could also be employed for the fine-tuning of lending restrictions and the allocation of credit. Identification of Systemically Important Financial Institutions and Capital Surcharges Applying capital surcharges for institutions with high large exposure to carbonintensive assets could alter the identification of Systemically Important Financial Institutions (SIFIs) and ensure that climate-risks are appropriately accounted for in order to reduce systemic risk.

92

S. Dikau and U. Volz

Green Macro-Prudential Regulation in Practice The Banco Central do Brasil has been among the first central banks to address climate-related environmental, as well as social, risks on a systemic level, through the issuance of binding amendments to its macro-prudential regulatory framework. In 2011, the Banco Central do Brasil extended its requirements on the Internal Process of Capital Adequacy Assessment, which originates from Pillar 2 of the Basel II accords and requires commercial banks to take the exposure to environmental damages and risks into account (Banco Central do Brasil 2011). These capital requirements aimed at pricing-in environmental risks are part of the Banco Central do Brasil’s broader green banking regulatory approach, through which it requires banks to evaluate and consider E&S in their lending practices, to stress-test against the exposure to environmental risks, and to furthermore issue annual reports outlining their risk assessment methods and exposure to social and environmental damages (Banco Central do Brasil 2017).

Green Financial Market Development The development of green security markets and green lending is another area in which central banks could play an assisting role. In many of today’s advanced economies, the evolution of financial markets precedes the establishment of central banks. However, central banks in developing countries can play a central role in supporting the development of financial markets, and encourage active trading in bond markets to encourage other actors to participate (Gray and Talbot 2007). With regard to green bonds, policy-directed development banks such as the European Investment Bank of Germany’s KfW have so far played this market-developing role in many countries by issuing the first green bonds, thereby aiding the creation of green bond markets. Central banks and other financial agencies can create an enabling environment for the issuance and trading of such green securities.

Information Disclosure Requirements Through the introduction of effective procedures for the disclosure of environmental and sustainability-related information on bonds and other assets, central banks and regulatory agencies can strengthen the identification and acceptance of green assets. Green Bond Guidelines In order to encourage the issuance of green bonds, central banks can issue green bond guidelines and define criteria according to which the financing of projects and firms qualifies as green bonds, what the use of the proceeds from the bond issuance can be, and disclosure standards. Establishing and enforcing criteria for green bond labels can be a further step in promoting green bond issuance. Green Financial Market Development in Practice A central bank that has played an active role in encouraging the development of green bond markets and innovative market institutions is the PBC. The Green

5

Central Banking, Climate Change, and Green Finance

93

Finance Task Force, an international cooperative group initiated by the PBC, in cooperation with UNEP Inquiry, with the aim of developing an action plan for the promotion of green finance in PRC, recommended that the PBC, together with China’s banking and securities regulatory agencies, should issue industry guidelines for green bonds (PBC and UNEP Inquiry 2015). The PBC issued the first official green bond guidelines in December 2015 to encourage unified standards for the issuance of green bonds (PBC 2016).

Green Credit Allocation Even though many of the policy instruments discussed above have potentially allocative consequences, there are also dedicated credit allocation instruments. These are not widely in use today by central banks in advanced economies, but remain fairly popular in many developing and emerging economies. For central banks that employ credit allocation policies today with regard to green finance, most notably Bank Bangladesh and the Reserve Bank of India (RBI), green investment has often been added as an additional priority sector to existing and longstanding credit allocation policy schemes that otherwise pursue developmental objectives (Dikau and Ryan-Collins 2017). Fry (1995), who makes a strong case against financial repression and credit allocation policies, lists subsidized loan rates for priority sectors, differential rediscount rates, direct budgetary subsidies, credit floors and ceilings, and the proliferation of development banks as the central allocative policy instruments, many of which can also be applied to promote green investment and sustainable development.

Targeted Refinancing Lines Green targeted refinancing lines by central banks offer refinancing for commercial banks at preferential terms for specified green asset classes, thereby compensating or overcompensating financial institutions for lending at lower-than-market interest rates to low-carbon or otherwise sustainable projects. However, this policy tool is only relevant in economies with relatively underdeveloped secondary security markets, and hence a lack of market-based refinancing options for banks that necessitates central banks to offer refinancing lines, some of which can be offered at preferred terms. Minimum and Maximum Credit Quotas Mandatory or minimum or maximum credit quotas or floors are fixed lending requirements that are set by the central bank and require commercial banks to allocate a percentage of their loan portfolio to specified classes of assets, industries, or geographical areas. Green minimum credit quotas, for example, require banks to at least lend a specified quota to green investments, while maximum credit ceilings could can be utilized to restrict lending to carbon-intensive industries. In contrast to all policy instruments discussed so far, the operating channel of credit quotas is not the creation of incentives for financial institutions to channel their resources to

94

S. Dikau and U. Volz

preferred causes, but a mandatory “hard” quota, which may potentially create severe market distortions.

Preferred Interest Rates for Priority Sectors Credit interest rate ceilings for priority sectors, asset classes, and firms are the central instruments of financial repression policy. The administrative setting of interest rates by the central bank of commercial banks’ lending rate with the aim of promoting green investment and curbing unsustainable lending is another heavy interventionist central banking tool that is not aimed at creating incentives, but targets setting lower rates for preferred sectors, or higher rates for less preferred ones, in order to reduce funding. Central Bank Assistance to Development Banks As specialized financial institutions, development banks can play an important assisting role in financing the green transformation by providing long-term investment (Stern 2016; UNEP Inquiry 2016). The failure of private financial institutions to provide the required financial resources for substantial investments into greening the economy has been interpreted as justification for the presence of development banks. The latter may play a risk-reducing and pioneering role by implementing green finance standards or by developing innovative financial products such as green bonds, thereby encouraging private institutions to engage in green lending and longterm finance activities. Historically, central banks have often played a supportive role for development banks by subscribing to the initial equity, or by buying and creating markets for bonds issued by development banks (Brimmer 1971). However, concerns have been raised that refinancing of public development banks by central banks may amount to monetary financing, which may cause inflation and undermine central bank independence. Green Credit Allocation in Practice Bangladesh Bank has introduced several policy initiatives to guide credit toward green sectors and to encourage banks to extend loans for renewable energy projects. Among the green credit allocation programs of Bank Bangladesh, targeted refinancing lines have been the most prominent policy tool. They were first utilized in 2009 when Bangladesh Bank established a revolving refinancing scheme, amounting to BDT 2 billion, through which commercial banks were compensated at reduced interest rates for loans extended for sustainable investment projects (Bangladesh Bank 2017). Subsequently, Bangladesh Bank has developed further green refinancing lines, such as in 2015, when it earmarked a USD 200 million refinancing window for refinancing green loans, with the specific aim of supporting investment improving water and energy usage (UNEP Inquiry et al. 2015) and in 2016, through the creation of a Green Transformation Fund, another green refinancing window worth USD 200 million targeting loans financing the import of environmentally friendly machinery in order to improve sustainability in the leather and textiles sector (Bangladesh Bank 2017).

5

Central Banking, Climate Change, and Green Finance

95

The RBI’s Priority Sector Lending (PSL) program, which has its origins in 1949, is another example of a heavily interventionist approach to credit allocation. The PSL forces commercial banks to allocate 40% of adjusted net bank credit or credit equivalent amount of off-balance sheet exposure, whichever is higher, to sectors and causes specified by the central bank—traditionally agriculture, infrastructure, education, and SMEs. Following an internal review by the RBI, the PSL was extended in 2015 to include lending for social infrastructure and renewable energy projects as two new categories qualifying to be listed under commercial banks’ PSL requirements.

Other Supportive Green Central Bank Initiatives Through their central position in the financial system and the powers vested in them, central banks have a great deal of convening or soft power (Volz 2017). By promoting a discussion of climate change-related risks and environmental issues, the central bank can drive the sustainability agenda in the financial sector. The expertise and special status of central banks, as a result of their unique relation to the government and the financial sector, allow central banks to influence the discussion on green finance in informal ways.

Green Finance Guidelines and Frameworks Central banks are in a good position to create or endorse industry-led, non-mandatory green finance guidelines, which may set out guidelines for the issuance of green bonds, E&S risk management practices, or general criteria for green lending. In many emerging and developing economies where green credit guidelines exist, these tend to be either voluntary industry-led green finance guidelines or, in most cases, central bank-led that often serve as a foundation for the creation of mandatory green credit regulation at a later stage (Dikau and Ryan-Collins 2017). Soft Power Central banks can also influence the reception, knowledge, and practice of green finance through their convening role and soft power, by including environmental issues and climate change on their wider agenda and by signaling the importance of these issues to market participants. The generally well-respected research departments of central banks are furthermore uniquely positioned to research topics around green finance and the impact of climate risks on the financial system. The research focus and output of central banks usually have a significant impact on raising awareness of their issues and directing broader macroeconomic research. Another area where central banks can contribute to the knowledge of green finance and threat of environmental risks are capacity-building workshops and seminars for bankers and investors, thereby addressing a potential lack of expertise on green financial issues, which has been identified as holding back the prevalence of E&S risk management practices. Finally, the participation of central banks in international bodies and networks, such as the Financial Stability Board and its TCFD, which

96

S. Dikau and U. Volz

discuss standards and methods of policy engagement, also play an important role in finding internationally coherent approaches to greening the financial system.

Supportive Green Central Bank Initiatives in Practice The Bank of England’s engagement with climate change is exemplar for a central bank’s use of soft power to raise awareness of climate and environmental risks for the financial sector. With his much-noticed speech in 2015 on “Breaking the Tragedy of the Horizon—Climate change and financial stability” (Carney 2015), the Governor of the Bank of England brought global attention to the potential systemic ramifications of climate change-related risks for the financial system, and especially the insurance sector, thereby also motivating further research at the Bank of England’s research department on climate change and green finance (Bank of England 2015; Batten et al. 2016), as well as the organization of workshops and conferences on the issue. The Bank of England also engages with a number of international initiatives, including the TCFD, as well as taking part in the Sustainable Investment Forum, and by co-chairing the G20 Green Finance Study Group (which was recently renamed G20 Sustainable Finance Study Group), which was established together with the PBC during PRC’s G20 presidency. Non-mandatory green finance guidelines, principles, or roadmaps that focus on sustainable banking have so far been issued by 17 members of the International Finance Corporation (IFC)’s Sustainable Banking Network, a knowledge-sharing network for financial regulators and banking associations aimed at enhancing E&S risk management practices and green lending of financial institutions (the 17 members include financial authorities and banking associations from Bangladesh, Brazil, Cambodia, the PRC, Colombia, Ecuador, Indonesia, Kenya, Mexico, Mongolia, Morocco, Nigeria, Pakistan, Peru, South Africa, Turkey and Viet Nam). Furthermore, in December 2017, central banks and financial supervisors, among them the Bank of England, the Banque de France, De Nederlandsche Bank, the Deutsche Bundesbank, the European Central Bank the Banco de España, the National Bank of Belgium, the Oesterreichische Nationalbank and the PBC, jointly created the Network for Greening the Financial System as a voluntary information and best practice sharing framework with the aim of mainstreaming green finance and more sustainable growth. This network potentially represents one of the most powerful initiatives to date, bringing the largest and most influential monetary and regulatory institutions together under the declared joint goal of supporting the transition toward more sustainable economies.

Conclusions Climate and other environmental risks have increasingly become an important topic for central banks and financial regulators. It is now largely accepted that environmental risks can have material impact on financial and macroeconomic stability, and an increasing number of central banks have started to develop micro- and macroprudential frameworks that incorporate risks related to climate change and the

5

Central Banking, Climate Change, and Green Finance

97

environment. At a recent meeting of financial supervisors, Bank of England Governor Mark Carney highlighted: “Once climate change becomes a clear and present danger to financial stability, it may already be too late [. . .]. Our responsibility is to work in a way that puts the financial system as a whole in a position so it can adjust in a smooth and effective and orderly fashion as climate policies adapt” (Hook 2018). Carney (2018) also reiterated that “[t]he catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors” in the financial sector, and that central banks should therefore use their unique position and oversight over financial markets to point out these risks and make sure that they are sufficiently addressed by financial institutions. This chapter has also highlighted the potential developmental role of central banks and has reasoned why central banks, especially those in developing economies, may be mandated by governments to use various instruments at their disposal to promote green or discourage brown lending and investment. However, it needs to be emphasized that in many cases, central banks may not be the public institutions that will be best positioned to correct market failures that lead to overinvestment in socially undesirable activities. The reader should, therefore, not conclude from this chapter that the authors want central banks to become responsible for fixing all environmental problems. Nevertheless, in cases where first-best policies are impossible to implement, targeted policy interventions by central banks or other financial regulators may indeed need to be considered and introduced.

Appendix 1: Sustainable Finance Policies 2008

2009 2011

2014

2008 2011 2015 2016 2017

Brazil Banco Central do Brasil: Starting in 2008, resolutions issued on environmental regulation, restricting lending to firms that operate in vulnerable geographic areas such as the Amazonas region (Resolution 3,545/2008, Resolution 3,813 Resolution 3,896/2010 and Resolution 4,008/2011) Brazilian Banking Association: Voluntary green finance guidelines adopted by commercial and state-owned banks Banco Central do Brasil: Resolution 3,988 incorporates risk of exposure to environmental damages into “Internal Process of Capital Adequacy Assessment” (ICAAP) requirements Banco Central do Brasil: Guidelines on “Social and Environmental Responsibility for Financial Institutions” discusses and defines E&S risk exposure Bangladesh Bangladesh Bank: Circular on “Mainstreaming Corporate Social Responsibility in Banks and Financial Institutions in Bangladesh” Bangladesh Bank: “Policy Guidelines for Green Banking” and “Guidelines on Environmental Risk Management” Bangladesh Bank: Mandatory Green Finance Credit Targets l Bangladesh Bank: “Integrated Risk Management Guidelines for Financial Institutions” Bangladesh Bank: Guidelines on Environmental & Social Risk Management for Banks and Financial Institutions (continued)

98

2014

2017

2007

2008

2009 2012 2013 2014

2015

2016

2017

2018

2016

2018

S. Dikau and U. Volz Canada Toronto Stock Exchange and CPA Canada: “A Primer for Environmental and Social Disclosure Ontario” Ministry of Finance: Regulation 235/14, amending the Pension Benefits Act and requiring pension plan administrators to disclose whether and if E&S risk factors are incorporated Green Ontario Fund created as government agency that invests proceeds from Ontario’s carbon market into the reduction of greenhouse gas emissions People’s Republic of China China Banking Regulatory Commission (CBRC), People’s Bank of China (PBOC), and Ministry of Environmental Protection (MEP): Green Credit Policy (“Opinions on Enforcing Policies and Regulations on Environmental Protection to Prevent Credit Risk”) MEP and China Insurance Regulatory Commission (CIRC): Green Insurance Policy (“Guiding Opinions on Environmental Pollution Liability Insurance”) China Securities Regulatory Commission (CSRC) and MEP: Green Securities Policy (“Guidance Opinions on Strengthening the Oversight of Public Companies”) Shanghai Stock Exchange: Shanghai CSR Notice and Shanghai Environmental Disclosure Guidelines Shenzhen Stock Exchange: Social Responsibility Instructions to Listed Companies CBRC: Green Credit Guidelines MEP and CIRC: “Guiding Opinions on Implementing the Pilot Programs of Compulsory Environmental Pollution Liability” CBRC: Green Credit Monitoring & Evaluation mechanism and Key Performance Indicators Checklist PBOC: Green Finance Task Force MEP and CIRC: “Guiding Opinions on Pilot Scheme for Compulsory Environmental Pollution Liability Insurance” PBOC: Green Financial Bond Directive and Green Bond-Endorsed Project Catalogue for Bonds Issued by Financial Institutions and Corporations PBOC: Green Finance Committee PBOC: Guidelines for Establishing the Green Financial System NDRC and Shanghai Stock Exchange: Green Bond Guidelines China Bond Green and Climate-Aligned Bond Index State Council: Establishment of five green finance pilot zones in Zhejiang, Jiangxi, Guangdong, Guizhou and Xinjiang MEP and CSRC: Environmental Disclosure for Listed Companies CSRC: Guidelines for Green Bond Issuance by Listed Companies MEP and CIRC: Draft Guideline on Environmental Pollution Liability Insurance Shanghai’s Lujiazui Financial City: Lujiazui Standard of Green Finance CSRC and MEP: Mandatory ESG disclosures for listed companies and bond issuers by 2020 Hong Kong, China Securities and Futures Commission: Principles of Responsible Ownership Financial Services Development Council: Report on “Hong Kong as a Regional Green Finance Hub” Hong Kong Quality Assurance Agency: Green Finance Certification Scheme (continued)

5

Central Banking, Climate Change, and Green Finance

2001

2010

2015

2017

2007 2011 2012 2014 2015 2016 2017 2012

2014 2015 2017

2012 2014 2015 2017 2015 2017

2008

99

France French National Assembly: Passes the New Economics Regulation law and introduces the reporting requirements on ESG issues as part of a broader framework on “ethical” aspect of financial practices French National Assembly: Passes the “Grenelle II” law, outlining the national commitment in favour of the environment, as well as environmental reporting requirements for asset managers French National Assembly: Passes Law on Energy Transition for Green Growth (ETGG), outlining procedures for the assessment of climate-related risks and addressing the role of the financial sector in the green transition Banque de France: Launches Network for Greening the Financial System (NGFS) for the sharing of experiences of the supervisory dimensions of climate- related and environmental risks and green finance India Corporate Social Responsibility, Sustainable Development and Non-Financial Reporting—Role of Banks Ministry of Corporate Affairs: National Voluntary Guidelines on Social, Environmental and Economic Responsibilities of Business Securities and Exchange Board of India (SEBI): Annual Business Responsibility Reporting SEBI: Infrastructure Investment Trusts (InvIT) Regulations Reserve Bank of India: Priority Sector Lending—Targets and Classification Indian Banks Association: National Voluntary Guidelines for Responsible Financing SEBI: Guidelines for the Issuance and Listing of Green Bonds SEBI: Disclosure Requirements for Issuance and Listing of Green Bonds Indonesia Bank Indonesia: Green Lending Model Guidelines for Mini Hydro Power Plant Projects Government Regulation on Social and Environmental Responsibility of Limited Liability Companies Otoritas Jasa Keuangan (OJK) / Financial Services Authority: Roadmap for Sustainable Finance in Indonesia 2015–2019 IFC, USAID, OJK: Clean Energy Handbook for Financial Service Institutions OJK: Framework and regulation for green bond issuance in Indonesia OJK: Regulation on the Application of Sustainable Finance for Financial Services Companies, Issuers and Publicly Listed Companies Japan Ministry of the Environment: Principles for financial action towards a sustainable society Financial Services Agency: Japan Stewardship Code Tokyo Stock Exchange: Corporate Governance Code and Infrastructure Fund Market Ministry of the Environment: Green Bond Guidelines Kenya Kenya Bankers Association (KBA): Sustainable Finance Initiative (SFI) Guiding Principles KBA, Central Bank of Kenya, Capital Markets Authority and the National Treasury: Green Bond Programme Republic of Korea Government launches Republic of Korea’s Green Growth Strategy and provides a strategic policy framework (continued)

100 2009

2013 2017

2014

2014

2017

2018

2008 2011 2015

2010 2015 2017 2011 2015 2017

2008 2014

2014 2015 2012

S. Dikau and U. Volz Ministry of Strategy and Finance and Financial Services Commission: Announce a certification system to verify green projects and companies’ eligibility for funds under government’s plans to promote investment into green industries Export-Import Bank of Korea: First financial institution in Asia to issue green bonds Korea Development Bank: Issuance of green bonds worth 300 million USD, using proceeds to finance or refinance investments in renewable energy projects, low carbon emission technology and green transportation Mongolia Bank of Mongolia & Mongolia Banking Association: Mongolia Sustainable Finance Principles and Sector Guidelines Netherlands De Nederlandsche Bank: Central Bank mandate updated to include “sustainable prosperity” and “financial stability,” as well as equipping the DNB with new macroprudential instruments and tools to fullfil the task Dutch Pensions Federation: Declaration to create an environmental, social and governance (ESG) covenant for pension funds De Nederlandsche Bank: Organises workshop on “Central Banking and Green Finance” De Nederlandsche Bank: Organises International Climate Risk Conference for Supervisors Philippines Government of Philippines: National Disaster Risk Reduction and Management Law Securities and Exchange Commission: Corporate Governance Guidelines for Companies Corporate Responsibility Act updated Government of Philippines: Joint Catastrophe Risk Insurance Facility for Governments (Local Government Units Pool) Singapore Singapore Stock Exchange (SGX): “Guide to Sustainability Reporting for Listed Companies” Association of Banks in Singapore: Guidelines on Responsible Financing Monetary Authority of Singapore: Green Bond Grant Scheme South Africa Institute of Directors in Southern Africa: “Code for Responsible Investing in South Africa (CRISA)” Banking Association South Africa: Principles for Managing Environmental and Social Risk Johannesburg Stock Exchange: Green Bond listing requirements and creation of Green Bond Segment Thailand Stock Exchange Thailand and Securities and Exchange Commission of Thailand: Guidelines for Sustainability Reporting Stock Exchange Thailand: CSR Reporting Requirements Securities and Exchange Commission of Thailand: Sustainability Development Roadmap for Listed Companies Turkey Banks Association of Turkey: Sustainability Guidelines for the Banking Sector Borsa İstanbul: ESG Reporting Guide United Kingdom London Stock Exchange: Mandatory Disclosure of Carbon Emissions for Listed Companies (continued)

5

Central Banking, Climate Change, and Green Finance

2015

2016

2015

2016 2017

101

Bank of England: Governor Mark Carney highlights the Bank’s view on climate change Prudential Regulation Authority (PRA): Report on the impact of climate change on the UK insurance sector Bank of England: Publishes further research on climate change and central banks and organizes workshops and conferences on the subject of climate risks and financial stability; co-chairs the G20 Green Finance Study Group Viet Nam State Bank of Vietnam (SBV): Directive on Promoting Green Credit Growth and Managing Environmental and Social Risks in Credit Extension SBV: Action Plan of Banking Sector to Implement the National Green Growth Strategy until 2020 SBV: Circular on lending transactions of credit institutions and/or foreign bank branches with customers SBV: Renewed commitment to implementing the Green Growth program and the program of preventing climate change

Source: Compiled by authors, drawing on Volz (2018)

References Banco Central do Brasil (2011) Circular 3,547 of 7 July 2011. Establishes procedures and parameters related to the Internal Capital Adequacy Assessment Process (ICAAP) Banco Central do Brasil (2017) Estudos sobre regulação financeira. Banco Central do Brasil, Brasília, Brazil Bangladesh Bank (2011) BRPD Circular no. 02. Policy guidelines for green banking. Bangladesh Bank, Dhaka Bangladesh Bank (2017) Annual report (July 2015–June 2016). Bangladesh Bank, Dhaka Bank of England (2015) The impact of climate change on the UK insurance sector: a climate change adaptation report by the Prudential Regulation Authority. Bank of England, London Banque du Liban (2010) Intermediate circular on reserve requirements, intermediate circular no. 236. Banque du Liban, Beirut. http://www.bdl.gov.lb/circulars/intermediary/5/37/0/Intermedi ate-Circulars.html Batten S, Sowerbutts R, Tanaka M (2016) Let’s talk about the weather: the impact of climate change on central banks. Bank of England, London Brasil (1988) Constitution of the Federative Republic of Brazil: constitutional text of 5 October 1988, with the alterations introduced by constitutional amendments no. 1/1992 through 64/2010 and by revision constitutional amendments no. 1/1994 through 6/1994. Chamber of Deputies, Documentation and information Center, Brasília, 2010 Brimmer AF (1971) Central banking and economic development: the record of innovation. J Money Credit Bank 3(4):780–792 Carney M (2015) Breaking the tragedy of the horizon – climate change and financial stability. Speech given at Lloyd’s of London, 29 September. www.bankofengland.co.uk/publica tions/Pages/speeches/2015/844.aspx. Carney M (2018) A transition in thinking and action. Remarks at the International Climate Risk Conference for Supervisors. De Nederlandsche Bank, Amsterdam Dafe F, Volz U (2015) Financing global development: the role of central banks. German Development Institute/Deutsches Institut für Entwicklungspolitik (DIE), Bonn Dikau S, Ryan-Collins J (2017) Green central banking in emerging market and developing country economies. New Economics Foundation, London. http://neweconomics.org/wp-content/ uploads/2017/10/Green-Central-Banking.pdf

102

S. Dikau and U. Volz

Fry MJ (1995) Money, interest, and banking in economic development, 2nd edn. Johns Hopkins University Press, Baltimore/London Gray S, Talbot N (2007) Developing financial markets. Bank of England, London Greenwald BC, Stiglitz JE (1986) Externalities in economies with imperfect information and incomplete markets. Q J Econ 101(2):229–264 Hook L (2018) Central bank chiefs sound warning on climate change. Financial Times, 9 April. https://www.ft.com/content/888616d6-3b07-11e8-b7e0-52972418fec4 Inquiry UNEP (2016) Greening the banking system – Taking stock of G20 green banking market practice. UN Environment Inquiry into the Design of a Sustainable Financial System, Geneva Lipsey RG, Lancaster K (1956) The general theory of second best. Rev Econ Stud 24(1):11–32 McKibbin WJ, Morris AC, Panton A, Wilcoxen P (2017) Climate change and monetary policy: dealing with disruption. Social Science Research Network, Rochester PBC (2016) The People’s Bank of China annual report 2015. People’s Bank of China, Beijing PBC, UNEP Inquiry (2015) Establishing China’s green financial system – detailed recommendations 1: create a green banking system. People’s Bank of China, UN Environment Inquiry into the Design of a Sustainable Financial System, Beijing People’s Republic of China (2003) Law of the People’s Republic of China on the People’s Bank of China. Promulgation date: 1995-03-18, Promulgation number: e00860, e02614, e02700, e03036, e03083e032951995031819950318, National People’s Congress, Order of the President of the People’s Republic of China, No. 46, Promulgation Department: The National People’s Congress Rozenberg J, Hallegatte S, Perrissin-Fabert B, Hourcade J-C (2013) Funding low-carbon investments in the absence of a carbon tax. Clim Pol 13(1):134–141 Schoenmaker D, Tilburg RV (2016) What role for financial supervisors in addressing environmental risks? Comp Econ Stud 58(3):317–334 Stern N (2016) Climate change and central banks. Presentation at a Bank for International Settlements event, 29 February. http://www.lse.ac.uk/GranthamInstitute/wp-content/uploads/ 2016/03/160309_BIS_slides_final_for_websites.pdf Stiglitz JE (1994) The role of the state in financial markets. World Bank, Washington, DC TCFD (2016) Phase I report of the task force on climate-related financial disclosures. Presented to the Financial Stability Board, 31 March. https://www.fsb-tcfd.org/wp-content/uploads/2016/03/ Phase_I_Report_v15.pdf UNEP Inquiry, IISD, Bangladesh Bank (2015) Designing a sustainable financial system in Bangladesh. IISD/Bangladesh Institute of Bank Management/UNEP Inquiry into the Design of a Sustainable Financial System, Dhaka/Geneva/Winnipeg Volz U (2016) Fostering green finance for sustainable development in Asia. German Development Institute/Deutsches Institut für Entwicklungspolitik (DIE), Bonn Volz U (2017) On the role of central banks in enhancing green finance. UN Environment Inquiry into the Design of a Sustainable Financial System, Geneva Volz U (2018) Fostering green finance for sustainable development in Asia. ADB Institute, Tokyo Zadek S, Chenghui Z (2014) Greening China’s financial system – an initial exploration. International Institute for Sustainable Development (IISD) and the Development Research Center of the State Council, Winnipeg/Beijing

Part IV Credit Risk and Credit Rating of Green Projects

6

Managing Credit Risk and Improving Access to Finance in Green Energy Projects Dhruba Purkayastha

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Constraints in Clean Energy Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit Risk in Infrastructure Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit Risks Specific to Clean Energy Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wider Financial Sector Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Managing Credit Risk and Improving Access to Finance for Clean Energy Projects . . . . . . . . . Public Finance as a Risk Mitigation Mechanism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk Mitigation and Structured Finance Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Possible Policy Solutions for Addressing Credit Risk in Clean Energy Projects . . . . . . . . . . Improving Credit Risk Assessment for Clean Energy Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

106 108 110 110 112 114 115 115 116 118 119 121 122

Abstract

Cost of finance has a high impact on returns and viability of clean energy projects compared to fossil fuel-based energy projects because operating costs for renewable energy projects are very low. Cost of finance is significantly influenced by credit risk assessment and ratings, which has usually been an inappropriate measure of credit risk for clean energy finance. Factors like inadequate credit information, lack of historical data at the project level, and higher risk of technological obsolescence lead to a credit market failure in clean energy finance, leading to mispricing of risk and poor capital allocation to clean energy infrastructure in the economy. Access to institutional finance is more constrained in the distributed renewable energy sector because of high transaction costs, high or

D. Purkayastha (*) Climate Policy Initiative, New Delhi, India e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_18

105

106

D. Purkayastha

unknown consumer credit risk, and a variety of other challenges. It is important that these constraints be eased through appropriate policy and financing interventions to crowd-in domestic banks by improving the quality of credit information—technical and commercial—creating suitable financial intermediaries and providing risk mitigation solutions. Keywords

Corporate finance · Financial risk · Financing · Ratings and rating agencies · Renewable energy JEL Classification

G23 · G24 · G41

Introduction The atmospheric concentration of carbon dioxide has been on a steady rise. In 2016, the CO2 levels in the atmosphere crossed 400 parts per million for the first time, and as per projections they are set to increase to the range of 500–1,000 parts per million by the year 2100 (IPCC 2014). This has garnered worldwide attention from governments, inter-governmental organizations, and corporations alike, and has given a strong push for the uptake of green projects. A project is identified as a green project based on the actual project activity, classified as “use of proceeds” in financial datasets (IFC 2016). The project activity should provide environmental benefits in the broader context of environmentally sustainable development. These environmental benefits include reductions in greenhouse gas emissions, use of clean energy sources over traditional fossil fuel-based sources, and improved energy efficiency while utilizing existing natural resources (G20 Green Finance Study Group 2016). Green finance flows reached a record high of US$437 billion dollars in 2015, followed by a 12% drop in 2016 to US$383 billion, although this was still higher than flows in 2012 and 2013. Taking into account annual fluctuations, the average flows across 2015/2016 were 12% higher than during 2013/2014 (Buchner et al. 2017) as shown in Figure 1. The Green Climate Fund has defined four strategic impact areas for the mitigation of carbon emissions: clean energy, sustainable transport, energy efficiency, and forests and land use. Clean energy has a major share in global mitigation efforts. The share of clean energy projects accounted for around 70% of the total green finance between 2015 and 2016 with investments of US$312.2 billion and US$241.8 billion respectively (REN21 2017). This data shows that some progress has been made in terms of financing of green projects and clean energy projects; however, it still represents only a small fraction of global financing. Less than 1% of global bonds are labeled green and less than 1% of the holdings by global institutional investors are green (G20 Green Finance Study Group 2016). In general, institutional investor allocation to infrastructure is small; for example, only 1% of global pension funds are invested in privately financed and infrastructure projects directly, and for

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

Public Sector

Private Sector

107

Total

500 450

437

400

388

360

350

342

300 250 200 150

224 136

383 299 242

241 199 143

147

138

141

100 50 0

2012

2013

2014

2015

2016

Figure 1: Global Green Finance by Private and Public Actors (Billion US$). (Reproduced with permission from Climate Policy Initiative 2017)

green infrastructure projects, the figure would be even lower (Della Croce 2011). In comparison, the total fossil fuel investments in the year 2016, at US$825 billion (International Energy Agency 2017) were more than double those of green finance, US$330 billion (Bloomberg New Energy Finance 2017). For clean energy to play a central role in the growing energy demand would require doubling the share of renewables in the overall energy supply by 2030. This would require an average annual investment of more than $500 billion between the years 2015 and 2020, and would need to scale up to an average of US$900 billion between 2021 and 2030 (IRENA 2016). Cumulative investments required in green infrastructure have been estimated to be around US$2 trillion per year till 2030, which is approximately 2% of the global gross domestic product (Kaminker et al. 2013). The scale of investment required in green infrastructure is very large, and it would require a large part of investment to be mobilized from private commercial sources through banking and institutional investor channels. Green investment allocation remains limited for a number of reasons, which include lack of policy and regulatory certainty, investor inexperience, new technology, and lack of suitable financing vehicles and instruments. The high cost of finance is one major factor that constrains green financing particularly in the clean energy sector. Cost of finance is particularly important for clean energy projects because of their front-loaded capital structure with capital costs contributing up to 90% of the total lifetime costs. Access to low-cost finance can reduce the cost of clean energy by as much as 20% in developed countries (Zuckerman et al. 2016) and as much as 30% in developing countries (Nelson and Shrimali 2014). The cost of clean energy is contingent on the cost of capital, which is dependent on the credit risk perception of investors. Credit risk is usually measured by credit ratings in both banking and institutional investor channels, and credit

108

D. Purkayastha

ratings influence both pricing and capital allocation. Clean energy projects are a subset of infrastructure projects and are usually financed through project finance structures (with the exception of small distributed renewable energy projects, which may be more amenable to corporate finance). Emerging economies face even higher challenges as the domestic funds are limited and expensive, while foreign funds come with currency hedging costs that increase the cost of finance, thereby reducing the viability of the project. The availability of hedging solutions is also dependent on the credit ratings of the borrower or the project. In terms of solutions for barriers to clean energy financing, one category of interventions focuses on credit risk mitigation for enabling banking finance and structured financing to reach out to bond markets (IRENA 2016). The Green Climate Fund has also advocated the use of risk sharing, credit enhancement, and guarantees for improving access to institutional financing for green investments (Green Climate Fund 2017). Credit risk assessment approaches including that of credit ratings affect the cost of finance, and would therefore impact pricing, the capital required, and the public cost of implementing risk mitigation solutions. This chapter focuses on credit risk assessment of clean energy projects, the implications of using credit ratings for financing clean energy projects in reducing the cost of financing, and possible credit risk mitigation mechanisms. The remainder of this chapter is organized into four sections: 1. Literature review and analysis of previous academic and industry research work on clean energy financing barriers and solutions 2. Constraints to clean energy financing with a focus on credit risk assessment and the implications of the use of credit ratings for infrastructure and clean energy projects 3. Risk mitigation solutions to improve access to finance for clean energy projects, including measures to improve credit risk assessment for clean energy projects 4. Conclusions and directions for future research

Literature Review Although the falling costs of renewable energy technology have significantly lowered the upfront capital needed, financing renewable energy projects remains difficult in many parts of the world. Various academic and industry research has tried to identify the issues that contribute to the lack of financing for clean energy projects. A research paper by the OECD on the role of institutional investors in financing clean energy cites the problem of scale, misalignment of term, and shortage of data as some of the key barriers to institutional investor allocation to the infrastructure sector (Kaminker and Stewart 2012). The authors further state that for clean energy investments, factors like new technology, buyer risk, and failure of credit ratings to communicate appropriate risks contribute to investors’ lack of interest in the sector. As possible mechanisms to mitigate the barriers for clean energy finance, the authors suggest the use of transitional financial instruments in addition to governments and

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

109

multilateral development banks providing financing mechanisms to cover the risks that are new and cannot be covered by the existing markets. According to IRENA’s report on unlocking renewable energy investment (IRENA 2016), the front-loaded cost structure of most clean energy projects is a major factor that obstructs their financing. The report states that national financial systems are also an obstacle to clean energy investments, as lack of experience and capacity gaps in the local financial markets lead to higher capital costs for clean energy projects. The report further identifies some specific barriers that are particular to large-scale investors, such as insufficient investment deal size, high transaction costs, and financial regulations that constrain illiquid and risky investments. Another barrier associated with renewable energy projects compared to fossil fuels is the lower risk-adjusted rate of return (Yoshino and Taghizadeh-Hesary 2017). The report suggests that public policy and finance can play an important role for catalyzing clean energy investments through enabling policies and by creating debtbased finance structures and hybrid structures. Another research paper on perceived barriers and policy solutions in clean energy infrastructure investment uses the Delphi method to list five major categories that act as barriers for clean energy investment: domestic policy barriers, domestic market barriers, general financial barriers, clean energy-specific barriers, and physical risks. These identified categories of risk lead to an increase in expected returns from these projects and thereby an increased cost of capital. The paper proposes to de-risk finance by creating public–private partnerships that will develop “investment grade” projects. It also calls for better engagement within the institutional investment community for addressing policy and financing risk (Jones 2015). Green Climate Fund’s analysis of barriers to crowding-in and maximizing the engagement of the private sector discusses barriers on the supply as well as on the demand side for clean energy investment (Green Climate Fund 2017) and mentions investors’ risk perception as one of the important barriers. Local financial institutions and institutional investors lack the understanding of low and moderate technological risks of some tested renewable technologies and hence demand high returns on investment. This misperception of risk leads to a high cost of finance and hence obstructs the development of the clean energy sector. As another major barrier for clean energy financing, the paper cites a market gap due to limited offering of a range of financial instruments. The proposed measures to address these barriers include public–private partnerships, hedging solutions for risks, and certain insurance products. These solutions focus on policy changes, regulatory interventions, and innovative finance structures for risk sharing and mitigation. Other barriers that continue to constrain the financing have been less focused upon in earlier research. The scope of this chapter is to address these research gaps, which include: • Investors’ credit risk perception of clean energy projects • Appropriateness of existing credit-assessment methods, like credit ratings, while evaluating clean energy projects • Inclusion of positive externalities of clean energy projects in credit assessment

110

D. Purkayastha

Constraints in Clean Energy Finance According to OECD estimates, around US$2.80 trillion per annum is potentially available from pension funds and insurance companies for clean energy projects (IRENA 2016). Despite the availability of capital, financing for clean energy projects remains constrained due to a number of barriers as well as investors’ perception of risk regarding clean energy projects. Pension and insurance funds are long-term sources that could potentially get invested in green infrastructure projects needing long-term investments. Commercial banks, on the other hand, have short-term sources and lending for longer term uses as in green infrastructure projects would increase maturity mismatch for banks (Yoshino and Taghizadeh-Hesary 2018). Credit risk and policy risk are two of the biggest constraints for mobilizing finance for clean energy projects. A number of measures have been taken, by governments and regulators across the world, to reduce policy uncertainty and complexity by putting specific policies and targets in place. Investors’ credit risk perception remains largely unaddressed. This, coupled with the ineffectiveness of existing credit assessment methods in evaluation of clean energy projects, drives up the cost of finance, thereby impacting the viability of the project and leading to a lack of investment interest. An OECD study (G20/OECD 2012) on institutional investment in green infrastructure discusses additional barriers in green infrastructure relative to conventional infrastructure. Credit risk related to clean energy projects has both generic and specific challenges. Generic ones are those that pertain to infrastructure projects in general. As described in Table 1, clean energy projects could be considered a subset of infrastructure projects and are subject to the same generic infrastructure issues, as well as additional issues that are specific to clean energy projects. This section discusses issues of credit risk assessment, the use of credit ratings, and implications for financing of infrastructure and clean energy projects. Some of these issues may also render the proposed risk mitigation solutions ineffective or expensive.

Credit Risk in Infrastructure Projects Infrastructure projects use project finance loans as the financing mechanism, and various studies have found that project finance loans are less risky than corporate finance loans of similar ratings (Beale and Fox 2002; Esty and Sesia 2004). Inadequate credit information and lack of historical data are some factors that hinder effective credit assessment for infrastructure projects. A study on linking financing structures and debt markets in India by the Asian Development Bank found that the credit spread in infrastructure projects is in a wide range with an average of 400–600 basis points over government securities (Rastogi and Rao 2011). The study further provides evidence that some part of the credit risk is overestimated and suggests the use of credit enhancement and guarantee products for enabling bond-market financing of infrastructure.

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

111

Table 1: Barriers to Institutional Investment in Green Infrastructure Issues with infrastructure investments

Issues particular to green investments

Lack of suitable investment vehicle

Direct investing challenges Short-term investment horizon and need for liquidity (illiquidity risk) Difficulties with bidding process and timing; lack of investor best practice and expertise Asset and liability matching (ALM) application issues; diversification and exposure limits Need scale >US$50 billion assets under management (AuM) and deal flow to maintain costly team Min US$100 million deal size; expensive and time consuming due diligence; higher transaction costs Regulatory and policy issues Political uncertainty Illiquidity and direct investment restrictions, e.g., capital adequacy rules Uncertain new policy application, e.g., Solvency II for pension funds? Accounting rules, e.g., mark-to-market for illiquid assets Lack of project pipeline and quality historical data Compounded by exit of banks (Basel III/deleveraging) Little historical pricing data or indices for investments such as private placement debt Risk/return imbalance Market failures: insufficient carbon pricing and incentives; presence of fossil fuel subsidies Unpredictable, fragmented, complex, and short-duration policy support Retroactive support cuts, switching and stopping incentives Use of tax credits popular with insurers can discourage tax exempt pension funds Unrelated policy objective discouragement, e.g., European Union unbundling preventing majority ownership of both transmission and generation/production Fiduciary duty debate Special species of risk, e.g., technology and volumetric, require expertise and resources Competition for capital with other traditional infrastructure assets Issues with fund and vehicle design High fees to support fund structure Liquidity trade-off with connection to underlying asset and associated benefits: difficult to offer liquidity without asset disconnect, churn and leverage in fund Nascent green bond markets, no indices/funds, restricted access to liquid vehicles (such as investment trusts) Small pipeline of projects, high transaction costs, minimum deal size and definition uncertainty, challenges with securitization, credit and ratings issues Historical lack of ratings, expensive process Absence of monoline insurers since financial crisis

Reproduced with permission from OECD (2016).

112

D. Purkayastha

Analysis of infrastructure debt and respective credit ratings has led to the following findings: 1. Infrastructure debt exhibits lower defaults and lower credit losses relative to corporate debt of similar credit rating; 2. The level of defaults exhibited by infrastructure projects is lower than that expected from the credit ratings assigned to them; and 3. The credit quality of infrastructure debt shows improvement over the longer term, as reflected by the declining defaults over time, and this is reflected by term structures (pricing of debt over time) of infrastructure project finance (Iyer and Purkayastha 2017). Overestimation of credit risk by credit ratings is an issue associated with infrastructure finance as a whole, of which clean energy is a subset, and the same issues may be expected for clean energy projects. Clean energy projects need very longterm financing like infrastructure projects. Infrastructure projects tend to default less over time and hence it is difficult for credit ratings to provide an assessment of credit risk in infrastructure projects (Sorge 2004). Figure 2 graphically depicts a comparison of defaults from BBB-rated infrastructure debt with higher A-rated corporate debt. Lower BBB-rated infrastructure debt shows lower default rates than higher A-rated corporate debt after 5–6 years. This indicates the improving credit quality of infrastructure over the life of the projects because they tend to default less over time. This pattern is not consistent with the typical use of credit ratings, where defaults are expected to increase with increasing maturity and hence credit ratings may not be useful in assessing credit quality of infrastructure projects based on the conventional probability of default approach. However, this finding is consistent with the term structure of credit spreads on project finance, where longer maturity project finance debt has lower spreads (Sorge 2004), which means that the financing market may not be relying on credit ratings for infrastructure project finance.

Credit Risks Specific to Clean Energy Projects Credit risk assessment by use of credit ratings for clean energy projects is expected to exhibit similar issues as infrastructure projects, and in addition, clean energy projects are faced with additional challenges, as described earlier. Clean energy’s lack of a track record and technological obsolescence are two challenges that act as a barrier to financing of such projects. Moreover, there is an information asymmetry that includes investors’ lack of information on commercial viability of such technologies, as well as policy uncertainties regarding clean energy projects (G20 Green Finance Study Group 2016). Clean energy projects are also faced with volumetric risks, which refer to volatility in production volume because of the uncertain nature of wind and solar resources. Unlike conventional power plants where production is

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . . 1.80% 1.60% 1.40%

y = 0.0003x1.7297 R² = 0.9914

1.20%

113

y = 0.0008x1.1733 R² = 0.9933 Baa - Total Infra

1.00% 0.80%

A - Non-fin Corporate

0.60% 0.40%

Power (Baa - Total Infra)

0.20% 0.00% Year Year Year Year Year Year Year Year Year Year 1 2 3 4 5 6 7 8 9 10

Power (A - Non-fin Corporate)

Figure 2: Comparison of Defaults from BBB-Rated Infrastructure Debt with Higher A-Rated Corporate Debt. A and BBB (Baa) Refer to Credit Rating Grades. (Reproduced with permission from Iyer and Purkayastha 2017)

usually a stable quantity, clean energy projects can sometimes have volatile production depending upon environmental conditions (Kaminker and Stewart 2012). The uncertainties and the lack of information lead to excessive risk aversion and increase the expected returns from these investments as the investors perceive that some of the technologies might not work effectively or as anticipated. The constraints in clean energy finance are aggravated for distributed clean energy projects as they have a problem of scale and higher consumer or off-taker credit risk. The small size of these projects leads to insufficient investment deal sizes and higher transaction costs, which causes large-scale investors to stay away from such projects, unless the projects are aggregated. Transaction cost risk is one of the biggest barriers in terms of severity and probability, which discourages investments from institutional investors. Investors can usually deal with complexities of such financing, provided that the cost of transactions is not high (Standard and Poor’s 2010). Credit risk in distributed clean energy is perceived to be very high or unknown. Developers are of small scale with little or no credit history, which has a negative impact on the credit assessment, making financing riskier as well as expensive. Maturity mismatch is another risk associated with clean energy projects. It arises due to inadequate availability of long-term funding relative to demand (Yoshino and Taghizadeh-Hesary 2017, 2018). It also gives rise to longevity risk, which refers to a mismatch between long-term capital commitments required for clean energy projects and the relatively short-term nature of regulations. Longevity risk is perceived by investors to have the highest probability and severity (Standard and Poor’s 2010). This is a common challenge for projects in developing countries, and often results in a lack of investments. Clean energy projects are more exposed to this risk as they have a more front-loaded capital structure and need larger capital upfront matching the longer tenures of project life. Clean energy projects have a high degree of

114

D. Purkayastha

uncertainty due to technology risk, which increases the perceived credit risk. This is aggravated for projects in developing countries, where currency and political risks are also present. Together, these risks make it difficult for clean energy projects to qualify for investment grade ratings. The implications of credit ratings for financing of green infrastructure projects has been discussed in the G20/OECD Policy Note on Pension Fund Financing for Green Infrastructure and Initiatives, which states that the willingness of institutional investors depends on the state of the balance sheet of holding companies of green infrastructure projects and their consequent credit ratings. (For more information on credit ratings, refer to Yoshino and TaghizadehHesary 2014, 2015.) Rating agencies have assigned BB or lower ratings for wind and solar project bonds (Kaminker and Stewart 2012). Non-investment or marginal investment grade ratings make it difficult for these projects to attract investors and the funds that are raised are at high interest rates. Adding the above-described issues pertaining to clean energy projects to those already present in infrastructure makes the perceived risks for clean energy even higher, and conventional credit rating approaches to assessment of credit risk seem to be constraining financing for clean energy from both banks and capital markets. Bond finance is being discussed as an underutilized tool and as the next frontier for clean energy investments. The prescription provided includes (1) scaling up bond-financed clean energy projects using credit enhancement and risk sharing to mitigate risks through demonstration projects and (2) creating a pipeline of rated and private placement deals to meet demand of institutional investors for clean fixed income securities (Milford et al. 2014). Any approaches to bond market finance at the clean energy project or business level would require credit ratings above investment grade levels. The majority of issuers (over 80% by value) of green bonds are public institutions, banks, or financial intermediaries—which are expected to have better credit ratings—and not clean energy projects or businesses (Climate Bonds Initiative 2017).

Wider Financial Sector Constraints Lack of experience and capacity gaps in the local financial sectors are the other factors that have a direct impact on investors’ confidence. This is particularly important for clean energy projects as the sector is relatively new and not yet fully commercialized. These factors have practical implications for investors to invest in developing countries. Lack of transparency, unavailability of swap markets or appropriate financial mechanisms, and unclear banking regulations restrict the investors from investing in such markets. Clean energy projects also require early equity for the bankability of the projects. Developing markets, however, often lack frameworks for supporting exits and put and call options that make it difficult for investors to plan an exit strategy. This limits equity and quasi-equity investments in such markets (Green Climate Fund 2017). Emerging regulatory frameworks for the banking and insurance sectors such as Basel III and Solvency II also limit lending and investment in clean energy projects.

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

115

It is becoming increasingly difficult to obtain capital from the commercial banks for green infrastructure. The new Basel III banking regulations are expected to have a negative impact on project financing with long maturities, the type required to fund green infrastructure. The absence of monoline insurance also imposes constraints on access to capital markets by green infrastructure projects (G20/OECD 2012).

Managing Credit Risk and Improving Access to Finance for Clean Energy Projects Access to affordable finance remains a major barrier for the growth of the clean energy sector. The sector needs new financing mechanisms, improved credit assessment methods, and policy interventions to overcome this barrier. Measures undertaken already, including regulations, taxes, and subsidies, have been successful to an extent; the capital mobilization, however, still remains insufficient for the sector. This section proposes some of solutions for addressing the constraints in clean energy finance, thereby improving the access to affordable finance. One of the approaches provided by IRENA, as detailed in Table 2, focuses on three major areas: (1) enabling policies, (2) financial risk mitigation, and (3) structured finance (IRENA 2016). These solutions focus on mitigating risks and improving access to capital markets. Both financial risk mitigation and structured finance approaches would usually need to use credit rating as a tool for setting up risk mitigation–credit enhancement and partial credit guarantee facilities, and in the case of structured finance, securitized instrument issuances to financial markets. If the credit ratings overstate the credit risk in infrastructure, they are also likely to do so for clean energy projects and may reduce the effectiveness of risk mitigation and structured finance initiatives. Clean energy projects come with many economic, environmental, and social benefits. Traditional energy projects, on the other hand, come with negative externalities that impose harm on third parties. Credit ratings have traditionally been unable to factor in these externalities, which results in underinvestment in clean energy projects and over-investment in traditional projects (G20 Green Finance Study Group 2016).

Public Finance as a Risk Mitigation Mechanism The share of public finance in clean energy investments currently stands at 15% and is not expected to increase above this level (IRENA 2016). With appropriate policies in place, public finance institutions can be critical in addressing the constraints and barriers in clean energy finance and can lead to catalyzing private sector investments. However, it is important that public finance be used effectively and efficiency to scale up clean energy investments and crowd in commercial private capital. Investors’ perception of risks inhibits clean energy investments, and the ability to mitigate these risks will be a key factor in determining financing flows for the sector

116

D. Purkayastha

Table 2: Policies and Tools that Reduce Barriers and Mitigate Risks Enabling policies and tools

Financial risk mitigation Instruments

Structured finance mechanisms and tools

Financial policies and regulations Project preparation facilities Project facilitation tools On-lending facilities Hybrid structures Guarantees Currency hedging instruments Liquidity facilities Resource risk mitigation tools Standardization Aggregation Securitization Green bonds Yieldcos

Reproduced with permission from IRENA (2016).

(OECD 2015). Public finance can play an important role in mitigating these risks and making such investments attractive for private investors. In clean energy finance, there is a general mismatch between the investor need for long-term, relatively low-risk investment and the currently available risk profile of the projects, as the cash flows of these projects are exposed to a lot of risks and hence not predictable. Public finance can be structured in a way to smoothen the cash flow from these projects, thereby matching the risk-return profile of these projects to investors’ requirements. For clean energy projects, securing an investment grade rating is difficult. Public finance institutions, however, have generally high and stable credit ratings, and can make use of them by offering a credit guarantee on behalf of the borrower. Yoshino and Taghizadeh-Hesary (2016) introduced a credit guarantee scheme that would be applicable for the development of green infrastructure projects. Such a scheme could benefit the borrower by securing financing with extended maturities from a variety of lenders, while lenders would benefit from the reduced probability of default as guarantees can be drawn to meet debt servicing during periods of illiquidity (Yoshino and Taghizadeh-Hesary 2016). A loan loss reserve, on the other hand, reduces the risk of repayment default by keeping aside some capital as reserve funds. In case of borrower default, loan loss reserve funds can be used to repay the lender (OECD 2015). By streamlining project cash flows, the loan loss reserve helps lenders by lowering the credit risk of the project while lenders also benefit from the lower financing cost as well as broader financing base.

Risk Mitigation and Structured Finance Approaches Credit enhancement: Credit enhancement is a risk mitigation concept used in financial markets to enhance a borrower’s credit profile (which is usually benchmarked by

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

117

credit rating) and enable access to market borrowings. The concept of credit enhancement was originally used in structured finance for securitization, which involves pooling of cash flows from loans, bonds, and assets, and issuance of securities against those cash flows. Credit enhancement has been used in many ways under many nomenclatures, such as bond insurance, financial guarantees, and credit wraps, but they provide the same economic benefit. Credit enhancement has been extensively used in the global financial markets and covers a wide variety of financial obligations, including loans, bonds, receivables, and swaps, with the core objective being to strengthen the credit profile of at least one of the participants in a financial transaction and to attract new sources of financing, thereby lowering the demands on the banking system. Credit enhancement can be provided externally or internally to the bond issuance. Internal credit enhancement is an approach in which structuring provides the required credit enhancement by overcollateralization, cash reserve accounts, capturing excess spread, or subordination, enabling different classes of securities to be issued. External credit enhancement refers to third parties providing credit support by instruments such as letters of credit, full and partial risk/credit guarantees, and bond insurance—which are usually in the nature of financial guarantees. By providing coverage for risks that are new, not already covered, or too expensive for private investors, the credit and default risk associated with clean energy projects can be lowered. Credit or performance guarantees, insurance products, payment security mechanisms, and public investment are some of the mechanisms that can be used as credit enhancement tools. The effectiveness of these tools will, however, be limited till credit assessment of underlying clean energy projects is improved. Managing currency risk: Currency risk is one of the major barriers for financing clean energy projects in developing countries. The high degree of political and country risk associated with developing countries increases the risk premium, thereby increasing the cost of clean energy. It also has an indirect impact on financing of clean energy projects where it acts as a factor in credit assessment of the projects, thereby resulting in low ratings for projects. Long-term currency swaps are generally used by foreign investors to cover the currency risk. However, this becomes expensive and nearly doubles the usual cost of finance (Nelson and Shrimali 2014). Another solution for managing currency risk is to index the project cash flows to the currency of financing. This would reduce the exposure of currency risk for project developers and eventually lower the financing cost for the project. The host country government could play a key role in providing currency-indexed tariffs by taking on the currency risk. Some studies have suggested that national governments are better placed, as they control the economic policy, to undertake the currency risk (Nelson and Shrimali 2014). The government can provide cheaper currency hedging by putting aside a hedge fund that would cover the risk of domestic currency depreciation. Addressing currency risks could have a partial impact though, as the overall cost of finance is contingent on the credit quality of the project, and access to currency hedging market instruments is also dependent on the credit quality of the borrower or the project.

118

D. Purkayastha

Structured finance mechanisms—warehousing and securitization: Use of structured finance mechanisms could help in enabling capital market financing for clean energy. Clean energy assets are typically small scale and illiquid in nature, which makes refinancing of such projects difficult. Measures like warehousing and securitization can help in transforming illiquid assets into liquid and tradable instruments and can help in the refinancing of the projects. Warehousing is a process in which smaller projects can be aggregated in order to reach a scale that can be securitized into a special-purpose tradable asset. These securitized assets are assessed for default by rating agencies and then could be traded in the secondary market as fixed-income instruments. The bundling of securities could diversify the risk for such instruments and can help in securing high credit ratings. Securitization can help the sector in multiple ways. It can help broaden the investor base by allowing developers to broaden their sources of capital. It can also improve the liquidity of the sector and can help create long-term financing structures with lower cost of capital. These instruments will, however, affect the credit quality of the projects, as the underlying value is derived from the projects and if credit ratings overstate the credit risks of clean energy projects, a greater amount of support capital would be required. Bond financing for clean energy: Securing investment grade credit ratings has been a big challenge for clean energy projects, and its absence keeps investors away from these projects. Public finance institutions, with their generally high credit ratings, can catalyze investments for the sector and can play several roles, from issuing new bonds to providing third-party guarantees to other bonds in order to improve the credit profile of clean energy projects. Facilitating bond financing for clean energy can help unlock large-scale and long-term non-bank financing for the projects. Bond financing has been typically low for pre-construction and construction-stage projects as they lack an established track record (IRENA 2016). Green bonds or dedicated clean energy bonds could address this issue as they can be tailored to investors’ risk profiles across project life cycle. Bonds could be full recourse, backed by the credit worthiness of the issuer, or backed by the cash flows from the project (IRENA 2016). The credit ratings assigned to the latter type of bonds would again depend on the credit assessment of the underlying projects and might not attract investments till the credit assessment measures are improved. Monoline insurance could also improve access to bond markets for larger green infrastructure and clean energy projects.

Possible Policy Solutions for Addressing Credit Risk in Clean Energy Projects Addressing policy barriers that limit financing for clean energy is also of utmost importance, as some work by behavioral economists suggests that the investment

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

119

behavior in clean energy finance is not driven entirely by a rational risk–return perspective but rather also by energy policy (Chassot et al. 2014). Lack of long-term transparent, coherent policy and absence of a regulatory framework often hinders private sector investors from investing in clean energy projects. A long-term policy commitment by the government leads to a stable investment environment and ensures stable revenue flow from projects. Transparency in policy measures helps investors by providing them a support mechanism and reducing the cost of capital. In the energy sector, incumbent technologies have the benefit of economies of scale and have created a lock-in effect for these technologies. Further barriers like network economies and information failures limit growth for new clean energy technologies. This often leads to a market failure and hence would need specific clean energy policies like lending guidelines for clean energy, dedicated clean energy targets, and funding for technical commercialization. These policies can address these market failures associated with technological learning and spill-over effects (Mitchell et al. 2011). Another policy solution could be stronger deployment policies for clean energy, which could lead to more demand and stronger uptake of clean energy projects. This could lessen the uncertainty over future regulation and attract longer-tenure funds from investors.

Improving Credit Risk Assessment for Clean Energy Projects Credit assessment is one of the major barriers for growth of clean energy finance. Credit ratings are the usual mechanism for credit assessment, and securing an investment grade rating is usually difficult for clean energy projects. This often results in a lack of investors’ interest and hence under-investment in the sector. Rating agencies have generally been conservative towards infrastructure projects. The long-term nature of such projects and other associated risks result in lower credit ratings. Clean energy investments are perceived to be more risky considering technological risk and the relative lack of a track record, as well as policy uncertainty surrounding the sector. This leads to sub-investment-grade ratings and low interest from investors. Also, the performance of clean energy projects has a relatively high degree of volatility, and this volatility often results in further downgrading of ratings from an already low level. Standard & Poor’s and Fitch both have downgraded the ratings of wind energy projects to the range of BB to B and have changed the outlook to negative in the past due to the underperformance of projects (Kaminker et al. 2013). This situation is still improving in developed countries, where the projects are able to secure low investment grade ratings. In contrast, in developing countries, where the sovereign ratings are low and political risk is greater, these factors combine to further downgrade credit ratings and block access to institutional finance. Studies have suggested that in developing countries, the political economy concerns

120

D. Purkayastha

can drive up the borrowing cost by 2% to 6%, thereby harming credit ratings (Inderst and Stewart 2014). Clean energy projects are a different asset class and may need a different approach for assessment. Use of technology to carry out remote resource assessment and availability of standardized credit information could help in reducing transaction costs for credit assessment of clean energy projects. Credit assessment should also account for the implicit benefits and positive economic externalities clean energy projects offer in contrast to conventional fossil fuel-based energy projects. A clean energy project may have higher construction costs but have positive externalities like reduction in emissions and pollution, and these benefits accrue to third parties. These externalities are not captured in the cash flows or credit assessments through credit ratings (G20 Green Finance Study Group 2016). While the short-term relationship between green projects and credit may be difficult to establish, it is intuitively clear that in the long run, green infrastructure projects are likely to have good long-term credit quality. A credit assessment framework for “green” credit ratings could be a solution that would internalize the implicit benefits of clean energy projects. A green credit rating could integrate environmental and social factors within the assessment mechanism, thereby improving the overall outlook of such projects. There have been certain initiatives like the Equator Principles and UNEP Finance Initiative, which are used by lenders for assessment of project finance structures; their application, however, remains limited due to lack of consistency between risk management and green lending guidelines (G20 Green Finance Study Group 2016). A universal credit assessment framework for clean energy projects could be effective as it can address this lack of consistency by removing the difficulties in measuring the provision and performance of clean energy lending. This modified rating approach, which could incorporate green factors, could be useful in attracting investment from institutional investors. Another example could be the approach taken by Global Infrastructure Basel’s SuRe credit ratings for infrastructure projects, which have incorporated environmental, social, and governance (ESG) factors into the rating mechanism. A similar framework can be used for clean energy projects where the ESG factors that are material to any energy projects can be factored into the rating methodology. The assessment based on such a rating methodology could ensure transparency for the overall impact created by the project, and could be particularly effective in attracting ESG-sensitive investors. Global rating agencies Moody’s and Standard & Poor’s have recently launched Green Bonds Assessment and Green Evaluations products, respectively. Green evaluations are positioned as second assessments that are defined as an asset-level environmental credential that aims to provide a more comprehensive picture of the green impact and climate-risk aspects of investors’ portfolios. Moody’s Investor Service has developed a Green Bonds Assessment methodology which provides a framework for raising and using proceeds of green bonds/securities.

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

121

Conclusion The typical prescriptions for enabling clean energy finance endorsed by institutions and development banks focus on a three-pillared approach: (1) enabling policies, (2) risk mitigation (primarily credit risk), and (3) structured finance (innovative financial instruments for access to capital markets). Risk mitigation approaches like credit enhancement—partial credit guarantees, first loss default guarantees, risk sharing facilities—would need credit risk measurement, and the usual practice is to rely on credit ratings. For structured finance approaches like securitization, green bonds, and yieldcos, credit ratings provide the assessment of credit risk for the instrument or structure, which is required for access to capital markets and also determines pricing. Commercial bank financing to clean energy also uses credit ratings for decision making and capital provisioning. Bank regulators use credit ratings for risk weights, which then determine the capital adequacy. If credit ratings overstate credit risks in infrastructure projects, and as clean energy projects are also developed as project finance structures, it is expected that credit risk would also get overstated for clean energy projects. The use of credit ratings may be constraining allocation of institutional capital to clean energy projects. The use of risk mitigation solutions and structured finance approaches for increasing the flow of institutional finance to clean energy projects may not be effective if they are developed using the benchmark of credit ratings. The effective cost of credit enhancement based on credit ratings for enabling financing to clean energy projects would be higher than the amount ideally required from public finance sources, and the price of risk mitigation would be higher. For access to capital markets through structured financial products like securitized receipts, enhanced credit ratings are required, which are often effected through additional collateralization or external credit guarantees. Credit ratings continue to play an important role in providing market signals for placement and pricing of bonds, and for access to bank financing. The problem of low credit ratings for clean energy projects needs to be examined closely to see if the credit ratings of infrastructure projects could assess risks in line with their economic and green characteristics. Effective use of public finance can improve the risk profile of the sector by targeting risks specific to clean energy, like lack of historical data and technological risks through a payment security mechanism; addressing refinancing risk through securitization can enable stable cash flows for the lenders, reduced risk, and improved credit ratings for projects in the sector. To address the policy barriers, developing financial risk mitigation and structured finance mechanisms to improve access to institutional finance may not improve the prospects for clean energy finance if they are based on conventional credit rating approaches, which would tend to attach higher credit risks to clean energy projects. Credit risk in clean energy projects seems to be overstated by rating agencies, and because positive environmental externalities are not factored into credit ratings, it may be useful to modify the approach to credit risk assessment in order to include sustainability measures.

122

D. Purkayastha

In addition to the People’s Republic of China and India, Southeast Asian countries need to significantly scale up clean energy investments, which would need low-cost financing. Credit support mechanisms such as credit guarantees could enable domestic and international capital flows. Credit enhancement facilities could enable clean energy projects to access bond markets. Public financial institutions are well placed to do so as a separate business, and this may pave the way for the market entry of other international insurance and reinsurance companies in this line of business. Enabling regulation for financial guarantees would be required for credit enhancement products to be offered by third parties and insurance companies. Some regulatory constraints on investments in bond markets by long-term institutional funds may also be eased. With the availability of credit enhancement and correction in credit ratings for infrastructure debt, investments from pension and insurance funds in clean energy would increase. In the long run, green factors are likely to reduce credit risk, so it may be useful to include positive externality factors of clean energy in credit rating frameworks, which would then tilt the playing field for both commercial banks and institutional investors and help in correcting the credit market failure for clean energy finance. Disclaimer The views and opinions expressed in this chapter are solely of the author and do not necessarily reflect the views of the institutions associated with him.

References Beale C, Fox N (2002) Credit attributes of project finance. J Struct Project Finan 8(3):5–9 Bloomberg New Energy Finance (2017) Clean energy investment. Bloomberg New Energy Finance, New York Buchner BK, Oliver P, Wang X, Carswell C, Meattle C, Mazza F (2017) Global landscape of climate finance 2017. Climate Policy Initiative, San Francisco. Available via https://climatepo licyinitiative.org/wp-content/uploads/2017/10/2017-Global-Landscape-of-Climate-Finance.pdf Chassot S, Hampl N, Wüstenhagen R (2014) When energy policy meets free-market capitalists: the moderating influence of worldviews on risk perception and investment decisions. Energy Res Soc Sci 3:143–151 Climate Bonds Initiative (2017) Green bonds highlights 2016. Climate Bonds Initiative, London Della Croce R (2011) Pension funds investment in infrastructure: policy actions. OECD working papers on finance, insurance and private pensions no 13. OECD, Paris Esty BC, Sesia AM (2004) Basel II: assessing default and loss characteristics of project finance loans. HBS publishing case no 203-035; teaching note: 5-203-047. Available via SSRN https:// ssrn.com/abstract=374800 G20 Green Finance Study Group (2016) G20 green finance synthesis report G20/OECD (2012) G20/OECD policy note on pension fund financing for green infrastructure and initiatives. OECD, Paris Green Climate Fund (2017) Analysis of barriers to crowding-in and maximizing the engagement of the private sector, including Private Sector Advisory Group recommendations. Green Climate Fund, Incheon IFC (2016) Green finance: a bottom-up approach to track existing flows. IFC, Washington, DC Inderst G, Stewart F (2014) Institutional investment in infrastructure in developing countries: introduction to potential models. World Bank, Washington, DC

6

Managing Credit Risk and Improving Access to Finance in Green Energy. . .

123

International Energy Agency (2017) World energy investment. Report. International Energy Agency, Paris IPCC (2014) IPCC data centre. International Panel on Climate Change, Geneva IRENA (2016) Unlocking renewable energy investment: role of risk mitigation and structured finance. IRENA, Abu Dhabi Iyer KC, Purkayastha D (2017) Credit risk assessment in infrastructure project finance: relevance of credit ratings. J Struct Finan 22(4):17–25 Jones AW (2015) Perceived barriers and policy solutions in clean energy infrastructure investment. J Clean Prod 104:297–304 Kaminker C, Stewart F (2012) The role of institutional investors in financing clean energy. OECD working papers on finance, insurance and private pensions, no 23. OECD, Paris Kaminker C, Kawanishi O, Stewart F, Caldecott B, Howarth N (2013) Institutional investors and green infrastructure investments: selected case studies. OECD working papers on finance, insurance and private pensions, no 35. OECD, Paris Milford L, Saha D, Muro M, Sanders R, Rittner T (2014) Clean energy finance through the bond market. Brookings-Rockefeller project on state and metropolitan innovation. Brookings Institution, Washington, DC Nelson D, Shrimali G (2014) Finance mechanisms for lowering the cost of renewable energy in rapidly developing countries. Climate Policy Initiative, San Francisco OECD (2015) Mapping channels to mobilise institutional investment in sustainable energy, green finance and investment. OECD, Paris OECD (2016) Institutional investors and green infrastructure investments. OECD, Paris Rastogi A, Rao V (2011) Product innovations for financing infrastructure: a study of India’s debt markets. ADB South Asia working paper series. ADB, Manila REN21 (2017) Renewables 2017 global status report. REN21, Paris Sorge M (2004) Credit spread in project finance. BIS Q, pp 91–101 Standard & Poor’s (2010) Can capital markets bridge the climate change financing gap? Climate change financing roundtable discussion. Standard & Poor’s, London Yoshino N, Taghizadeh-Hesary F (2014) Analytical framework on credit risks for financing SMEs in Asia. Asia-Pac Dev J 21(2):1–21 Yoshino N, Taghizadeh-Hesary F (2015) Analysis of credit risk for small and medium-sized enterprises: evidence from Asia. Asian Dev Rev 32(2):18–37 Yoshino N, Taghizadeh-Hesary F (2016) Optimal credit guarantee scheme ratio for Asia. ADBI, Tokyo Yoshino N, Taghizadeh-Hesary F (2017) Alternatives of bank finance: role of carbon tax and hometown trust funds in developing green energy projects in Asia. ADBI working paper. ADBI, Tokyo Yoshino N, Taghizadeh-Hesary F (2018) Alternatives to private finance: role of fiscal policy reforms and energy taxation in development of renewable energy projects. Springer, Heidelberg Zuckerman J, Frejova J, Granoff I, Nelson D (2016) Investing at least a trillion dollars a year in clean energy. Contributing paper for Seizing the global opportunity: partnerships for better growth and a better climate. New Climate Economy, London

Part V Green Bond

7

Differences Between Green Bonds Versus Conventional Bonds An Empirical Exploration Suk Hyun, Donghyun Park, and Shu Tian

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Players Involved in Green Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Differences Between Green Bonds and Conventional Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Green Bond Premium Does Exist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Green Bond Premium Does Not Exist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Empirical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sample Construction Using the Matching Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Descriptive Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Empirical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary and Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

128 129 130 130 131 132 133 133 134 134 135 137 140 145 154

Abstract

This chapter empirically investigates how the green bond markets price greenness. Using the liquidity-adjusted yield premium of green bonds over their synthetic conventional bonds, this study explores the possible determinants that drive green bond premiums. Evidence shows that, on average, there is no significant yield premium or discount on green bonds compared with their paired conventional bonds. Interestingly, in the case of a subsample, such as the euro and S. Hyun (*) East Asia International College, Yonsei University, Wonju, Republic of Korea e-mail: [email protected] D. Park · S. Tian Economic Research and Regional Cooperation Department, Asian Development Bank, Manila, Philippines e-mail: [email protected]; [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_34

127

128

S. Hyun et al.

the US dollar, to control for the currency effect, most explanatory variables are not statistically significant, which suggests that a green bond premium does not exist in dollar-denominated and euro-denominated bonds, while a green bond premium does exist in other currency-denominated bonds. However, green bonds are also not standardized instruments. Certain factors, like “greenness,” are necessary to match the needs of issuers and investors. These factors might have an impact on the price, liquidity, and volatility of green bonds. Keywords

Green bond · Green premium · Market development JEL Classification

G12 · G14 · G19

Introduction The green bond market has grown rapidly over the past decade. It started with the “climate awareness bond” issued by the European Investment Bank in 2007 as the first green bond. A key catalyst for the subsequent market development was the International Capital Market Association’s (ICMA) introduction of the Green Bond Principles (GBPs) in January 2014. Although the green bond market has expanded substantially since then, Ehlers and Packer (2017) showed that it is nevertheless still very small compared to the wider global bond market, with a share of less than 1.6% of the global debt issuance in 2016. While the green bond market began to form in 2007, due to the lack of a globally accepted definition and standards for green bonds, the nascent market faced two issues. First, as Ehlers and Packer (2017) pointed out, while the GBPs and the Climate Bonds Standard (CBS) serve as the general guidelines to distinguish between green bonds and conventional bonds, due to the lack of enforcement mechanisms, some countries have produced their own standards for regulating green bonds. The European Union (2016) stated that the central bank of the People’s Republic of China (PBoC) suggested its own version of what constitutes green bonds in 2015 in lieu of the Green Bond Principles and Climate Bonds Standard. This has led to the issue of heterogeneous data sets on green bonds and the problem of the generation of green bonds that do not necessarily improve the environment. Second, the green bond premium, which Zerbib (2017) defined as the difference in yield between a green bond and an equivalent conventional bond, is not associated with the impact that green bonds exert on the environment but the sizeable excess demand. As VanEck (2017) asserted, whether projects are successful or not does not affect the principal and the interest payment of green bonds. Therefore, this chapter addresses the above issues as follows. Section “Green Bonds” is devoted to understanding issuers and investors and the other players involved in green bonds, since a thorough understanding of them could facilitate further development of green bond markets and improve policy measurements.

7

Differences Between Green Bonds Versus Conventional Bonds

129

Section “Differences Between Green Bonds and Conventional Bonds” uncovers the differences between green bonds and conventional bonds and addresses the determinants of a green bond premium. Section “Empirical Analysis” focuses on the measures and building blocks to develop further green bond markets.

Green Bonds Green bonds, in short, are fixed-income securities that fund exclusively green projects with environmental or climate-related benefits. In most countries, any issuer can label its bonds “green,” because only the People’s Republic of China (PRC) and India have defined the term legally. In practice, issuers can label bonds “green” only if they comply with the GBPs, the CBS, or the national guidelines and regulations governing green bond issuance. Each national standard incorporates many or most elements of the GBPs; however, there are some differences between them. Therefore, more coordination is necessary to facilitate further development of green bond markets. ICMA’s GBPs, which are a voluntary process and guidelines, best describe the specific criteria and requirements underpinning the concept of green bonds. Major private financial institutions compiled these under the aegis of ICMA (2017). The GBPs guide prospective issuers on the four key components of green bond issuance: (a) the use of proceeds, (b) the process for project evaluation and selection, (c) the management of proceeds, and (d) reporting. Though external review is not one of the main four GBPs, the 2015 edition of the GBPs recommended that green bond issuers “use external assurance to confirm alignment with the key features of green bonds”. This can include second opinions and verifications. From 2016, the Principles referred to “external reviews” rather than “external assurance,” while the list of recommended external reviews expanded to include those that rating agencies provide (ICMA 2017). Once issuers have issued green bonds in accordance with the GBPs, certification and scheduled reporting are necessary. If the proceeds from the green bonds do not fund green projects, as the pre-issuance reports suggest, within 24 months of issuance, then the issued bonds will lose their green status, according to Petrova (2016). As investors do not have reliable data and analyses of the impact of green bonds on the environment, all that investors may use as a yardstick with which to discern what is green from what is not green is the green bond label. According to the Asian Development Bank (2018), issuers in 38 jurisdictions had brought green bonds to the market by the end of June 2017. In many countries, the green bond issues are very limited in unlocking private investments, except for those in the most established markets, such as the PRC, the US, and Europe. Although the green bond markets have rapidly grown over the last 10 years since the European Investment Bank’s first green bond in 2007, the Climate Bonds Initiative estimated that $895 billion of climate-aligned bonds were outstanding in 2017, comprising both labeled and unlabeled green bonds and amounting to $221 billion and $674 billion, respectively, in 2017. The labeled green bonds account for only 24.7% of the

130

S. Hyun et al.

climate-aligned bond universe, while the remaining 75.3% are unlabeled and generally non-investable, although they also contribute to a low-carbon economy. Therefore, the lack of a common practice and definition might deter the further development of green bonds enough to unlock the private sector’s issuance and investment in green projects. For the green bond market to channel a significant amount of funds into environment-friendly projects, green bonds should also meet the needs of both issuers and investors at the same time.

Issuers Green bonds are no different from conventional bonds, except that their proceeds are earmarked for investment solely in certain green projects with environmental benefits. Green bonds are also in general less liquid than conventional bonds, since many investors in green bonds are long-term investors who seek incentives to protect themselves against inflation risk, default risk, and market volatility. Therefore, most green bonds offer tax privileges, guarantees, and letters of comfort to attract more investors (Veys 2010). Although maintaining the green label helps reduce the environmental risks for the issuer, the costs of providing scheduled reports and recurring research and development (R&D) expenditure to become green may be burdensome to small-sized green bond issuers. As the concerns in addressing environmental risks associated with corporate finance increase, global reporting on greenhouse gas emissions has become a requirement rather than an option. Standard & Poor’s Ratings Services (2016) introduced the Carbon Disclosure Project on behalf of 827 institutional investors, managing $100 trillion in assets, and the United Kingdom (UK) government’s 2013 requirement for all UK-listed companies for reporting greenhouse gas emissions. Considering the same issuer, the risk characteristics of a green bond are essentially identical to those of a conventional bond: while the proceeds from the issuance of a green bond are earmarked for environment-friendly projects, the cash flows of the entire operations of the issuer—not just the green project—service the green bonds.

Investors Investors in green bonds do not purchase them only because they can hedge against environmental risks for their portfolios. Investors check the indexes and reports that the issuers provide to make their investment decision regarding green bonds. Investors in green bonds are usually institutional investors, such as pension funds, insurance companies, and so on. Treasurers like to offer green bonds since doing so diversifies their investor base. When the market is volatile, a diverse portfolio deals better with the volatility of the market. In many cases, fans of green bonds have no alternative investment, since green bonds are insufficient to meet the increasing demand. Thanks to oversubscription in the green bond market along with solid supporters of green bonds, the pricing of green bonds is tighter than that of conventional bonds.

7

Differences Between Green Bonds Versus Conventional Bonds

131

Furthermore, because there is no widely recognized mechanism to monetize the environmental impact of green bonds, green bond investors currently take advantage of the same yields as conventional bonds, with the bonus of the reputation of investing in green projects that resolve environmental issues. In other words, if investors are not in need to withdraw cash from green bonds, in the current market with imperfect information, green bonds compensate investors for their patience. Investigations into whether a green bond premium exists have produced mixed empirical results. Investors who purchase green bonds clearly do not do so because they have a special preference for green bonds over conventional bonds. However, Östlund (2015) found no evidence of green bond preference. An empirical analysis with 28 matching pairs would not be highly random, but it is hard to be confident about the existence of a green bond premium. Zerbib (2017) reported evidence of the existence of a green bond premium, but the amount of data is limited for green bonds. In addition, depending on the framing of the data, the results lead to different conclusions. If investors have green preferences, it would mean that they would accept a lower return on their investment at the identical risk level as the alternative to conventional bond if and only if the bond they are investing in is green. The distinction between conventional investors and responsible investors is an important factor for green bond markets. In the case of conventional investors, their investment decision making depends mainly on financial factors, such as profitability and cash flows. The financial statements of securities issuers provide this information. On the other hand, the decision-making processes of responsible investors include both financial and nonfinancial factors, such as ESG (environmental, social, and governance) factors. Both conventional and responsible investors hold green bonds. However, green bonds are especially attractive to responsible investors because their proceeds are limited to environmentally beneficial projects, although the division between conventional investors and responsible investors is not clear-cut. Given the absence of institutional investors with responsible investment mandates to guide issuers and underwriters in structuring green bonds, a comprehensive policy framework for green bonds is necessary to support the further development of green bond markets.

Other Players Involved in Green Bonds For green bond issuance, there are four players who play different roles in the market in addition to issuers and investors. They are the underwriters, the external reviewers, the index providers, and other market intermediaries. Underwriters are the financial institutions that set up the public issuance and distribution of the bonds. Underwriters specify the terms, definitions, and obligations of the bonds. External reviewers verify the greenness of the underlying projects. Index providers are not directly involved in the issuance and distribution of the bond; however, they create green bond indexes according to their own standards. In practice, a widely recognized index provider’s inclusion of a green bond may add an extra inch of reliability for investors. Lastly, other market intermediaries are optional in a way, since most green bonds are traded over the counter (Östlund 2015).

132

S. Hyun et al.

Rating agencies and third-party auditors generally check the financial soundness of bond issuers or projects. However, when it comes to green bonds, their main objective is to check whether green bonds are environmentally responsible and observe the eligibility criteria that they pledged to abide by at the time of issuance (ADB 2018). Rating agencies, such as Moody’s, investigate green bonds and climate-related bonds and assign quantitative scores to them based on their greenness. Both Moody’s and S&P Global Ratings use a transparent scoreboard approach to provide forward-looking opinions about the issuer’s effectiveness in meeting the green criteria. In both cases, green bonds receive a grade, which assesses their greenness. The green bond ratings are not credit ratings, which the agencies issue separately. In the PRC, the China Chengxin International Credit Rating Company has also developed a green bond methodology, which follows the GBP approach and assigns one of five ratings to green bonds. While only a handful of issuers have sought green ratings, both Moody’s and S&P Global Ratings have made efforts to develop their green bond assessment capabilities expecting that all issuers will look for both a credit and a green rating soon. The following section will analyze the differences between green bonds and conventional bonds more thoroughly. These characteristics have implications for the pricing of green bonds and their attractiveness to investors. A premium at issuance over comparable bonds without a green label would indicate that a significant number of investors value the label, enough to give issuers an extra incentive to issue bonds that have it. At the same time, these investors will still be interested in an acceptable financial performance of green bonds over time.

Differences Between Green Bonds and Conventional Bonds Apart from the fact that green bonds require scrutiny by observing the GBPs and strive to meet the requirements that the Climate Bonds Initiative suggested, VanEck (2017) and Östlund (2015) insisted that they are not particularly different from conventional bonds, especially in primary markets, where brokers must sell green bonds to a large pool of investors buying both green bonds and conventional bonds. Standard & Poor’s Ratings Services (2016) showed that green bonds’ trading occurs near the yield spreads of conventional bonds. However, in secondary markets, investors also consider the green bond label as a criterion for selecting bonds. Therefore, the only way to assure investors that the bonds they are buying are truly green bonds is for them to check the binding guidelines regulating green bonds’ issuance and maintenance. The PRC, for example, strongly limits the use of the proceeds of green bonds to the environmental projects of the issuers only. In fact, the country has two guidelines for overseeing green bonds: China’s Green Bond Guidelines and the PBoC’s Green Bond Endorsed Project Catalogue, according to the European Union (2016). In Norway, on the other hand, for green bonds to maintain their label, their issuers need to list them on Oslo’s Stock Exchange. The European Union (2016) introduced Norway’s example of how to run green bonds. Norway also requires green bonds to seek a second opinion for listing on the stock exchange.

7

Differences Between Green Bonds Versus Conventional Bonds

133

The issuer must make the result of the second opinion available to the public. Lastly, the only certified green bond in Mexico underwent a second review in accordance with the CBS. Whether a green bond premium exists or not has been a topic of fierce discussion among economists. The chapter introduces the existing analyses of the green bond premium to scrutinize the issue further.

A Green Bond Premium Does Exist To investigate the existence of a green bond premium, Zerbib (2017) used a matching method, comparing each eligible green bond with two similar conventional bonds with identical conditions, such as currency, rating, bond structure, seniority, collateral, and coupon type. He started out with 681 green bonds complying with the GBPs on 30 December 2016; however, after filtering out the outliers and incomplete data, he selected only 135 investment grade senior bullet fixed-coupon bonds for analysis. Zerbib (2017) aimed to estimate the green bond premium and to identify its determinants. He found that the average green bond premium was –8bps against conventional bonds within the whole sample of investment grade bonds, –5bs in US dollar bonds and –2bps in euro bonds. He drew attention to the presence of an excess demand for green bonds in the market. Ehlers and Packer (2017) compared the credit spreads at issuance of a crosssection of 21 green bonds issued between 2014 and 2017 with the credit spreads at issuance of conventional bonds of the same issuers with the closest possible issue date. They showed that green bond issuers on average have borrowed at lower spreads than they have through conventional bonds. Their findings confirmed the results from other recent studies, such as Barclays (2015) and Zerbib (2017). Wulandari et al. (2018) investigated the relationship between the liquidity risk and the yield spread for both green and conventional bonds. The evidence showed a positive relationship between the liquidity risk and the yield spread. However, for green bonds, the impact of liquidity risk on the yield spread has become negligible over time. Barclays (2015) indicated in across-sectional analysis a–17 bps premium as of mid-2015. However, the historical returns of green bonds are like those of conventional bonds.

A Green Bond Premium Does Not Exist Östlund (2015) used a data set of 28 matching pairs of bonds from Bloomberg on 17 March 2015, focusing on the essence of a green bond premium defined as the spread differentials between green bonds and conventional bonds of the same issuer. The analysis tests the null hypothesis that there are no differences between green bonds and conventional bonds. The results showed that indeed there is no evidence of a green bond discount in the overall dataset. However, using the data for the year 2015, the mean difference was statistically significant at the level of 10%, and the yield spread was 0.0758, indicating that conventional bonds have lower yields than green bonds. The only case in which a green bond premium was apparent involved the six green bonds related to the real estate industry.

134

S. Hyun et al.

Petrova (2016) conducted both panel regression analysis and timeseries analysis to evaluate and compare the performance of green bonds and conventional bonds during a sample period covering 2008–2016. After controlling for various possible factors, such as default risk and term premium, and different time-series parameters, no statistically significant difference between green bond and conventional bond yields was documented.

Empirical Analysis Sample Construction Using the Matching Method The matching method is a useful and simple technique as a model-free approach to analyzing the specificity of a financial instrument by matching a pair of instruments with the same characteristics except for the one characteristic of interest from the point of view of its effects. In line with Zerbib (2017), the authors construct a database to evaluate the yield spread between a green bond and an equivalent conventional bond of the same issuer. For this purpose, for each pair, we match a green bond to a conventional bond with identical characteristics except for its liquidity. We, therefore, define the difference between the green bond yield and the equivalent conventional bond yield as the so-called “green bond premium.” We collect conventional bonds with a maturity that is neither 2 years shorter nor 2 years longer than the green bond’s maturity, because the maturities cannot be exactly equal. The difference between the two categories of bonds is their liquidity, which is possible to measure from either the issued amount or the issuance date of the benchmark. A substantial difference in liquidity can considerably affect the yield level; therefore, we must control for it. We restrict the eligible conventional bonds to those with an issued amount of less than four times the issued amount of green bonds and greater than one-quarter of this amount to ensure a fair approximation. We also restrict the range of conventional bonds to those with an issue date that is 6 years earlier or 6 years later than the green bond’s issue date. We examine the entire sample of 990 green bonds complying with the GBPs on 10 November 2017. This set includes bonds of various kinds: supranational, sub-sovereign, and agency, municipal, corporate, financial, and utilities. In the first step in building the equivalent conventional bond, for each green bond, we search for the conventional bond with the closest maturity from the same issuer, with the same characteristics: they all have the same currency, rating, bond structure, seniority, collateral, and coupon type. Among the 158 green bonds stemming from the selection process following Zerbib (2017), we focus on 123 remaining green bonds with an investment grade senior bullet fixed coupon, while we select the 123 equivalent conventional bonds from the same issuers among 121,777 observations. The 123 green bonds of the sample are the ones for which we managed to find

7

Differences Between Green Bonds Versus Conventional Bonds

Figure 1: Issuers by Sector (Unit: $ Million). (Source: Bloomberg)

135 Others, 2,262.8 , 3%

Utilities, 8,755.0 , 11% Financial, 16,065.3 , 20%

Government, 51,564.4 , 66%

Government

Financial

Utilities

Others

an equivalent conventional bond. The issuers are mainly among the most active bond issuers in the market. In the second step, we eliminate the maturity bias by building a data set consisting of pairs of bonds: we assign one conventional bond with the closest characteristics to each green bond. We retrieve the bid and ask yields of the green bonds and the corresponding conventional bonds from Bloomberg on 10 November 2017. Since this study focuses on the investors’ demand and the issuers’ supply of green bonds, we focus on the ask yields of each bond to ensure a more precise analysis.

Descriptive Statistics Considering the green bond issuance by sector in our data set by using the BICS level 1 of the Bloomberg classification, Figure 1 shows that the government and the finance sectors are the major issuers of green bonds. Although corporate (others) activity has grown recently, it is still limited. Table 1 presents the descriptive statistics of all the green bonds and conventional bonds in our data set and definitions of variables are listed in Table A1. All the statistics show no statistically significant differences between the 123 pairs of green bonds and conventional bonds except for the amount issued. For example, while the mean of the issue amount of green bonds is $639 million, the mean of the issue amount of conventional bonds is $1.18 billion. Considering the issue amount by sector, significant variations are observable in the issue amount of the government and the finance sectors. However, statistically significant differences are not apparent in the case of utilities and other sectors in Tables A2, A3, A4 and A5 in the appendix. Statistically significant differences in amount issued are apparent in the case of the US dollar and the euro as seen in Tables A6–A7 in the appendix. The difference in the issue amounts can affect the liquidity of green bonds and conventional bonds. Therefore, it is necessary to consider the impact of the difference between them on the liquidity to calculate the green bond premium.

Source: Authors.

Variables AskYLD (%) AskYLD_M (%) BidYLD (%) BidYLD_M (%) BidAskSP (%) BidAskSP_M (%) TimeToMat (days) TimeToMat_M (days) CPN (%) CPN_M (%) AmtIssued ($) AmtIssued_M ($)

N 123 123 123 123 123 123 123 123 123 123 123 123

Table 1: Descriptive Statistics

Mean 1.30 1.32 1.37 1.38 –0.07 –0.06 1,535 1,506 1.72 1.73 639,410,207 1,180,293,338

Median 0.85 0.89 0.90 0.94 –0.05 –0.05 1,328 1,299 1.63 1.50 500,000,000 816,550,000

Std Dev. 1.72 1.72 1.74 1.73 0.11 0.04 926 965 1.40 1.30 529,038,534 1,331,281,622

Min. –1.22 –0.71 –0.56 –0.50 –1.14 –0.24 18 75 0.00 0.00 27,531,000 23,940,000

Max. 12.60 12.19 13.07 12.42 0.00 0.00 4,944 5,176 8.50 8.00 3,499,500,000 7,353,425,000

$1 billion) CCS funding programs in Australia, Canada, EU, Norway, US, and United Kingdom (UK). Several of these were included in stimulus packages following the global financial crisis. Not all of this announced funding was ultimately expended on CCS projects. In fact, less than $3 billion in public funds was actually invested between 2007 and 2014. These programs have been unable to fulfill their original objectives due to a variety of reasons, including mismatches among the factors such as regulatory

9

Financial Barriers and Strategies for Promoting Carbon Capture and. . .

197

Table 6: Policy Incentives for CCSTs Storage

Integrated project

Methods Storage exploration and development

Capital cost reduction

Capital grants and subsidies Tax credits

Enhanced exploration tax incentive credits Capital support

Tax credits Operation cost support

Feed-in tariff CCS certificate Contact for difference

Risk mitigation

Loan grantees

Public private partnership Liability transfer

Contents Capital grants and subsidies for eligible exploration Eligible exploration activities to be subject to 100% tax deductibility in line with other resource exploitation Exploration activities quality for Enhanced exploration tax incentive Grant/preferred equity position (leveraging government’s cost of capital) allocated competitively Investment tax credits to offset corporate profit. A fixed premium added to the price of each unit of output A fixed payment for every tonne of CO2 stored A payment to (or from) the proponent where the actual CO2 price is higher (or lower) than an agreed strike price Government Guarantee on Concessional loads, e.g., export credit facilities arranged by technology provision Project proponent based on agreed performance and risk parameters Government accepts liability for stored CO2 rehabilitation and agreed monitoring period

CCS carbon capture and storage, CCST carbon capture and storage technologies. Source: von Stechow et al. (2011).

deadlines, sponsor timetables and inadequate support in the operational phase (OECD/IEA 2016). In spite of the challenges experienced in delivering these large capital funding programs, much of the current momentum in large-scale project deployment stems from these commitments. For example, the Quest CCS project in Canada, which commenced operations in 2015, secured funding from the Alberta CCS Fund and the Canadian Clean Energy Fund in 2009. Moreover, the Kemper County IGCC, Petra Nova, and Illinois Industrial CCS projects all secured government funding through the US Clean Coal Power Initiative in 2008, 2009 and 2010 respectively, and all are expected to come online in 2016–2017. These time frames also highlight that there can be a significant lag between government funding commitments and project commissioning.

198

A. Ogihara

Countermeasures to Solve Higher Operating Costs Project experience over the past 20 years has highlighted the importance of addressing higher operating costs for CCS projects. The initial emphasis of many funding programs had been on capital support; however it became increasingly apparent that CCS projects operating in competitive markets would also require assistance to compensate for the ongoing impact on the costs of production. The introduction of operating support measures can, in turn, increase the ability of the project to raise private capital and reduce up-front subsidy requirements. The level and nature of support will be determined by the specific industry and market, and might include direct subsidies tied to production or feed-in tariffs in the power sector. The UK introduced feed-in tariffs, with a contract for difference mechanism, for power generated from plants equipped with CCS. This complemented the capital support on offer through the UK CCS Commercialisation Programme. CO2 storage tax credits have also been introduced in the US to incentivize the injection of CO2 for enhanced oil recovery or dedicated geological storage.

Policy and Regulatory Frameworks for Supporting CCSTs Over the last 2 decades, a wide range of policy and regulatory measures have been adopted by governments in an attempt to facilitate and incentivize CCS projects deployment. The combination of measures has varied depending on national or regional situations but can broadly be considered as falling into the following three categories: (1) Climate-based regulations which may require or encourage CCS projects (2) Targeted policy incentives specifically designed to support CCS projects (3) Regulations on CCS operations, notably to facilitate safe and effective storage of CO2 The nature of the required policy support changes as the technology matures. Efforts to move the technology from research and development and piloting phases through to the early deployment phase—that is, through the so-called “valley of death”—involve increased support, which has proven more challenging for governments and industry. CCS projects are capital-intensive, carry technology and integration risks, and offer limited commercial value for proponents beyond technical learning. Accordingly, the level and complexity of the policy support needs to accelerate CCS projects through the early deployment phase increases by an order of magnitude compared with the research and development stages. Understanding the nature and scope of existing policy support can help highlight where greater governmental support and engagement is required. Climate-Based Regulation at National level: Various climate-based regulations that are more general than CCS-specific have so far proven effective in incentivizing CCS projects in certain specific circumstances.

9

Financial Barriers and Strategies for Promoting Carbon Capture and. . .

199

1) Norway The Norwegian CO2 tax for offshore oil and gas production represents the preliminary case that provided the major impetus for investment in Sleipner and Snøhvit. In the longer term, a carbon price is expected in many jurisdictions to promote shifts to low- and zero-carbon technologies such as CCS. While global carbon markets are expanding, they are unlikely to mature quickly enough and with a sufficiently robust price to support technology investment in CCS projects at the scale and pace required in the near term to achieve ambitious climate targets. 2) Canada In addition, the emissions standards for coal-fired power generation have played important roles in supporting CCS deployment in the early stages. The decision to retrofit Unit 3 at Boundary Dam in Canada was in response to the introduction of strict performance standards for new coal-fired units and units that had reached the end of their useful life. The Canadian federal government also contributed Can$240 million to the project, which was undertaken by SaskPower, a power utility fully owned by the Province of Saskatchewan. 3) United States Similarly, emissions standards in the United States, together with direct financial support, have been key factors behind the two large-scale CCS projects currently under construction. Regional and Global Regime: From a global policy perspective, CCS has always been covered implicitly by the UNFCCC process and the Kyoto Protocol. It has received growing recognition and attention under these frameworks. The IPCC 2005 SRCCS helped focus attention on CCS as a mitigation technology in the global climate negotiations. CCS received further explicit recognition in 2011, when it was included in the Clean Development Mechanism (CDM). While the CDM has not provided direct incentives to CCS projects, it is widely anticipated that any future mechanism developed under UNFCCC will follow these principles (Dixon et al. 2015). Targeted Policy Incentives: Programs that specifically target CCSTs have been an important part of the policy landscape to promote the implementation of CCSTs. Various CCS-targeted policy incentive mechanisms have been considered or deployed by different jurisdictions (see Table 6). Regulatory Framework on CCS Operations, Notably to Facilitate Safe and Effective CO2 Storage: Regulatory frameworks for CCS will build upon the existing laws and be governed by existing institutions, but current regulatory systems are not yet suited to addressing some of the special issues that arise in CCS, such as the need for thorough site characterization, careful monitoring and long-term stewardship. The current status of CCS related regulation varies significantly across the world.

200

A. Ogihara

Diverse and Future Challenges for Enhancing Carbon Capture and Storage Technologies (CCSTs) This section highlights the current status and future potential of CCSTs. CCS, including in combination with bioenergy, is expected to contribute considerably to CO2 reduction, especially in the energy sector and the thermal power generation and industrial sectors more specifically (OECD/IEA 2012). On the other hand, in the past 10 years CCS technologies in the thermal power generation and industrial sectors have failed to achieve sufficient progress even in the demonstration stage.

Key Barriers for Enhancing CCSTs In order that technologies can spread, they should be mature and robust. In addition, improvements to the laws and regulations that support technological development (legal requirements for CCS), economic conditions (such as commercialization, low-cost and high-cost effect) and social understanding or acceptancy are very important. Legal Aspect: Although CCS is internationally deemed an indispensable technology for reducing CO2 emissions, its diffusion has progressed slowly (see Table 7). Realistic projects that allow technologies to mature are rarely implemented, and a reliable pathway remains to be seen. In order to promote CCSTs, the basic requirement would be legal regulations (legal requirements to be satisfied by CCS) that support technology, economic relevance (commercialization, low-cost and high-cost effect) and social acceptability. In many countries, regulations for introducing CCSTs have been developed. It is inevitable that CCS projects are costly and requires substantial investment. CCS projects were also forced to cease due to social opposition. Legal regulations can be classified into the three major types: 1) Introduction of legal or economic promotion measures for implementation of CCS projects i) Plant capable of adding CCS function ii) Capture Ready Plant iii) Transport Ready Plant iv) Storage Ready Plant 2) Setting CO2 emission standards that directly suppress CO2 emissions 3) Safe and environmentally friendly implementation of CCS projects Economic Aspects: According to the Global CCS Institute, comparative analyses to estimate the CO2 removal cost of various power generation technologies and the relative costs of various power generation technologies, including coal-fired power plants with CCS and natural gas power generation, have been conducted. The costs are as follows:

9

Financial Barriers and Strategies for Promoting Carbon Capture and. . .

201

Table 7: Representative Laws and Regulations for Enhancing Finance European Union Directive on the geological storage of CO2 (2009) United Kingdom Energy Act 2008 Electricity Act Overarching National Policy Statement (EN-1) National Policy Statement for Fossil Fuel Electricity Generation Infrastructure (EN-2) Electricity Market Reform United States Proposed New Source Performance Standards for Coal Fired EGUs (CAA) Underground Injection Control (UIC) Class VI Program for Carbon Dioxide (CO2) Geologic Sequestration (GS) Wells (SDWA) Hazardous Waste Management System: Conditional Exclusion for Carbon Dioxide (CO2) Streams in Geologic Sequestration Activities (Resource Conservation and Recovery Act:RCRA) Canada Federal Government Reduction of CO2 Emissions from Coal-fired Generation of Electricity Regulations (Canadian Environmental Protection Act) Alberta State The Carbon Capture and Storage Statutes Amendment Act Carbon Sequestration Tenure Regulation Japan Act on Prevention of Marine Pollution and Maritime Disaster Source: GCCSI (2013).

1) Coal of thermal power generation with CCS: US$68 to US$23 per ton of CO2 2) Gas combustion thermal power generation with CCS: US$108 to US$224 per ton of CO2 3) Solar power generation (PV): US$ 184 to US$307 per ton of CO2 4) Solar thermal power generation: US$ 219 to US$273 per ton of CO2 As can be seen from the economic analysis, the cost of PV and the cost of solar thermal power generation have exceeded that of coal with a CCS or gas combustion power generation system. There is the possibility that thermal power generation with CCS may compete with the power generation cost by renewable energy (solar power or solar thermal power generation). However, it is necessary to demonstrate these perspectives and possibilities through actual projects. At present, CCS projects are expensive and require considerable investment. It is evident that demonstration or commercialization is not feasible without any support by public funds. Successful project implementation requires not only strong sponsors but also their consistent and strong financial support. Indeed, the Boundary Dam project and Kemper County project are the first CCS projects in the world, implemented by large public funding support. The technology lacks a clear investment signal that would enable developers to move forward in a sure-footed way. Banks are not yet prepared to consider the space “real” (in the same way as renewables). Therefore, in order to implement CCS projects, we must find such public funding sources in advance.

202

A. Ogihara

Social Aspects: The text analysis conducted by Corry and Riesch (2012) on various assertions and discourses on CCS projects of environmental NGOs in Europe indicates the following two points. Different interpretations (deliberately intentionally) are made within the range of uncertainty depending on the difference, and this is the factor that determines approval or disapproval of the implementation of CCS projects: 1) The existence of a knowledge gap: uncertainty including in terms of scientific and technical knowledge on climate change problems and the effectiveness of CCS technologies. 2) Diversity of problem recognition: each stakeholder has different beliefs regarding environmental problems and economic and social issues. Based on the combination of the two elements, each stakeholder should come to a different interpretation (at a given time) within the range of uncertainty according to the difference in position. Moreover, this also constitutes a factor that distinguishes approval/disapproval in implementing CCS projects. Environmental nongovernment organizations (NGOs) with information dissemination capabilities regarding environmental, economic, and social issues and that have a certain influence on public problem recognition present different perspectives. It should be considered that a situation such as being different from those of CCS projects is an important point to be acknowledged in this study, considering public perceptions of CCS projects and efforts towards forming a broad consensus. Furthermore, since the 2000s and due to social rebounding (opposition to the public), some projects were delayed or ceased, such as the projects in Barendrecht (Netherlands), Greenville (US), and Shwarzepumpe (Germany). It is difficult to introduce CCS projects, which is externally uneconomical and specialized, in order to cope with the global warming problem by market principle alone. Economic incentives such as subsidies and taxation systems, emissions trading, and regulations should be established. In order to promote CCS projects, it is also necessary to investigate storage capacity, improvements in the legal system, and the promotion of citizens’ understanding.

Lessons Learnt from Foregoing and Ongoing CCS Projects At present, four large commercial-scale carbon storage or Enhanced Oil Recovery (EOR) projects at as Sleipner (North Sea), Snøhvit (Barents Sea), In-Salah (Algeria), and Weyburn (Canada) are being deployed. These projects are related to resource development. Indeed, no CCS project on CO2 originating from thermal power plants currently exists, but it is expected that there will soon be two projects: the Boundary Dam project (lignite combustion, Canada) and Kemper County project (lignite IGCC, US). The EU launched its flagship program on CCS in 2007 and attempted to promote CCS projects, but no projects repeatedly proceeded to the demonstration stage.

9

Financial Barriers and Strategies for Promoting Carbon Capture and. . .

203

Currently, four projects are in the final stage before the investment decision. Those projects include the Don Valley Power Project, Peterhead Gas CCS Project, White Rose CCS Project, and the ROAD Project. The ROAD Project is the Dutch project whereas the other three are British. Even outside the EU, the number of CCS projects is on the increase (e.g., US, Canada, and the PRC). Japan is currently developing a unique technology with distributed storage systems. The construction cost of this system is cheaper than the conventional and concentrated version. The demonstration test plant at Tomakomai (in Japan) will be finalized in 2 years. More than 10 projects worldwide are projected to reach the final decision stage in investment next year. Therefore, existing policies and new initiatives taken in the next 12–18 months will shape the portfolio of CCS projects up to 2020 to a considerable extent. Early financial and policy boosts are important to shift the “potential portfolio” of such planned projects to the “actual portfolio” of projects that are in operation by 2020. Trends of Mobilization and Distribution of CCSTs: The OECD/IEA (2013) has suggested the following actions to mobilize and distribute CCSTs: 1) Some issues to be clarified by the examination so far: i. A lack of stakeholder understanding (including the public) regarding CCS causes delays and difficulties in deployment. ii. Governments should not only establish an incentive and regulatory framework but also promote cooperation between governments. iii. CCS needs to be applied not only for the electric power business but also for industries such as steelmaking and cement. 2) Important actions in the future include the following: i. Introduction of financial support mechanisms for demonstration and early development of CCS. ii. Exploration and characterization of storage sites of CCS. iii. Policy development and implementation aiming at promoting development. iv. Institutional development including domestic laws and regulations that effectively inquire about CCS-Ready capability for new thermal power plants. v. Understanding the importance of CCST development and diffusion by the general public and stakeholders. It is essential to implement these initiatives in the near future. In order to promote CCS technologies, it is necessary to establish related laws and regulations (legal requirements to be satisfied by CCS) that support technologies, to have economic incentives (commercialization, low-cost and high-cost effect), and to have social understanding or acceptability. In major countries, regulations on CCS are being developed. Concerning the economic efficiency aspect, most of the technologies are currently expensive and require considerable investment. Moreover, one CCS project was forced to stop due to public dissatisfaction.

204

A. Ogihara

In order to disseminate CCS projects, policies for legal development and financial support are being introduced in each country. The regulatory efforts include the four areas below: • “CCS Ready” (Directive 2009/31/EC EU; Energy Act 2008 UK) for avoiding or suppressing “carbon lock-in” by establishing a new or operating an existing fossil fuel combustion plant in future. • Setting emission standards for CO2 that directly reduce CO2 emissions (EN-1, EN-2 UK; Standards of Performance for GHGs Emissions for New Stationary Sources: Electric Utility Generating Units US; SOR/2012-167 Canada). • Safe and environmentally friendly implementation of CCS projects (Directive 2009/31/EC EU; Class VI rule US). • Other financial support such as FIT (EU DIRECTIVE 2009/29/EC EU; EMR UK). Social Acceptability: Large-scale CCS projects such as Sleipner (CO2 storage), InSalah (CO2 storage), and Weyburn-Midale (CO2-EOR) have been promoted without social rebound. However, some recent CCS projects have experienced delays due to social rebound, with a few, including Barendrecht (Netherlands), Greenville (Ohio, US), and Shwarzepumpe (Germany), forced to stop. 1) General success factors in the participatory process include the following: i. Sharing of vision ii. Core communication function iii. Consideration of social significance iv. Early interest relationship v. Focused goals of the project objective or framework vi. Flexible response tactics to accommodate concerns of stakeholders vii. Fostering education and experience regarding CCS projects 2) It is important for the stakeholders to be interested in social acceptability and to participate in the communication process. Stakeholders tend to be concerned about the following issues: i. Project- or regional-level discussions based on environmental, social, and health impacts and safety. ii. The role of climate change and CCS projects in global level discussion. Positioning at least CCS projects for stakeholders (global, local new value creation). 3) Communication of real projects and responses to the community participation process require a diverse approach. Taking into account the situation that different concerned people are interested in site-specific issues derived from CCS projects, many of the cases utilize case-by-case approaches. Enhancing the Advantages Derived from Distributed CCSTs: Two types of CCSTs exist. Distributed CO2 geological storage is the method used to dissolve CO2 in small shallow sources and storing them in a shallow stratum (depth of

9

Financial Barriers and Strategies for Promoting Carbon Capture and. . . Sink

Fuel

Power Market

Policy

Options

205

Scale

Unscreened

Possible

Possibilities

Projects

Fundamentals for Feasibility Study

Value uplifts

CCST = carbon capture and storage technologies Source: Author

Figure 2: Key Value Chain Components Related to Decision-Making for Financing CCSTs Projects. (Source: Author)

300–500 meters), with advantages in terms of cost compared to large-scale concentrated storage. In comparing centralized CCSTs (conventional) and distributed CCSTs, the former have restrictions on geological conditions and scale as shown below. 1) CO2 storage is limited to supercritical and cap locking. 2) The scale of CCS is large and the amount of CO2 storage is limited from several hundred thousand tons to one million tons. However, there is no common language between these actions. Furthermore, diverse risks and rewards are expected from those actions as shown in Figure 2. The CCSTs also lack a clear investment signal that would enable developers to move forward in a sure-footed way. Investment Trends Towards Future CCS Projects: CCS projects are becoming increasingly common in order to accommodate longer-term climate change policies and/or future prospective carbon offset markets, as well as to anticipate these. While such trends in CCS projects indicate a bright future for climate change policies, it is difficult to develop business cases, especially if the project is unable to use EOR or any other revenue sources (IPCC 2005, 2014). In comparing the cost of various power generation technologies, there exists the possibility that conventional power generation can compete with power generation cost by renewable energy (solar power or solar thermal power generation). However, it is necessary to demonstrate these perspectives through realistic projects in particular. At present, CCS projects are expensive and require considerable investment. The technology lacks a clear investment signal that would enable developers to advance in a sure-footed way. Without any support derived from public funds, demonstration or commercialization is not feasible. Therefore, project implementation requires strong sponsors and a consistent financial support mechanism during the project

206

A. Ogihara

period. The large scale of CCS projects such as transboundary dam projects and the Kemper County project utilized a large amount of public support. Minimizing Technical Barriers for Project Development and Implementation: One of the characteristics of the storage site is that it takes a long time (from 5 to 10 years) from the start to the completion of the project. Many of the projects that are yet to commence detailed storage assessment at the project sites face challenges in operating before 2020. Strategies for Fund-Raising: From the above, in order to raise funds to help develop and promote CCS projects, it is essential to solve institutional and technical problems through the implementation of research and development and demonstration projects. In addition, it is also important that: (i) the government creates “funds” for CCS project development, and that (ii) the government grants “guarantees” to facilitate the entry of private funds.

Conclusion: Financing Strategies for the Development of Carbon Capture and Storage Technologies (CCSTs) Ultimately, the international community should recognize that the cost will be increased as the development and spread of CCSTs are delayed. A clean investment equivalent to $1 avoided in terms of power by 2020 will increase up to an additional cost of $4.30 after 2020. As the lights are brought down and the generators continue to burn coal and gas, the amount of CO2 released into the atmosphere and accumulated (the emission amount accumulated each year) continues to increase. If we do our utmost to fight the issue of climate change, we should recognize that over the next few decades CCSTs will play an important role in limiting the increase of CO2 emissions derived from our economic activities. Despite it being internationally recognized that CCSTs are indispensable technologies for reducing CO2 emissions, realistic projects that allow technology to mature are scarcely implemented at present. In order to commercialize and disseminate CCSTs, numerous problems emerge, such as (i) improvement of regulations, (ii) improvement of economic efficiency by cost revolution, and (iii) promotion of social acceptability of CCSTs. The following are the key issues regarding large-scale CCSTs, summarized based on the preliminary analysis in the previous sections.

Large-Scale Demonstration Numerous projects are being planned globally, and among them, large-scale CCSTs are recommended in order to use economy of scale and to render them

9

Financial Barriers and Strategies for Promoting Carbon Capture and. . .

207

more financially feasible for private sector investment. A large number of fullscale demonstration plants are scheduled for operation soon. However, infrastructure development for transportation and storage is indispensable. In addition to thermal power generation, it is also necessary to apply it to general industries.

Unclear Competitiveness Since project costs of CCS are still unclear, it is difficult to discuss the competitiveness with other technologies. Therefore we still have to wait for the progress.

Appropriate and Effective Institutional Schemes The institutional scheme for financing CCSTs is progressing gradually in major countries such as the US, Canada and in the EU. If we cannot develop supporting regulations related to CCS, we will face difficulties in realizing CCS. It is necessary to promote appropriate and effective policies and legislation for CO2 accumulation in particular.

Community Participation and Case-By-Case Approach CCSTs are fragmented, with diverse participants from different backgrounds. There is currently no common language among these key players. Different expectations in terms of risks and rewards exist. Since the latter half of 2000s, some projects have been delayed or cancelled, largely due to social dissatisfaction. In response, appropriate processes such as community participation and a case-by-case approach should be taken that consider site-specific issues.

Diverse Funding Schemes CCSTs generally lack a clear investment signal that would enable developers to move forward in a sure-footed way. Possible and probable funding/financing approaches of Clean Coal Technologies (CCTs) and CCSTs may include the following schemes: 1) 2) 3) 4)

Self-financing by project developers Project loans Public loans International funding scheme (e.g., Green Climate Fund)

208

A. Ogihara

Many on-going CCST projects have utilized self-financing and public funding for project development as indicated in Figure 2 and Table 7. Therefore, a consistent financial support mechanism is crucial in order to maintain the long-term operation of CCSTs. Consequently, fund-raising through private investment will be indispensable for future business development with substantial CO2 reduction. In order to attract private funds for low-carbon projects, it is important to increase capital through investment. The case of the UK Government would be a good example for developing funds, based on collaboration between public and private entities (see Box 3). Box 3: UK CCS Commercialisation Programme

The UK government launched the CCS Commercialisation Programme competition in April 2012, and allocated £1bn in support. This, combined with incentives under the Electricity Market Reform, forms the package of funding available for up to four commercial-scale CCS projects to be in operation by 2016–2020. According to the Department of Energy and Climate Change’s announcement on 30 October 2012, four of the eight bidders have been shortlisted for the next phase of the competition. Source: ZERO CO2 (2017) Source: Carbon Capture and Storage Association http://www.ccsassociation.org/why-ccs/policy-and-regulation-for-ccs/

Ultimately, the international community should recognize that expenses for CO2 reduction will be increased as long as the dissemination of CCSTs is delayed. Taking into account the situation where we rely on keeping burning coal and gas and lighting the lamps, the amount of carbon dioxide stored in the atmosphere (the amount of emissions accumulated each year) continues to be increased. If we do our utmost to fight climate change, we should recognize that over the next few decades, CCSTs will come to play an essential role in achieving the 2 Degree Scenario Goal Presented at COP21. In order to utilize the CCSTs to this end, public funding schemes like the Green Climate Fund (GCF) (see https://www.greenclimate.fund/home) and the Climate Fund are indispensable and should be enriched. The GCF is an international funding scheme established under the framework of the UNFCCC in order to assist developing countries in adaptation and mitigation practices to counter climate change. The GCF is a financial mechanism under the UNFCCC that helps fund climate finance investment in low-emission, climate-resilient development through mitigation and adaptation projects and programs in developing countries. It is intended that the GCF could be the centerpiece of efforts to raise the GCF under the UNFCCC, and raise $100 billion a year by 2020. The GCF will provide a good opportunity to increase investment and private funds financing, which will contribute to the realization of low-carbon projects.

9

Financial Barriers and Strategies for Promoting Carbon Capture and. . .

Carbon Taxes

209

Private financial institutions

Investment

 Wind power generation

Climate Fund

Investment

 Hydroelectric power generation

Business entities

Investment

 Carbon Capture Storage

Source: Author

Figure 3: Funding Schemes in Japan. (Source: Author)

Implementation of the low-carbon projects will contribute to regional revitalization and in the process lead to employment creation and industrial development in the region. As an example of a Domestic Climate Fund, a “regional low carbon investment promotion fund project” was developed under the jurisdiction of the Ministry of the Environment, Japan in order to support businesses and others promoting low carbon projects in the region in the form of investment (see Figure 3).

References Asian Development Bank (ADB) (2013a) Prospects for carbon capture and storage in Southeast Asia. Asian Development Bank, Manila Asian Development Bank (ADB) (2013b) Primer energy statistics in Asia and the Pacific (1990–2009) and energy outlook for Asia and the Pacific. Asian Development Bank, Manila Bloomberg (2017) NEF private and public investment for large-scale CCS projects (2005–2014). https://about.bnef.com/new-energy-outlook/. Accessed 10 Dec 2017 Canon Institute for Global Studies (2015). http://www.canon-igs.org/research_papers/energy/ 20150218_2962.html. Accessed 16 Dec 2017 Climate Action Tracker (2017). https://climateactiontracker.org/. Accessed 10 Dec 2017 Climate Focus (2015) The Paris agreement summary. Climate focus client brief on the Paris agreement III Briefing Note, Dec 2015 Clinton Climate Initiative (2012) Clinton Foundation 2012: annual report. Clinton Foundation, 2013 Corry O, Riesch H (2012) Beyond for or against, environmental NGO–evaluations of carbon capture and storage as a climate change solution. In: Markusson N, Shackley S, Evar B (eds) The social dynamics of carbon capture and storage. Earthscan, London Dixon T, McCoy S, Sean T, Havercroft I (2015) Legal and regulatory developments on CCS. Int J Greenhouse Gas Control 40:431–448 Dulac J (2015) Energy technology perspectives: pathways, for low carbon transport. IEA, Paris. http:// www.its.leeds.ac.uk/fileadmin/documents/seminars/Dulac_J_ITS_Seminar_07072015.pdf Global Carbon Capture and Storage Institute (GCCSI) (2011) The costs of CCS and other lowcarbon technologies. Issues brief 2011, No. 2 Global Carbon Capture and Storage Institute (GCCSI) (2013) Making the case for funding carbon capture and storage in developing countries, 2013, March

210

A. Ogihara

Intergovernmental Panel on Climate Change (IPCC) (2005) Carbon capture and storage. https:// www.ipcc.ch/report/srccs/. Accessed 16 Dec 2017 Intergovernmental Panel on Climate Change (IPCC) (2014) Climate change 2014: synthesis report summary for policymakers. Contribution of working groups I, II and III to the fifth assessment report of the Intergovernmental Panel on Climate Change. IPCC, Geneva Intergovernmental Panel on Climate Change (IPCC) WG3 (2005) Special report on carbon dioxide capture and storage. https://www.ipcc.ch/report/carbon-dioxide-capture-and-storage/. Accessed 16 Dec 2017 Nakano J (2015) Coal in the mix: challenges and opportunities for the future use of coal, 5 January. Center for Strategic and International Studies. https://www.csis.org/analysis/coal-mix-chal lenges-and-opportunities-future-use-coal. Accessed 10 Dec 2017 New Energy and Industrial Technology Development Organization (NEDO) (2008) Current situation and future of CO2 capture and storage (CCS). Overseas report No.1020, 9 April (in Japanese) OECD/IEA (2012) Energy technology perspectives 2012: pathways to a clean energy system. OECD/IEA, Paris OECD/IEA (2013) Redrawing the energy-climate map. OECD/IEA, Paris. https://www.iea.org/ publications/freepublications/publication/WEO_Special_Report_2013_Redrawing_the_Energy_ Climate_Map.pdf OECD/IEA (2015a) CO2 emissions from fuel combustion 2015. OECD/IEA, Paris OECD/IEA (2015b) Energy technology perspectives 2015: mobilising innovation to accelerate climate action. OECD/IEA, Paris OECD/IEA (2016) Secure sustainable together. OECD/IEA, Paris Taghizadeh-Hesary F, Rasoulinezhad E, Kobayashi Y (2016) Oil price fluctuations and oil consuming sectors: an empirical analysis of Japan. Econ Pol Energy Environ 2(19):33–35. https:// doi.org/10.3280/EFE2016-002003 von Stechow C, Watson J, Praetorius B (2011) Policy incentives for carbon capture and storage technologies in Europe: a qualitative multi-criteria analysis. Glob Environ Chang 21 (2):346–357 Yoshino N, Taghizadeh-Hesary F (2018) Alternatives to private finance: role of fiscal policy reforms and energy taxation in development of renewable energy projects. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, Singapore, pp 335–358 ZERO CO2 No (2017) UK CCS commercialisation programme http://www.zeroco2.no/projects/ countries/united-kingdom. Accessed 16 Dec 2017

Part VII Banks and Non-bank Financial Institutions

Stimulating Non-bank Financial Institutions’ Participation in Green Investments

10

Gianfranco Gianfrate and Gianni Lorenzato

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Definition and Relevance of Non-bank Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Climate Risks Affecting Non-bank Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increasing Non-bank Financial Institutions’ Focus on Green Investment Themes . . . . . . . . . . . . Avenues for Non-bank Financial Institutions’ Participation in Green Investments . . . . . . . . . . . Negative Screening . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Active Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sustainability Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Asset Classes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Policy Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

214 215 216 218 221 221 223 224 225 226 232 235

Abstract

This chapter analyzes the approaches adopted by institutional investors to manage climate risk in their portfolios and proposes policies to increase climate awareness in this large segment of the capital markets. Because of their size and their role as a conduit of savers’ climate concerns to the capital markets, most non-bank financial institutions are ideally positioned to steer corporate capital allocation towards more sustainable uses. Over the past decades, an increasing number of institutional investors have adopted strategies to mitigate climate exposure. These include negative screening, positive screening, active ownership, sustainability ratings, and hedging of climate risks. These strategies reflect specific fund G. Gianfrate (*) Harvard University, Cambridge, MA, USA e-mail: [email protected] G. Lorenzato Independent Development Advisor, New York, NY, USA e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_23

213

214

G. Gianfrate and G. Lorenzato

manager mandates and the recognition that climate risks can have a tangible impact on financial assets’ valuations and, as a result, institutional fund performance. We review the evidence from the adoption of these strategies, in both advanced and developing capital markets. We then analyze the pros and cons of each strategy in promoting more sustainable climate practices and identify best practices. We conclude with policy recommendations for capital markets regulators to incentivize the adoption of sustainable practices among institutional investors. Keywords

Climate risks · Asset management · Institutional investor · Carbon pricing · Sustainability JEL Classification

G11 · G21 · G23 · G24 · G28

Introduction As climatic change and global warming are addressed by tougher regulation, emerging technologies, and shifts in consumer behavior, global investors are increasingly treating climate risks as a key aspect when pricing financial assets and deciding the allocation of their investment portfolios. So far, the focus of investors has been on whether policies on carbon emissions will strand the assets of investee fossil-fuel companies. For example, the Norwegian sovereign wealth fund—one of the largest institutional investors globally— announced in November 2017 the decision to drop its investments in oil and gas stocks. However, new estimates are shedding light on the broader indirect impact of climate change on the value of assets held by banks and financial companies. Dietz et al. (2016) show how a leading integrated assessment model can be used to quantify expected impact of climate change on the present market value of global financial assets. They find that the expected “climate value at risk” of global financial assets today is 1.8% along a business-as-usual emissions path, which amounts to US$2.5 trillion—however, for the 99th percentile, the value estimate is US$24.2 trillion. Importantly, Battiston et al. (2017) find that while direct exposures to the fossil fuel sector are small (3%–12%), the combined exposures to climate-policy relevant sectors are large (40%–54%), heterogeneous, and amplified by large indirect exposures via financial counterparties. In other words, substantial climatechange-related risks are borne by the global financial system, and those risks are similar in magnitude to the ones that ignited the financial crisis. Regulators’ growing concern about climatic change as a source of risk for the global financial system is reflected in the creation of the Task Force on Climaterelated Financial Disclosures decided by the Financial Stability Board. The Task Force has recommended global organizations to enhance their financial disclosures

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

215

related to the potential effects of climate change. However, enhanced transparency is only the first step. As climate risks do appear more pervasive and material for the financial system than previously thought, the compelling issue for banks as well as for non-bank financial institutions (NBFIs) is how to quantify, manage, and possibly hedge off such risks. If investors do not want to retain carbon risk—by covering the potential losses out of the capital invested—what are the possible strategies? This chapter discusses to what extent NBFIs are exposed to climate change risks and how they can manage their exposure by “greening” their investments’ portfolios. After having defined NBFIs, we discuss how to identify climate change risks and what the possible approaches to manage them are. We finally present some policy recommendations to stimulate further NBFIs’ participation in green investments.

Definition and Relevance of Non-bank Financial Institutions A non-bank financial institution (NBFI) is a financial institution that does not have a full banking license and is not supervised by a banking regulator. The definition is very broad and ranges from insurance companies and asset managers to brokers, market-makers, and financial advisors. This chapter focuses on NBFIs that invest capital on behalf of clients with the objective to maximize risk-adjusted returns, or what is commonly known as the asset management industry. This, in turn, comprises several constituents, categorized on the basis of their main source of capital or investment strategy. The most prominent and largest asset managers include pension funds managing savers’ capital, insurance companies investing insurance premium proceeds, endowment funds managing capital donated to universities and other institutions, sovereign wealth funds managing the proceeds derived from a country’s natural resources or other sources, and alternative asset managers such as private equity, venture capital (VC), and hedge funds. Depending on the return and liquidity requirements of their clients, NBFIs invest across the entire securities spectrum. The largest allocations are to bonds, both sovereign and corporate, and stocks listed and traded on exchanges worldwide. The liquidity of such securities allows NBFIs to alter portfolio composition over time, reflecting changed macroeconomic, sectoral, and market circumstances. A smaller portion of the NBFI portfolio can be allocated to illiquid investments, compatibly with the contractual arrangement between the NBFI and its clients. Private equity and venture capital funds that require clients to commit capital for, usually, 10 years, are a prominent example of such illiquid allocations; their most prominent clients are other NBFIs (pension, insurance, sovereign wealth funds, endowments) together with wealthy individuals investing directly. Private equity and VC funds require long-term capital commitments because they invest in unlisted securities—usually equity—issued by private companies and hold on to their investments for several years, until the portfolio company can be sold to a competitor, another private equity fund, or the stock market through an initial public offering. The pool of capital managed by NBFIs is substantial, which makes them a potentially large source of capital for green investments. Total capital managed

216

G. Gianfrate and G. Lorenzato

globally by the asset and wealth management industry (assets under management, or AuM) reached US$85 trillion in 2016, of which US$47 trillion was in North America, US$22 trillion was in Europe, and US$12 trillion was in Asia and the Pacific. Future growth will be driven by population growth and aging, and the related increase in global savings (PwC 2017). Pension fund AuM globally reached an all-time high of US$38 trillion in OECD countries in 2016; the US is the largest pension fund market in the world, with US$25 trillion managed, followed by Canada, the UK, Australia, Japan, and several other western European countries (OECD 2017a). Insurance companies and sovereign wealth funds managed US$29 trillion and US$7 trillion in 2016, respectively (PwC 2017). Private equity AuM reached US$2.5 trillion in June 2016, also an all-time high (Preqin 2017a). The common denominator of all asset managers is the fiduciary duty to maximize risk-adjusted returns for their clients. This is true for any NBFI investment, including in green sectors. NBFIs are not a suitable source of “concessional capital”—willing to accept sub-market returns as a trade-off for the achievement of policy objectives. The only possible exception is some sovereign wealth funds with a hybrid mandate, which includes policy goals, although it should be noted that some of the largest sovereign wealth funds operate on a purely commercial basis (e.g. the Norwegian and most Gulf countries’ funds).

Climate Risks Affecting Non-bank Financial Institutions Climate change is a problem calling for coordination across countries, the resolution of which would involve the establishment of sufficiently high costs of emitting CO2 throughout most of the world through taxes or quotas. Without sufficiently high carbon prices the path to lower emissions will be both more difficult and less effective. In fact, existing carbon markets are incomplete and subject to market failure, which reflects mostly political shortcomings. In particular, there exists a lack of relevant long-term price signals for companies and investors, and where markets do exist, the current prices in most cases are far below the levels needed for a path towards sustainable climate targets. Nevertheless, especially after the United Nations Climate Change Conference (COP21) agreement more decisive actions seem likely to be taken by various governments around the world. In these circumstances, it should not be a surprise that the phrase “put a price on carbon” has become increasingly popular as the debate about how to address climate change quickly moves from theory to action. From a practical point of view, there are several possible ways to price carbon, and they all tend to lead to the same result. The various possible approaches try to quantify and capture the external costs of carbon emissions—costs that society pays in other forms, such as droughts, heat waves, agricultural damages, health care—and tie them to their sources just through a price on carbon. The objective of carbon pricing is to shift the social costs of damage back to those who are responsible for them (also known as the polluter pays principle), and who can actually curb them. In this way, polluters are ultimately left with the decision on

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

217

whether to discontinue their polluting operations, to reduce emissions (e.g. by adopting cleaner technologies), or to continue to pollute and pay for it. Therefore, the price of carbon provides an economic signal to polluters who can decide for themselves how to respond. In this way, the global and local environmental goals are expected to be achieved in a flexible and efficient way. The pricing of carbon also has the advantage of stimulating technology and operational innovation, fostering the transition of the economy toward a low-carbon configuration. There are two main approaches for pricing carbon: carbon taxes and emission trading systems. The former consists of defining a tax rate on greenhouse gas emissions or—more frequently—on the carbon content of fossil fuels. Following this approach, the overall emission reduction associated with the carbon tax is not predefined (but it can be estimated), while the carbon price is. With the latter approach (also known as the cap-and-trade system), the objective is to cap the total level of greenhouse gas emissions. The firms who perform better than expected in reducing the emissions can sell their surplus allowances to the larger emitters. In this way, the firms that are more effective in reducing the emissions get rewarded, while the least effective ones get penalized. This is a market mechanism where the interplay between supply and demand for emissions allowances is reflected in a market price for greenhouse gas emissions. The caps ensure that the required emissions reductions will progressively take place by keeping all the emitters within the boundaries of the pre-allocated carbon budget. The choice between carbon taxes and emission trading systems (or the coexistence of the two) depends on national policy makers and economic circumstances. According to recent estimates (World Bank 2017), as of 2016, 40 countries have a carbon pricing system in place, and that number is expected to increase significantly over next few years following the climate change agreement reached in Paris in 2015. From the current systems of carbon prices in place, carbon price risk emerges as a new form of political risk for both companies and investors. Such risk is related to the probability of the emergence of future international climate agreements and of national policies. The timing and extent of carbon-related policies will dramatically determine when and which real and financial assets will be affected. The risk is not merely political but technological as well as there is uncertainty about possible future technologies which might affect the speed and scope of the transition towards a low-carbon economy. This aspect further influences an investor’s ability to form long-term expectations about assets to be invested in. In this framework, a trend towards comprehensive climate legislation and technological progress towards cheaper renewables and clean technologies are emerging robustly across the globe. These developments already affect the relative prices of fossil and non-fossil fuel sources, thus creating stranded assets. In all, the growing evidence of the increasing physical impacts of climate change is making the current lack of adequate response more and more unsustainable and therefore forces governments to take decisive actions. As a consequence, investors and financial regulators are debating on whether the implementation of climate policies to meet the COP21 agreement target of limiting global temperature increase to 1.5 C will generate systemic risks or, instead,

218 Figure 1: The Components of Climate Risk. (Reproduced with permission from Gianfrate (2018))

G. Gianfrate and G. Lorenzato

Climate risk Regulatory

Regulatory Systematic Pre-COP21

Post COP21

opportunities for low-carbon investments. Therefore, assessing the impact of climate risks and climate policies on the financial system is easily ranked among the most urgent and prominent societal issues (Battiston et al. 2017). From a purely financial point of view, the question becomes whether climate risks are diversifiable or not. In other words, using portfolio theory jargon, climate risk can be broken down into two components that together make up a portfolio’s total climate risk exposure: systematic risk and unsystematic (idiosyncratic) risk. Systematic risk is associated with macroeconomic concerns. Climate change (and the policies to combat its impacts) will create systematic risk across the entire economy, affecting energy prices, national income, and all the industries regardless of their direct exposure to carbon policies. On the other hand, unsystematic climate risk is the component of investment risk specifically attached to an individual security. This component of climate risk is assumed to be potentially diversifiable away. In the framework of climate change, there is a systematic risk related to natural disastrous events and erosion of the living standards on the planet, which in turn can provoke instability in societies and economies. The unsystematic risks mostly refers to the regulatory risks associated with the implementation of policies (i.e., carbon tax, cap-and-trade systems, new regulations against carbon emissions) that could affect especially the companies which have a relevant carbon footprint. This latter component of risk is assumed to be increased following the COP21 agreement (see Figure 1).

Increasing Non-bank Financial Institutions’ Focus on Green Investment Themes NBFIs are increasingly more focused on green investment themes for several reasons. We discuss these reasons in the sections below. The growth of “responsible” assets globally is illustrated in Figure 2.

Apr-06

Apr-08

Apr-09

Apr-10

Assets under management (US$ trillion)

Apr-07

Apr-12

Apr-13

AO AUM ($ US trillion)

Apr-11

Apr-15 Number of AOs

Apr-14

Apr-17

Apr-18 Number of signatories

Apr-16

0

500

1,000

1,500

2,000

2,500

Nº signatories

Figure 2: The Growth of “Responsible” Assets Under Management Globally. (Reproduced with permission from the United Nations-sponsored Principles for Responsible Investment, www.unpri.org/about-the-pri)

0

10

20

30

40

50

60

70

80

90

Assets under management (US$ trillion)

10 Stimulating Non-bank Financial Institutions’ Participation in. . . 219

220

G. Gianfrate and G. Lorenzato

Impact on investment risks and returns. NBFIs increasingly recognize that the generation of long-term, sustainable financial returns depends on stable, wellfunctioning, and well-governed social, environmental, and economic systems. Public and private pension schemes, insurance companies, sovereign wealth funds, mutual funds, and other institutional asset managers have a long-term investment horizon. For them, the reduction of medium to long-term risks such as climate change is of paramount concern. Some NBFIs also have substantial direct and indirect exposure to sectors that are particularly exposed to climate risks, such as infrastructure and energy. Increasing anecdotal and statistical evidence points to a positive correlation between companies’ environmental compliance and their operating and financial performance. Pressure from savers. Climate sustainability concerns are increasingly affecting the saving and investment decisions of individuals, the same way they affect consumption decisions. This trend is particularly visible in advanced economies and among younger generations. Savers, as ultimate clients of NBFIs, are demanding stricter compliance with environmental, social, and governance (ESG) standards as well as the broadening of product offerings to include more environmentally responsible investment options. The inclusion of socially responsible investment products in their product offering is becoming compelling from a business perspective. Pressure from regulators. In some jurisdictions, it is debated whether financial institutions should mandatorily integrate ESG issues into their investment decisions policies. While such debate mostly concerns banks, the repercussions on the NBFIs would be immediate and straightforward. As an example, the Financial Stability Board has created the Task Force on Climate-related Financial Disclosures. The Task Force has recommended global organizations to enhance their financial disclosures related to the potential effects of climate change. Pressure from industry and advocacy organizations. In other jurisdictions, there are industry-sponsored initiatives that, although not legally binding, strongly encourage asset owners to mandate their trustees to adopt a more active stewardship approach through direct engagement, proxy voting or impact investing. The leading initiative in the field is the United Nations-sponsored Principles for Responsible Investment (UNPRI), a non-profit organization that studies the investment implications of ESG factors and supports a broad network of international investor signatories in incorporating these factors into their investment and ownership decisions. Other examples include the UK Stewardship Code, issued in 2010 (and revised in 2012) by the Financial Reporting Council, which sets transparency standards on how institutional investors enhance the sustainability of their portfolio companies, and the Portfolio Decarbonization Coalition, a multi-stakeholder initiative that seeks to encourage and mobilize institutional investors to decarbonize their investment portfolios. As a result of these factors, the integration of ESG information into NBFI investment decisions is becoming common practice. And failure to consider sustainability factors in long-term investment practices is considered a failure of fiduciary duty.

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

221

Avenues for Non-bank Financial Institutions’ Participation in Green Investments The possible approaches for NBFIs to participate in green investments can vary greatly. Some try to “greenify” existing investments, others to mitigate climate risks, others to channel capital directly to green investments. In the following sections, we discuss the most widespread ones. We also suggest ways for governments to proactively incentivize NBFI investments in green projects.

Negative Screening NBFIs that invest in listed securities apply exclusion mechanisms to avoid investments in companies involved in the production of either certain products (e.g. weapons, tobacco, alcohol), or when there is a risk that a company might be responsible for or contribute to unethical conduct (e.g. exploitation of child labor). When the exclusion criteria are defined and implemented, investors are expected to divest from the portfolio investments that fall under the scope of the exclusion. This mechanism is often adopted on the basis of ethical considerations and can vary depending upon the cultural and religious beliefs of the asset manager or its clients. Exclusion criteria can be either “product-based,” when an asset is excluded solely on the basis of what its operations produce, or “conduct-based,” when a financial asset is associated with an issuer whose conduct is not consistent with the stated ethical principles. Negative screening can apply to a variety of social and environmental domains and is not exclusively a green strategy. Sectors and assets with a negative carbon footprint, however, are increasingly prominent candidates for exclusion lists. According to the website of Fossil Free, a global advocacy initiative aimed at accelerating the transition to 100% renewable energy, the value of assets represented by institutions and individuals committing to some sort of divestment from fossil fuel companies reached $5 trillion as of December 2016; to date, 688 institutions and 58,399 individuals across 76 countries have committed to divest from fossil fuel. When evaluating carbon-related investments, the issue is whether the products alone may warrant exclusion, or other aspects of the productive process should also be taken into account. Currently, energy is to a large extent derived from fossil fuel sources—coal being the least eco-sustainable. Even recognizing the negative consequences of a slow transition to renewables, an abrupt transition could generate high social and economic costs, for instance in emerging and developing countries that rely on fossil fuels for growth and employment, or cannot afford to pay for expensive renewable sources. Recognizing this dilemma, the Council of Ethics that sets the investment policy of the Norwegian Government Pension Fund states (per the recommendations page on its website) that “fossil fuel companies’ energy production, energy use or CO2

222

G. Gianfrate and G. Lorenzato

emissions cannot per se be said to be contrary to generally accepted ethical norms, as these products and activities constitute an important basis for our society.” The Interfaith Center on Corporate Responsibility holds a similar view: “the energy industry should not be seen as sole creators of the problem as long as global markets remain inextricably linked to fossil fuels to propel growth” (ICCR 2013). Underinvesting in carbon producers is of little effect when there is continued market demand for their products. While exclusion criteria can be easily implemented for coal or petroleum producers, the same cannot be said for the many industries that ultimately rely on coal and petroleum as energy sources. First, these industries represent a huge portion of the entire global economy. Second, they may not be fully aware of the origin of their energy sources (e.g. the energy mix of the utilities that supply them with electricity). Third, even further downstream, consumers may not be aware of or concerned about the implicit energy mix of the products they purchase from such industries. It would be unrealistic and harmful to compile exclusion lists so broad as to incorporate any indirect user of fossil fuels. By design, exclusion lists are meant to capture only the first-order effects of fossil fuel production. At a very minimum, negative screening forces more transparent reporting of environmental metrics by companies at risk of falling into exclusion lists. In a more optimistic scenario, companies with residual non-green assets and operations may divest of them in order not to fall in exclusion lists. In the long term, negative screening will divert NBFIs’ asset allocation toward sustainable sectors. Increased supply of capital, relative to non-green sectors, could reduce the long-term cost of capital for sustainable companies, which will facilitate their investment activities and implementation of growth plans. On the flip side, it is unlikely that negative screening alone will be able to “kill” non-green sectors. Capital will continue to be attracted to sectors that generate high financial returns. NBFIs are one step in between individual savers and the investment opportunities. Many savers are not sophisticated enough to delve into the portfolio decisions of the institutional funds to whom they have entrusted their savings. They will instead focus on headline performance figures. At the same time, many fund managers operate under the simple fiduciary duty to maximize risk-adjusted returns for their clients and are incentivized accordingly. Government role. In many countries, especially emerging ones, some NBFIs are under direct government ownership or management (“public NBFIs”). Examples include sovereign wealth funds, strategic developments funds, or pension funds that manage the savings of civil servants. These NBFIs are very often large, if not the largest, capital market participants in a given country. In Malaysia, for instance, Khazanah owns a large portfolio of stakes in government-linked companies, including the national electricity provider, a telecom operator, a large bank, and many infrastructure businesses. Governments with such exposure and influence over local capital markets can apply negative screening to their portfolios, build awareness of their screening criteria, and try to mainstream them to the broader NBFI sector.

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

223

Active Ownership Active ownership by institutional investors encompasses both engaging with the management and boards of directors of investee companies and proxy voting on issues concerning governance and performance, including those related to the environmental strategy. From a theoretical perspective, active ownership is a way to address principal-agent problems arising when there is an incomplete alignment of interests between the asset owner (principal) and the person charged with managing the asset (agent). Practically, active ownership is based on the full exercise of the rights attached to the status of “owner” of the securities issued by companies or other entities. The effectiveness of active ownership is receiving increasing attention in literature. For example, Dimson et al. (2015) report enhanced financial performance (about 2% yearly abnormal returns) of investee companies after structured engagement activities by asset managers. While most active ownership initiatives focus on the investee’s business and financial performance, some initiatives try to affect the investee’s environmental performance. The latter usually involve mobilizing the public opinion and the media, in particular to bring attention to proxy votes on environmental-related issues at upcoming shareholders’ meetings. Other active ownership initiatives are carried out behind the scenes and consist of discreet dialogues and interactions between investors and management and/or board directors. Climate-focused active ownership engagements are conducted either independently or through collaborative platforms. These include the Carbon Disclosure Project (CDP) and major investor networks focused on climate change, such as the European Institutional Investors Group on Climate Change, the Asia Investor Group on Climate Change, the Australia/New Zealand Investor Group on Climate Change, and the Investor Network on Climate Risk. These collaborative engagements aim to encourage companies to disclose their climate change strategies (e.g. the CDP information requests), to set emission reduction targets, and to take action on sector-specific issues such as gas flaring in the oil and gas sector. Successful engagements on specific environmental issues typically aim at punctual objectives. They are not limited to requesting corporate boards to consider certain sustainability issues, but they explicitly call for defined environmental targets to be delivered on. However, just as important as overcoming agency issues between an owner and manager is avoiding micromanagement of companies while expecting full accountability from board and senior executives. As for carbon risks, the lack of a robustly defined long-term price for CO2 emissions can definitely create incentives for non-optimal investment behavior by corporate leaders. Examples of engagement objectives in this area include ensuring compensation policies are consistent with environmental targets, or requiring improved disclosure from companies on their carbon price assumptions. As a recent example of collaborative engagement on climate-related risks, in May 2017 63% of Exxon Mobil shareholders approved a proposal at the company’s annual meeting calling for the world’s largest listed oil

224

G. Gianfrate and G. Lorenzato

producer to improve its disclosure on business risks through global climate change policies. Active ownership builds on the assumption that it is the responsibility of a longterm shareholder to question the robustness of financial analyses behind significant new investments made by investee entities. Since fossil fuel companies face the prospect of business decline and must adapt to new circumstances to survive, active ownership by investors may push them to leverage their present strengths towards a low-carbon energy productive system. Since this transition will take time, those entities exposed to carbon risks will need the engagement and support of large longterm investors. By engaging on climate resilience and transition strategies for fossil fuel companies, the investors adopting active ownership can manage their portfolio exposure to climate change risks and protect the long-term value of their investments. Government role. Public NBFIs are ideally positioned to champion green active ownership in their domestic financial markets. They often own large, if not controlling stakes in listed national champions and have the power to steer corporate strategies (e.g. through Board representation and appointment of senior management). Unlike NBFIs that are more focused on short-term stock price appreciation, such as activist hedge funds, public NBFIs are long-term investors that can pursue long-term transformational objectives. Evidence of success by public NBFIs practicing active ownership should encourage other NBFIs to pursue similar strategies.

Sustainability Ratings Sustainability research assesses the environmental, social, and governance performance of corporations and other security issuers, such as central and local governments. This research translates into a range of ESG ratings, rankings, and indices aimed at capturing external costs and benefits disregarded by financial accounting and reporting. Rising investor demand has fueled the strong growth of the ESG information market over the last two decades. A range of asset managers use sustainability analyses and ratings to manage and map their portfolios, by benchmarking issuers on various quantitative metrics. Sustainability ratings rely on the data, information and analyses provided by the issuers themselves and, as such, their quality and reliability varies. Company-level ESG disclosure does not necessarily feature materiality aspects or predictive data, and thus bears the risk of being incomplete, inconsistent and difficult to compare between different industries, markets, and rating schemes. To compensate for this deficit, ESG research providers, analysts, and asset managers would need to proactively investigate the sources, something they are not fully able to do due to resource constraints. With regards to carbon emissions, the data available and environmental ratings do not appear to be yet reliable enough to enable investors to set decarbonization targets or measure their performance against rating-based targets.

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

225

A further practical consideration is that it takes time for investors to set up their data gathering processes and to educate their analysts and fund managers about how these ratings may be interpreted and adopted in the investment process. Moreover, there is often a time lag between data being available, ratings being issued, and those ratings being integrated into investment research and decision-making processes. Government role. Governments can implement regulations that promote rigorous ESG monitoring and disclosure by companies listed on the domestic stock exchange as well as any NBFI operating under domestic financial regulation. In consultation with NBFIs, governments should define best practices concerning the selection of sustainability metrics, measurement procedures, consistency of definitions and, importantly, frequency and detail of disclosure to NBFI and company investors and the broader public. This effort would raise awareness of sustainability issues among investors in NBFIs and potentially create a virtuous circle in which savers proactively demand more rigorous ESG compliance and reporting from companies or funds in their investment portfolios. By promoting standardization, it should also lower the cost of ESG monitoring over time—listed companies and NBFIs would not need to reinvent the wheel and could adopt off-the-shelf methodologies. Standardization of metrics would also help green benchmarking horizontally, across portfolios of stocks or NBFIs, and over time for a single stock or fund holding.

Hedging In a context of carbon priced dynamically, the hedging of carbon exposure for NBFIs would be, at least in theory, a viable strategy. Formally, a risk is hedged off when the action taken to reduce investments’ exposure to a loss also causes the investor to give up on the possibility of a gain from a favorable configuration of the risk source. Hedging therefore usually involves linear instruments whose contractual payoffs move one-for-one with the value of the underlying asset. Those linear contracts tend to be obligations or commitments usually in the form of forward, futures, and swaps (Gianfrate 2018), but the construction of synthetic positions that deliver the same payoff of a hedging strategy is also possible. Andersson et al. (2016) for example shows that an alternative strategy to hedge off climate is feasible. This strategy can optimize the composition of a low-carbon portfolio index so as to minimize the tracking error with the reference benchmark index. They show that tracking error can be almost eliminated even for a low-carbon index that has 50% less carbon footprint. By investing in such an index investors are holding, in effect, a free option on carbon: as long as the introduction of significant limits on carbon emissions is postponed they are essentially able to obtain the same returns as on a benchmark index, but the day when carbon emissions are priced the low-carbon index will outperform the benchmark (Andersson et al. 2016). More traded green assets should emerge in order to make the hedging of climate risks more viable. Interestingly, carbon negative assets do exist but, mostly, they cannot be employed by investors yet. Carbon permits in cap-and-trade systems or the

226

G. Gianfrate and G. Lorenzato

financial contracts related to the REDD and REDD+ schemes are some examples. If the financial system moves—autonomously or because of direct regulation of the climate exposures—towards the implementation of effective risk management policies for such risks, financial innovations, for instance, the securitization of the REDD schemes or the creation of climate and carbon-related derivative securities, could become an avenue to explore. Moreover, financial engineering could be used to design new carbon-neutral vehicles and indexes that make climate risk hedging more effective and accessible to institutional and individual investors. Government role. The adoption, cost, and effectiveness of hedging—any hedging, not just green—are affected by the availability, transparency, and liquidity of financial instruments and contracts used in hedging strategies. While hedging remains a decision taken individually by NBFIs in light of their fiduciary duty to maximize risk-adjusted returns for investors, governments could facilitate green hedging by promoting the creation of markets for carbon-negative assets and related financial contracts.

Green Asset Classes New asset classes are emerging whose direct and primary objective is to address climate issues. The list below—while not exhaustive—includes asset classes that, while prioritizing the achievement of climate objectives, do not sacrifice financial returns. Since NBFIs have a fiduciary duty to maximize risk-adjusted returns for their clients, this section does not cover asset classes that accept sub-market financial returns (frequently referred to as concessional returns) as a trade-off for higher environmental impact. A detailed discussion of each asset class is beyond the scope of this chapter. Instead, this section highlights common barriers to the development and widespread acceptance of these new products, as a basis for future policy action. Green bonds. Green bonds are bonds whose proceeds are devoted to financing or refinancing green projects, assets, or business activities. Both companies and public entities can issue them. They can be structured as asset-backed securities whose returns are tied to specific projects, but, in practice, most green bonds issued to date are, from a credit standpoint, equivalent to any other bond issued by the same entity. What differentiates them is the commitment to use the proceeds specifically for green purposes. Green bonds represent a small but growing segment of the global fixed income market. The OECD estimates that annual issuance of green bonds increased from US$3 billion in 2011 to US$95 billion in 2016 (OECD 2017b). Despite a number of normative initiatives, such as the Green Bond Principles, the industry still lacks generally accepted standards, especially as it pertains to measurement and monitoring of environmental impact. This dilutes the effectiveness of green bonds in tackling climate problems and their appeal as investment products. On the supply side, compliance with the bonds’ green requirements generates additional transaction costs and can be a disincentive for prospective issuers.

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

227

Green banks. Green banks are a relatively new phenomenon and it is perhaps premature to speak of them as an asset class. They are a heterogeneous group of public or quasi-public entities that aim to stimulate private financing of green projects, assets, or businesses through a variety of lending, de-risking, and investment tools. Over 10 institutions call themselves green banks, in countries including the US (New York, New Jersey, California, and other states and counties), UK, Australia, Japan, Malaysia, Switzerland, and United Arab Emirates. In December 2015, five green banks launched the Green Bank Network, a membership organization that fosters collaboration and sharing of best practices. Despite this initiative, there is still a notable lack of standard definitions and industry guidelines. The “bank” definition does not properly capture the large variety of business models and funding sources. Some green banks (notably, the UK Green Investment Bank) were set up by governments with the mandate to act as privatesector lenders/investors and be ultimately spun-off as independent entities funded by the capital markets. Other green banks are little more than a separate budget window for relevant ministries, offering financial subsidies and de-risking that are more typical of development rather than commercial finance. The blurred distinction between private and public finance models can lead to market distortions, in particular the crowding out of private lenders and investors by those green banks that are subsidized public vehicles. Private equity. Private equity funds make long-term equity investments in unlisted companies, after securing capital commitments from their investors typically for a 10-year period. As of mid-2016, private equity funds globally managed US$2.5 trillion (Preqin 2017a). Private equity funds usually acquire control of companies by purchasing the majority of the equity and funding the remaining portion of the transaction through loans and high-yield bonds. They target companies with stable cash flows, which can be used to pay down the acquisition debt over time. The complexity of private equity transactions calls for a strong businessenabling environment with high standards of corporate governance, disclosure, and shareholder protection. Fund managers are remunerated with annual management fees, usually set at 2% of AuM, and a 20% share of the fund’s capital gains, known as “carried interest” or “carry.” Renewable energy is one area of focus for private equity funds. The trend of fund launches focused on the sector is affected by a variety of cyclical, structural, and regulatory factors. These include the price of energy from conventional sources, which is linked to the oil and gas cycle, the manufacturing cost of renewable equipment and infrastructure, such as solar panels, and evolving subsidy regimes for renewables, which reflect fiscal and not just environmental considerations. Preqin reports of a recent increase in renewables fund-raising, with US$14 billion and US$13 billion raised in 2015 and 2016, respectively, versus an average of US$8 billion raised annually in the previous 7 years. Funds with a mixed mandate, targeting both conventional and renewable energy investments, have witnessed even faster growth (Preqin 2017b). The last observation reflects an important feature of private equity and also, potentially, a limiting factor when it comes to its involvement in renewables and

228

G. Gianfrate and G. Lorenzato

other green investments. Funds investing in private companies have much higher operating costs than funds investing in a liquid portfolio of listed companies. Private transactions require lengthy due diligence, financial structuring, and negotiations; once companies are part of a private equity portfolio, the fund manager is represented on the board of directors and takes an active role in strategy and management. Small funds may not produce sufficient fees (usually 2% of the assets under management) to cover these operating costs. This may be the case for private equity funds targeting specific renewable technologies or geographies. In addition, private equity funds that raise capital from development finance institutions may face further costs for impact measurement and ESG compliance.

Development Finance Institutions’ Incentives to Private Equity

Development finance institutions (DFIs) have a long track record of promoting the launch and operations of private equity funds. They do so to (1) direct capital to specific sectors and geographies that are consistent with their development objectives, (2) achieve efficient capital allocation by delegating the investment decisions to a professional, private-sector fund manager, (3) overcome some of the barriers to private equity investment in nascent or niche markets (as described above), and (4) demonstrate the viability of private equity in new markets and spearhead market growth. Many DFIs invest in private equity funds and, alternatively or in addition, use a variety of other tools to facilitate fund setup and operations. To avoid market distortions, in particular the crowding out of private equity funds that do not receive any support from the development finance community, the use of these tools must be carefully balanced. Crucially, the fund manager must retain full independence over investment decisions, so that market incentives—rather than policy objectives—drive capital allocation to portfolio companies. The tools described below can apply to private equity funds targeting any sector, including the green economy. Fund investment. DFIs invest in private equity funds launched and managed by professional third-party managers, with the expectation to realize market returns. DFIs usually limit their investments to a minority of the fund’s capital—several institutions have set the threshold at 20%. To qualify for DFI money, funds must comply with the ESG requirements of the funding institutions. DFI investors may require a seat on the fund’s investment or advisory committee. The International Finance Corporation, the private sector funding unit of the World Bank Group, is a prominent investor in private equity funds targeting emerging markets. It had an active portfolio of 291 funds at the end of 2016, representing a total capital commitment of US$5.6 billion. It commits approximately US$500 million annually to 20–30 new funds, (continued)

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

229

targeting four strategies: growth equity (representing 60%–75% of commitments), venture capital (10%–15%), small and medium enterprises (5%–10%), and sector funds (10%–15%); the latter include renewable energy. The European Bank for Reconstruction and Development invests between Eur150–250 million each year in private equity funds. Per its website, it is the largest investor in private equity funds in Eastern Europe and Central Asia, having provided capital to more than 170 funds and benefiting, indirectly, over 1,400 underlying investee companies. The African Development Bank is also an active investor in private equity funds, with a reported portfolio of 37 funds in 2012 and US$836 million committed capital (AfDB 2012). Many other national and multinational DFIs also invest in private equity funds. Fund manager selection. A more proactive approach encompasses the DFI providing seed capital for a private equity fund and also selecting the fund manager through competitive procurement. The seed capital commitment incentivizes qualified managers to tender for the role. The fund manager selection is based on factors such as experience of the investing team, country/sector knowledge, previous investment track record, prospective deal pipeline, and ability to attract other investors to the fund. This approach is used typically for countries and sectors where private equity is a novelty and the DFI intends to spearhead the industry. Return enhancement. Private equity funds typically target a 15%–20% internal rate of return on portfolio company investments. In some sectors and markets such returns may be unrealistic. In many emerging markets, for instance, returns on infrastructure investments—including renewable energy projects—are constrained by the low affordability of tariffs charged for infrastructure use (e.g. electricity tariffs). Some institutions offer cheap leverage at fund level to enhance the returns for the fund’s investors. For instance, OPIC offers low-interest, non-amortizing loans to competitively selected private equity/debt funds, for an amount up to 25% of the fund’s capital base; this boosts the returns of other fund investors, who capture all the upside above the OPIC interest rate. Operating subsidies. As previously noted, scale is essential to make funds a viable business for their managers, since management fees are charged as a percentage of AuM. For this reason, small markets (countries or sectors) are inherently less attractive for fund managers. To overcome this barrier, DFIs sometimes offer subsidies to cover part of the operating expenses of the fund. This could take the form of a set annual payment in the first few years after fund launch. The size of such payment is determined on the basis of a realistic estimate of a fund’s running costs. Technical assistance. As an alternative or in addition to operating subsidies, a DFI may choose to subsidize deal-making costs. A private equity deal involves an extensive phase of due diligence, covering the target company’s (continued)

230

G. Gianfrate and G. Lorenzato

business, historic and projected financials, accounting information, and systems and legal documentation, followed by valuation and financing work, bidding, and negotiations with the selling shareholders. This process is timeconsuming for the fund’s investing team and costly insofar as legal, financial, and accounting experts are involved. Some DFIs provide funds with technical assistance lines, whose size can be determined on the basis of a set amount per target portfolio company. Private equity funds investing in SMEs are great beneficiaries of this technical assistance support—in SME investing, transaction costs can be disproportionately high compared to the small deal value. DFIs’ convening power. DFIs that invest in funds are usually happy to share their network with the fund manager, to increase the likelihood of success. This may involve presenting pipeline transactions, based on the DFI’s technical expertise on the ground in the targeted sectors, or introducing fund managers to other DFIs that could be prospective investors during the fund-raising process. Especially with regards to deal selection, however, the fund manager will want to retain full independence—a DFI that is too intrusive may be a distraction. All the incentives previously described apply at fund level. This does not prevent DFIs from becoming involved at portfolio company level with the full array of typical DFI products. For instance, a DFI may choose to lend to a portfolio company, or make a direct equity investment in conjunction with the private equity fund. DFIs with credit guarantee or political risk insurance units (e.g. MIGA within the World Bank Group) may use these tools to de-risk loans to portfolio companies, attracting lenders and lowering the cost of debt.

Venture capital. Venture capital funds invest in early-stage innovative companies whose business model is not yet fully tested. By definition, the risk profile of such investments is more pronounced than that of a later-stage private equity investment. On the back of its early success in the Silicon Valley IT sector, venture capital has expanded to a wide range of “-techs.” Clean energy innovation, or clean-tech, is one of them. Large amounts of capital were raised by clean-tech funds in the years preceding the global financial crisis, reflecting the capital markets’ exuberance of the time as well as very high oil and gas prices. At the peak in 2008, VC clean-tech investments surpassed US$8 billion. The subsequent drop in energy prices triggered by fracking, commoditization of certain technologies such as solar panels, and general failure to identify truly innovative business models, however, decimated the large majority of clean-tech startups launched in the boom years, causing a major contraction in clean-tech VC investment. Gaddy et al. (2017) estimate that investment dropped to US$2 billion in 2013 and has remained at that level since. Clean-tech startups are particularly risky, especially when they develop hardware requiring a high upfront investment. They may also take longer to reach financial sustainability than software startups (Gaddy et al. 2017). These specificities notwithstanding, clean-tech VC is broadly subject to the same dynamics as the VC

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

231

industry as a whole. VC funds, regardless of the target industry sector, realize the majority of returns from a small number of “star” investments that more than offset losses in the rest of the portfolio. While it may remain a niche, clean-tech VC is unlikely to disappear altogether as an asset class. Government role. Governments can, and in some countries already do, back the launch and expansion of new green asset classes. Green banks, mentioned above, are one example. Development finance institutions and development banks (backed by one or more countries) routinely invest in private equity funds that fit within their development mandates and meet their eligibility criteria, often with a focus on green themes. The European Commission, for instance, set up the Global Energy Efficiency and Renewable Energy Fund (GEEREF) to invest in private equity funds with a green mandate. The European Union, Germany, and Norway provided the initial capital in 2008, complemented by subsequent fund-raising from private sector investors. With assets under management of €222 million as of May 2015, GEEREF invested in 12 funds across Africa, Asia, Latin America, and the Caribbean by December 2016. An important question when governments play an active role as investors in green funds, projects, or securities is that of additionality. To avoid distorting markets and crowding out private investors, governments should deploy capital only when private capital would not get involved on its own. The application of the additionality principle is easier said than done; for instance, not all investment opportunities are marketed through a thorough auction process that allows for screening of all potential sources of capital. Still, additionality remains a key principle and should be explicitly embedded in any government strategy that involves deploying capital in potentially profit-making projects and opportunities. Summary considerations. These emerging asset classes have the advantage of funneling private capital directly and exclusively into projects, assets, and businesses with a green focus. With the exception of green banks, some of which are still heavily influenced by public finance models, these new asset classes operate strictly under market criteria. Green bonds bear the same credit risk—and cost for the issuer—as conventional bonds. Green private equity and VC funds operate under the same performance criteria and management incentives as any other fund, a model that some green banks (e.g. in the UK) have tried to follow closely. On the other hand, the green mandates and investment guidelines of some of the asset classes above are still poorly or too broadly defined. The definition of a green bond, for instance, can be stretched to include any general obligation of a company that deems its business as green, as opposed to a security whose proceeds are applied to a specific, predefined green project. Green banks that are funded from budget allocations and managed as ministerial units may not be as efficient capital allocators as the ones operating under private-sector frameworks. Measurement and monitoring of environmental impact is, in most cases, left to the discretion of issuers and fund managers. While most of them will show evidence of green impact, the heterogeneity of metrics and methods used makes benchmarking of environmental performance difficult. Increasing transparency and accountability is key to steer private capital towards issuers and fund managers that deliver on both the financial and environmental fronts.

232

G. Gianfrate and G. Lorenzato

The standardization of green mandates, investment guidelines, and impact metrics is an important step to the creation of proper asset classes, able to attract more capital from pension funds, insurance companies, and other institutional investors. Green banks, renewable private equity funds, and clean-tech VC are niche products, especially when a specific regional or country focus is layered on top of the green investment mandate. As noted above, size matters when launching a new fund, since the investment management industry earns fees as a percentage of assets under management. Large global or regional funds are, on paper, an appealing solution. In practice, green investments are often so country-specific (for instance because of regulation) that a global investment team with limited presence on the ground would not be able to execute them. Table 1 presents a comparison of the advantages and disadvantages for each greening strategy discussed in this section.

Policy Recommendations This section discusses several high-level lessons learned and guidelines that can inform specific policy actions aimed at stimulating NBFI participation in green investments. Detailed recommendations, based on the proposed guidelines, must take into account the individual features and goals of different types of NBFIs—a private equity fund investing in unlisted companies is different from a pension fund investing in liquid securities. In addition, NBFIs’ strategies and operations vary significantly depending on their countries or regions of domiciliation and, more broadly, their target investment geographies. NBFIs are not subject to banking regulation but this does not mean that they are exempt from regulation altogether. For instance, most countries and regional organizations (e.g. the European Union) have rules protecting savers from risks such as fraud and poor fund disclosure; the insurance industry is also heavily regulated. When it comes to investment targets, each region poses different challenges. Advanced economies tend to have more developed corporate governance, minority investor protection, and bankruptcy regimes, which makes them suitable targets for private equity, and large and liquid financial markets, which makes them suitable targets for pension funds, for instance. On the other hand, the business and legal environment of many emerging and developing economies and the smaller size of their financial markets and investment opportunities pose a significant challenge to most types of NBFIs; these issues are compounded when one restricts the investment mandate to specific and sometimes untested sectors, such as some in the green economy. With these caveats in mind, the following lessons learned and policy guidelines can find applications across a broad spectrum of NBFI types, geographies, and regulatory environments. Our recommendations are summarized in Table 2. First, a concerted and coordinated effort should be undertaken to further promote the standardization of definitions of green investments and financing tools. Too often the initiative is left to individual NBFIs or issuers—a problem that is evident for green bonds and green banks. Not only does this risk diluting green goals in favor of

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

233

Table 1: Advantages and Issues of Existing Green Strategies Strategy Negative screening

Advantages Promotes more transparent reporting of environmental compliance May lead some companies to divest from non-green assets In the long term, may divert more NBFI capital to green sectors

Active ownership

Increasing evidence that active ownership improves financial performance Keeps management accountable for a variety of corporate decisions Effective in improving corporate disclosure Catalyzes media and public attention to specific corporate issues Allows benchmarking of investments based on a range of non-financial metrics Provides a quantitative basis for negative screening and active ownership

Sustainability ratings

Hedging

Protects investors from financial downside of climate exposure

Green asset classes

Direct avenue for NBFIs to invest in green Wide range of financial products to match NBFIs’ different risk/return and liquidity objectives Product definitions usually include explicit measurement and monitoring of green impact

Issues Focus on product-based more than conduct-based screening Screening criteria still to a large extent discretional Works on the basis of limited parameters (e.g. green but not economic considerations) Many NBFIs will continue to avoid screening to maximize financial returns for their investors Still mostly focused on financial metrics Effective in tackling specific issues, not broad strategic repositioning (e.g. towards green sectors)

Ratings rely on information provided by the issuers, hard to control quality and sources Lack of generally accepted green metrics and indices prevents benchmarking of companies and securities Ratings need to be integrated into NBFIs’ systems and investing processes—may require upgrade of IT and human resources Passive strategy, does not address underlying climate problems Mostly financial Non-financial hedging not very developed yet Hard to do (esp. non-financial) if climate metrics not accurately disclosed by companies Some asset classes are very broadly defined, risk of greenwashing Rigorousness of impact measurement varies by asset class Some asset classes have a limited track record Scalability is an issue for certain investment strategies

IT information technology, NBFI non-bank financial institution.

234

G. Gianfrate and G. Lorenzato

Table 2: Summary of Policy Recommendations Area Definition of green asset classes

Environmental impact metrics, measurement, and reporting

Policy guidelines Build on existing efforts to improve and standardize definitions of green products and asset classes (e.g. green bonds, green banks) Build on existing efforts to standardize metrics, methodologies, and reporting standards

New financial tools

Promote adoption of new products such as carbon credits

Niche green funds

Incentivize fund managers to launch and operate small funds targeting green niches Governments to remain passive when it comes to the fund’s investment decisions (within pre-agreed parameters) Seed investments, fund manager selection, operating subsidies, and technical assistance are some of the tools

Advantages Narrow down green goals to a workable level Increase asset class acceptance among investors Increased transparency Easier benchmarking between investments Reduced measurement costs Increased trading volumes and product acceptance among NBFIs Expanded climate hedging toolset Attract professional fund managers to green investing Minimize market distortions Use a well-established DFI toolset of incentives (no reinventing the wheel) Create template for similar interventions in other green sectors/regions

DFI development finance institution, NBFI non-bank financial institution.

generic “green PR,” but also hinders the widespread acceptance of green financial products among savers and asset managers. Second, a similar effort should be undertaken to further promote the standardization of environmental impact metrics, assessment methodologies, and reporting standards. This would introduce greater green visibility in both the public and private investment spheres and facilitate the “environmental benchmarking” of portfolio companies and funds. One could imagine a system of environmental ratings applied to listed companies and generally recognized by the public and the investment community, with the same level of recognition of the ratings issued by the main rating agencies. Similarly, a set of generally accepted environmental principles could be introduced for impact measurement, the same way that generally accepted accounting principles (GAAP) exist. As previously discussed, some efforts are ongoing on these fronts, but the NBFI industry is still far from having adopted standardized solutions. Standardization, besides increasing transparency, would also reduce the costs incurred by NBFIs to design and apply their own environmental impact models. Third, governments should continue to promote the adoption of new financial tools, such as carbon credits. The novelty of some of these products and limited trading volumes are obstacles to the widespread acceptance by NBFIs. This limits the viability and effectiveness of, for instance, carbon credits as a hedging tool for

10

Stimulating Non-bank Financial Institutions’ Participation in. . .

235

climate-affected portfolios. With the People’s Republic of China—the world’s biggest source of climate-warming greenhouse gases—considering launching a national carbon trading scheme, the potential for the securitization of carbon allowances could be of primary importance per se and for the related financial products. Last, governments should continue to incentivize the setup and operations of funds targeting niche investment opportunities. These funds may not be large enough to be economically viable for the respective fund managers. The capital allocation expertise of the private sector, however, should not go wasted or be diverted to non-green causes. Through seed investments, competitive fund manager selection, small operating subsidies, and technical assistance, governments and DFIs can incentivize fund managers to take on investment mandates that they would otherwise disregard. This is particularly useful to attract fund money to green investment opportunities that are of limited size because of the technology, infrastructure, or geography involved. To avoid market distortions and policy creep-in, it is crucial that governments and DFIs leave full independence over investment decisions to the fund manager, within pre-agreed parameters and subject to the DFI’s overall ESG criteria. Importantly, all the incentives mentioned above are already in use among DFIs. This guideline should therefore find easy application among climate and development finance players. To the extent that a certain mix of incentives proves particularly effective, DFIs and governments should consider making it a template for similar interventions in other green sectors or regions. Focusing on Asian economies, most Asian economies are bank-dominated and the share of the capital market in their financial systems is very small (Yoshino and Taghizadeh-Hesary 2017). For green smaller-sized projects, innovative financing tools such as crowdfunding (Bento et al. 2018), hometown investment trust funds, and village funds should be fostered (Yoshino and Taghizadeh-Hesary 2017).

References AfDB (2012) Private equity investment in Africa in support of inclusive growth. African Development Bank, Tunis Andersson M, Bolton P, Samama F (2016) Hedging climate risk. Financ Anal J 72(3):13–32. https://doi.org/10.2469/faj.v72.n3.4 Battiston S, Mandel A, Monasterolo I, Schütze F, Visentin G (2017) A climate stress-test of the financial system. Nat Clim Chang 7:283–288. https://doi.org/10.1038/nclimate3255 Bento N, Gianfrate G, Groppo SV (2018, forthcoming) Do crowdfunding returns reward risk? Evidence from clean-tech projects. Technol Forecast Soc Change. https://doi.org/10.1016/j. techfore.2018.07.007 Dietz S, Bowen A, Dixon C, Gradwell P (2016) “Climate value at risk” of global financial assets. Nat Clim Chang 6:676–679. https://doi.org/10.1038/nclimate2972 Dimson E, Karakaş O, Li X (2015) Active ownership. Rev Financ Stud 28:3225–3268 Gaddy BE, Sivaram V, Jones TB, Wayman L (2017) Venture capital and cleantech: the wrong model for energy innovation. Energy Policy 102:385–395. https://doi.org/10.1016/j. enpol.2016.12.035 Gianfrate G (2018) Designing carbon-neutral investment portfolios. In: Walker T et al (eds) Designing a sustainable financial system. Springer International Publishing, New York

236

G. Gianfrate and G. Lorenzato

ICCR (2013) Insights for investors working for bolder intervention on climate change. Interfaith Center on Corporate Responsibility, New York. http://www.iccr.org/sites/default/files/page_ attachments/ICCRInsightsOnClimateChange2013.pdf OECD (2017a) Pension markets in focus. http://www.oecd.org/pensions/private-pensions/PensionMarkets-in-Focus-2017.pdf OECD (2017b) Mobilising bond markets for a low-carbon transition. In: Green finance and investment. OECD Publishing, Paris. https://doi.org/10.1787/9789264272323-en Preqin (2017a) Preqin global private equity & venture capital report. Preqin, New York Preqin (2017b) Preqin special report: conventional and renewable energy. Preqin, New York PwC (2017) Assets & wealth management revolution: embracing exponential change. PricewaterhouseCoopers, London World Bank (2017) Carbon pricing watch 2017. World Bank, Washington, DC. https:// openknowledge.worldbank.org/handle/10986/26565 Yoshino N, Taghizadeh-Hesary F (2017) Alternatives to bank finance: role of carbon tax and hometown investment trust funds in developing green energy projects in Asia. ADBI Working Paper Series 761. https://www.adb.org/sites/default/files/publication/329221/adbi-wp761.pdf

Role of Bank Lending in Financing Green Projects

11

A Dynamic Stochastic General Equilibrium Approach Maria Teresa Punzi

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Theoretical Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Firms and Price Settings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital Producers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Entrepreneurs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banking Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Market Clearing Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exogenous Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Parameterization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Theoretical Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Impulse Responses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Policy Experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Only Green Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions and Policy Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

238 241 241 242 243 244 245 246 247 247 248 248 252 256 257 258

Abstract

This chapter develops an environmental dynamic stochastic general equilibrium (E-DSGE) model with heterogeneous production sectors. In particular, the model specifies for the inclusion of low-carbon emissions firms that finance their investments and production only through banking loans, and high-carbon emissions firms that finance their investments either with bank loans or by issuing equities. Moreover, governments impose intensity targets to reduce pollution and allow high-carbon emissions firms to buy permits to allow their production. The model studies the transmission mechanism of technology, monetary, and financial shocks and finds that only a positive financial shock to green firms can boost M. T. Punzi (*) Webster Private University Vienna, Vienna, Austria e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_24

237

238

M. T. Punzi

production and credit. Financial shocks can be interpreted as those that affect the borrowing capacity of firms by tightening or relaxing the enforcement of collateral constraints. By contrast, a positive technology shock and easier monetary policy lead only to a short output on impact; over the longer term, green firms experience losses. The chapter analyzes the impact of several macroprudential policies and finds that only differentiated capital requirements can sustain green financing. Keywords

E-DSGE model · Environmental policy · Green financing · Macroprudential policy JEL Classification

E32 E50 · Q43 · H23

Introduction During the last decade, policy makers have emphasized economic growth coupled with environmental policies that aim to reduce pollution and greenhouse gas emissions. The 2015 Paris Agreement stipulated maintaining the global average temperature increase to below 2
C. This strategy implies a shift to low-carbon investments in low-emissions technology. There are two major barriers associated with green energy projects compared to fossil fuel projects: a lower rate of return, and a higher risk of investment. (See Yoshino and Taghizadeh-Hesary 2018). Because of the associated risk, and due to the Basel capital requirements, many banks are reluctant to lend to the green energy sector. Hence the need to look for various financing tools and methods (banking and non-banking solutions) to secure the flow of funds and growth in green energy. Academics and policy makers have suggested the imposition of a price on carbon dioxide and other greenhouse gases either through price instruments, e.g., a carbon tax, or quantity instruments, e.g., cap-and-trade. In the case of carbon taxes, the final consumers support the production cost. As a result, supply decreases and the equilibrium price increases. In the cap-and-trade system, producers buy pollution permits in order to emit carbon; otherwise, they incur an abatement cost. If the abatement cost is less than the price to buy a permit, then the producers will prefer to face the former. In both cases, the production cost increases, supply decreases, and the price of the final good increases. Given such cost increases, specific investments are essential to transform the green production sector, which requires a sustainable financial environment. In general, inadequate external financing is the main obstacle to producers, and these financial constraints are exacerbated for the green sector, as the private sector fears the associated risk. In this context, green financing will play a central role in allocating resources to sustainable investments. Moreover, the current unsustainable

11

Role of Bank Lending in Financing Green Projects

239

environment unbalances the real economy as environmental damage (e.g., floods and droughts) affects price stability by impacting food and energy prices. Such environmental risk can lead to market distortions and losses for financial institutions. To reduce carbon emissions and maintain financial stability, a green macroprudential framework provides incentives for banks to lend more to low-carbon emissions firms. This chapter aims to develop an environmental dynamic stochastic general equilibrium (E-DSGE) model with heterogeneous production sectors to evaluate possible macroprudential policies with the goal to support green financing. DSGE models are useful to identify the source of uncertainty on shock-driven business cycles. Further, DSGE models can be used by policy makers in choosing instruments after the uncertainty is identified. In the context of climate change, E-DSGE models can introduce uncertainty due to abatement costs, environmental tax policies, and cap-and-trade that drives economic fluctuations as emissions tend to increase during expansions and to decrease during recessions. Vasilev (2018) has developed an environmental, real business cycle model for Bulgaria to study the transmission mechanism of carbon taxes and the use of government spending on abatement costs. Vasilev (2018) found that the model performance increases by imposing certain environmental regulations, such as by-product reduction of pollution. Xu et al. (2016) developed an E-DSGE model calibrated to the People’s Republic of China for the period between 1978 and 2014. They found that the introduction of environmental policies leads to economic losses and taxes might encourage firms to participate in emissions-cutting activities. In particular, I develop an E-DSGE model to evaluate the transmission mechanism of several sources of macroeconomic uncertainty such as productivity, monetary, and financial shocks in a setup that includes policies to reduce greenhouse gas emissions. Investment in low-carbon production will require a large amount of purchasing: production of energy from renewable sources, improvement of energy efficiency in buildings and transportation, management of natural capital, waste management, water management, sustainable agriculture, and others. Given the upfront costs of investments—particularly high in the case of renewable energy production—firms are typically unable to finance them through their own savings. This chapter will focus on the role of banks in low-carbon investments, as loans are the most important source of external finance for firms. In particular, the relevance and feasibility of green macroprudential monetary policies to expand the amount of credit flowing to low-carbon activities will be assessed. The model differentiates low- from high-carbon emissions firms in terms of external finance sources and environmental regime adopted. Bank loans are the only source of finance for representative low-emissions firms. Moreover, such firms make use of renewable energy in the production process. On the other hand, high-emissions businesses are subject to an extra cost in the form of intensity targets, i.e., an exogenous limit per unit of output produced. Alternative measures can be implemented through cap-and-trade or a carbon tax. In terms of financing, highemissions businesses can draw on bank loans or by equities in the form of share

240

M. T. Punzi

capital. Therefore, high-emissions firms implement a strategy substitution between debt and equity. Usually, debt is preferred to equity, but the firms’ ability to borrow is limited by a collateral constraint; in this case, firms shift to equity financing. Figure 1 reports the net payments to equity holders and the net debt repurchases in the nonfinancial corporate and non-corporate sector for the US (Jermann and Quadrini 2012). The figure reveals the existence of a negative correlation between equity payouts and debt repurchases, suggesting a strong substitutability between equity and debt financing. The model shows that aggregate productivity shocks and easier monetary policy lead to a short-lived positive effect on output for low-emissions firms. Over the long term, such firms suffer losses due to a shortage of loans as the price of capital falls. On the other hand, when capital is cheap, high-carbon firms also face a lower collateral value and can borrow less from banks; therefore, they shift to equity to finance new investments. Only financial shocks can boost production for low-emissions firms. Financial shocks can be interpreted as tightening or relaxing the enforcement of borrowers’ collateral constraints. In the context of low emissions, a positive financial shock can also be interpreted as the capacity to create innovative financial products to finance and insure the projects involved, such as “green bonds” or the emergence and expansion of green investment banks. There is a growing literature on E-DSGE models and environmental policies. Angelopoulos et al. (2010) analyzed the impact of alternative environmental policy rules in a real business cycle model under a total factor productivity where emissions

Figure 1: Financial Flows in the Non-Financial Corporate and Non-Corporate Sector in the United States. Note: Equity Payout is given by the sum of the net dividends of non-farm, non-financial business and the net dividends of farm business, minus the sum of the net increase in corporate equities of non-financial business and proprietors’ net investment of non-financial business. Debt Repurchase is the net increase in credit markets instruments of non-financial businesses. (Sources: Flow of funds accounts of the Federal Reserve Board)

11

Role of Bank Lending in Financing Green Projects

241

are a byproduct of production, and only the government can engage in pollution abatement activity. Fischer and Springborn (2011) evaluated volatility and welfare costs by comparing cap-and-trade, carbon taxes, and the intensity target in a dynamic stochastic general equilibrium model with one polluting intermediate input. Heutel (2012) determined an optimal emissions policy in a dynamic stochastic general equilibrium model with a pollution externality during phases of expansions or recessions. Annicchiarico and Di Dio (2015) analyzed different environmental policy regimes in a new Keynesian model with nominal and real uncertainty to evaluate the transmission mechanism of shocks with the presence of nominal rigidities and a monetary authority. Relative to previous literature, this chapter develops two productivity sectors where one representative firm produces in a low-carbon emissions scenario while the other one produces in high-carbon emissions scenario, but must buy permits from the government. Moreover, no paper has evaluated the implementation of potential macroprudential policies to support green financing, and no paper has studied the transmission channel of monetary policy shocks and financial shocks. This chapter fills these gaps. The chapter is organized as follows. Section “The Theoretical Model” describes the DSGE model. Section “Theoretical Results” presents the theoretical impulse responses on productivity, monetary and financial shocks, and evaluates several macroprudential policies. Section “Conclusions and Policy Recommendations” concludes and provides policy recommendation.

The Theoretical Model The model consists of a representative household, final goods firms, intermediate goods firms, capital producers, a banking sector, and two types of entrepreneurs. In particular, the production sector includes the presence of green firms producing with low-carbon emissions and high-emitting non-green firms. To curb pollution, the latter is subject to limits on aggregate emissions in the form of taxes. Debt is the main financial vehicle for low-carbon climate-resilient firms. Debt-to-equity ratio in overall infrastructure projects is about 70:30 (Dobbs et al. 2013), while renewable energy financing shows a debt-to-equity ratio around 75:25. Therefore, the model assumes that low-emissions firms can finance their activities only with bank loans, while high-emissions firms can also issue equities.

Households The household decision is: 1    X  t βth ln C h,t  max E 0 t¼0

 τ 1þφ ðH t Þ , 1þφ

242

M. T. Punzi

subject to the budget constraint:   C h,t þ Θt ðDt Þ þ qEt Ξt ¼ W t H t þ Rdt Dt1 þ d t þ qEt1 Ξt1 þ F t :

(1)

Households derive utility from consumption, Ch, t and hours worked, Ht, Wt is real wage rate paid for household labour. Dt is the household’s holding of real deposits with the banking sector at the beginning of time t, Rd is the return on deposits in period t, which is known at time t. Ξt is a household’s equity investment (private equity) in the large firms at the beginning of time t, dt is large firms’ equity payout, and qEt is the price of equity shares. Ft is the net payoffs to the household from ownership of large firms. βh  (0, 1) is the subject discount factor. Households face a portfolio selection problem by choosing the level of deposit or equity to hold. Portfolio selection problems of non-risk-neutral agents are generally solved in a mean-variance framework, in which the risk attitude and the risk relative to the expected mean matter. In DSGE models, such a problem requires an approximation of a higher order than the usual one because the portfolio choice is indeterminate in the deterministic steady state otherwise (e.g., Tille and Van Wincoop 2010; Devereux and Sutherland 2011). In this model, we solve the portfolio selection problem by adding portfolio costs for deposit, as in Schmitt-Grohee and Uribe (2003) to induce stationarity. Therefore, Θt ðDt Þ ¼ Dt þ 2κ Þ2 , where κ > 0 is the adjustment cost parameter. ðDt  D

Firms and Price Settings The Final-Goods-Producing Firms The final good produced, Yt, derives from perfectly competitive firms using Yt(i) units of each type of intermediate good i and a constant return to scale, a diminishing marginal product, and a constant elasticity of substitution technology: ξ 21 3ξ1 ð ξ1 Y t  4 Y t ðiÞ ξ di5 ,

(2)

0

where ξ > 1 is the constant-elasticity-of-substitution parameter. The price of an intermediate good, Yt(i), is denoted by Pt(i) and is taken as given by the competitive final-good-producing firms. Solving for cost minimization yields a constant-priceelasticity demand function for each goods type i which is homogeneous to degree h iξ one in the total final output, Y t ðiÞ ¼ PPt ðtiÞ Y t , and the domestic price index Pt ¼

1 Ð 0

1=ð1ξÞ Pt ðiÞ1ξ di

.

11

Role of Bank Lending in Financing Green Projects

243

The Intermediate Sector There is a continuum of monopolistically competitive firms indexed by i  [0, 1] that produce intermediate goods, y(i), using the following technology:  1α Y ðiÞt ¼ At Az,t H ðiÞt K ðiÞαt1 ,

(3)

K ðiÞt ¼ σK ðiÞH ,t þ ð1  σ ÞK ðiÞL,t ,

(4)

where

with K ðiÞσH and K ðiÞ1σ being capital rented by high- and low-emissions entrepreL neurs. Therefore, (1  σ) is the the share of utilized low-emissions firms’ capital in utilized total capital. At is an aggregate productivity shock, while Az, t is sector-specific productivity shock.

Capital Producers Capital producers combine a fraction of the final goods purchased from retailers as investment goods, Ik, t, with the existing capital stock in order to produce new capital goods. Each period, capital producers buy back the undepreciated capital stocks at real prices qkt :  2 I Capital production is subject to an adjustment cost specified as ψ k k,t  1 2

k t1

I k ,t1 , where ψ k governs the slope of the capital producers’ adjustment cost function. Capital producers choose the level of Ik, t that maximizes their profits max qkt I k ,t I k ,t



!  2 ψ k I k ,t I k ,t þ  δk K t1 : 2δk K t1

From profit maximization, it is possible to derive the supply of capital as follows:    I k ,t ψ 1 , qkt ¼ 1 þ k 2δk I k ,t1

(5)

where qkt is the relative price of capital. In the absence of investment adjustment costs, qkt , is constant and equal to one. The usual capital accumulation equation holds: I k ,t ¼ K t  ð1  δk ÞK t1 :

(6)

244

M. T. Punzi

Entrepreneurs Green Firms: Low-Carbon Emissions There is a continuum j  [0, 1] of entrepreneurs indexed by L that maximize consumption, as following: max E 0

1    X  βtS ln C L,t t¼0

subject to the budget constraint: C L,t þ W t H L,t þ qkt K L,t þ RLt BL,t1 ¼ ð1  δÞqkt K L,t1 þ Y L,t þ BL,t ,

(7)

 1ακ α Y L,t ¼ At AL,t H L,t K L,t1 E κt ,

(8)

and

and a borrowing constraint: 

 ð1  δÞqktþ1 K L,t ϵ f ,t : BL,t  θt Et RLt

(9)

βts < βth , which means that entrepreneurs producing with low-carbon emissions are more impatient than households; therefore they prefer to consume rather than to save in the present. BL is the level of borrowing via banking loans, and RL is the repayment interest rate. θt represents the loan-to-value ratio, and ϵ f,t is a financial shock that can relax or tighten the borrowing constraint. Firms produce goods by combining capital, KL, labor HL and renewable energy, Et. Moreover, firms can experience an aggregate technology progress, At or a green sector-specific technology shock, AL,t.

Non-Green Firms: High-Carbon Emissions with Limits on Pollution Firms decide on capital and labor inputs before the arrival of the technology shock, At. Part of the capital is financed through the equity investment from the household sector at the beginning of each period, denoted by Ξt, and the rest is borrowed from the banking sector, BL,t; therefore, K H ,t ¼ BH ,t þ Ξt :

(10)

The consumer’s contribution to capital acquisition can be viewed as a private equity investment with possible gains/losses to be settled at the end of the period, once the shocks are realized. Note that we assume that firms are owned by the household. From the household’s viewpoint, the leverage ratio of firm i is given by νi = KH, t/Ξt. Then, the share of capital financed by the banking sector is given by

11

Role of Bank Lending in Financing Green Projects

 BH ,t ¼

νi  1 K H ,t : νi

245

(11)

Firms acquire their entire capital stock, KH, t at the beginning of each period t. It is also assumed that firms transfer any excess profits to the household sector. Large firms maximize the cum-dividend market value of the V(s; KH,t, BH,t), as in Jermann and Quadrini (2012). For each firm i, KH,t and HL,t are derived by solving the following optimization problem:  

  V s; K H ,t , BL,t ¼ max Ξt þ E t βE V s; K H ,tþ1 , BH ,tþ1 subject to RLt BH ,t1 þ W t H H ,t þ qkt K H ,t þ φðΞt Þ ¼ Y H ,t þ qkt ð1  δÞK L,t1 þ BH ,t :

(12)

and  1α α Y H ,t ¼ At AH ,t ð1  ΓðM t ÞÞ H H ,t K H ,t1 , (13)  2 where φðΞt Þ ¼ Ξt þ 2κ Ξt  Ξ : To formalize the rigidities affecting the substitution between debt and equity, we assume that the firm’s payout is subject to a quadratic cost. κ  0, and Ξ is a coefficient equal to the long-run payout target (steady state). Γ is an increasing and convex function in the form of taxes on pollution emitted, and Mt is the current level of pollution stock. Emissions are proportional to output as follows: M t ¼ ð1  δM ÞM t1 þ φY H ,t ,

(14)

where δM expresses a decay fraction of pollution which naturally decays, while φ represents the emission per unit of output, YH, t. For a different perspective, Vasilev (2018) introduced environmental policy for Bulgaria in the form of time-varying proportional environmental tax on revenue. Banks’ loans are also subject to collateralized constraint, such as: 

 ð1  δÞqktþ1 K H ,t BH ,t  θt E t : RLt

(15)

Banking Sector We assume there is a banking sector which receives at time t deposits from domestic households, Dt, and makes loans to both firms, BL,t and BH,t. This setup is similar to Kollmann et al. (2011) and Kollmann (2013).

246

M. T. Punzi

Therefore, Bt ¼ BL,t þ BH ,t The banking sector faces a capital requirement that the capital (Bt  Dt) cannot be smaller than a fraction γ of the bank’s assets Bt. The banking sector maximizes max E 0

1 X

  βtb ln C b,t ,

t¼0

subject to the flow of funds C b,t þ Rdt Dt1 þ Bt þ ΓðDt , Bt Þ ¼ Dt þ RLt Bt1 and Dt  ð1  γ ÞBt , where Cb, t denotes the banker’s consumption (dividends) and βb is its discount factor; Bt=BL, t + BH,t represents one-period bank loans extended to low- and highemissions firms in period t and Γ > 0 denotes the real marginal operating cost of collecting deposits and extending loans Γ(Dt, Bt) = ΓDDt + ΓBBt. We assume that the bank can hold less capital than the required level, but that this is costly (e.g., because the bank then must engage in creative accounting). The excess capital is given by (Table 1) xt ¼ ð1  γ t ÞBt  Dt

Market Clearing Conditions H t ¼ σH L,t þ ð1  σ ÞH H ,t K t ¼ σK L,t þ ð1  σ ÞK H ,t Y t ¼ σY L,t þ ð1  σ ÞY H ,t C t ¼ C h ,t þ C L ,t þ C H ,t þ C b ,t

11

Role of Bank Lending in Financing Green Projects

247

Table 1: Bank Balance Sheet Assets Loans to Green Firms (BL, t) Loans to non-Green Firms (BH, t)

Liabilities Domestic Deposits (Dt) Bank Capital (xt)

Source: Author

As in Kollmann et al. (2011), we assume that the bank purchases the resources that are necessary for deposits and lending, Γ(Dt + Bt), from the final good producer, and that 50% of the resource cost ϕ(xt) is borne in final good units. As Γ and ϕ are physical inputs used by the banking firm, they have to be subtracted from final good production when computing GDP. Hence, Home GDP, denoted by Yt, is 1 Y t ¼ Z t  ΓðDt þ Bt Þ  ϕðð1  γ ÞBt  Dt Þ 2 and the final market clearing condition is: Y t ¼ Ct þ I t þ

2 κ Ξt  Ξt 2

Exogenous Shocks Aggregate Technology Shock: ln At ¼ ρA ln At1 þ eA,t ,

(16)

Firms’ Specific Technology Shock: ln Ak ,t ¼ ρA ln Ak ,t1 þ eA,t ,

(17)

ln ϵ f ,t ¼ ρϵ ln ϵ f ,t1 þ eϵ ,t ,

(18)

Financial Shock:

Parameterization The model is parameterized quarterly based on Jermann and Quadrini (2012). Discount factors are set such that βh=βS=βb= 0.9825, implying that the annual steady state return from holding equities is 7.32%. The Cobb-Douglas parameter for the capital share in the production of intermediate goods, K(i), is set to 0.36, the depreciation rate of capital, δk, is set to 0.025, and

248

M. T. Punzi

the adjustment cost parameters for investment are set equal to 0.001. In terms of collateral, we generate the loan-to-value (LTV) parameters θL and θH to 0.7. These parameters ensure a steady state value of banks’ loans-to-GDP rate about 30%. The portfolio adjustment cost parameter is set equal to 0.25. The required bank capital ratio is calibrated to be equal to 0.08. This value reflects the rules under Basel II and Basel III, which require that the total risk-weighted capital requirements, defined as total (Tier 1 and Tier 2) capital divided by total riskweighted assets, to be at least 8%. The discount factor is set equal to the savers’ discount factor. The bank operating cost coefficient is set equal to 0.0018, while the cost on banks’ excess capital is set to 0.1264, similar to Kollmann et al. (2011).

Theoretical Results Impulse Responses The following section reports impulse responses to exogenous shocks. Figure 2 shows impulse responses to an aggregate technology shock when no policy on emissions is imposed (solid line) and when the government limits emissions (circle line). An aggregate technology shock increases the impact on output for green and non-green firms. However, the prospect of high productivity leads to higher equity prices issued by non-green firms, while the price of capital decreases. Non-green firms decide to pay out net equity and borrow more to finance their investments and production. On the other hand, the lower price of capital decreases the collateral value of green firms, which will have less access to credit. As a result, after an initial increase, output for green firms decreases. When an emissions policy is implemented, the responses of output, loans, and equity prices are lower relative to cases where there is no policy. As the price of capital levels out, the decrease in loans for green firms is less pronounced. Figure 3 shows the impulse responses to an expansionary monetary policy shock. A lower interest rate leads to higher output for non-green firms, which decide to pay out net equity and borrow more. However, banks are more willing to extend credit to non-green firms rather than green firms, because the latter are considered riskier. As a result, green firms obtain less credit and their output increases only for one period, but later decreases because of less access to external finance. The overall output increases, but then decreases to reflect the drop in the green sector production. Similar results can be found in Annicchiarico and Di Dio (2015), who showed that an increase in the policy rate leads to a short-term reduction in output with a quick increase after a few quarters. Figure 4 shows impulse responses to an exogenous credit shocks that hit only green firms. Credit shocks and financial shocks are used interchangeably. Results are different from previous cases, with equity prices decreasing while the price of capital

11

Role of Bank Lending in Financing Green Projects

249

Technology Shock (Deviations from S.S.) Output-H

Output-L

Total Output

0.5

0.5

0.5 0.4

0.4

0

0.3

0.3

0.2 -0.5 0.1

0.2

0

-1

0.1

-0.1 -0.2

0

10

20

-1.5

0

SPREAD

10

0

20

0

Loans-L 0

0.35

0.04

-0.2

0.3

-0.4

0.25

-0.6

0.2

-0.8

0.15

-1

0.1

-1.2

0.05

0

20

10

20

Loans-H

0.06

0.02

10

-0.02 -0.04 -0.06 -0.08 -0.1

0

10

20

-1.4

0

Net equity payouts to gdp 0.2 0 -0.2 -0.4 -0.6 -0.8

0

10

20

10

0

20

0

Price of Capital

Equity Price

0.03

0.8

0.02

0.7

0.01

0.6

0

0.5

-0.01

0.4

-0.02

0.3

-0.03

0.2

-0.04

0.1

-0.05

0

10

20

0

0

10

No Policy on Emission Benchmark with emission policy

Figure 2: Aggregate Technology Shock. GDP gross domestic product. (Source: Author)

20

250

M. T. Punzi

Monetary Policy Shock (Deviations from S.S.) Total Output

Output-H

Output-L

0.04 0.03

0.04

0.035

0.02

0.03

0 0.02

0.025

-0.02

0.02

-0.04

0.01

0.015

-0.06

0

0.01

-0.08 -0.01 -0.02

0.005

-0.1 0

10

20

-0.12

0

10

-3

4

0

20

0

0.03

0

2

20

Loans-H

Loans-L

x 10 SPREAD

10

0.025

-0.02

0.02

0 -0.04

0.015

-2 -0.06

0.01

-4 -0.08

-6 -8

0

10

20

-0.1

0

10 -3

Net equity payouts to gdp 0.02

3

0.01

2

0

0.005

x 10

10

20

Equity Price 0.06 0.05 0.04

0 0.03

-0.02 -1

-0.03

0.02

-2

-0.04

0.01

-3

-0.05 -0.06

0

Price of Capital

1

-0.01

0

20

0

10

20

-4

0

10

20

No Policy on Emission Benchmark with emission policy

Figure 3: Monetary Policy Shock. (Source: Author)

0

0

10

20

11

Role of Bank Lending in Financing Green Projects

251

Credit Shock - Low Carbon Firms (Deviations from S.S.) -3

4

x 10

Output-L

Total Output

-3

0.025

4

0.02

2

2 0.015 0

0.01

-2

0.005

x 10

Output-H

0 -2 -4

0 -4

-6

-0.005 -6

0

10 -3

2

x 10

20

-0.01

0

10

SPREAD

20

-8

0

10 -3

Loans-L 0.03

4

x 10

20

Loans-H

0.025

1.5

2 0.02

1

0.015

0

0.01

-2

0.5 0

0.005 -4

-0.5 -1

0 0

10

20

-0.005

0

10

20

-6

0

10

20

Net equity payouts to gdp -4

-3

12

x 10

6

10

x 10

Price of Capital

-3

4

Equity Price

2

4

0

8 2

6

-2 -4

0

4 2

-6

-2

-8

0 -4

-2 -4

x 10

0

10

20

-6

-10 0

10

20

-12

0

No Policy on Emission Benchmark with emission policy

Figure 4: Credit Shock. GDP gross domestic product. (Source: Author)

10

20

252

M. T. Punzi

increases after the shock. As the collateral value increases for green firms, loans and output increase. The increase is less pronounced when the emissions policy is implemented (circle line).

Policy Experiments This section analyzes the impact of some macroprudential policies with the aim to support the production under low emissions. Figure 5 compares the impact of exogenous shocks when a higher capital requirement is imposed on banks based on prior Basel II and Basel III agreements (point-dotted line), which, in turn, impose a minimum capital ratio of 8% (Basel II) plus an additional 2.5% (Basel III), and a countercyclical LTV ratio applied only to low-carbon firms (starred line). A countercyclical ratio is a policy that aims to increase the LTV when there is a sector slowdown or decreases it when there is excess borrowing in order to avoid asset bubbles. In all cases, these policies reduce the quantitative impact of every shock. However, these policies can reduce the negative impact on green firms when technology and monetary shocks hit the economy, but these policies are not strong enough to boost the investment and production under low-carbon emissions. Relative to countercyclical LTV ratios on green firms, a higher capital requirement is more effective in reducing the negative impact on this sector. Table 2 reports the stochastic volatility implied in the model simulation under the policy rules adopted. The environmental policy to reduce pollution with an intensity target applied to output per unit highly reduces business cycle fluctuations. However, a countercyclical LTV ratio that responds to variation of total output generates the same stochastic volatility and in cases where the intensity target is implemented. Therefore, a macroprudential policy that aims to allow for higher LTV during economic slowdown doesn’t help low-emissions firms to obtain higher credit to finance their new investments. Still, the financing behavior of high-emissions firms negatively spills over on green firms as the price of collateral falls; even if those firms can access higher LTV, the asset price is still too low to obtain higher credit. From a different perspective, a higher capital requirement on banks leads financial intermediaries to allocate their supply of credit to guarantee a certain bank return and the negative impact of the price of capital is reduced, bringing down the volatility of business cycle fluctuations. Policy makers and central banks can implement several policy tools to incentivize green lending and allocate credit away from environmentally harmful activities. Some recent macroprudential tools suggest policies to differentiate rediscount rates and capital or money multiplier reserve requirements in order to affect investment decisions and allocate credit toward green investments. However, if central banks adjust the green financing capital requirement, it might endanger their financial

11

Role of Bank Lending in Financing Green Projects

Figure 5: Policy Experiments. LTV loan-to-value. (Source: Author)

253

254

M. T. Punzi

Table 2: Stochastic Volatility VARIABLE Total Output Output-L Output-H Consumption SPREAD Loans-L Loans-H Net-equity Price of Capital Equity Price

No Policy 0.4207 1.9415 0.3996 0.0528 0.2754 1.1119 0.1842 1.8977 0.1318 0.4351

Intensity Target 0.1855 0.8467 0.1738 0.0227 0.1218 0.4879 0.0794 0.837 0.0595 0.1896

LTV 0.1855 0.8467 0.1738 0.0227 0.1218 0.4879 0.0794 0.837 0.0595 0.1896

CapReq 0.1365 0.6267 0.13 0.016 0.1024 0.3655 0.0575 0.6056 0.0416 0.136

Diff.CapReq 0.0502 0.2186 0.0548 0.0061 0.0498 0.1216 0.0278 0.2193 0.0119 0.0338

Notes: “CyC LTV” denotes a macroprudential policy that target only low-emission firms and borrowing is constrained by a countercyclical loan-to-value ratio relative to changes in total corporate indebtedness. “Cap.Req.” denotes a banking capital requirement where an extra 2.5% is added to the standard 8% implied by Basel II and Basel III. “Diff. Cap.Req.” denotes differentiated capital requirements applied to low- and high-emissions firms Source: Author

stability because of accumulating riskier assets. As a result, central governments need to establish green credit guarantee schemes in order to cover the risk of banks, for keeping the stability in the financial system (Yoshino and Taghizadeh-Hesary 2016). Figure 6 shows that standard macroprudential policies are not enough to avoid losses experienced by low-emissions firms under macroeconomic uncertainty. Therefore, the model evaluates the impact of implementing green differentiated reserve requirements as suggested in Chandavarkar (1987), Rozenberg et al. (2013), and Campiglio (2016). Reserve requirements have the power to influence the banks’ ability to create credit and distribute the stock of money into the economy. Lower reserve requirements allow banks to increase their lending. In particular, Campiglio (2016) suggested that lower rates of banks’ reserve on green assets would encourage green investments over conventional investments. In this chapter, we propose a macroprudential policy that encourages differentiating capital requirements. In addition, it is important to develop a comprehensive supervision mechanism by the central banks or financial services authority in order to monitor whether or not the excess capital of banks is really being allocated to the green sector. Like reserve requirements, different types of banks or different lending activities can imply different capital requirements. Minimum capital adequacy ratios imposed under Basel II (i.e., the ratio of a bank’s capital over its risk-weighted assets) can directly affect the ability of financial institutions to extend credit. For instance, Basel III imposes a lower capital requirement for loans to small and medium-sized enterprises (SMEs) in order to provide a differentiated treatment compared to large

11

Role of Bank Lending in Financing Green Projects

Figure 6: Policy Experiments. (Source: Author)

255

256

M. T. Punzi

enterprises. Similarly, the implementation of a policy that foresees lower capital requirements for loans to green firms and higher capital requirements to non-green firms is evaluated. This policy should encourage banks to extend more credit to the former and less to the latter to protect the environment from excess pollution. Figure 6 shows that a macroprudential policy that differentiates capital requirements helps to avoid losses of green firms, as they can have easier access to credit from the banking sector. Moreover, the last column in Table 2 shows that such a policy causes business cycle fluctuations relative to other policies.

Only Green Firms It is worthwhile to compare a case in which only green firms are present in the market. Figure 7 shows that an emissions policy such as cap-and-trade or intensity

Figure 7: Technology Shock (Low-Emissions Firms). LTV loan-to-value, MaPru macroprudential, SS standard shock. (Source: Author)

11

Role of Bank Lending in Financing Green Projects

257

targets will decrease the quantitative impact in all macro-variables when a positive technology shock hits low- emissions companies. Similar results are found in Annicchiarico and Di Dio (2015). When a macroprudential policy relaxes the borrowing constraint, firms have easier access to credit and can invest more in clean or renewable energy. However, the use of DSGE models with only one type of production sector as in Annicchiarico and Di Dio (2015) is limited as they showed that green firms experience only a short period increase in output. The increase in equity prices leads a large drop in other asset prices, negatively affecting the collateral value for obtaining more bank credit. The transmission mechanism differs greatly.

Conclusions and Policy Recommendations This chapter develops an E-DSGE model with heterogeneous production sectors. In particular, the model addresses low-emissions firms that finance their investments and production only through banking loans, and high-emissions firms that buy permits from the government to allow their production. The latter firms can finance their investments either with bank loans or by issuing equities. The model studies the transmission mechanism of technology, monetary, and financial shocks and finds that only a positive financial shock to low-emissions firms can boost production and credit for the green sector. By contrast, a positive technology shock and easier monetary policy lead only to a short output on impact; longer term, however, green firms experience losses. The second part of the chapter analyzes the impact of several macroprudential policies and finds that only differentiated capital requirements can help to sustain green financing. To commit to the 2015 Paris Agreement, many initiatives have been launched to support the transition to a green environment. Several of these, such as carbontrading schemes and carbon taxes, have been focused on reallocating existing private capital from institutional investors. However, results do not show a positive outcome. Lately, many policy makers have been advocating the intervention of central banks in addressing climate change risk and to support green financing. To make the transition phase successful, there is a need for financial regulators and central banks to coordinate their policies in order to guarantee that the credit and monetary system is in line. Some central banks are recognizing that climate change is a potential risk for the stability of the financial system and economic growth. Climate change policy can negatively affect firms’ financial position and asset price valuation, raising issues for stability. The Bank of England has explicitly recognized that climate change can affect the safety and soundness of financial firms, with obvious implications for central banks. The Central Bank of the Netherlands and the Norges Bank have recognized that, even if the production of non-green sectors cannot represent a systemic risk, their financing exposure can turn into potential systemic threat. Central banks and financial regulators should consider alternative policy measures to mitigate environmental risk coupled with the major goal of enhancing

258

M. T. Punzi

green financing. Suggested measures include higher capital requirements for loans granted for non-green economic activities, and lower capital requirements to support the transition to a green economy. Academic research also suggests the implementation of green quantitative easing, by allowing central banks to directly purchase bonds issued by green corporations. An alternative approach would be to purchase bonds from development banks or green banks, such as the European Investment Bank. In parallel with monetary policy, macroprudential regulations should consider climate-related financial risks. The most obvious instrument would be the imposition of increased capital requirements against “brown” loans. Alternative macroprudential measures include the implementation of a “countercyclical buffer”, which would require banks to hold increasing amounts of capital as the growth rate of lending to carbon-intensive sectors increases, or lowering requirements on green assets in order to encourage investment. The Bank of Lebanon (officially Banque du Liban) has introduced differentiated reserve ratios by reducing the commercial bank’s obligatory requirements by an amount equal to 100%–150% of the loan value for project under energy savings. The Central Bank of Brazil mandates commercial banks to incorporate environmental and social risks in their governance framework and to evaluate these risks in the calculation of their capital needs. The Bank of Bangladesh has been providing additional liquidity to commercial banks’ lending to the green sector, while the Reserve Bank of India has implemented a minimum proportion of bank lending to flow to green financing. The Bank of Japan is offering subsidized priority loans to financial institutions via a Loan Support Program to support environment and energy businesses. However, few countries have thus far implemented monetary and macroprudential tools in order to mitigate environmental risk and to support green financing. There is a need for urgent international cooperation to facilitate the transition to a below 2-degree economy, compatible with the Paris Climate Change agreement.

References Angelopoulos K, Economides G, Philippopoulos A (2010) What is the best environmental policy? Taxes, permits and rules under economic and environmental uncertainty. CESifo working paper series 2980. Munich Annicchiarico B, Di Dio F (2015) Environmental policy and macroeconomic dynamics in a new Keynesian model. J Environ Econ Manage 69:1–21 Campiglio E (2016) Beyond carbon pricing: the role of banking and monetary policy in financing the transition to a low-carbon economy. Ecol Econ 121:220–230 Chandavarkar A (1987) Promotional role of central banks in developing countries. International Monetary Fund working paper 87/20. Asian Seminar on Financial Structure and Policies, 8–20 February, Bombay, India Devereux MB, Sutherland A (2011) Country portfolios in open economy macro-models. J Euro Econ Assoc 9(2):337–369

11

Role of Bank Lending in Financing Green Projects

259

Dobbs R, Pohl H, Lin D-Y, Mischke J, Garemo N, Hexter J, Matzinger S, Palter R, Nanavatty R (2013) Infrastructure productivity: how to save $1 trillion a year. McKinsey Global Institute, New York, p 88 Fischer C, Springborn M (2011) Emissions targets and the real business cycle: Intensity targets versus caps or taxes. J Environ Econ Manage 62(3):352–366 Heutel G (2012) How should environmental policy respond to business cycles? Optimal policy under persistent productivity shocks. Rev Econ Dyn 15(2):244–264 Jermann U, Quadrini V (2012) Macroeconomic effects of financial shocks. Am Econ Rev 102(1):238–271 Kollmann R, Enders Z, Müller GJ (2011) Global banking and international business cycles. Eur Econ Rev 55(3):407–426 Kollmann R (2013) Global banks, financial shocks, and international business cycles: Evidence from an estimated model. Journal of Money, Credit and Banking 45(s2):159–195 Rozenberg J, Hallegatte S, Perrissin-Fabert B, Hourcade J-C (2013) Funding low-carbon investments in the absence of a carbon tax. Clim Pol 13(1):134–141 Schmitt-Grohe S, Uribe M (2003) Closing small open economy models. J Int Econ 61(1):163–185 Tille C, Van Wincoop E (2010) International capital flows. J Int Econ 80(2):157–175 Vasilev A (2018) A real-business-cycle model with pollution and environmental taxation: the case of Bulgaria. J Environ Econ Pol 7:441–451 Xu W, Xu K, Lu H (2016) Environmental policy and China’s macroeconomic dynamics under uncertainty – Based on the NK model with distortionary taxation. MPRA Paper 71314, University Library of Munich, Germany Yoshino N, Taghizadeh-Hesary F (2016) Optimal credit guarantee ratio for Asia. ADBI Working Paper 586. Asian Development Bank Institute, Tokyo. Available: http://www.adb.org/publica tions/optimal-credit-guarantee-ratio-asia Yoshino N, Taghizadeh-Hesary F (2018) Alternatives to private finance: role of fiscal policy reforms and energy taxation in development of renewable energy projects. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, Singapore

A Comparative Study on the Role of Public–Private Partnerships and Green Investment Banks in Boosting Low-Carbon Investments

12

Dharish David and Anbumozhi Venkatachalam

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Using PPPs to Scale Up Green Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Role of Green Investment Banks in Boosting Low-Carbon Investments . . . . . . . . . . . . . . . . . . . . . . Types of PPPs and GIB Interventions in Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green PPP Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Green Finance Organisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . International Green Lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Types of PPPs and GIB Interventions in India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green PPP Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . GIB Interventions and Co-investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IREDA Is the Ideal Candidate for a Green Investment Bank in India . . . . . . . . . . . . . . . . . . . . . Capitalizing Japan’s Private Finance Support to Green Investments in India . . . . . . . . . . . . . . . . . Conclusions and Policy Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

262 264 266 269 269 271 271 273 273 277 278 281 283 286

Abstract

Following the successful climate agreement in Paris, global attention shifted quickly to how countries will achieve their Nationally Determined Contributions. To achieve these goals, governments need to make full use of the private sector’s capacity to unlock much larger investment flows in low-carbon infrastructure. This chapter focuses on two different types of mechanism, Public–Private Partnerships (PPPs) and Green Investment Banks (GIBs). While PPPs are more practical for countries that have robust demand and are complemented by strong D. David Singapore University of Social Sciences (SUSS), Singapore, Singapore e-mail: [email protected] A. Venkatachalam (*) Economic Research Institute for ASEAN and East Asia (ERIA), Jakarta, Indonesia e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_25

261

262

D. David and A. Venkatachalam

institutions and governance, protection of investments, and dispute resolution mechanisms, GIBs leverage public funding to mobilize much larger pools of private capital using innovative transactions, risk reduction structures, and market expertise. Although their common objective is to scale up low-carbon investment, both PPPs and GIBs have been established in a variety of national contexts to achieve a range of goals, including access to concessional capital with lower interest rates and longer tenures for green investments. This chapter examines the rationale, mandates, and financing activities of these two categories of financial architecture within the context of India and Japan. It takes stock of the actual and potential use of these two approaches and for strengthening bilateral cooperation between India and Japan. Keywords

Climate change · Clean energy · Green infrastructure · Green investment bank public–private partnership JEL Classifications

F21 · F34 · G29 · Q28

Introduction Following the successful climate agreement in Paris at the end of COP 21, global attention shifted quickly to how countries will achieve their Nationally Determined Contributions (NDCs). Achieving NDCs requires a range of technologies, projects, and businesses in a variety of sectors, including energy supply and distribution. These investments, often termed “green”, are needed throughout the cycle of innovation and market transformation. The specific sectoral investment needs are challenging (Anbumozhi et al. 2018), as they involve several interrelated risks. According to the Climate Policy Initiative (2017), climate finance peaked at US$ 437 billion in 2015, followed by a 12% drop to US$ 383 billion in 2016; nevertheless, finance remains far below estimates of what is required. Further, Treco et al. (2018) estimated that the energy sector in Asian emerging economies, including efficiency improvements in transportation and buildings, needs over US$ 1 trillion per year through 2030. While it is encouraging to see increased private sector activity in the maturing markets for renewable energy, steady public financial support has been key, though it remains a daunting task. The expected financing needs are large: a review of the NDCs and other policies in ASEAN, the People’s Republic of China, and India, which represent 37% of global greenhouse gas emissions, finds an initial investment opportunity of US$ 22.6 trillion from 2016 to 2030 in key energy sectors (Kumar et al. 2017). Although these estimates refer to levels of investments, most of these resources are intended to flow through the financial sector as bank lending, project finance, institutional investing, or equity investing (United Nations Environment Programme and the World Bank Group 2017).

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

263

The largest climate mitigation sectors, i.e., clean energy supply and energy efficiency improvement, are expected to see an overall increase of US$ 120 billion in global investment. In total, about US$ 200 billion in additional investment needs to be mobilized annually. This does not include the underlying investment requirements that various sectors would normally need regardless of Paris agreement commitments. For instance, in the energy sector, when the underlying investment requirements are added to additional decarbonization costs, about US$ 148 billion out of US$ 432 billion is projected to be green or low-carbon, such as for renewables, carbon capture, and storage. Of these green infrastructure needs, 70% will be in emerging markets and developing economies (Meltzer 2016). Public finance and international official development assistance can and will play a critical role to guide green investments, but transformational change will inevitably require large-scale private financing of low-carbon energy transition. However, traditional sources of private financing for green energy infrastructure also face significant financial, regulatory, and structural constraints. Green markets are unable to realize their full potential due to issues such as creditworthiness and bankability. Moreover, many banks are reluctant to lend to green energy, because many of its technologies are new (Anbumozhi and Rakhmah 2018). Especially in Asia, where banks dominate the financial markets and capital markets are tiny, this is a big challenge; hence, it is crucial to develop new financing instruments (Yoshino and Taghizadeh-Hesary 2018). In such cases, governments, though risky partners, will benefit from private sector participation through public–private partnerships (PPPs) and green investment banks (GIBs). Whether private capital can be mobilized to support green infrastructure will depend on the risk-return profile of the investments and the regulatory environment in which they operate. Alternatively, PPPs and GIBs can be understood as the intersection and alliance between public and private financial institutions to jointly supply cost-effective green finance. While PPPs deliver public services through a mutually beneficial partnership, GIBs leverage private finance for green investments. They therefore provide frameworks to ensure private leadership and accountability in tackling public good challenges like climate change. Moreover, PPPs and GIBs provide countries with limited public finance to “crowd in” private finance. In this situation, efficient and effective risk allocation is crucial, and international cooperation can play a further constructive role, providing a variety of funding, technical assistance, and guarantee measures (Gardiner et al. 2015). PPPs in effect allow for the transfer of public sector investment risks to the private sector. The objective of this chapter is to provide policy makers with a comparative review of PPPs and GIBs and the associated interventions that can mitigate risk or lower transaction costs. Based on the analysis, it proposes a framework that can identify how advanced economies like Japan can support emerging economies like India in providing public-private investments and in the establishment and funding of GIBs when investments are not flowing at the pace and scale required. This chapter builds on the review of general trends in PPP investments, the rise of numerous GIBs, and detailed analysis of case studies that contribute to a better understanding of these institutional mechanisms.

264

D. David and A. Venkatachalam

Using PPPs to Scale Up Green Investment According to the Climate Policy Initiative (2017), private sector investment has taken the largest share in low-carbon finance, and project developers have been consistently driving the largest volume of private finance as exemplified in Figure 1. While the share of more traditional lenders in the climate financing mix signals a Public Sector Investors

Investment in $ Billion

300

250

Public Financial Institutions National

200

Public Financial Institutions Multilateral

150

Public Financial Institutions Bilateral

100

Governments and Agencies

50

Climate Funds

0 2012

2013

2014 Year

2015

2016

Private Sector Investors

300

Project developers

Investment in $ Billion

250

Commercial Financial Institutions

200

Households

150 Corporate actors 100 Institutional investors 50 PE VC and infrastructure funds

0 2012

2013

2014 Year

2015

2016

Figure 1: Global Investment to Address Climate Change by Public and Private Sector Investors, 2012–2016. PE private equity, VC venture capital. (Source: Climate Policy Initiative 2017)

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

265

maturing technology market, more commercial finance institutions are taking a larger role, with institutional investment growing rapidly. In terms of public sector investment, in 2015, development finance institutions accounted for the majority of public flows, contributing 89% of the total (Climate Policy Initiative 2017). The general trend suggests the need for dedicated green finance institutions in leveraging private finance that can help close the funding gap for many low-carbon investments, especially in developing countries like India, where the market needs are high and growing. As green energy projects require high up-front investment, private sector capital, technology, and innovation have often been routed through PPPs to supplement limited public funding. The real challenge to green technology investment is that the market is small, though it is similar to other infrastructure projects that generally face high upfront capital costs and long-term payoffs. High transaction costs, lack of viable funding models, and exposure to political risk are other barriers that increase the risk of investing in green infrastructure (Meltzer 2016). With the private sector being unable to mitigate externalities and monetize them alone, many green investments often require the public support through PPPs and GIBs. However, these still need to exist in an overarching policy environment that subsidizes green technologies, which are no different from many other infrastructure projects. Nevertheless, green infrastructure investment faces such barriers as small average size, relatively high transaction costs and the corresponding need to aggregate the risks knowledge, financial viability, and technology. Such hybrid financing schemes are more common as projects become more complex and are not viable purely on private financing structures. Green technologies must develop an equitable risk allocation framework that can provide a compelling argument for different stakeholders to support these investments through subsidized financing to the extent that this financing is justifiable from a public good perspective. Moreover, the successful closure of green energy projects will lock in new investments into clean technology over their lifetime, while displacing low-cost polluting alternatives. This is significant as carbon mitigation initiatives often deal with emissions of pre-existing assets, rather than introducing new clean investments (Baietti 2013). Concessional PPPs are especially needed at the early project preparation and construction phases of infrastructure projects, where risks are highest and capital most costly and scarce. Concessional PPP schemes have a particularly key role as a low-cost source of finance which, when blended with other sources of public finance, can de-risk green infrastructure projects and crowd-in private finance. Once green energy projects commence operation and generate returns, risks are reduced, and these projects can be securitized and sold to institutional investors looking for stable returns. The higher-risk, early-stage concessional green PPPs can then be recycled into other infrastructure projects. Moreover, the development of financial instruments such as green bonds can be linked to PPP projects that can attract institutional investment (Meltzer 2016). With PPPs, the spillover effects originally created for energy supplies need to be used, and

266

D. David and A. Venkatachalam

tax revenues refunded to the investors in energy projects (Yoshino and TaghizadehHesary 2017). Thus, a well-designed PPP can be an opportunity to scale-up funding for clean energy internationally and in effect contribute to the battle against climate change. Though the potential benefits of PPPs are many, there remain challenges for host governments and various partners. When disputes occur between the private sector and host governments, international financial institutions can play an important role in resolving disputes and help ensure the fair sharing of the risks and the rewards of the PPP for all the parties involved. A critical aspect of green energy PPPs is the way risks are allocated within the public and private entities (Delmon 2009). Since effective risk allocation is key to the success of any PPP, a general principle is that risk should fall on the party that is more capable of handling it. PPP risks, however, tend to be allocated based on commercial, financial and negotiating strength. The stronger party, either public or private, will allocate the risk that it does not bear. Efficient allocation of risk will generally result in a more successful and profitable investments.

Role of Green Investment Banks in Boosting Low-Carbon Investments GIBs as public or semi-public entities are increasingly being used to facilitate private capital into domestic investments, mainly in low-carbon energy infrastructure that can help to meet NDC targets. These new institutions are publicly funded and offer preferential rate lending to finance renewable energy, energy efficiency, and other clean energy infrastructure projects in partnership with private lenders. Using innovative transaction structures, risk-reduction and transaction-enabling techniques, with local market expertise, GIBs are well positioned to channel private investments into green projects. GIBs primarily leverage the impact of relatively limited public resources; as of 2015, 13 national and sub-national governments have created public GIBs or similar entities (Table 1). GIBs and similar entities have been established at the national level (Australia, Japan, Malaysia, Switzerland, United Kingdom), the state level (California, Connecticut, Hawaii, New Jersey, New York and Rhode Island in the United States), the county level (Montgomery County, Maryland, United States) and the city level (Masdar, United Arab Emirates) (OECD and Bloomberg Philanthropies 2015). A key factor in creating green investment banks is when there is a greater risk in investing in low-carbon energy projects. Some of these risks are attributed to a lack of suitable financial instruments and shortage of objective information and skills to assess the financial transactions. GIBs address local market and policy failures, and are especially important to countries that do not have national development banks or similar entities that are actively promoting private investment in green domestic infrastructure. Even if dedicated infrastructure and development banks do exist, governments can consider establishing GIBs in “mainstreaming” green investment objectives in existing national development banks.

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

267

Table 1: Selected Examples of GIBs and GIB-Like Entities and Their Funding Operational GIBs and GIB-like entities Connecticut Green Bank

Clean Energy Finance Corporation UK Green Investment Bank Green Fund Green Energy Market Securitization (Hawaii Green Infrastructure Authority) New Jersey Energy Resilience Bank NY Green Bank

Location Connecticut, US

Year instituted 2011

Australia

2012

Funding sources Loans and emissions trading schemes revenue and utility bill surcharges, renewable portfolio standards, energy efficiency resource standards Appropriations

United Kingdom Japan Hawaii, US

2012

National government funding

2013 2014

Carbon tax revenue Bond issuance

2014

National government funding

2014

Emissions trading schemes revenue, utility bill surcharges, renewable portfolio standards, energy efficiency resource and utility bill surcharges, renewable portfolio standards, energy efficiency resource standards and reallocation of funds from existing programmes

New Jersey, US New York, US

GIB green investment bank. Source: Adopted from OECD 2017.

GIBs are created not only for meeting ambitious green investment targets, but also for supporting local community development, lowering energy costs, developing green technology markets, creating jobs, and lowering the cost of capital for green infrastructure (OECD and Bloomberg Philanthropies 2015). For this reason, it is also important to track the performance of these projects to keep them accountable. Specialized metrics generally focus on emissions saved, job creation, and leverage ratios (i.e., private investment mobilized per unit of public spending); when these banks are required to be profitable, the rate of return is also included. GIBs adopt a different approach from many grant-making public institutions and follow strict mandates to mobilize investment using limited public capital by catalyzing private financing for low-carbon technologies via financial tools such as long-term and lowinterest loans, revolving loan funds, insurance products (loan guarantees or loan-loss reserves), green bonds, and low-cost public investments (Geddes et al. 2018). When a GIB uses public funds for financing, rather than grants or subsidies, the public funds are preserved through loan repayment. GIBs are essentially mandated to provide the following services: (i) attractive and flexible low-cost financing terms; (ii) credit support; (iii) co-investment; (iv)

268

D. David and A. Venkatachalam

standards; and (v) increased supply of capital (NRDC and CEEW 2016). It is important ensure that GIBs do not to replace or “crowd out” commercial banks and private investors but actually “crowd in” private capital. They can play a transformative role as they are neither a traditional government program with limited engagement with markets, nor a private entity weighed down by competitive pressures and fiduciary constraints. There are examples of governments cognizant of technical and regulatory barriers and opportunities for mobilizing private capital sometimes appointing state investment banks as GIBs to close the financing gaps, such as with Germany’s Kreditanstalt fuer Wiederaufbau (KfW). The UK’s GIB was founded in 2012 in the same way with public funding and a goal to mobilize private sector capital into low-carbon energy projects (UK Green Investment Bank 2017). It was set up as an independent government-owned entity capitalized with GBP 3 billion (US$ 4.6 billion) and invests on terms similar to those of commercial banks, with a minimum 3.5% annual return required on investments before tax (OECD and Bloomberg Philanthropies 2015). To comply with EU rules, approval of the GIB’s creation was contingent on it only lending to projects and sectors that were not considered investable by private or commercial funding. This provided the GIB with an additional focus of crowding-in finance to such projects, especially as the private sector could leverage them as risk mitigation instruments. Today, GIBs provide a wide range of financial instruments, including long-term fixed market rate debt, mezzanine and subordinated debt, equity and bridging equity loans to target sectors such as offshore wind, waste-to-energy, bioenergy, energy efficiency, and, more recently, onshore wind. The bank disburses loans through direct financing, co-financing partnership programs, and contributing to third-party managed funds, financing 69 projects between 2012 and 2016 (GIB 2017). The financial performance and other indicators of GIB are presented in Table 2 for the years 2013–2017. By 2016, the GIB had committed GBP2.1 billion (US$ 3.2 billion) cumulative investments toward a total of GBP8.5 billion (US$ 13 billion) worth of project value, leveraging 3 pounds from the private sector for every 1 pound invested by the bank (UK Green Investment Bank 2017). In addition, there is a positive correlation between the capital committed and profit before tax and renewable energy produced, indicating a successful lending portfolio. KfW is another exemplary effort. While originally established in 1948 with Marshall Funds as the country’s development bank, it has also been very active in low-carbon energy financing (KfW 2017). KfW is an AAA- rated institution that currently raises over 90% of its funds in capital markets through governmentguaranteed bonds. Its shareholders include the German government at the federal (80% share) and state (20% share) levels, which together hold €3.75 billion (US$ 4.6 billion) of equity capital (KfW 2016). Though KfW is not exclusively a GIB, it is mandated to support Germany’s low-carbon energy transition and it has been one of the largest development bank investors in clean energy projects globally (Table 3). Between 2012 and 2016, KfW issued commitments with a total volume of €103 billion for projects in connection with the energy transition, contributing towards the

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

269

Table 2: UK Green Investment Bank Limited (GIB) Performance Highlights Performance indicator Capital committed (£ million) Profit before tax (£ million) Total transaction value (£ billion) Projected portfolio return (%) Projects financed Renewable energy produced (TWh)

2013–14 617 (5.7) 2.3 8 17 12.8

2014–15 723 0.1 2.5 9 22 16.3

2015–16 770 9.9 3.7 10 30 20.3

2016–17 839 24 1.4 10 24 21.5

Source: GIB Annual Report http://greeninvestmentgroup.com/media/185901/gib-annual-report2016-17-final.pdf. Table 3: KfW Key Figures of the Statement of Financial Position

Total assets Volume of lending Volume of business Equity Equity ratio

31 Dec 2016 € in billions 507.0 472.4 609.2 27.1 5.3%

31 Dec 2015 € in billions 503.0 447.0 587.2 25.2 5.0%

KfW Kreditanstalt fuer Wiederaufbau. Source: KfW Annual Report 2016.

German Federal Government’s Energy Turnaround Action Plan and reaching the nation’s environmental and climate goals (KfW 2017). KfW’s low-carbon focus areas are energy efficiency, renewable energy, and energy-related innovation projects. KfW mostly provides standardized, fixed-rate concessional debt through its domestic programs, which are then distributed through its extensive network of local banks via on-lending. The bank also provides guarantees, grants, up-front repayment-free periods, and a limited amount of equity and long-term market rate debt for large corporate projects. Domestically, KfW IPEX18 focuses on large-scale offshore and onshore wind and specializes in project finance offering a dedicated fixed market rate, and long-term debt products.

Types of PPPs and GIB Interventions in Japan Green PPP Investments PPPs have recently been promoted more aggressively by the Japanese government as part of its economic growth and stimulus strategy. The high costs of retrofitting aging public infrastructure in combination with falling fees and populations is pushing local governments to look for alternative ways to finance and maintain public assets. Renewable energy, public sewage facilities, and waste treatment plants

270

D. David and A. Venkatachalam

and projects form the biggest class of public infrastructure, with more than 3,600 enterprises operating in the country. In March 2016, there were 527 total PPP projects, also known as Private Finance Initiatives (PFIs). These arrangements cover operations and management of public energy facilities, water, and waste sectors, as well as cultural centers and medical facilities. Waste-to-energy projects have attracted considerable financing through PFIs. Although many cities have introduced power generation at waste incineration plants, they are not financially viable enough to make the necessary large-scale investments. The case of Yokote is interesting as the city is in an agricultural area with a population of only 100,000. After evaluating the costs of different business models, including a conventional engineering-procurementconstruction model and a design-build-operate model, the city chose the latter. The city offered a tender and concluded contracts with a private consortium for construction operation and management for ¥8,267 million and ¥7,070 million, respectively, for 20 years. The city prepared the funding for the construction of the plant, using the Special Bond for Municipality Amalgamation, where about 70% of principal and interest payment was shouldered by the national government, and a government subsidy programme for promoting investments that contributed to circular economies. More than three-quarters of capital expenditure were directly or indirectly paid by the national government. The design-build-operate model is now standard in Japan for such projects (Hongo 2016). In 2013, there were amendments to the PFI Act, allowing for a public-private infrastructure fund to be established with public funds of ¥10 billion to assist in certain market risk-bearing PFI/PPP projects. In the 2017 update to the PPP/PFI Action Plan for the 10-year period beginning from 2013, the government set a target of ¥21 trillion for PPP/PFIs for concession-style projects, i.e., projects in which the operating rights of government-owned facilities are assigned to a private company, which recoups its investment through service fees and tolls charged). This was a significant increase from the initial PPP/PFI Action Plan targets of ¥12 trillion (US$ 110 billion). The PPP/PFI Action Plan addresses ageing infrastructure, disaster prevention, and climate mitigation, and leveraging of standalone PFI/PPP projects (GTDT 2018a). On the low-carbon sector front, the feed-in tariff (FIT) scheme introduced in 2012 made investments in renewable power generation projects more bankable; as a result, the number of PPP projects, particularly in photovoltaic power generation, increased dramatically. However, the government decreased the pricing under the FIT scheme to address overconcentration in the photovoltaic power generation market and to promote other sources such as offshore wind power, biomass, and geothermal. While the FIT price is being modified annually, “greenfield” projects in renewable power production are expected to increase. The major challenge, though, for many renewable energy projects is that most of them are small to medium in scale, and concession and stand alone-type projects are usually suited for and target large-scale projects.

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

271

One reason PPPs have not taken off in Japan is that public facility-type PFI projects are not attractive in terms of profitability. Other reasons include municipalities being inexperienced in the regional projects that constitute the majority of domestic PFIs. Moreover, PPPs are not incentivized for financing public projects; on the contrary, municipal bonds are preferred as they are less expensive and less complicated (GTDT 2018b). Nonetheless, the most interesting development in the Tokyo Stock Exchange has been the opening up of the market for listed infrastructure funds investing in renewable energy projects and concession projects. This is expected to boost the number PPPs in infrastructure projects, further aided by the development of a secondary market for domestic infrastructure. Growth in this sector is also attracting alternative investors such as insurance companies and the Government Pension Investment Fund, which manages over ¥140 trillion (US$ 1.2 trillion) in public assets (GTDT 2018b).

The Green Finance Organisation In Japan, the Green Fund commenced its operations in 2013. The Green Finance Organisation (GFO), which controls the fund, aims to support local community development to address the impacts of slow economic growth and an aging society. The Green Fund is capitalized by the proceeds from the national Climate Change Countermeasure Tax, established in 2012 on petroleum and coal consumption. The Green Fund was established in response to the challenges associated with financing clean energy, including high up-front costs for development and construction, as well as long operation and income phases that increase risk for owners as well as developers. The Green Fund’s objective has been to enhance the business case of clean energy projects by making equity and mezzanine investments that attract further capital from private sources. Equity investments are limited to less than 50% of the total amount (Figure 2); in some cases, a sub-fund is created that aggregates equity investments from GFOs and other sponsors prior to funding the project vehicle (Green Bank Network 2018). Since its inception in 2013 through March 2017, the GFO through the Green Fund made investment commitments of US$ 110 million into projects with a total value of over US$ 900 million, achieving a private source leverage ratio of over 10:1. Table 4 provides the details of the project invested by the Green Fund between 2013 and 2015. Projects in which GFOs have invested are expected to avoid nearly 1 million tons of CO2 every year (Green Bank Network 2018).

International Green Lending Japan has also established several international programs with significant funding to support clean infrastructure investments. This includes, most notably, the Clean

272

D. David and A. Venkatachalam

Low-Carbon Projects

Climate Change Mitigation Tax

Financial institutions

Debt

Loans

Green Fund

Invest

Sponsor

Invest

Green Fund Equity*

Equity

*Green Fund investment capped at half of the total equity amount Figure 2: Funding Structure of the Japan Green Fund. (Source: Green Finance Organisation 2016)

Table 4: Transactions by the Japan Green Fund by Project Type, 2013–2015 (in US$ 1,000) Project Type Solar Wind Hydro Biomass Binary Mixture Total

2013 Amount 500 6,000 0 2,000 3,000 0 11,500

Number 1 2 0 2 1 0 6

2014 Amount 4,400 0 6,350 15,000 0 5,000 30,750

Number 3 0 2 3 0 1 9

2015 Amount 6,700 13,900 0 0 0 7,000 35,600

Number 2 2 0 0 0 1 8

Total Amount 11,600 19,900 6,350 17,000 3,000 12,000 77,850

Number 6 4 2 5 1 2 23

Source: Green Finance Organisation 2016.

Technology Fund, Global Environment Facility, and the Clean Development Mechanism created by the Kyoto Protocol. Japan’s climate finance is composed of the publicly financed Official Development Assistance, other official flows, and private investments. Besides these, public–private finance is assuming an evergreater importance. Public institutions like the Japan Bank for International Cooperation (JBIC) and Nippon Export and Investment Insurance support Japanese companies in their investments overseas, thus promoting private climate finance (PCF). In this sense, PPP projects are key components in the promotion of PCF.

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

273

The ODA programs are coordinated by the Japan International Cooperation Agency. Further, Japan mobilized US$ 3.8 billion in PCF support 2010 and 2011 to mitigate climate change in developing countries as their primary or secondary goal (Konrad-Adenauer-Stiftung eV 2017). PCF support is often linked to programs that are either co-financed by Japanese financial institutions, or that use Japanese technology or expertise. It is also tailored to the market conditions of recipient countries, and has an overwhelming focus on climate change mitigation, rather than adaptation (Anbumozhi and Yao 2016). Given the domestic project finance market outlined earlier, many Japanese banks are also actively participating in offshore project finance transactions. In particular, the Japanese government has adopted a policy of using ODA loans and export credit agency financing to achieve infrastructure exports of approximately ¥30 trillion (US$ 275.2 billion) in 2020 (GTDT 2018b). According to the Japanese government, infrastructure exports hit ¥20 trillion (US$ 183.4 billion) in 2015. This initiative continues to be one of the most important government infrastructure policies, and it is anticipated that there will be a corresponding increase in project finance transactions related to renewable infrastructure projects in developing countries like India.

Types of PPPs and GIB Interventions in India Green PPP Investments India has seen a rapid increase in private investment in infrastructure since 2000. Its PPP programs grew rapidly during 2006 and 2012 and then gradually declined (Figures 3 and 4) both in terms of value and number of projects. In an assessment of 19 economies in Asia and the Pacific by the Economic Intelligence Unit (EIU and ADB 2015), India was considered, along with Republic of Korea, Japan, and the Philippines, as having a developed overall policy, with a regulatory, and institutional environment to attract private agents to public projects. India was the top recipient of private participation in infrastructure (PPI) activity from 2008 to 2012. India alone accounted for almost half of the investment in new PPI projects in developing countries during 2011. This was the result of regulatory and institutional initiatives undertaken by the relevant government institutions to rapidly develop infrastructure. The establishment of the apex committee—the Public Private Partnership Appraisal Committee—with the adoption of standardized bidding documents, helped in dramatically streamlining the appraisal and approval of infrastructure projects. According to the PPI Database, in 2015, PPI investment in India fell for the fifth consecutive year, hitting a 10-year low of US$ 3.9 billion. While the global economic slowdown played a role, other major issues also contributed to the decline. On the

274

D. David and A. Venkatachalam

50,000

Natural Gas 45,000

Water and sewerage 40,000 Total Investment (in $ million)

Airports 35,000

ICT 30,000

Ports 25,000

Railways

20,000

Roads

15,000

Electricity

10,000 5,000 2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Year

Figure 3: Annual Investments in PPPs in Infrastructure in India by Sector (2005–2017*). ICT information communications technology. *Data for 2017 for the first half of the year only. (Source: Authors’ calculation from World Bank’s Private Participation in Infrastructure Database)

140

Natural Gas ICT

To t a l In v e s t m e n t ( i n $ m i l li o n )

120

Airports

100

Railways Water and sewerage

80 Ports

60

Electricity Roads

40

20

0 2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Year

Figure 4: Annual Project Count of PPPs in Infrastructure in India by Sector (2005–2017*). ICT information and communications technology. *Data for the first half of 2017 only. (Source: Authors calculation from World Bank’s Private Participation in Infrastructure Database)

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

275

12

Percentage (%)

10 8 6 4 2 0 2011 - 2012

2013 - 2014

2014 - 2015

2015 - 2016

2016 - 2017

Year Non-performing loans (%)

Gross loans (%)* *Combined fiscal deficit as % of GDP

Figure 5: Non-Performing Loans and Gross Loans (as Combined Fiscal Deficit as % GDP) in India. GDP gross domestic product. (Source: National Accounts Statistics, MOSPI Government of India 2018)

domestic side, PPPs were adversely affected by delays in land acquisition and clearances, shifting of utilities, and right-of-way issues, leading to time and cost overruns. Additionally, the private sector faced inadequate due diligence by developers and banks, resulting in many loans being rendered as non-performing (Figure 5). Moreover, Indian companies are currently saddled with debt, stretched balance sheets and are sitting on underutilized capacity. Therefore, in the immediate future they are unlikely to increase capital expenditure for risky low-carbon projects (GTDT 2018c). PPP transactions in India have been mostly funded through commercial debt, with Public Sector Undertaking (PSU) banks leading the way. Infrastructure loans were a major contributor to the rise in non-performing assets approved by the stateowned PSU banks. Further capital markets were inadequately developed and dominated by a safe asset class of quasi-government entities leaving virtually no appetite for infrastructure projects that were perceived as risky assets, while the government debts were increasing rapidly, reducing the fiscal space available to green infrastructure (World Bank 2017). Though the government has been keen on resuscitating investments in infrastructure over the last year, there has only been limited interest in project financing in the renewable energy and transportation sectors, and most of this has been from the government or PSU banks (Figure 5). Nevertheless, energy is taking in most of the foreign direct investment, particularly in solar, with India overtaking the US to become the world’s second-most attractive renewables market. As of March 2017, India had a combined renewable energy capacity of 57 GW, and it hopes to expand that to 175 GW by 2022. Most of this is expected in solar, which also saw a significant drop in tariffs in 2017. Table 5 showcases the numerous renewables PPP projects for the first quarter of 2017, using the latest available data. The trends in PPP financing in India highlight several issues with implications for financing large-scale concessional projects envisaged by the government, including

276

D. David and A. Venkatachalam

Table 5: Solar and Wind Power Greenfield PPIs in India for H1 2017a Total investment (in US$ million) 66.2 52.1 41.85 59.56 149.7 28.66

Project Rising Bhadla 2 Solar Farm Telangana Solar PV Plant Suryoday Solar Plant Divine Solren Solar park Bhadla Solar park Bhagwanpur & Bindookhadar & Haridwar Solar Projects FRV Solar India

141

Karnataka Wind Farm Janardan Wind Energy Vayu Urja Bharat Wind Farm

80.62 19.3 164.9

Sponsors Rising Sun Energy (100%) Renew Power Limited (100%) Shapoorji Pallonji Group (100%) Mahindra & Mahindra (100%) Solairedirect S.A. (100%) EDF Energies Nouvelles SA (25%), Others (51%), Eren Holding (25%) Fotowatio Renewable Ventures (FRV) (100%) Renew Power Limited (100%) Others (100%) Hero Group (100%)

Projects that reached financial closure and are operated under Build, Own, Operate (BOO) contracts. Source: World Bank Private Participation in Infrastructure Database 2018.

a

for green projects. Long-term financing exposes banks to the risk of asset liability mismatch; the main source of funds for Indian banks is savings deposits and term deposits, whose maturity profile ranges from less than 6 months to 5 years. Over much of the period, PPP developers were comfortable with shorter rest periods; as interest rate began to increase, however, concerns arose because the concessions contracts have no provisions for passing on higher rates. Continued rate increases as well as tightening of credit could have adverse effects on some green PPP projects. Key challenges include overcoming the mismatch between long-term assets and short-term credit provision, as well as the imperative of attracting additional flows of foreign public and private capital (UNEP 2016). On the equity side, participation by foreign players, particularly strategic institutional investors, has accounted only for only 11% of total investment, even though PPP projects in the sectors studied can have 100% foreign direct investment. Encouraging pure equity providers and institutional investors to participate will require more liberal norms at the time of bidding or allowing them to enter later with a majority stake in projects that are highly profitable and share more risk with the public counterpart. Further, both central and state governments need to develop mechanisms through which non-banking financial institutions could also finance low-carbon projects. Unlike in Japan, manufacturing of low-carbon energy and waste-toenergy equipment are not included in the concessional PPP guidelines in India. Manufacturing could play an important in the transformation of energy sector to achieve NDC targets. Hence, in addition to direct lending by banks, lending by intermediate financial institutes and specialized banks could benefit low-carbon projects.

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

277

GIB Interventions and Co-investments To generate 175 GW of renewable energy by 2022 and to reduce greenhouse gas emissions by 33–35% from 2005 levels by 2030 as part of its NDC commitments, India has set ambitious goals for five key sectors: (i) ground-mounted, large-scale solar; (ii) rooftop solar; (iii) off-grid solar; (iv) wind energy; and (v) energy efficiency. India is part of a green infrastructure coalition launched in December 2015 to bring together investors who have strategic interests in scaling up green energy infrastructure. From that context, GIBs as special purpose vehicles get prominence since they are designed to address local market and policy failures. Based on international models, GIBs can provide financing solutions to grow India’s green energy market. Not all will be appropriate to the Indian context and actual opportunities will be determined through detailed market research. In India, both a GIB and green bonds could support low-carbon projects by providing broader access to domestic and foreign capital as well as better financing terms, including lower interest rates with longer lending terms. GIBs, as financial institutions, typically issue bonds to raise additional capital beyond government grants, and sell loans and recapitalize their balance sheet. The bonds issued by a GIB would, by definition, be green bonds, because all bank capital goes towards low-carbon projects. With a pledge to have cleaner energy sources account for 40% of total energy generation capacity by 2030, India will require tremendous effort to achieving these targets through competitive auctions. Indian banks have begun to rise to the challenge in issuing green bonds overseas, which now include the Exim Bank, Yes Bank, and IDBI Bank. But to boost more investments, more incentives for such domestic bonds have to be developed by the Securities and Exchange Bureau of India (SEBI). With the Reserve Bank of India (RBI) announcing renewables as a priority lending sector, many Indian banks will be obliged to discover ways to make green bonds work, especially in the context of developing low-carbon infrastructure and allocate more investments to their loan portfolio. According to RBI, total corporate bond issuances have increased from Rs2.7 trillion in 2010–11 to Rs4.8 trillion in 2014–15, and the number of issuances has increased by 77% (RBI 2015). Yet the bond market in India is small compared to Japan, both in terms of volume and issuances. In Japan, bond markets accounted for 16.2% of GDP in 2016 (Hongo 2018). GIBs differ in scope and approach, but place a strong demand on public sector capacity to communicate and negotiate both with the private participants as well as other international institutions, who have the potential to link new stakeholders to projects and attract and channel international capital and accelerate domestic investment by leveraging limited public funds. In general, they follow the characteristics of mainly mobilizing private green infrastructure investments; independent special purpose financial vehicle, and inject additional capital to facilitate transactions that would not occur without their involvement. GIBs will also mediate and reduce risks, resulting in abundant and affordable capital to scale up clean energy projects.

278

D. David and A. Venkatachalam

IREDA Is the Ideal Candidate for a Green Investment Bank in India The India Renewable Energy Development Agency Limited (IREDA) was established in 1987 to promote, develop, and extend financial assistance to renewable energy and energy efficiency/conservation projects. It is a public financial institution and registered as a non-banking financial institution. IREDA’s financial services include direct project financing, equipment finance, business development finance, loans for manufacturing facilities of energy efficiency equipment and to banks and other financing institutions for on-lending. It is funded partly through the central government and also receives funding from the German Development Bank (KfW), French Development Bank (AFD), Nordic Investment Bank (NIB), European Investment Bank (EIB), Japan International Cooperation Agency (JICA), World Bank, Asian Development Bank, and other international financial institutions. From 2006 to 2010, IREDA’s total funding grew from approximately US$ 391 million to US$ 665 million. One of IREDA’s important functions is providing low interest-bearing funds and refinance schemes based on capital from the National Clean Energy Fund (NCEF). NCEF was established by the Government of India by levying a cess (tax) on locally produced as well as imported coal. The IREDA-NCEF Refinance Scheme aims to bring down the cost of funds for renewable energy projects by providing concessional rates of interest. Besides its financial offerings, IREDA has also set up its own low-carbon projects. IREDA floated its first green Masala bond in September 2017, making it the first to be listed on the London Stock Exchange’s International Securities Market. The 5-year dated green Masala bond raised approximately US$ 300 million (Rs19.5 billion) with a coupon of 7.125%. The green bond is certified by the Climate Bonds Initiative. After IREDA floated its first international masala bond on the London Stock Exchange, it also filed a draft red herring prospectus for an initial public offering in December 2017. The company plans to issue 139 million fresh shares through the offering. The lending model of IREDA is illustrated in Figure 6, outlining its structure, activity, and source of funds (Table 6). In addition to offering lower rates and longer terms, GIBs such as IREDA may cover 100% of the project cost, but more commonly use co-lending or risk mitigation strategies to bring in private investment. For instance, many GIBs use credit enhancements like loan loss reserves to support more private lending on better terms. Currently in India, credit enhancement schemes with entities such as the IDFC Bank, YES Bank, and the India Infrastructure Finance Company have been providing first-loss partial credit guarantees to many recently issued renewable energy bonds. However, there are still very few of these credit enhancement tools in place. Though these institutions possess major characteristics of GIB-like entities, they also differ in many areas. Typically, they aim to demonstrate the profitability of lowcarbon investments and bridge financial market access to such projects. Mainstream lenders and investors in India are often too slow in gaining confidence in new green energy technologies. These GIB-like institutions accelerate the process by reducing real and perceived risks and increasing the number of transactions in markets.

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

279

Future Plans • To raise another Rs4 trillion by 2022: • Masala bonds listing at Singapore and London Stock Exchanges • Cabinet Committee approval of the initial public offering of 139 million shares of Rs10 each

International Sources Domestic Sources • Taxable bonds with 10-year tenor • Tax-free bonds with 10-, 15- and 20-year tenor • Borrowing from bank/financial institutions such as Union Bank of India and Small Industrial Development Bank of India

Repayment

Lending

• German development bank (KfW) • French development bank (AFD) • Nordic Investment Bank (NIB) • European Investment Bank (EIB) • Japan International Cooperation Agency (JICA) • World Bank • Asian Development Bank • and other IFIs Repayment

Lending

India Renewable Energy Development Agency Limited (IREDA) • Public limited government company established in 1987 under the Ministry of New and Renewable Energy (MNRE). • 100% owned by the Central Government of India (7.846 million physical shares) • Mission: to promote, develop and extend financial assistance for renewables and energy efficiency projects Repayment

Lending

Promote and Lend to Energy Service Companies and for Demand Side Management • Preferential lending for the implementation of: • Demand Side Management • Development of Energy Service Companies using escrow accounts

Repayment

Lending

Direct Lending to Projects and On-lending • Direct project financing, for equipment, business development, manufacturing facilities of renewables and energy efficiency • Loans to banks/financing institutions for on-lending.

Figure 6: IREDA Lending Model. (Source: Developed by authors based on information available at IREDA 2016–17 Annual Report and www.ireda.gov.in)

Nevertheless, in order to become a full-fledged green investment bank, these key questions regarding IREDA need to be answered. Does IREDA have the institutional flexibility to provide low-cost loans at the level a GIB can? Does IREDA’s status as a Regulated Non-Banking Financing Institution and fully owned by the central government prevent it from engaging in certain kinds of financing that GIBs can

280

D. David and A. Venkatachalam

Table 6: IREDA Resources, Operation Details, and Sector-Wise Resource Disbursements for 2012–2017 (Rs Billion) Resources 2012–13 2013–14 2014–15 2015–16 Equity capital 6.996 7.446 7.846 7.846 Reserves and surplus 9.888 12.883 13.940 15.115 International assistance 37.940 41.417 47.603 55.529 Domestic borrowings 14.062 26.138 26.789 44.516 Total 68.885 87.883 96.177 123.005 Operations 2012–13 2013–14 2014–15 2015–16 Loan sanction 37.474 38.184 45.488 78.065 Loan disbursement 21.255 24.711 26.195 42.574 Repayment of borrowers 4.368 8.910 19.630 27.698 Net outstanding loans (IREDA) 64.769 81.900 88.035 102.017 Working results 2012–13 2013–14 2014–15 2015–16 Total income 7.296 8.954 11.184 11.745 Profit before tax 2.506 3.403 3.786 4.176 Profit after tax 2.027 2.405 2.719 2.980 Earnings per share (in `) 330.90 327.29 355.05 379.86 FY 2016–17 FY 2016–17 Sectors sanctions % disbursementsa Wind power 24.605 24.12 25.356 Solar energy 48.304 47.36 15.240 Short-term loan 20.400 20.00 20.050 Hydro power 3.297 3.23 3.409 Biomass & co-generation 1.464 1.44 0.868 Bridge loan against GBI/capital subsidy to 0.352 0.35 0.505 channel partners and loan against pending energy bills Energy efficiency and conservation 2.950 2.89 0.066 Miscellaneous (biomass 0.618 0.61 0.440 gasification + NCEF) Total 101.990 100.00 65.935

2016–17 7.846 17.254 78.716 51.772 155.588 2016–17 101.990 65.935 33.704 133.368 2016–17 14.817 5.282 3.650 465.22

% 38.4 23.11 30.41 5.17 1.32 0.76

0.10 0.67 100.00

Amounts of disbursements includes the projects sanctioned during the financial year 2016–17 and previous years. Source: IREDA 2017 Annual Report. a

otherwise provide? For example, can IREDA use the proceeds from the NCEF to create a reserve to support more lending? Does IREDA’s mandate and internal expertise allow it to develop markets and demand generation activities of a GIB? How are its on-lending activities with other banking and non-banking institutions structured and managed? Nevertheless, leveraging IREDA’s financial assets and lending capability to increase the green infrastructure projects enable further channelling of finance toward the Paris climate target. Currently, IREDA is categorized as a sector-specific development financial institution and a non-banking financial institution, allowing it to make capital expenditure on new green products, approve modernization

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

281

measures, and make power purchase agreements without government approval on deals up to US$ 80 million. A larger mandate as a GIB would allow IREDA to harness domestic bond markets via the deployment of international funding through such facilities as the Green Climate Fund. Additionally, currency swaps and hedging could be undertaken by IREDA with other designated GIBs in Japan, Europe, and the US. This will allow it to issue credit guarantees and mobilize additional lines of finance to provide low-cost, longer-term financing in India. Another crucial aspect would require IREDA to make amendments in its operating guidelines to improve its performance on par with other GIBs operating globally, which include (i) the revision to the existing lending guidelines for approval of the projects eligible for financing under green infrastructure; (ii) establishing the monitoring, reporting, and verification procedures for the approved projects; and (iii) eliminating barriers that have prevented the participation of other institutional and foreign investors.

Capitalizing Japan’s Private Finance Support to Green Investments in India The list of finance sources for India’s solar projects now includes a JBIC loan agreement with SBG Cleantech, a clean energy joint venture between Japan’s SoftBank Group, India’s Bharti Enterprises, and Taipei, China’s Foxconn Technology Group. This is the first time a loan is being co-financed with a Japanese commercial bank, Mizuho Bank, and its financing portion will be insured by Nippon Export and Investment Insurance (NEXI). JBIC is using this financing to increase the global competitiveness of Japanese companies, and promote green investments in India. Earlier in 2012, JBIC had signed a loan agreement with other Japanese private institutions, co-financing up to US$ 300 million (JBIC portion: US$ 180 million) with ICICI Bank, the largest private bank incorporated in India. The loan was co-financed with Sumitomo Mitsui Banking Corporation (SMBC; lead arranger) and The Bank of Tokyo-Mitsubishi UFJ, with JBIC providing a guarantee for their co-financed portion. The loan was extended to finance green energy projects in India. This follows similar JBIC agreements signed in 2011 with ICICI Bank in support of its financing of environment-related projects. Table 7 shows JBIC project finance to Indian green energy projects. A lot can be done to build on the momentum that existing initiatives, whether by the concessional PPPs across the sectors or by specialized channels such as GIBs, have provided. Improving the capacity of the financial sector around a low-carbon investment paradigm is a critical need. The G20 Green Finance Study Group (GFSG, constituted in 2016) has identified five thematic areas for greening the banking system, bond markets, institutional investors, risk analysis and measuring progress (UNEP and the World Bank Group 2017). These five themes could be further explored to include areas of cooperation for improving the green investment environment between Japan and India (Table 8). Table 9 summarizes three common areas pertaining to India and Japan’s cooperation in boosting green finance through PPPs and GIBs that can also be beneficial to other emerging markets in the region.

282

D. David and A. Venkatachalam

Table 7: JBICs Project Finance to Green Infrastructure to India (2010–2017)

No. 1

Public sector funder JBIC

Private sector participant Mizuho Bank, Ltd.

Financial instrument Project finance Loan Loan cofinancing, with partial guarantee Loan cofinancing, with partial guarantee Loan cofinancing, with partial guarantee

2

JBIC— Green Initiative

Sumitomo Mitsui Banking Corp.

3

JBIC— Green Initiative

The Bank of TokyoMitsubishi UFJ, Ltd.

4

JBIC— Green Initiative

5

JBIC— Green Initiative

The Bank of TokyoMitsubishi UFJ, Ltd. (lead arranger) and Sumitomo Mitsui Banking Corp. Sumitomo Mitsui Banking Corp.

6

JBIC

Other private institutions

7

JBIC— Green Initiative

8

JBIC

Sumitomo Mitsui Banking Corp. (lead arranger) and The Bank of TokyoMitsubishi UFJ, Ltd. Bank of TokyoMitsubishi UFJ, Ltd. (lead arranger)

Year 2017

2014

2014

2013

Loan cofinancing, with partial guarantee Loan cofinancing

2013

Loan cofinancing, with partial guarantee

2012

Bank-tobank loan to finance the export

2011

2012

Recipient entities, sector SBG Cleantech Project Co Pvt. Ltd., Renewable Energy ICICI Bank Ltd. For Renewable energy and energy efficiency projects IDFC Bank Ltd., for renewable energy and energy efficiency projects State Bank of India for renewable energy and energy efficiency projects

ICICI Bank Ltd., for renewable energy and energy efficiency projects ICICI Bank Ltd., for export of renewable energy-related equipment ICICI Bank Ltd., for export of renewable energy-related equipment

ICICI Bank Ltd. for joint venture between L&T and Mitsubishi

Cofinancing and total amount (in $ million) Not available

45 of a total 90 million

45 of a total 90 million

45 of a total 90 million

45 of a total 90 million

30 of a total 50 million

180 of a total 300 million

Total of 15.3 billion yen (continued)

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

283

Table 7: (continued)

No.

Public sector funder

Private sector participant

Financial instrument

Year

of thermal power boiler

9

JBIC— Green Initiative

Sumitomo Mitsui Banking Corporation (lead arranger)

10

JBIC (Equity)— Green Initiative

Subsidiary of Global Environment Fund

Loan cofinancing, with partial guarantee Private equity fund

2011

2011

Recipient entities, sector Heavy Industries, Ltd., to fabricate supercritical pressure boiler, exported by Marubeni Corp and sold to Jaiprakash Power Ventures Ltd ICICI Bank Ltd. For Renewable energy and energy efficiency projects South Asia Clean Energy Fund, LLP

Cofinancing and total amount (in $ million)

Total of 200 million

Total of 20 million

JBIC Japan Bank for International Cooperation. Source: compiled by authors from JBIC Press Releases 2018.

Conclusions and Policy Recommendations While many emerging economies like India and advanced countries like Japan are taking innovative approaches in financing the clean energy transition, it is equally clear that green energy investments tend to be large, capital-intensive, and with long repayment periods. The potential to harness private capital through concessional PPPs and GIBs is opportune, as they enable pooling of public, private, and other international funds. Experiences from UK and Germany confirm that investment and finance through such channels serve optimally to advance the transition. India is committed to speeding up the transition through PPPs. For countries like Japan, banking is the focus of green financing efforts. However, in both countries, capital markets, institutional investors such as insurance and pension funds, and green bonds are also being considered as complementing PPP and GIB approaches. Following the ratification of the Paris Agreement, emerging economies like India are taking actions that help accelerate the investments in low-carbon infrastructure. While PPPs and GIBs differ in name, scope, and approach, they share the following core characteristics: mobilizing private investment using interventions to mitigate

284

D. David and A. Venkatachalam

Table 8: Examples of Green Finance Innovation Since June 2016 (Linked to At Least 1 of the 7 GFSG Options and PPPs and GIBs) Options available for green finance Provide strategic policy signals and frameworks Promote voluntary principles for green finance Expand learning networks for capacity building Support the development of local green bond markets Promote international collaboration to facilitate cross-border investment in green bonds Encourage and facilitate knowledge sharing on environmental and financial risk Improve the measurement of green finance activities and their impacts Establish GIBs or quasi-public financial institutions that leverage public funds to mobilize private investment to lend to green projects at preferential rates and provide risk mitigation PPPs in green sectors, especially for renewable energy green field projects, with/without the support of MDBs

Japan

India ✔

✔

✔ ✔

✔ ✔

✔

GFSG Green Finance Study Group, GIB green investment bank, PPP public–private partnership. Source: Adopted and amended by authors from the Green Finance Study Group UNEP 2017. Table 9: Study Summary Successfully implemented in Japan Measures to make GIBs as an investment channel Risk assessment measures related to private financial initiatives/PPPs Definition and disclosures on green bonds and securities in support of PPPs and GIBs

Particularly relevant to India Green PPPs and GIB when public financing options are limited Integrating financial inclusion as an enabling frame work for GIBs and PPPs Effectiveness of public finance to “crowd in” private capital

Regionally relevant Role of FDI in PPPs and GIB as an investment channels for meeting Paris targets Access to green finance by SMEs and mini-grid communities through market principles Integrating green financing factors into public procurement of financial services

FDI foreign direct investment, GIB green investment banks, PPP public–private partnerships, SME small and medium-sized enterprises. Source: Authors.

risks and enable transactions; innovative transaction structures and market expertise; independent authority; a focus on cost effectiveness; and public-private win-win outcomes. A well-designed PPP and a targeted GIB can be vehicles for the scaling up of funds for green energy investment and meeting the NDC targets. Nevertheless, in the Indian context, GIBs should be understood as being a new player in the broader financial ecosystem of generally much larger institutions and specialized funds that are mobilizing green investments and could become a potential tool to mitigate climate change. Sharing the risks in a fair and sustainable manner is important for the success of PPPs and GIBs. Both concessional PPPs and GIBs can address investment gaps for projects with very large upfront capital costs, as well as gaps arising when lending costs are too

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

285

high or when there is a limited source of public capital. GIBs also perform a derisking role to mobilize private capital into low-carbon projects. Concessional PPPs and GIBs can also foster knowledge in areas where country-level expertise does not exist in order to better assess risks, create and standardize de-risking instruments, and diffuse this new knowledge throughout the industry. PPPs, through co-financing large-scale projects, ensure they “crowd-in” additional private finance. GIBs also take on the risky role of supporting “first or early mover” projects, investing in technologies that need to be tested or scaled in the context of the local regulatory and financial environment. It can also support new green technologies, new business models, or a new entrant, such as a first-time developer or equipment supplier. Key areas with potential for enhancing Japan-India cooperation in support of PPPs and GIBs include the following: • Enabling market education and capacity building for Green PPPs and GIBs. Building learning networks between Japanese and Indian stakeholders that will play a key role in scaling up initiatives. It may be useful, if institutions like the JBIC were to map the broad set of domestic policy initiatives and regulatory reforms that could be taken up by the emerging markets, taking India as a test bed. Such a roadmap-building exercise could assess what works and where the gaps and overlaps are, as well as the opportunities for further improving the financial efficiency through knowledge sharing. • Many states in India are making an initial move into the green finance space through concessional PPP and GIB projects, but they are slowed by general lack of familiarity among the investors with the concept, definitions, purpose, legal framework, and advantages of the approaches, and by a lack of available advisory services. Much could be done, if a network of banks and institutional investors both within India and between India and Japan were established to build awareness and develop guiding materials on best cases. • Japan and India, as members of G20, are using green infrastructure investment as a coalition for engaging with overseas institutional investors. Given the importance of concessional PPPs and GIBs, a key challenge is how to support green lending to enable securitization of those lending portfolios linked with the monitoring reporting and verification system on the emission reductions. Japan’s technical assistance in the development of monitoring reporting and verification and how best it could be used to support inbound FDI will be critical. While PPPs and GIBs recognize the importance of private capital, the nature of green investments in India as well as in other emerging markets involves a combination of public and private finance. Hence it is also critical to learn lessons from Japan and other advanced economies on how to mobilize such blended finance in the most efficient way to meet the NDC targets. Many states in India have special purpose vehicles that are policy-influenced or state-owned, such as linked pension funds. These institutions could be a starting point, while drawing a new roadmap and articulating the policy, regulatory, and institutional development to foster green private finance through the limited public finance.

286

D. David and A. Venkatachalam

References Anbumozhi V, Rakhmah TF (2018) Prospects of catalysing regional solutions and the role of low carbon transition fund. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for lowcarbon energy transition: unlocking the potential of private capital. Springer, Singapore, pp 397–422 Anbumozhi V, Yao X (2016) Serendipity of low carbon energy systems and the scope of regional cooperation. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Investing in low-carbon energy systems: implications for regional economic cooperation. Springer, Singapore, pp 1–27 Anbumozhi V, Kimura F, Kalirajan K (2018) Unlocking the potentials of private financing for lowcarbon transition. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, Singapore, pp 1–16 Baietti A (2013) Green infrastructure finance: a public-private partnership approach to climate finance. World Bank, Washington DC. https://openknowledge.worldbank.org/handle/10986/ 14857. License: CC BY 3.0 IGO Climate Policy Initiative (2017) Global landscape of climate finance 2017, October 2017. https:// climatepolicyinitiative.org/wp-content/uploads/2017/10/2017-Global-Landscape-of-ClimateFinance.pdf and http://www.climatefinancelandscape.org/ Delmon J (2009) Private Sector Investment in Infrastructure. Project Finance, PPP Projects and Risk. 2nd edition. Kluwer Law International. The Netherlands Economist Intelligence Unit (EIU) and Asian Development Bank (ADB) (2015) Evaluating the environment for public–private partnerships in Asia-Pacific: the 2014 Infrascope. http://www. adb.org/publications/evaluating-environment-ppp-asia-pacific-2014-infrascope Gardiner A, Bardout M, Grossi F, Dixson-Declève S (2015) Public-private partnerships for climate finance. TemaNord 2015. Nordic Council of Ministers, p 577. https://doi.org/10.6027/TN2015/577 Geddes A, Schmidt TS, Steffen B (2018) The multiple roles of state investment banks in low-carbon energy finance: an analysis of Australia, the UK and Germany, Energy Policy 115 (2018):158–170. https://www.sciencedirect.com/science/article/pii/S0301421518300090 Green Bank Network (2018) Green finance organization (Japan). http://greenbanknetwork.org/ green-finance-organisation-japan/. Accessed 20 Jun 18 Green Finance Organisation (2016) Green Fund Japan`s experiences, presentation at the Green Bank Congress 2016 by Takejiro Sueyoshi, CEO, Green Finance Organisation, 13 Oct 2016 Green Investment Bank (GIB) (2017) UK Green Investment Bank Limited Annual Report and Financial Statements 2016–17, UK Green Investment Bank Limited. http://greeninvest mentgroup.com/media/185901/gib-annual-report-2016-17-final.pdf GTDT (2018a) Project finance in Japan, April 2018. https://gettingthedealthrough.com/intelligence/ 168/article/6057/project-finance-japan. Accessed 27 Jun 18 GTDT (2018b) Project finance in India, April 2018. https://gettingthedealthrough.com/intelligence/ 168/article/6055/project-finance-india. Accessed 27 Jun 18 GTDT (2018c) In India – an interview with Anjan Dasgupta, June 2018. https://gettingthe dealthrough.com/intelligence/21/article/3042/project-finance-india. Accessed 27 Jun 2018 Hongo T (2016) Circular economy potential and public–private partnership models in Japan. In: Anbumozhi V, Kim J (eds) Towards a circular economy: corporate management and policy pathways. ERIA research project report 2014-44, ERIA, Jakarta, pp 17–29 Hongo T (2018) Prospects of quality infrastructure program and private sector MRC for accelerating the transition towards low-carbon energy system. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, Singapore, pp 359–396 IREDA (2017) IREDA 30th annual report for 2016–17. http://www.ireda.in/writereaddata/Ireda_ Annual_Report_Final_2016-17.pdf JBIC Press Releases (2018) JBIC press releases sectors: environment. https://www.jbic.go.jp/en/ information/press/environment.html. Accessed 25 May 2018

12

A Comparative Study on the Role of Public–Private Partnerships and. . .

287

KfW (2016) Responsible banking, financial report 2015. Frankfurt, Germany. https://www.kfw.de/ PDF/Download-Center/Finanzpublikationen/PDF-Dokumente-Berichte-etc./3_Finanzberichte/ KfW-Finanzbericht-2015-E.pdf KfW (2017) Responsible banking, financial report 2016. Frankfurt, Germany. https://www.kfw.de/ PDF/Download-Center/Finanzpublikationen/PDF-Dokumente-Berichte-etc./3_Finanzberichte/ Finanzbericht-2016-D Konrad-Adenauer-Stiftung eV (2017) Climate finance report 2017: private sector and climate finance in the G20 countries. http://www.kas.de/wf/doc/kas_49478-544-2-30.pdf?171025093514 Kumar S, Anisuzzaman M, Das P (2017) Estimating the low-carbon technology deployment costs and INDC targets. In: Anbumozhi V, Kalirajan K (eds) Globalization of Low-carbon technologies –the impact of the Paris agreement. Springer, Singapore, pp 335–366 Meltzer JP (2016) Financing low carbon, climate resilient infrastructure: the role of climate finance and green financial systems, Brookings Institution. https://www.brookings.edu/wp-content/ uploads/2016/09/global_20160921_climate_finance.pdf MOSPI, Government of India (2018) National accounts statistics 2018, Ministry of Statistics and Program Implementation (MOSPI) Government of India. http://www.mospi.gov.in/publication/ national-accounts-statistics-2018 NRDC and CEEW (2016) Greening India’s financial market: opportunities for a green bank in India. Natural Resources Defense Council International: India (NRDC)/Council on Energy, Environment and Water (CEEW), New York/New Delhi, August 2016. https://www.nrdc.org/ sites/default/files/india-financial-market-opportunities-green-bank-report.pdf OECD (2017) Green investment banks: innovative public financial institutions scaling up private, low-carbon investment. OECD environment policy papers, No. 6, OECD Publishing, Paris. https://doi.org/10.1787/e3c2526c-en OECD and Bloomberg Philanthropies (2015) Green investments banks: policy perspectives. https:// www.oecd.org/environment/cc/Green-Investment-Banks-POLICY-PERSPECTIVES-web.pdf Private Participation in Infrastructure Database (2018) World Bank’s PPI database. Retrieved March 13, 2018, from https://ppi.worldbank.org/snapshots/country/india RBI (2015) Corporate bond markets in India: a framework for further action, Speech by Shri Harun R. Khan, Deputy Governor, 27 October 2015 at FICCI CAPAM – 2015, Mumbai. https://www. rbi.org.in/scripts/FS_Speeches.aspx?Id=980&fn=6 Treco K, Stephens C, Marten D (2018) Estimation of current flows and future needs of low-carbon transition in major economies of Asia until 2030. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, Singapore, pp 17–44 UK Green Investment Bank (2017) UK green investment bank limited annual report and financial statements 2016–17, Edinburgh. http://greeninvestmentgroup.com/media/185901/gib-annualreport-2016-17-final.pdf UNEP (2016) Delivering a sustainable financial system in India, UNEP Inquiry: design of a sustainable financial system. UNEP and the World Bank Group (2017) Roadmap for a sustainable financial system. UN Environment Inquiry. http://unepinquiry.org/publication/roadmap-for-a-sustainable-financial-system/ World Bank (2017) PPPs in India – will they regain their former glory? http://blogs.worldbank.org/ ppps/ppps-india-will-they-regain-their-former-glory Accessed 27 Jun 2018 Yoshino N, Taghizadeh-Hesary F (2017) Alternatives to bank finance: role of carbon tax and hometown investment trust funds in development of green energy projects in Asia. ADBI working paper 761, Asian Development Bank Institute, Tokyo. https://www.adb.org/publica tions/alternatives-bank-finance-role-carbon-tax-and-hometown-investment-trust-funds Yoshino N, Taghizadeh-Hesary F (2018) Alternatives to private finance: role of fiscal policy reforms and energy taxation in development of renewable energy projects. In: Anbumozhi V, Kalirajan K, Kimura F (eds) Financing for low-carbon energy transition: unlocking the potential of private capital. Springer, Singapore, pp 335–354

Part VIII Fintech and Financial Innovation

Energy Efficiency Finance Program Best Practices to Leverage Private Green Finance

13

Simon Retallack, Andrew Johnson, Joshua Brunert, Ehsan Rasoulinezhad, and Farhad Taghizadeh-Hesary

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Framework for Energy Efficiency Finance Programs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Best Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property Assessed Clean Energy in the US . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Deal in the United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Carbon Trust SME Energy Efficiency Programme in the United Kingdom . . . . . . . . . . . . . . . Commercializing Sustainable Energy Finance Program in Turkey . . . . . . . . . . . . . . . . . . . . . . . . China Utility-Based Energy Efficiency Finance Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Energy Efficiency Revolving Fund in Thailand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Energy Efficiency Services Limited in India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sustainable Energy Financing Facilities in 22 Eastern European Countries and North Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PROESCO in Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Energy Saving Insurance in Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusion and Recommendation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

292 295 301 301 302 303 304 305 306 307 308 309 310 311 313

Abstract

A common struggle across energy efficiency programs is the creation of sustainable private sector markets that reduce demand. The purpose of this study is to S. Retallack · A. Johnson · J. Brunert Carbon Trust, London, UK e-mail: [email protected]; [email protected]; joshua. [email protected] E. Rasoulinezhad (*) Faculty of World Studies, University of Tehran, Tehran, Iran e-mail: [email protected] F. Taghizadeh-Hesary Faculty of Political Science and Economics, Waseda University, Tokyo, Japan e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_26

291

292

S. Retallack et al.

outline best practices for smart public programs that overcome the main energy efficiency challenges and leverage the private finance needed for deployment at scale. Our concluded program is based on an assessment of 10 case studies, interviews, and evaluations of past programs. The results revealed that policy frameworks should strengthen investment business cases with the right economic and regulatory drivers. Furthermore, more resources should support technical assistance. Activities such as awareness raising, pipeline generation, and de-risking are essential to create sufficient demand and commitment. In addition, upskilling, equipping, and accrediting suppliers and technical advisors is critical to create a sustainable, scalable, and bankable pipeline. Keywords

Energy efficiency · Financing energy programs · Best practices JEL Classifications

O13 · P18 · C90

Introduction A vast number of studies discuss energy efficiency (particularly Patterson 1996; Greening et al. 2000; Sarkar and Singh 2010; Turner and Hanley 2011; Popescu et al. 2012; Tuominen et al. 2013; Markus et al. 2015; Ihara et al. 2015; Sorrell 2015; Koesler et al. 2016) as a way to improve an economy. They consider efficiency, the act of controlling and minimizing energy use, as a major priority of governments around the world. The importance of energy efficiency in this era is due to the gradual reduction of the planet’s natural resources. Furthermore, energy efficiency has significant effects on various economic aspects. For instance, Smulders and De Nooij (2003); Saboori et al. (2017); Aung et al. (2017) and Rasoulinezhad and Saboori (2018) believe that energy conservation and efficiency can stimulate innovation and long-run economic growth, while Bataille and Melton (2017) express that efficiency improvements reorient the economic structure from capital-intensive energy supply sectors to relatively labor-intensive manufacturing and services. Taghizadeh-Hesary et al. (2016) and Taghizadeh-Hesary et al. (2017) found that government energy targets increase developed economies’ resilience toward price shocks and strengthen security. Moreover, the links between energy efficiency and energy intensity are important to consider. Figure 1 illustrates the trends of energy intensity changes in several different countries. It is apparent that all the nations have reduced their energy intensity. For instance, Japan has one of the lowest levels of energy intensity (and very high energy efficiency), while, in the People’s Republic of China (PRC), it is still high but improving. Reduced energy intensity exists for India, Republic of Korea, and the United States (US), and even for the average of all nations in the world (represented by “world” in the figure).

13

Energy Efficiency Finance Program

293

12 10 8 6 4 2 0 2005

2006 India

2007 Japan

2008

2009

2010

Rep. of Korea

2011

2012

United States

2013 World

2014

2015 PRC

Figure 1: Energy Intensity Trend in Several Nations (2005–2015, MJ/$ 2011 PPP GDP). GDP gross domestic product, MJ megajoules, PPP purchasing power parity, PRC People’s Republic of China. (Source: Authors’ compilation from the World Bank)

According to the International Energy Agency’s 2014 World Energy Investment Outlook, to unlock the economic and environmental advantages of energy efficiency, a huge finance increase is necessary, with estimates projecting a need for over $550 billion a year by the 2030s. To this end, public finance plays a major role. At the 21 Conference of the Parties (COP21), national governments and multilateral development banks (MDBs) announced significant increases in funding for climate mitigation, with some pledging to double their contributions. Even more recently, the G20 members officially affirmed their post-Paris commitment to scaling up green financing. Generally, public finance has a crucial role to play in energy efficiency (see, e.g., Bardhan et al. 2014; Braun and Hazelroth 2015; Gouldson et al. 2015; Hall et al. 2016). It is a fact that energy efficiency markets face challenges across the supply chain, from financiers to end-users via technology suppliers and consultants. While the specific barriers to energy efficiency in any given context are likely to be numerous and varied, there are three broad categories, shown in Table 1, into which they fall. These challenges are a complex combination of technical and financial barriers. Facing market distortions (such as energy subsidies), and a lack of externalities (such as carbon) priced to incentivize energy efficiency, the private sector historically has not invested in energy efficiency relative to other opportunities. Hence, public programs are essential to overcome both the technical and the financial obstacles, stimulate energy efficiency markets to unlock the opportunity, and leverage the far greater sums of private finance needed to scale up to $550 billion per year. It should be noted that a principle source of public funding for programs is development banks (Oji et al. 2016). They help developing economies—where the

294

S. Retallack et al.

Table 1: Overarching Barriers to Energy Efficiency Deployment Barrier Awareness and commitment

Technical solutions and expertise

Financial resources

Explanation Lack of knowledge and awareness of energy efficiency, skepticism and misunderstanding of benefits, conflicting priorities, and a lack of motivation across businesses stymie the potential demand. Linked to this is the lack of a convincing business case in contexts with cheap energy and absent regulation. Insufficient technical capacity and a lack of commonality on best practice and standardization of procedures and technologies, including difficulties in project assessment, monitoring, and verification, act as obstacles to energy efficiency solutions that are trustworthy and minimize hassle. Perceived high investment costs, coupled with prohibitive calculations of risk and return, limit the supply of affordable capital and the demand for such investments.

Figure 2: Multilateral Development Bank Mitigation Finance by Sector Type, 2015. (Source: Authors’ compilation from the 2015 Joint Report on Multilateral Development Banks’ Climate Finance (Asian Development Bank 2015))

Waste and wastewater 3%

Transport 26%

Cross-cutting 12%

Agriculture, forestry, and land 6% Energy efficiency 14%

Lower carbon and efficient energy generation 7%

Renewable energy 30%

Other sectors 2%

greatest opportunities lie—to be sustainable. In 2015, MDBs alone committed $2.9 billion to energy efficiency programs. However, this represents just 14% of all mitigation investments and is less than half the amount invested in renewable energy (Figure 2). Given the tremendous potential in energy efficiency, there is scope for this to increase many times over while also improving the deployment of existing investment. There is also an urgent need to reassess and reorient the focus of investment. There has been a common struggle across many programs worldwide to create sustainable private sector markets that reduce the energy demand and, consequently, greenhouse gas (GHG) emissions, with very few undisputed examples of success. Too often, programs have only addressed part of the problem, leaving other barriers deeply entrenched. A more comprehensive approach needs to replace the narrow focus on finance, credit, and enhanced liquidity.

13

Energy Efficiency Finance Program

295

Our study aims to contribute to the energy efficiency finance discussion by drawing from the Carbon Trust’s 15 years of experience with energy efficiency in addition to insights from interviews with development banks, commercial investors, program implementers, and non-governmental organizations. The objective is to build a greater common understanding across these organizations about how best to design self-sustaining energy efficiency finance programs. The remainder of this study is organized as follows. Section “A Framework for Energy Efficiency Finance Programs” sets out a framework for assessing and indeed designing energy efficiency finance programs. The next section represents a number of best practices around the world. Section “Conclusion and Recommendation” concludes the paper and offers recommendations.

A Framework for Energy Efficiency Finance Programs The first point in setting out an energy efficiency framework is the question of “what is the target market?” The definition of the target market will shape the parameters of every solution package. Across a number of programs that we examined, there was often insufficient understanding of the market before the design began. Consequently, the programs failed to exert their expected impact. Given that any program will have limited available resources, it needs to target the market appropriately to achieve the maximum impact. The most important indicators include energy benefits (as measured by demand reduction and cost savings for consumers and the energy system as a whole) and non-energy benefits (such as avoiding GHG emissions, increasing productivity, reducing poverty, and other socio-economic benefits). The second point is the question “are there drivers for action?” It is imperative to understand whether the existing market and policy drivers fundamentally undermine or support the business case for energy efficiency in the target market. If any of these drivers hinder energy efficiency, or are not strong enough, they will undermine the goals of a finance program. Though challenging to address, drivers that weaken the case for action should prompt efforts to align the policy with energy conservation where possible, such as removing energy subsidies. It is important to recognize that, if it is not possible to mitigate counterproductive drivers, it may be preferable for a program to focus on narrowly targeting emission reductions for a fixed period, as creating a sustainable market will be problematic. The third element of the framework is the question “is there a supply chain?” To realize the benefits of energy efficiency in a target market, a flow of information to build the essential knowledge, skills, and behavioral change is necessary. When a program needs capital investment, appropriate flows of technology and funding are essential. Institutions and companies with the expertise and connections to deliver them efficiently and reliably facilitate these flows. Figure 3 sets out a stylized supply chain illustrating the major components that must be in place for an energy efficiency program to succeed. Examining the barriers across the supply chain is the next step in our framework. The problem for energy efficiency is the perceived absence of a convincing business

296

S. Retallack et al.

Sources of capital Donors – international funds and governments Multilateral, bilateral, and rational development banks Institutional investors – pension and insurance funds

Capital (and, in some cases, technical assistance)

Technical assistance

Financiers Local banks, special purpose companies, equity investors, leasing companies, insurers

Capital

Capital

Target market

Suppliers Technology providers, technology installers, ESCOs, auditors, accreditors

Energy efficiency solutions and technical assistance

Public sector, heavy industry, large corporations, SMEs, residential

Figure 3: Indicative Supply Chain for Energy Efficiency Finance Showing Components and Flow. (Source: Authors)

case. A lack of pricing of energy and carbon externalities does not help. Furthermore, energy savings do not create sales or cash directly but deliver a return by reducing costs relative to a counterfactual situation. This can be a hard sell, and homeowners, boardroom directors, and potential financiers do not regard energy savings as a transparent and trusted revenue stream. The immediate objective of a program is to confront the unfamiliar and/or unattractive business case that manifests in barriers to the flow of information, technologies, and capital across the supply chain. These barriers can be very specific to a particular context and apply to individual components of the supply chain as well as the connections between them. In an immature market, the barriers are likely to be numerous and varied, but there are three broad categories into which they fall (Table 1 provides an overview). Following the above barriers, the fifth element of our framework is the question “what solutions can address the barriers?” The reality of designing different aspects of programs rarely, if ever, bears a one-to-one relationship with the barriers that are present. In fact, some design features target multiple barriers, several of which demand more than one solution. Across the sample of case studies, the variety of program features that we identified and scrutinized is presented in Table 2. We assessed them according to their relative impact on the three challenges that Table 1 outlines, for which darker shading indicates that the design feature is more relevant to that challenge.

13

Energy Efficiency Finance Program

297

Table 2: The Relevance of Different Solutions to Addressing the Overarching Barriers

Title of Program Awareness raising

Purpose Build a critical mass of demand by increasing the knowledge and understanding in the target market and among financiers

Project identification and pipeline generation

Develop and prepare a pipeline of bankable projects to establish a sufficient market scale to interest financiers

Policy development

Tackle the fundamental drivers that subvert the business case to create a long-term, sustainable market environment

Incentives

Temporarily alter the business case to encourage the demand or

Method Advertising, educational events, or direct outreach depending on the level of preexisting awareness and the feasibility of reaching the target audience Training suppliers, facilitating interactions across the supply chain, tracking potential customers, and demonstration projects can all help to create market scale in different ways Advising on removing the pricing distortions of energy and carbon, introducing tax breaks, promoting policy roadmaps, and developing energy-efficient codes and standards Concessional terms of finance, performance subsidies, tax breaks for

Barriers Awareness and Commitment Very relevant

Technical Solutions –

Financial Resources –

Very relevant

Relevant

–

Very relevant

Slightly relevant

Relevant

Very relevant

–

Relevant

(continued)

298

S. Retallack et al.

Table 2: (continued)

Title of Program

Purpose

Method

supply of finance

energy-efficient equipment, and discounted TA Training local suppliers of goods and services or installing entities capable of transferring skills or outlasting the program Formal, authoritative qualifications based on historical performance for suppliers and equipment

Project assessment, monitoring, and verification

Develop the local capacity and a track record for ensuring and measuring the profitability of projects to reduce the perceived risks

Accreditation

Mitigate the perceived risks and consolidate trust in promised energy savings for financiers and end-users alike Minimize the extra cost and hassle associated with unfamiliar transactions across the supply chain

Standardization

Support for monetizing energy savings

Grow a market of suppliers that use energy savings within their revenue model, supporting confidence in the promised cash flow

Simple and replicable contracts between parties, userfriendly interfaces, and fast decisionmaking processes Support for de-risking investments in ESCOs to encourage growth in their business model

Barriers Awareness and Commitment

Technical Solutions

Financial Resources

Relevant

Very relevant

Slightly relevant

Relevant

Very relevant

Slightly relevant

Slightly relevant

Very relevant

Slightly relevant

Slightly relevant

Relevant

Very relevant

(continued)

13

Energy Efficiency Finance Program

299

Table 2: (continued)

Title of Program On-bill financing

Unsecured lending

Leasing

Insurance

Purpose Overcome the lack of upfront capital and lack of trust in energy savings as revenue for property owners

Alleviate the need for endusers to provide collateral to secure financing for energy efficiency investments Free end-users from capital constraints associated with high upfront costs

Mitigate the risk of the technology not performing as expected

Method Integrating investment costs with preexisting bills where energy savings prevent the former from exceeding the latter over the payback period Financiers will lend against the merits and predicted cash flow of a project and not require assets as security

Leasing parties will lend equipment as part of a service, possibly including maintenance or until the enduser pays off the cost and owns it outright Premium that the end-user or supplier pays to cover potential losses, reducing the perception of high risk and possibly the cost of capital if financiers concur

Barriers Awareness and Commitment Relevant

Technical Solutions –

Financial Resources Very relevant

Relevant

–

Very relevant

Relevant

–

Very relevant

Slightly relevant

–

Very relevant

(continued)

300

S. Retallack et al.

Table 2: (continued)

Title of Program Guarantee

Credit line

Aggregation

Purpose Risk-sharing facility to encourage financiers to expand into new markets that they perceive to be too risky under normal conditions Address limited liquidity in financial institutions, increasing their willingness to use funds for energy efficiency Increase the supply of capital in the market by reducing the relative transaction costs for investors through scale

Method The program will cover a fixed percentage of the losses that financiers incur if their loans do not perform

Barriers Awareness and Commitment Slightly relevant

Technical Solutions –

Financial Resources Very relevant

Injection of government, MDB, or other donor funds for on-lending, with specified terms for eligible projects attached

–

–

Very relevant

Either “pooling” capital prior to identifying projects, or “bundling” preidentified projects ready for investment

–

–

Very relevant

ESCO energy service company, MDB multilateral development bank, TA technical assistance. Source: Authors.

Considerations of scale and time play pivotal roles here, too. If awareness raising is deployed either too early or too late in relation to the availability of a concessional credit line or a lack of resources hampers its reach, it will neutralize the potential impacts. Programs also require monitoring and a degree of flexibility in their design to respond to changing conditions. Ultimately, to stimulate sustained private sector investment, a market for projects that adhere to attractive rates of risk and return and are accessible is necessary. The objective of a program is to influence perceived risk

13

Energy Efficiency Finance Program

301

and/or actual returns positively and to structure the opportunity in such a way that financiers invest in energy efficiency of their own accord. Local banks are often the primary target investors for energy efficiency due to their financing the public sector, businesses, and homeowners alike. A program can counter any disincentives through project assessment, standardization, incentives, or aggregation. However, it must consider how to influence the target market as a whole, rather than just isolated projects, and investigate whether there is sufficient scale to interest investors. The last point of our framework concerns “how can change be sustained?” As the first highlighted point of this section, we set out two objectives for measuring the success of an energy efficiency finance program: energy demand reduction and the sustainability of activity in the market when the program expires. While the first is realizable in isolation, too often the targeted programs involve one-off or short-term fixes. The danger for any seemingly successful program is that, once its support is no longer available, the supply of and demand for finance withers. To achieve lasting change, a program must focus on the energy efficiency problem comprehensively and on the legacy of its solution package. Since a sustainable legacy must involve the attraction of new entries into the supply chain to grow the private sector market, solutions must either be simple or, if they begin from a complicated starting point, develop over time to approximate the commercial conditions as closely as possible. The above-mentioned points can manifest themselves in energy efficiency programs aiming to achieve sustainable legacies. The next section describes a number of the most important lessons to emerge from our study.

Best Practices This section assesses the strengths and weaknesses of 10 case studies of energy efficiency programs from around the world, namely Property Assessed Clean Energy in the United States, the Green Deal in the United Kingdom, the Carbon Trust SME Energy Efficiency Programme in the United Kingdom, Commercializing Sustainable Energy Finance in Turkey, China Utility-Based Energy Efficiency in the PRC, the Energy Efficiency Revolving Fund in Thailand, Energy Efficiency Services Limited in India, Sustainable Energy Financing Facilities in 22 Eastern European countries and North Africa, PROESCO in Brazil, and Energy Service Insurance in Mexico (IEG 2010; IFC 2014a). Each program gives an insight into the common challenges and best practices in energy efficiency finance.

Property Assessed Clean Energy in the US The initial intention of the Property Assessed Clean Energy (PACE) funding framework was to act as a financing mechanism for solar photovoltaic projects to help meet climate goals in San Francisco, California. PACE’s design incentivized renewable energy projects by tackling one of the biggest barriers to implementation:

302

S. Retallack et al.

upfront costs. Energy efficiency exacerbates this barrier in the residential sector, particularly as property owners often move house before investments have paid for themselves. As a result, PACE tries to mitigate this influential disincentive. More broadly, from 2015 onwards, people viewed PACE as a key mechanism to help policy makers to deliver the US’s economy-wide target of a 26–28% reduction in emissions by 2025 from the 2005 levels (Bardhan et al. 2014). California first introduced the PACE financing legislation in 2008. Using PACE, homeowners pay for new technology projects through additional tax assessments placed on their property. These types of loans are available across a range of sectors. By 2010, 31 states had put legislation in place for renewable energy and energy efficiency financing in both the commercial and the residential sector. The case below provides an example in Boulder County, Colorado, which used bonds to finance energy efficiency technologies, a unique approach to a PACE scheme. In 2009, a Council on Environmental Quality report identified PACE financing programs as a means of expanding residential energy efficiency and the retrofit market. In Boulder County, Colorado, the residential sector was particularly important due to the County’s 2008 program, BuildSmart, mandating energy efficiency improvements for homes. Scholars largely considered the PACE framework to be a success, since the tax assessments combined with senior liens addressed the separate resourcing barriers for both homeowners and third-party investors, namely the lack of capital and the requirement for collateral, respectively. In addition, local municipalities engendered trust through their technical assistance and program outreach to homeowners by linking them with technology suppliers and ensuring that financiers had registered properly. Despite the successes of this design, however, the sustainability of this model was brought into doubt in 2010 after mortgage lenders Fannie Mae and Freddie Mac complained that the liens had priority over mortgages, thereby causing difficulties in the residential sector. The scheme was revitalized in 2015 following new legislation, but the extent to which the model described above can be sustainable without interfering with other markets (e.g., the mortgage market) could represent a limiting factor.

Green Deal in the United Kingdom The Green Deal intended to capture some of the estimated £3 billion per year in energy cost-saving opportunities for UK households and businesses, reduce carbon emissions, and reduce fuel poverty (for homes) by improving the efficiency of the residential and commercial building sectors. The introduction of the Green Deal also brought the UK into compliance with the EU Directive on the Energy Performance of Buildings 2010, requiring member states to draw up financing schemes for private property owners, SMEs, and ESCOs. More broadly, the initiative was part of the work toward meeting the 2008 Climate Change Act’s requirement to reduce the UK’s emissions by 80% from the 1990 levels by 2050 (Webb et al. 2016).

13

Energy Efficiency Finance Program

303

The Green Deal financing scheme was launched by the UK Department of Energy and Climate Change (DECC) at the end of 2012 to help households and workplaces make energy-saving improvements with loans that they could repay through their energy bills. Despite the addition of a £214 million Home Improvement Fund in 2014 (released in three stages), providing homeowners with upfront grants, the Green Deal was scrapped in July 2015 as it was far off course from achieving its target of upgrading 14 million homes by 2020, with only 14,000 homes taking up loans. The target markets for the Green Deal were the residential and commercial building sectors, which represented 13% and 20% of the UK’s CO2 emissions, respectively (Pettifor et al. 2015). People largely regarded the Green Deal as a failure, as it did not meet the anticipated targets for uptake and then transformed into a grant scheme after the introduction of the Home Improvement Fund in 2014. One of the main flaws of the scheme was its failure to address the lack of technical understanding of the bankability of energy efficiency projects in the financial sector. This resulted in high interest rates on finance of around 7%, reflecting the perception of the high risk of such projects. The high finance cost worsened the payback periods of the loans for property owners. Moreover, the very fact that the Green Deal providers communicated the funding as “loans” when arranging the financing limited the scheme’s appeal to property owners, who were unwilling to incur further debt. The scheme therefore failed to address the lack of awareness among property owners of the longer-term benefits of energy efficiency upgrades. To compound this problem, the technical assistance that property owners received was conservative in its estimation of which energy efficiency technologies would satisfy the Golden Rule, limiting the pipeline of viable projects. The complexity of having to deal with multiple separate parties for both the households and the installer industry also dampened the demand, as did confusion with the Energy Company Obligation scheme, which targeted a similar pool of customers. Finally, the Home Improvement Fund, while very popular among homeowners, became unsustainable and ran out of funds in its first 6 weeks. Furthermore, though connected to the Green Deal scheme, it had very little lasting impact on the uptake of loans from the original scheme or in the marketplace in general, as the Government scrapped both the fund and the scheme in July 2015.

Carbon Trust SME Energy Efficiency Programme in the United Kingdom Under the 1997–2010 Labour Government, there was a growing commitment from the UK to ambitious climate goals, leading to the world’s first legally binding GHG target with the 2008 Climate Change Act. Increasing energy efficiency was a key instrument in this commitment, which could also reduce SMEs’ operating costs and grow the nascent energy efficiency job market. At this time, business groups viewed the government’s Climate Change Levy negatively, perceiving it as a tax without the support to move to a more sustainable basis. As a result, the Government created the

304

S. Retallack et al.

Carbon Trust as an independent company to accelerate the shift to a lower-carbon future. The Carbon Trust was a natural home for implementing the energy efficiency loans scheme that it introduced shortly afterwards. The Carbon Trust, which the UK government set up as an independent company in 2001, has managed a $300 million program with the objective of opening up the market for energy efficiency. The Government originally provided the funds and disbursed them via unsecured, 0% interest loans ranging from $4,600 to $600,000. The program has realized savings of over two million tons of CO2 and $560 million on energy bills. Since 2011, it has only been available in Northern Ireland and Wales due to changes in the UK government’s priorities. The loan scheme targeted many non-domestic businesses but particularly SMEs. The emphasis on SMEs reflects the difficulties that they face in providing the necessary collateral for debt financing in general, which exacerbates their tendency to deemphasize efficiency given their (typically) low energy bills. The types of project financed included building technologies (e.g., air conditioning and heating), industrial process technologies (e.g., compressed air fittings and motors), and on-site renewables (e.g., solar photovoltaic and solar thermal). The scheme selected projects on the basis of meeting a minimum CO2-saving threshold. In total, it reached over 7,000 SMEs across a range of non-domestic business sectors. The extensive marketing and supplier engagement was influential not just in building awareness but also in connecting potential customers with technology providers. The training and accreditation of suppliers, which gradually built greater trust, enhanced this integration across the supply chain. Strict quality assurance was necessary to ensure that supplier-led projects met quality standards. Demand was generated through attractive loan conditions and the ease of the application process. The unsecured lending and 0% headline rate circumvented the conventional barriers of SMEs needing to post their limited collateral against the loans and the high cost of capital. The difficulty involved in sustaining the activity beyond the life of the program emerged. The loan terms on offer, as well as the free technical advice, are unsustainable in the long term without ongoing government funding. The scheme has left a legacy in the shape of a recognized accreditation process and standard. There are indications of greater commercial lending to SMEs for energy efficiency, but ideally the scheme would have created a smoother transition to working with banks and suppliers directly in the UK with a clear pipeline of projects extending beyond those that the program supported.

Commercializing Sustainable Energy Finance Program in Turkey Economic growth has corresponded to high growth rates in Turkey’s energy and electricity usage, raising the country’s coal and natural gas imports and thereby driving up the national debt. Turkey’s GHG emissions grew from 188 to 422 million tons of CO2 between 1990 and 2011. As a result, the Turkish Government made energy efficiency a key priority for a number of years, enacting several new laws and policies. These included a wide-ranging energy efficiency law in 2007 and an energy

13

Energy Efficiency Finance Program

305

efficiency strategy in 2012 setting a target of reducing the energy intensity by 20% by 2023 in comparison with the 2008 levels. The move to a cost-based energy pricing mechanism from 2008, which has increased the exposure of customers to the underlying costs of energy, particularly electricity, has abetted greater efficiency. The Commercializing Sustainable Energy Finance Program (CSEF) was a leasing initiative that the International Finance Corporation set up in 2010 with funding from the Clean Technology Fund ($21 million) and the IFC’s own balance sheet ($100 million). The aim was to help local financial institutions (including leasing companies) to develop the capacity to assess and finance energy efficiency projects. Phase II received approval in April 2015 (IFC 2014b). People have considered the scheme to be a success, and in the first 4 years of its operations, leasing companies invested approximately $100 million of CSEF funds in over 50 energy efficiency projects. The expectation is that the CSEF will directly mitigate over 200,000 tons of CO2 per year. The CSEF targeted the commercial, residential, and municipal sectors with a particular emphasis on SMEs and smaller energy efficiency projects. SMEs represent a key sector within the Turkish economy, generating 25% of the country’s GDP and 10% of its exports. Additionally, as the largest energy consumer accounting for 33% of the total consumption, the residential sector was a key target market. The leasing model of the CSEF has catalyzed an increase in both the supply of and the demand for energy efficiency equipment, enabling Turkish leasing companies to progress from receiving concessional loans to loans at commercial rates. Indeed, in 2014, the IFC was able to provide Yapi Kredi Leasing with a $96 million loan on fully commercial terms. This was largely thanks to the financial and technical assistance that the leasing companies received. Having addressed the supply-side challenges, the leasing companies, which already had extensive customer networks, were able to assess the technologies and market them to end-users. The customers benefit as SMEs that can access the products through leasing but that perhaps do not have strong enough balance sheets to be able to purchase equipment themselves. This growth in technical expertise has made leasing companies more confident in seeking finance for energy efficiency equipment. To have a self-sustaining market, the awareness and expertise of Turkish commercial banks, which have traditionally been more reluctant to provide the loans with lengthier tenors that are suited to energy efficiency projects, will need to match the confidence that leasing companies generate.

China Utility-Based Energy Efficiency Finance Program Building on the success of previous World Bank programs in the PRC energy efficiency market, the IFC blended its own funds with those of the Global Environmental Facility. The scheme, launched in 2006, was known as the China UtilityBased Energy Efficiency Program. It comprised two phases and ran from 2006 to 2012, with Phase III commencing in 2013. Banks lent $512 million until June 2009 ($384 million linked to the impact of the scheme) to 98 projects, with zero defaults, with estimated an CO2 savings of 14 million tons per year over the initial target.

306

S. Retallack et al.

The energy demand in the PRC increased by over 100% in less than a decade, with the country becoming the world’s largest CO2 emitter in 2007. Correspondingly, the PRC Government has committed to energy efficiency, particularly in industry and construction. The 2006 Five-Year Plan set a target of reducing energy consumption by 20%. The initial target market for the China Utility-Based Energy Efficiency Program scheme was SMEs, which traditionally found it difficult to access finance, particularly for energy efficiency, due to banks perceiving them as having high credit risks and the projects as having high performance risks. However, during the program, large companies from energy-intensive industries, such as steel, chemicals, and cement, dominated the loan applications. Small loans, intended for SMEs with smaller balance sheets, represented less than 10% of the total loans disbursed. Overall, the program exceeded its CO2 savings target; however, there were limitations in its design. The sustained change in the PRC energy efficiency market that this program drove has been modest. First, large companies from energyintensive industries dominated the lending under the program, rather than the initial target of SMEs. This was perhaps due to the guarantee mechanism mitigating the perceptions of performance risk, related to energy efficiency technologies, but, with no distinction in the mechanism dependent on company size, the banks favored the lower credit risk of larger companies over SMEs. Second, one of the two banks was responsible for 98% of the loans. This bank had a strategic desire to expand into the market and a viable customer base, mainly large customers in the energy-intensive industries, representing an accessible demand. By contrast, the other bank lacked this connection to the market and was not as prepared to commit internal resources to developing the opportunity. Such a result emphasizes the importance of involving the right participants.

Energy Efficiency Revolving Fund in Thailand In 2003, the Thai Government launched the Energy Efficiency Revolving Fund (EERF) as part of its wider Energy Conservation Program to stimulate investment from Thai banks. As of February 2012, 294 energy efficiency projects had been funded, without any defaults on the loans, realizing savings of 0.98 million tons of CO2 per year. In addition, the EERF was able to leverage private sector investment with a 3:1 ratio. However, as of 2015, only one of the original 11 participating banks was still actively financing energy efficiency (Streitferdt and Chirarattananon Streiferdt and Chirarattananon 2015). This program fell under the Government of Thailand’s policy target to reduce energy intensity by 25% between 2005 and 2025. It also aimed to promote the competitiveness of Thai businesses by reducing their energy costs and their dependence on oil imports from abroad. Though not a specified driver, the program also needed to redress the price distortions caused by historic subsidies for diesel and the longstanding Oil Stabilization Fund that maintained the oil price and reduced the effects of price fluctuation.

13

Energy Efficiency Finance Program

307

The program has realized significant energy savings, with over THB7 billion disbursed to projects that have helped to save 0.98 million tons of CO2 per year. However, there are questions regarding whether the program has stimulated a market that can work without the incentives of concessional finance and technical assistance. It was initially effective in attracting interest from commercial banks, with the numbers of participants increasing from six to 11 over the course of the program. However, their initial interest, which was prompted by the market distortions of the concessional credit and technical assistance, was not sustained; as previously stated, only one bank actively continues to finance energy efficiency projects. This could suggest that the technical assistance has resulted in a lack of skills transfer. Part of the problem here could be the reliance on banks to assess the technical aspects of the projects. Given the immaturity of the supply chain, people could consider this process to be desirable, but ultimately commercial banks are not geared to providing such a service. In addition, because the solutions are primarily aimed at increasing the supply of finance, they may not fully address the demand-side issues. Outside the banks selling the cheap finance and raising awareness themselves, there is no provision for technical training of the supply chain to provide a reliable pipeline. This is evident because, even when the banks have lent money, they have tended to favor larger, energy-intensive companies, because they see these as lowerrisk entities. This situation left the original target market of SMEs underserved.

Energy Efficiency Services Limited in India India’s Ministry of Power set up Energy Efficiency Services Limited (EESL), a joint venture company of power utilities, to offer street lighting solutions using LED lighting to municipal corporations and urban local bodies (ULBs) via an energysaving performance contract. EESL is billed as a “super ESCO” and is intended both to support activity directly and to stimulate the ESCO market in India more generally (Jituri and Sarin 2015). The program run by EESL aims to replace street lighting across multiple municipalities in India with LED lighting. The Government of India estimated that it would take only 2 years to replace the country’s existing 35 million light bulbs with LEDs and save approximately 9 billion kWh annually from the time of installation. Given the estimate of India’s electricity consumption in 2013 of 897 TWh, this 1% reduction is a sizeable opportunity considering the speed of LED installation. The EESL model is also expanding into other technologies and sectors. In 2001, the government introduced the Energy Conservation Act to provide a conducive regulatory and policy framework to catalyze market-based energy efficiency implementation in India. In 2008, the government followed the Energy Conservation Act with a National Mission on Enhanced Energy Efficiency, which promotes innovative policy and regulatory regimes, financing mechanisms, and business models for achieving national energy efficiency. The work of India’s Bureau of Energy Efficiency also supports municipal energy efficiency via projects across 15 states. However, while the economic incentive for energy-efficient

308

S. Retallack et al.

streetlights is present, the upfront costs of replacing the existing lights constitute a major barrier for many municipalities. The provision of standardized contracts without a minimum saving guarantee for municipal corporations, coupled with repayments as fixed annuities, is expected to encourage multinational corporations to commit to contracts with longer payback times, as they do not face such stringent requirements, which are difficult to prove due to poor data availability. In addition, the capital investments that EESL provides for manufacturers, with the backing of municipal corporations or state guarantees of payment, are likely to reduce the risk of investing in LED lighting. However, though the scheme is ongoing, there are outstanding questions regarding its sustainability. These arise first because manufacturers rely on the capital investment from the EESL to pay for LED lighting, and second because it is unclear how effectively multinational corporations will retain the technical assistance for installation, operation, and maintenance. To be both effective and sustainable in design, manufacturers will need to see a clear market case for energy efficiency, meaning that they no longer require grant financing. In addition, municipal corporations will need to retain the technical knowledge that they will require for the installation and maintenance of LED lighting once the technical assistance is withdrawn.

Sustainable Energy Financing Facilities in 22 Eastern European Countries and North Africa It is important to note that the energy context and challenges are similar across many Eastern European and North African countries. This situation has laid the foundation for the wide-reaching Sustainable Energy Finance Facilities (SEFF) program. The most important drivers include: • Technical inefficiencies of old equipment and long-standing underinvestment, which had reduced the international competitiveness of industries; • For those in Eastern Europe, a political desire to align with the EU directives and regulations as Eastern European countries sought EU membership, despite their carbon intensity ranging from two to four times the EU-15 average; • A desire to correct the energy pricing and regulatory distortions that did not incentivize energy efficiency investments, thereby highlighting the need for changes in policy. The objectives of the SEFFs, to boost local investment in cleaner energy solutions, matched these drivers with a particular focus on offsetting the market distortions by incentivizing energy efficiency. Policy discussions, where possible, also worked toward correcting these distortions. The SEFFs, which the European Bank for Reconstruction and Development (EBRD) first launched in 2004, aimed to promote efficient energy use in 22 Eastern European and North African countries with relatively high energy intensity across various sectors. Since their introduction, they have saved over 4 million tons of CO2,

13

Energy Efficiency Finance Program

309

channeling over €2.8 billion of the EBRD’s own funding via 104 local financiers to over 75,000 end-users (EBRD 2014). The bank designed the SEFFs to target either a country or a specific region, with Turkey and Bulgaria being the largest beneficiaries in both absolute and relative terms. In terms of specific sectors, while the largest number of projects (93%) were in the residential sector, the industrial sector (including SMEs) has been the main beneficiary in terms of funds (85%), followed by the residential (12%) and municipal (2%) sectors. The SEFFs tended to focus initially on sectors that were easier to reach and had a convincing business case for energy efficiency. Therefore, energy-intensive industries were often the first to receive attention, before markets such as the residential sector. This helped to establish a track record and familiarity within a location. The scheme considers technical assistance to be invaluable to financiers, helping to reduce the perceived risk of energy efficiency projects and build their awareness and capacity. For every euro invested in technical assistance, the SEFFs leverage €83 in private sector investment. Financiers and end-users do not suffer any deterioration in their returns from energy efficiency projects as a result of this technical assistance because it is grant-funded. However, it is difficult to know whether the transfer of skills to local organizations has ensured self-sustaining private sector markets. Performance-based incentives increase the potential returns for end-users, fueling greater demand. As the SEFFs have matured, there has been a greater emphasis on tying incentives to CO2 reduction, mimicking the function of a carbon price. The incentives have diminished over time as markets have become established and shifted to new sectors to avoid creating dependence on subsidized returns. The relatively unusual policy dialogue component addresses the longer-term problems with incentivizing energy efficiency in commercial markets. Importantly, action on the ground complements it—actual projects delivering energy and carbon savings—to reinforce the case with policy makers considering the impact of policy settings. Overall, while countries can undertake more to establish sustainable markets, the SEFFs’ synchronization of financial and technical elements has helped to realize impressive results in diverse contexts and sectors. The simplicity of the program represents a key attraction, especially for financiers, when compared with other EU programs, such as the Structural Funds.

PROESCO in Brazil The two main objectives of the PROESCO scheme were to support investments in energy efficiency equipment across Brazil’s industrial, public, and commercial sectors and to accelerate the development of its SME-sized ESCO market. These represented significant opportunities for boosting competitiveness and growing a new industry. PROESCO’s introduction occurred within a policy environment that had clear objectives to promote an energy efficiency market. Specifically, in 2001,

310

S. Retallack et al.

the country introduced the Brazilian Clean and Efficient Energy Program to establish a dialogue between ESCOs and financial institutions. The Brazilian Development Bank, BNDES, created the PROESCO program in 2006, providing ESCOs with direct concessional loans and guarantees and commercial banks lending to ESCOs with guarantees covering credit risk. The project witnessed very limited demand and eventually closed in 2015. This was due to several factors, such as an overly bureaucratic process when applying for finance, high collateral requirements limiting the capacity of small and medium-sized players to access it, and a general lack of technical assistance to build the pipeline of projects. The target clients of the program were ESCOs, utilities, and end-users interested in funding the purchase of energy efficiency equipment for the commercial, public, and industrial sectors. These sectors accounted for approximately twothirds of electricity consumption in Brazil in 2006. Although there was no specific threshold, the intention was for PROESCO loans to be above R$1 million, drawing from a credit facility of R$100 million. Additionally, it was anticipated that the equipment being installed would have a payback period of 6 years. Both the payback duration and the initial funds show this scheme was intended for ESCOs at the larger end of the SME scale. The solutions that the bank developed for PROESCO largely failed to incentivize the uptake of energy efficiency projects. This was partly due to the fact that, despite guarantees to cover 80% of the project costs, the perceived risk for these projects made commercial banks unwilling to accept even the remaining 20% on their own. For SME-sized ESCOs, this was also problematic due to low awareness as well as low willingness to adopt efficiency upgrades that made it challenging for them to secure finance. The collateral requirements of participating in the scheme further limited the demand for finance. In addition, the capping of interest rates at 9.1% for loans channeled through banks, while potentially decreasing the risk for ESCOs, also decreased the available returns for the banks, thereby disincentivizing them from appraising energy efficiency loan applications. Finally, the process by which ESCOs could obtain loans, or banks could obtain guarantees, was overly bureaucratic, thereby hindering the uptake. Complex processes were particularly unwelcome given the perception of energy efficiency as a low priority due to the historic low cost of energy.

Energy Saving Insurance in Mexico In Mexico, there is an increasingly positive policy framework for energy efficiency. The framework includes subsidies for energy efficiency, efficiency standards for technologies, a national accreditation system for technologies, and standardized contractual arrangements for supply-side energy efficiency. The Energy Saving Insurance (ESI) is a pilot program that commenced in 2015, which the Inter-American Development Bank (IDB) administered and the IDB, the FIRA (Mexico’s Development Bank), and the Clean Technology Fund (CTF) funded, with additional support from the Danish Energy Agency. Separate pilots

13

Energy Efficiency Finance Program

311

are also underway in Colombia and in preparation in El Salvador. It is the first energy efficiency program to deploy an insurance mechanism mitigating the perceived performance risk in developing countries. A standardized performance contract, validation mechanisms, and processes designed to increase the trust between contracting partners, to reduce the perceived risk, and to ensure that energy savings are realized that can ultimately pay back a loan taken out for an energy-saving project complement the insurance. This provided a derisking solution aimed at aligning market participants’ incentives and thereby creating a sustainable local environment for increasing private investments. As this program is currently in the pilot phase, with several technology providers having received validation and the first projects undergoing assessment, there is insufficient information to judge its design yet. However, the combination of standardized energy performance contracts, project assessment and verification, and insurance against potential energy-saving shortfalls represents an impressively holistic approach. This could be effective in building trust within the supply chain and, consequently, the establishment of a self-sustaining market. This multifaceted solution package requires a balancing act to align benefits and transaction costs. In short, these extra processes need to bring down the cost of capital sufficiently for end-users to increase their energy efficiency investments and for financiers to supply finance at adequate rates. The aim is for the market to align with real rather than perceived risks, become more familiar with energy efficiency, and therefore spur competition. The effects of these shifts would be a reduction in transaction costs and the expansion of both the supply of and the demand for finance in the long term.

Conclusion and Recommendation This study reviewed several programs for financing energy efficiency based on earlier empirical case studies around the world. As a major result, we identified some categories of barriers, namely awareness and commitment, technical solutions and expertise, and financial resources. It is possible to match the most common solutions that have emerged from the case studies and wider energy efficiency programs with these barrier categories. We can suggest the following solutions to each of these barriers from the empirical best practices: (I) Awareness and commitment barrier: some policies, such as advertising, educational events, or direct outreach, depending on the level of pre-existing awareness and the feasibility of reaching the target audience, can address the lack of knowledge and awareness of the benefits of energy efficiency. (II) Technical solutions and expertise: project assessment, monitoring, and verification are difficult without sector knowledge if there is insufficient capacity, commonality on best practice, and standardization of procedures and technologies. To overcome this barrier, it is possible to train local suppliers of goods and services to access potential opportunities for a given business properly

312

S. Retallack et al.

through gaining an understanding of different technologies and building the capacity to conduct or at least understand key reports, such as energy audits. Alternatively, programs can install entities with existing experts that are then capable of either transferring skills to the local supply chain or outlasting the programs. (III) Financial resources: lack of familiarity and trust from end-users and investors in business models that monetize energy savings, such as ESCO) (energy service companyservice offers, can represent a crucial barrier. This makes it difficult for companies based on these business models to raise capital. To solve this problem, schemes can implement support for derisking investments in ESCOs to encourage growth in their business model. In the case of awareness and commitment, it is possible to conclude that programs should not focus solely on finance; they need to stimulate and scale up the demand concurrently. Furthermore, to link supply and demand, projects must be identified, prepared, and delivered to financiers in a commercially viable way. Moreover, timing and synchronization with the other components of a program are paramount for using awareness-raising and pipeline generation tools effectively. In addition, there should be a mutually reinforcing relationship between policy development and action on the ground. Besides, incentives (such as concessional finance) can temporarily create an attractive business case, but they are more suited to realizing shortterm energy demand reduction than sustainably transforming markets. Regarding the barrier of technical solutions and expertise, the main conclusions and lessons from the best practices are the following: (I) trust is the essential glue that binds together any supply chain, performing a crucial derisking function for unfamiliar energy efficiency investments; (II) properly assessing, monitoring, and verifying projects provide the raw data for achieving trust, but these require standardization of procedures, contracts, decisions, and technologies to aid the process of aggregating and scaling credible data; (III) formal accreditation completes the process; (IV) implementing all, or even some, of the above requires skills and investment in the local supply chain; and (V) as a general rule, it is necessary to maintain simplicity wherever possible. In the case of the financial resources barrier, programs should not use financial solutions to address non-financial barriers. Moreover, financial solutions are often limited to addressing one financial problem at a time, and a good understanding of their shortcomings is necessary. In addition, simplicity is a fundamental principle. Furthermore, to nurture a self-sufficient private sector market, any financial program needs to exit the scene with its conditions as close as possible to commercial conditions. Besides, implementing energy efficiency finance demands a close connection between the financial and the technical support to sell energy savings to justify investment. There are three indispensable recommendations to reorient programs and thereby drive transformational and sustainable change: (I) Energy efficiency finance schemes will not be enough to change markets. Strong policy frameworks with the right economic and regulatory drivers to

13

Energy Efficiency Finance Program

313

incentivize change need to strengthen business cases. Therefore, influencing such frameworks must be a key objective of future programs. (II) Programs should devote more resources to technical assistance than they have allocated historically. Activities such as awareness raising, pipeline generation, and derisking are essential to create sufficient demand and commitment to act. Careful synchronization of technical and financial elements must also complement adequate attention and resources. (III) Upskilling and equipping suppliers and technical advisors, connecting the financial and technical aspects of energy efficiency, are also critical to creating a sustainable, scalable, and bankable pipeline. Across the supply chain, they have the greatest inherent incentive in their business model to identify, appraise, and deliver viable projects ready for financing.

References Asian Development Bank (2015) 2015 Joint report on multilateral development banks’ climate finance. http://www.adb.org/documents/joint-report-mdbs-climate-finance-2015. Accessed 14 Aug 2017 Aung T, Saboori B, Rasoulinezhad E (2017) Economic growth and environmental pollution in Myanmar: an analysis of environmental Kuznets Curve. Environ Sci Pollut Res 24 (25):20487–20501 Bardhan A, Jaffee D, Kroll C, Wallace N (2014) Energy efficiency retrofits for U.S. housing: removing the bottlenecks. Reg Sci Urban Econ 47:45–60 Bataille C, Melton N (2017) Energy efficiency and economic growth: a retrospective CGE analysis for Canada from 2002 to 2012. Energy Econ 64(C):118–130 Braun G, Hazelroth S (2015) Energy infrastructure finance: local dollars for local energy. Electr J 28 (5):6–21 European Bank for Reconstruction and Development (EBRD) (2014) The EBRD’s sustainable energy finance facilities. http://www.ebrd.com/downloads/about/evaluation/1407APSEFF.pdf. Accessed 10 Sep 2017 Gouldson A, Kerr N, Millward-Hopkins J, Freeman MC, Topi C, Sullivan R (2015) Innovative financing models for low carbon transitions: exploring the case for revolving funds for domestic energy efficiency programmes. Energy Policy 86:739–748 Greening LA, Greene DL, Difiglio C (2000) Energy efficiency and consumption – the rebound effect – a survey. Energy Policy 28(6–7):389–401 Hall S, Foxon TJ, Bolton R (2016) Financing the civic energy sector: how financial institutions affect ownership models in Germany and the United Kingdom. Energy Res Soc Sci 12:5–15 Ihara T, Gustavsen A, Preter Jelle B (2015) Effects of façade components on energy efficiency in office buildings. Appl Energy 158:422–432 International Energy Agency (IEA) (2014) World energy investment outlook. www.iea.org. Accessed 10 Aug 2017 International Energy Group (IEG) (2010) Assessing the impact of IFC’s China utility-based energy efficiency finance program. www.ifc.org. Accessed 10 Aug 2017 International Finance Corporation (IFC) (2014a) Terminal evaluation of China utility based energy efficiency program (CHUEE). www.ifc.org. Accessed 10 Aug 2017 International Finance Corporation (IFC) (2014b) Boosting energy efficiency in Turkey. www.ifc. org. Accessed 10 Sep 2017 Jituri VV, Sarin A (2015) LED lighting in India: analysis on progress. Int J Bus Manag 3(3):30–35

314

S. Retallack et al.

Koesler S, Swales K, Turner K (2016) International spillover and rebound effects from increased energy efficiency in Germany. Energy Econ 54:444–452 Markus S, Brunauer W, Bienart S (2015) How does energy efficiency influence the market value of office buildings in Germany and does this effect increase over time? J Eur Real Estate Res 8 (3):243–266 Oji C, Soumonni O, Ojah K (2016) Financing renewable energy projects for sustainable economic development in Africa. Energy Procedia 93:113–119 Patterson MG (1996) What is energy efficiency? Concepts, indicators and methodological issues. Energy Policy 24(5):377–390 Pettifor H, Wilson C, Chryssochoidis G (2015) The appeal of the Green Deal: empirical evidence for the influence of energy efficiency policy on renovating homeowners. Energy Policy 79:161–176 Popescu D, Bienert S, Schutzenhofer C, Boazu R (2012) Impact of energy efficiency measures on the economic value of buildings. Appl Energy 89:454–463 Rasoulinezhad E, Saboori B (2018) Panel estimation for renewable and non-renewable energy consumption, economic growth, CO2 emissions, the composite trade intensity, and financial openness of the Commonwealth of Independent States. Environ Sci Pollut Res 25 (18):17354–17370 Saboori B, Rasoulinezhad E, Sung J (2017) The nexus of oil consumption, CO2 emissions and economic growth in China, Japan and South Korea. Environ Sci Pollut Res 24(8):7436–7455 Sarkar A, Singh J (2010) Financing energy efficiency in developing countries – lessons learned and remaining challenges. Energy Policy 38(10):5560–5571 Smulders S, De Nooij M (2003) The impact of energy conservation on technology and economic growth. Res Energy Econ 25(1):59–79 Sorrell S (2015) Reducing energy demand: a review of issues, challenges and approaches. Renew Sustain Energy Rev 47:74–82 Streiferdt V, Chirarattananon S (2015) Energy efficiency finance support in Thailand: lessons learned from the energy efficiency revolving fund. J Sustain Energy Environ 6:13–16 Taghizadeh-Hesary F, Yoshino N, Abadi H, Mohammadi M, Farboudmanesh R (2016) Response of macro variables of emerging and developed oil importers to oil price movements. J Asia Pac Econ 21(1):91–102. https://doi.org/10.1080/13547860.2015.1057955 Taghizadeh-Hesary F, Yoshino N, Rasoulinezhad E (2017) Impact of the Fukushima nuclear disaster on the oil-consuming sectors of Japan. J Comp Asian Dev 16(2):113–134 Tuominen P, Forsstrom J, Honkatukia J (2013) Economic effects of energy efficiency improvements in Finnish building stock. Energy Policy 52:181–189 Turner K, Hanley N (2011) Energy efficiency, rebound effects and the environmental kuznets curve. Energy Econ 33(5):709–720 Webb J, Hawkey D, Tingey M (2016) Governing cities for sustainable energy: the UK Case. Cities 54:28–35

The Role of Fintech in Unlocking Green Finance

14

Policy Insights for Developing Countries Darius Nassiry

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fintech and Blockchain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fintech and Sustainable Development Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supply Chain Transparency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Digital Identity and Financial Inclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Blockchain Technology for Renewable Energy and Distributed Electricity Systems . . . . . . . . . Peer-to-peer Energy Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trade and Exchange of Carbon Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Climate Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Innovation and Green Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subnational Pooled Financing Mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Implications for Asia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Fintech in the PRC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conclusions and Preliminary Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Preliminary Recommendations for Policy Makers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

316 318 320 321 322 322 323 324 326 326 327 327 329 329 330 331 332

Abstract

The achievement of the Sustainable Development Goals (SDGs) and implementation of the Paris Agreement will require significant new investment. New financial technologies (“fintech”) offer the potential to unlock green finance technologies, such as blockchain, the Internet of Things (IoT) and big data, The author is writing in his personal capacity and is responsible for any errors or omissions. The views expressed do not necessarily represent those of the Overseas Development Institute (ODI) or its Board. D. Nassiry (*) Overseas Development Institute (ODI), London, UK e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_27

315

316

D. Nassiry

developed over the same timeframe as the Paris Agreement and the SDGs. This chapter outlines three broad areas for the possible application of fintech to green finance: blockchain applications for sustainable development; blockchain use-cases for renewable energy, decentralized electricity market, carbon credits, and climate finance; and innovation in financial instruments, including green bonds. This chapter focuses on blockchain use-cases pertaining to sustainable development and renewable energy and highlights examples from Europe, which has been a leader in blockchain technology. The chapter explores the implications for developing economies in Asia and draws preliminary recommendations for policy makers interested in harnessing fintech and blockchain for low-carbon, climate-resilient investment, and the achievement of the SDGs. Keywords

Green finance · Fintech · Blockchain JEL Codes

O13 · O33 · O38 · Q01 · Q54 · Q55 · Q56 · Q58

Introduction Implementation of the Paris Agreement and achievement of the Sustainable Development Goals (SDGs) will require significant new investment (World Economic Forum 2013; Global Commission on the Economy and Climate 2014; Organisation for Economic Co-operation and Development 2017; Bhattacharya et al. 2016; Bielenberg et al. 2016). Indeed, the latter will require additional investment of US$2–3 trillion per year and US$1.4 trillion per year in developing countries, including US$343–360 billion for low-income countries and US$900–944 billion for lower-middle-income countries (Schmidt-Traub 2015; Schmidt-Traub and Sachs 2015). Trillions of dollars in new investment, including incremental investments to ensure that long-term investments such as infrastructure are low-carbon and climate-resilient, will be required to meet the Paris Agreement’s key objective of ensuring that global average temperature increase remains “well below” 2 C and to achieve the SDGs. The United Nations Conference on Trade and Development (UNCTAD 2014) estimates total global annual investment needs as equating to US$5–7 trillion, including US$3.3–4.5 trillion in developing countries in key SDG sectors (comprising infrastructure, food security, climate change mitigation and adaptation, health and education). The OECD (2017) estimates current levels of investment as approximately US$1 trillion per year, i.e., less than one-third of the amount required. Developing countries in Asia will need to invest an estimated US$26 trillion by 2030 (or US$1.7 trillion per year) in infrastructure, including US$4.7 trillion for power and US$8.4 trillion for transportation, in order to maintain growth, eliminate poverty, and address climate change (ADB 2017). Due to limited public budgets, private capital must constitute a large proportion of this new investment. The Paris Agreement includes a commitment to “[making]

14

The Role of Fintech in Unlocking Green Finance

317

finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development” (United Nations Framework Convention on Climate Change (UNFCCC) 2015, p. 2, Article 2.1 (c)). Ensuring that capital flows to sustainable investment has therefore become an important focus for policy makers. The United Nations Environment Program explored the potential for alignment of the financial system to meet sustainability objectives (Zadek and Robins 2018). Innovations in green finance offer the potential to contribute to global goals and reshape the economy in favor of access to services such as energy, poverty reduction, and economic activity, as well as lowering aggregate investment and operating costs and, thereby, helping to improve our capacity to achieve agreed sustainability outcomes. Technology innovation and new financial instruments will be required to lower costs and raise capital at the appropriate scale and speed. Green finance and fintech are relevant to policy makers, particularly in emerging and developing countries, as they pursue the implementation of the Paris Agreement and achievement of the SDGs. Fintech broadly refers to “companies or representatives of companies that combine financial services with modern, innovative technologies” (Dorfleitner et al. 2017, p. 5). Green finance can be described as constituting “financial investments flowing into sustainable development projects and initiatives, environmental products, and policies that encourage the development of a more sustainable economy” (Lindenberg 2014, p. 1). Innovations in new technologies such as blockchain that have the potential to accelerate the flow of capital to a more sustainable economy technology, as well as financial instruments such as green bonds that meet the riskreturn requirements of investors for sustainable investments, will help meet global policy objectives. The aim of this chapter is to survey the potential applications of fintech and blockchain for green finance, with an emphasis on renewable energy as a key element of implementing the Paris Agreement and achieving the SDGs. Moreover, the chapter will suggest areas for future policy consideration. Where applicable, it highlights examples from Europe, which has emerged as a leader in blockchain innovation, and therefore relevant for developing countries in Asia, especially in the energy sector. The chapter is organized as follows: First, “Fintech and Blockchain” provides an introductory overview of fintech, focusing on blockchain and with reference to the complementary role of the Internet of Things (IoT)) and big data. Second, “Fintech and Sustainable Development Applications” highlights the potential application of fintech (with emphasis on blockchain) for a range of sustainable development goals. Third, “Blockchain Technology for Renewable Energy and Distributed Electricity Systems” outlines potential use-cases of blockchain technology for carbon credits, renewable energy, and distributed electrical power systems. Fourth, “Financial Innovation and Green Bonds” describes the application of fintech and green finance, specifically on green bonds as a financing tool for sustainability investments.

318

D. Nassiry

Where applicable, the chapter highlights examples from Europe, which has assumed a leadership role in sustainable finance and fintech innovation, including blockchain start-ups. The chapter also draws linkages from these innovations to the People’s Republic of China (PRC), which is a leader in both green bonds issuance as well as in fintech and blockchain technology. Finally, “Conclusions and Preliminary Recommendations” puts forward recommendations for policy makers in developing countries seeking to tap the potential of these new technologies to advance climate and sustainability goals.

Fintech and Blockchain Fintech in its initial applications involves “technologies used and applied in the financial services sector, chiefly used by financial institutions themselves on the back end of their businesses,” but its applications have enlarged “to represent technologies that are disrupting traditional financial services, including mobile payments, money transfers, loans, fundraising, and asset management” (Marr 2017). Prominent among fintech applications are blockchain or distributed ledger technologies. The concept of a blockchain protocol and its application for bitcoin was first proposed in a white paper published in 2008 by an unknown person or persons named Satoshi Nakamoto (Nakamoto 2008). Blockchain, which is a type of distributed ledger technology, enables the creation of a distributed database that removes the need for trusted intermediaries, such as banks or other institutions, to facilitate transactions. A blockchain is “a type of database that takes records and puts them in a block (akin to, say, a sheet in your Excel file). Each block is then ‘chained’ to the previous block, using a cryptographic signature. This allows blockchains to be used like a ledger, which can be shared and corroborated by anyone with permission” (DeCaprio and Beck 2017). Blockchain thereby ensures “the integrity of the data exchanged among billions of devices without going through a trusted third party” (Tapscott and Tapscott 2016, 2017, p. 5). As Crosby et al. (2015, p. 3) explain: A blockchain is essentially a distributed database of records or a public ledger of all transactions or digital events that have been executed and shared among participating parties. Each transaction in the public ledger is verified by consensus of a majority of the participants in the system. And, once entered, information can never be erased. The blockchain contains a certain and verifiable record of every single transaction ever made.

Blockchains can be public (open access) or private (controlled access). Vitalik Buterin (2015), who created Ethereum, a decentralized platform that runs selfexecuting ‘smart contracts, describes public blockchains as “ones that anyone in the world can read, anyone in the world can send transactions to and expect to see them included if they are valid, and anyone in the world can participate in the consensus process.” By disintermediating institutions that were previously required to establish trust, blockchain offers the potential of “a world without middlemen” (Gupta 2017a, b).

14

The Role of Fintech in Unlocking Green Finance

319

Public distributed ledgers combine economic incentives with cryptography, peerto-peer protocols, and data storage to create a transparent, immutable and decentralized record of transactions that is visible to all parties on the blockchain (Gupta and Knight 2017; Meunier 2018). As the Blockchain Trust Accelerator (2017) explains: The innovation of the blockchain begins with the fact that no central entity owns or controls it. Data is stored across a global network of computers. When we put an asset of value onto the blockchain, these transactions are cryptographically linked in data blocks, providing a complete history for every piece of data in the system. Each transaction on the record is digitally signed so we know who submitted it to the network. Every asset can also be directly transferred in a secure, fast, and transparent way. The blockchain provides unprecedented data security. The blockchain system selfguarantees the authenticity of all the data within it, eliminating the need for trust in other parties. This prevents double spending, falsified asset ownership, and other forms of data tampering. ... The blockchain is highly transparent; a record of all transactions is permanently available. All users on the system can see in real time as new transactions are added to the database. ... The blockchain is also entirely auditable. Every time a new transaction is added to the record, it is also cryptographically linked to every previous transaction. Therefore, the blockchain ledger cannot be altered once it is verified.

As a result, blockchain technology has been described as a “trust machine” because it produces the efficiencies of trust between parties without a central intermediary (The Economist 2015). Blockchain proponents note the far-reaching, transformative potential of the technology in financial services and across the global economy, even as blockchain applications remain at an early stage of development. Indeed, Tapscott (2016) describes blockchain as “the biggest innovation in computer science—the idea of a distributed database where trust is established through mass collaboration and clever code rather than through a powerful institution that does the authentication and the settlement.” Recent market activity involving bitcoin and other crypto-currencies has drawn attention to blockchain and the related digital ledger technologies that underpin them as having broader and deeper long-term societal and economic implications than the volatile market prices of cryptocurrencies such as bitcoin might suggest (citations from The New York Times, Wall Street Journal and the Financial Times.) As Johnson (2018) writes: The true believers behind blockchain platforms such as Ethereum argue that a network of distributed trust is one of those advances in software architecture that will prove, in the long run, to have historic significance. That promise has helped fuel the huge jump in cryptocurrency valuations. But in a way, the Bitcoin bubble may ultimately turn out to be a distraction from the true significance of the blockchain. The real promise of these new technologies, many of their evangelists believe, lies not in displacing our currencies, but in replacing much of what we now think of as the internet, while at the same time returning the online world to a more decentralized and egalitarian system.

Technologies such as the Internet of Things (IoT) and big data can be deemed as complementing blockchain as a platform for the exchange of value, where data is the

320

D. Nassiry

core underlying element. IoT refers to connecting any object or electronic device with a sensor, which is then connected to the Internet, while big data refers to the large-scale collection, analysis, and application of data, which may be generated by the IoT. IoT and big data provide a base layer of information that can then be managed, automated, and acted upon by either human or automated decision processes. This interrelationship between technologies will enable a future in which these complementary technologies are integrated. As Outlier Ventures (2016, p. 40) state: “Blockchains, artificial intelligence, the Internet of Things, autonomous robotics, 3D printing, and virtual and augmented reality are all converging to significantly disrupt existing industries and create whole new markets and economic models.” In this future economy, big data collected by the IoT are “authenticated, validated, and secured using distributed ledgers, consensus, and other decentralised technologies” (Outlier Ventures 2018, p. 13). As IoT, big data, and blockchain continue to evolve, their gradual convergence will create new possibilities for the fulfillment of sustainability goals where these digital technologies are developed with such objectives in mind.

Fintech and Sustainable Development Applications Fintech—and blockchain in particular—have important potential implications for the implementation of a range of sustainable development applications, owing to the potential impact of fintech on the economy and the fact that these new technologies will continue to develop over the same timeframe as the implementation of the Paris Agreement and SDGs. Fintech and blockchain have already been related to sustainability applications and use-cases. The United Nations Environment Programme has identified over two dozen distinct applications of fintech for sustainable development in varying levels of implementation, including four applications in energy described in greater detail below: pay-as-you-go resource utilities; flexible energy supply and demand, peer-topeer renewable energy, and community distributed generation (UNEP 2016). Chapron (2017, p. 403) has compared blockchain technology “to the invention of double-entry book-keeping...which enabled the modern economy” and has highlighted the potential for blockchain applications that blend cryptography and sustainability. Gupta and Knight (2017) have highlighted innovations in mobile money services such as M-Pesa as an example of how developing countries can leap ahead: “[Imagine] what full-scale transformation built on blockchain might do. It could create hyper-efficient governments with provably trustworthy infrastructure; new markets and opportunities for citizens to access the formal economy on equal terms; efficiencies of operations that lower prices and improve the quality of goods for all consumers; and provide a kickstart to high-tech innovation around the world.” The World Bank (2017) has cataloged a wide range of blockchain applications in the financial sector, including money and payments, financial services infrastructure,

14

The Role of Fintech in Unlocking Green Finance

321

agriculture, governance, healthcare records, and humanitarian and aid applications, such as tracking and delivery of aid. Examples of potential use-cases that are relevant to sustainable development include supply chain transparency, identity and financial inclusion, and property rights, as described below.

Supply Chain Transparency A major set of use-cases with implications for sustainable development involves supply chain transparency. Blockchain’s application in tracking assets is expanding into natural resources and offers the potential to transform the ways in which natural resources are recorded and traced across several subsectors, including forestry and fisheries to carbon accounting and energy. DeCaprio and Beck (2017) have cited the example of a pilot blockchain project to establish a sustainable supply chain in Indonesia to track the provenance of skipjack and yellow fin tuna caught by local fishermen, which enables compliance at origin, and could replace the current system of hard-to-verify paper records, which are subject to corruption. In 2018, Maersk, the world’s largest shipping company, based in Denmark, and IBM, announced plans to form a joint venture “to provide more efficient and secure methods for conducting global trade using blockchain technology” with the aim of reducing costs and inefficiencies (White 2018). Golden and Price (2018, p. 2) have noted the number of pilot projects that have been launched by major supply chain companies—including agriculture traceability tied farmers’ digital identity, shipping and logistics software to reduce inefficiencies in container shipping, mapping to create transparency in supply chains for consumer goods to improve ethical sourcing, and efforts to build solutions for the sustainability of seafood supply chains—and predict that if “blockchain-based supply chain solutions reach scale over the next five years, they could deliver a transformation in global supply chain management.” Indeed: Blockchain solutions constitute the rare innovation that could provide both profits and social purpose. Regulators, social enterprises, and civil society organizations are poised to harness the transparency and accountability available through blockchain-based tools to help solve supply chain problems including dangerous labor conditions and environmentally destructive practices. (Golden and Price 2018, p. 3)

Blakstad and Allen (2018, passim), from the fintech start-up Hiveonline based in Denmark, have highlighted the potential of fintech solutions across a number of intervention areas tied to sustainability, as well as diverse ways in which blockchain can improve supply chain integrity, including: the traceability of transactions, allowing consumers to “be confident where their money is going”; provenance across the lifecycle of an asset or commodity such as location of origin; disintermediation using self-executing contracts that “can be encoded so that the need for administration and central intermediaries is significantly reduced or removed, taking

322

D. Nassiry

much of the challenge and cost out of running circular economies”; and transparency in “removing the need for third-party auditing” and facilitating identification of value through a supply chain.

Digital Identity and Financial Inclusion For many people in developing countries, participation in the financial economy (including capital formation through savings, opening a bank account or borrowing money from a financial institution, or financial leverage to support investment and growth) remains impossible due to a lack of sufficient identity and credit history, which are elements of identity that are often taken for granted in developed economies. Economic identity can be defined as “the marriage of identity and commerce, resulting in a global, vetted, and manageable asset. This identity consists of the digital or electronic credentials that define a person’s history of economic interactions in the world economy” (BanQu 2018). As the United States Agency for International Development (USAID 2017, p. 1, 72) has observed: There may be no single factor that affects a person’s ability to share in the gains of global development as much as having an official identity. Identity unlocks formal services as diverse as voting, financial account ownership, loan applications, business registration, land titling, social protection payments, and school enrollment. A functioning digital economy hinges on the critical infrastructure of digital identity. Emerging trends in digital identity have the potential to offer more inclusive biometrics, leveraging digital footprints to identify those who lack official ID, and potentially providing individuals with more convenient, secure, and portable identification options.

Examples of relevant blockchain-based use-cases include economic identification, in which identification is “built up over time through a series of transactions stored on a blockchain and verified by others”; humanitarian cash transfers where the potential for fraudulent claims is reduced or eliminated; and land titling, described in further detail below (USAID 2017, p. 57).

Property Rights Closely tied to the application of fintech and blockchain for economic identity and financial inclusion are property rights and land titles. In nearly every country, the way in which people know that they own property is dependent on a well-established and often complex set of documents certifying that the title holder has a legal claim on the property. In some countries, title insurance is required in the event of a dispute between the parties about the validity of the transfer of the property. A wide range of countries, including Estonia, Georgia, Ghana, Honduras, and Rwanda, have started to test the potential of putting land titles on a blockchain

14

The Role of Fintech in Unlocking Green Finance

323

platform, thus simplifying the process of transferring title and rendering future disputes less likely. Sweden, where land records are already recorded in digital form, may represent the country that is farthest ahead in this pilot testing process. A recent report on the second phase of Sweden’s test for the feasibility of putting property titles on a blockchain highlighted the significance of this application for developed as well as developing economies: For countries without a trustworthy real estate ownership record and land registry, a similar project may be the easiest, most cost efficient, and fastest way to increase GDP in the medium term. It will serve as a foundation for better investments in land, enable the development of a mortgage market and a credit market in general, and become an institution of trust in one of the most fundamental parts of an economy: land and real estate. (Kairos Future 2017, p. 5)

Moreover, as Pisa and Juden (2017, p. 28) note: [Sharing] a land registry across a distributed network greatly enhances its security by eliminating “single point of failure” risk and making it more difficult to tamper with records.... A blockchain cannot, however, address problems related to the reliability of records. ... This suggests that using the technology to store land records works best in places where the existing system for recording land titles is already strong.

Blockchain Technology for Renewable Energy and Distributed Electricity Systems In addition to the potential applications of fintech and blockchain for SDGs, blockchain and related technologies have important early use-cases in the energy sector, including peer-to-peer energy trading, climate finance, and carbon credit trading. Applications have drawn attention from the financial sector, where the potential for blockchain to improve the efficiency of settlement and other intermediary functions has represented a key attraction. Energy has been the second major sector where blockchain has attracted interest due to its potential role in disrupting current business models. According to the World Energy Council (2017, p. 3), blockchain was identified as “one of the most critical uncertainties” and “is perceived by energy leaders globally to be an issue of both relatively high impact and uncertainty,” with IoT blockchain scoring highest in terms of impact and uncertainty among issues facing the energy sector. In the energy sector, blockchain’s potential implications include dis-intermediation of utility business models of centralized generation and grid distribution, with significant implications for distributed energy systems and decentralized grids: Blockchain is in an early stage of the innovation process ... [but] is expected to lead to much more direct relationships between energy producers and consumers, and to strengthen the market participation opportunities for small energy providers and prosumers. In a decentralised energy system, blockchain could enable energy supply contracts to be made

324

D. Nassiry

directly between energy producers and energy consumers, and for them to be carried out automatically. (World Energy Council 2017, p. 4)

Europe has been pioneering innovation and financing for blockchain firms involved in energy and the clean technology sector. According to data from the Cleantech Group, which tracks firms spanning energy, logistics and supply chains, blockchain and IoT, mobility, agriculture, and other applications, the number of companies or consortia involved in the broader blockchain ecosystem has grown over the past year from about 35 to over 150. European companies had raised some US$723 million as of May 2018, compared to US$251 million in Asia and US$140 million in North America (Besnainou 2018). An analysis of companies and pilot projects working with blockchain and energy found that over half were based in Europe, followed by North America and Asia, and nearly three quarters had been founded in either 2016 or 2017, reflecting their early stage of development (SolarPlaza 2018). Livingston et al. (2018) have described a range of potential applications of blockchain technology to electric power systems, including peer-to-peer and grid transactions, energy financing, sustainability attribution, electrical vehicles, as well as other applications such as smart appliances. Examples of applications for renewable energy and distributed energy systems described below include peer-to-peer energy transactions, carbon credits, and climate finance.

Peer-to-peer Energy Transactions A prominent set of use-cases of blockchain technology for sustainability applications involves peer-to-peer energy exchange, including from distributed energy systems using renewable energy (Tapscott 2018). As PwC (2017, p. 16) explains: “so called ‘prosumers’ not only consume energy but also dispose of generation in the form of solar systems, small-scale wind turbines or CHP plants; moreover, blockchain technology could enable them to sell the energy they generate directly to neighbors.” As a result, “[b]lockchain based energy processes would no longer require energy companies, traders, or banks (for payments). “Instead, a decentralized energytransaction and supply system would emerge, under which blockchain-based smart contract applications empower consumers to manage their own electricity supply contracts and consumption data” (PwC 2018, p. 18). As of 2017, over 90 companies and pilot projects were working with blockchain and energy, including the US start-up L03 Energy, which has a pilot peer-to-peer energy exchange called the Brooklyn Microgrid; PowerLedger, an Australian blockchain-based trading platform that enables the decentralized selling and buying of renewable energy; and Energy Web Foundation, a consortium of major global energy and blockchain companies aiming to develop an energy sector blockchain (Solarplaza 2018). In Norway, the state-owned energy company Statkraft has demonstrated the feasibility of energy exchange on a blockchain platform and has

14

The Role of Fintech in Unlocking Green Finance

325

predicted that within five years “[b]lockchain will be able to provide many rapid, low-cost transactions in an electricity market with a growing share of renewable energy” (Statkraft 2018). According to Livingston et al. (2018, pp. 9–10), “[even] if blockchain does not replace the grid, it could enable more participants to trade electricity. For example, Vattenfall, the largest Nordic utility, is running trials in which it uses a private blockchain network to record electricity transactions in which department stores or even individual homes can sell electricity generated by distributed batteries or solar panels; previously, such transactions would have been prohibitively expensive or time-consuming to process.” In his design principles for the power markets of the future, Liebriech (2017, pp. 7–8) views blockchain technology applied to payments for transmission and distribution as well as the attribution of carbon content of imported power as being part of a broader “digital convergence of energy, infrastructure, and services.” In Europe, over 40 energy-trading firms have joined forces under the project name Enerchain, a blockchain project to conduct peer-to-peer trading in the wholesale energy market: The main goal of Enerchain is to deploy a technical infrastructure allowing participants in the energy wholesale markets to trade power and gas in a decentralised way, thus avoiding intermediaries and central market platforms. ... Operating costs for a decentralized system are different from operating a ‘classical’ central platform, i.e., dramatically reduced. (Merz 2018, pp. 7, 10)

Enerchain is at the proof of concept stage and is designed to determine whether a decentralized blockchain-based model can support the trading volumes and transaction speeds required for trade execution in the gas and electricity markets (World Energy Council 2017). Other early-stage initiatives include Alliander in the Netherlands, which is piloting a blockchain-based energy tool to enable consumers to manage and share their renewable energy, and Conjoule, a start-up launched by Innogy in Germany, which is developing blockchain-enabled peer-to-peer energy markets (World Energy Council 2017). The International Energy Agency (IEA)) (2017, p. 98) has stated: “Although still early-stage and small-scale, projects of this kind suggest that decentralized energy, flexibility from transactive energy, and blockchain could develop together to positive effect.” Indeed, these use-cases remain at an early stage, and the technologies and regulatory frameworks for these approaches must develop further for these use-cases to reach their potential scale or disruptive impact (Medium 2018; Metlelitsa 2018). Similarly, as Basden and Cottrell (2017) argue: To be sure, as with any new technology, blockchain remains largely unproven, and significant barriers remain. ... Nevertheless, if it proves reliable and scalable, blockchain technology may ultimately accelerate the transition to what the energy industry calls a “distributed world” made up of both large and smaller power-generation systems for homes, businesses, and communities.

326

D. Nassiry

Trade and Exchange of Carbon Credits According to the World Bank (2018), current markets for climate assets have created a “patchwork” of climate actions with different units, governance structures, registries, and rules, resulting in a system that does not encourage economic efficiency, scale, or complexity. At the same time, the rapidly developing technological landscape is creating new opportunities for the harmonization of climate assets among different systems, instruments, and assets. According to a recent World Bank study, “Blockchain, Big Data, the Internet of Things (IoT), smart contracts, and other disruptive technologies hold out the promise of addressing the needs of new generation climate markets post-2020” (World Bank 2018, p. 4). For different physical commodities, a digital asset can be created to represent and provide title to the commodity asset, as well as multiple outputs (e.g., energy content) and outcomes (e.g., greenhouse gas emissions, energy access enhancement, and poverty reduction impact) associated with its production and/or lifecycle. Blockchain technology can provide a digital mechanism for recording and tracking these separate streams of information associated with units. This delineation and tracking of separate value elements in the unit is the central idea behind this new architecture (World Bank 2018). Marke (2018) has explored ways in which blockchain may increase the efficiency of emissions trading schemes, including by suggesting more efficient systems to transfer or trade carbon credits and proposing the networking of carbon markets using blockchain technology, as well as boosting peer-to-peer renewable energy trading, and accelerating international climate finance transfers.

Climate Finance A broad group of over 40 organizations, including the International Emissions Trading Association (IETA)), CDP (formerly the Carbon Disclosure Project), the Energy Web Foundation, and Power Ledger, recently launched the Climate Chain Coalition (CCC)) “to cooperatively support the application of distributed ledger technology (‘DLT’, including ‘the blockchain’) and related digital solutions to addressing climate change” (Climate Chain Coalition 2018). The UNFCCC has expressed support for the CCC initiative and “the potential of blockchain technology to contribute to enhanced climate action and sustainability” (UN Climate Change News 2018). Blockchain offers significant promise for creating new flows of finance for climate investments. As Thomason et al. (2018, p. 148) note, “[b]lockchain enables new forms of finance to address global climate finance problems, including crowdfunding and dynamic funding mechanisms from private finance markets.” More broadly, Marke and Sylvester (2018, p. 58) state: Climate finance and green investment provide the best ground on which to apply blockchain as a “fintech” to combine technology and finance. ... As a loop, the energy sector provides

14

The Role of Fintech in Unlocking Green Finance

327

valuable production data very useful for the research and development of financial products, whereas new financial products benefit the energy sector reciprocally. Among the fintechs including big data, cloud computing, machine learning, and distributed computing technology, blockchain is the most impactful and revolutionary to the bottom-level (green) finance architecture, especially in lowering regulatory costs and expanding regulatory boundaries.

Financial Innovation and Green Bonds Financial instruments with the ability to mobilize public and private capital toward low-carbon, climate-resilient investment are therefore key to success. One of the most dynamic instruments in the area of sustainable finance comprises green bonds, which are fixed-income instruments whose proceeds are used by the issuer for environmental projects. Over the past decade, investor demand for these instruments has been growing in response to shifts in policy and capital allocation due to growing concerns about climate change and sustainability. Moody’s (2018) projects that the global issuance of green bonds will grow to between US$175 billion and US$200 billion in 2018, up from US$155 billion in 2017. In Europe, Nordic countries have pioneered the use of green bonds to mobilize capital for investment in sustainable infrastructure and related sectors. Beginning in the 1970s, Sweden, Norway, Denmark, and Finland have demonstrated leadership in environmental policy, regulation, and changes in behavior consistent with a sustainable economy (McCormick et al. 2015). Nordic countries have also pioneered the use of green bonds to mobilize capital for sustainability goals.

Subnational Pooled Financing Mechanisms One of the key financial innovations at the institutional level for green finance has been the use of a structure known as subnational pooled financing mechanisms (SPFMs)) as means of raising sustainability-oriented capital from financial markets. An SPFM aggregates the financial needs of members into a pooled financing agency (PFA), which then issues debt and distributes the proceeds from the bond offering to its members. As International Institute for Sustainable Development (IISD) (2018) explains: Most SPFMs require the set-up of a Special Purpose Vehicle (SPV) that has transparent governance structure and processes. These SPVs, whose structure depends on national laws, are responsible for contracting debt and making debt service payments. They are usually owned by governments, though owners can also include the private sector, development partners, NGOs, etc. SPFMs must be structured in such a way as to have a high-level of creditworthiness. This can be achieved by using several levels of credit enhancements, which would be cost-prohibitive if applied to individual projects. These enhancements include reserve accounts, cash flow over-collateralization, intergovernmental financial transfers and intercepts, partial credit guarantees, first loss-facilities, and subsidies. (IISD 2018)

328

D. Nassiry

According to the Global Fund for Cities Development (FMDV)) or Fonds Mondial pour le Développement des Villes), SPFMs “have been successfully used since 1898 in securing finance for both large and small local projects, securing over $1.0 trillion in finance in the US and Europe, and over $2.6 billion in developing countries” (FMDV 2017, p. 6). In Europe, Nordic countries in particular have applied the SPFM model to meet subnational financing needs. Examples of Nordic PFAs include Kommuninvest (Sweden), an organization jointly owned by local government authorities, which acts as an aggregator and conduit issuer to Swedish local governments and uses proceeds from its green bond capital-raising for lending to Swedish municipalities in the form of green loans, which members then use to invest in environmental projects. Kommunalbanken, Norway’s largest lender to local governments, has an active green bond and green loan program; KommuneKredit (Denmark), which serves as a municipal credit aggregation agency and is similar in function to Kommuninvest and Kommunalbanken; and MuniFin (Finland), which is the main financial services provider to Finland’s local governments and offers a discount margin to its borrowers to provide an incentive to propose projects depending on how “green” the project is in terms of its environmental sustainability (Climate Bonds Initiative 2018). An important blockchain use-case has begun to take shape in monitoring green bonds proceeds in the form of the Green Asset Wallet initiative (Repinski 2017). The project, led by Stockholm Green Digital Finance and backed by Norway’s Center for International Climate Research (CICERO), applies the concept of sustainability attribution to green financial investments. As CICERO (2018) explains: The project ... is designed to equip green investors with the technology to better deliver on the goals of the Paris Climate Agreement and the SDGs.... The wallet is based on opensource technology tailored for capital market actors. The technology will offer a platform for validation of, as well as impact reporting on, green investments. The Green Assets Wallet will help to effectively channel private institutional capital to green projects globally, specifically supporting green emerging markets investments.

Despite rapid growth in the green bond market, transparency remains a concern among investors. Continued momentum in the growth of green bonds and more broadly in the expansion of green finance will be contingent on transparency in the use of proceeds (Santibanez et al. 2015; Kyriakou 2017; Linsell 2017). In order to raise capital for the implementation of the Paris Agreement and the SDGs, developing countries in Asia and other regions may expand the use of green bonds, adopt financing models such as SPFMs, and further develop and implement innovative fintech and blockchain approaches to enhance and promote the growth and transparency of their growing green bond markets. Adoption of innovative approaches, such as the Green Asset Wallet initiative described above, could provide additional means to boost investor confidence in the underlying quality of green financial instruments.

14

The Role of Fintech in Unlocking Green Finance

329

Implications for Asia Major developing countries in Asia have recently begun to adopt and extend innovative approaches to promote green finance. The PRC has identified the establishment of a green financial system as a goal in its Thirteenth Five-Year Plan (Central Committee of the Communist Party of China (CPC)), 2016) and has taken the lead in creating new institutional frameworks and incentives for green finance and green bonds. The Guidelines for Establishing the Green Financial System, released in 2016 by the People’s Bank of China (PBOC)), the Ministries of Finance and Environmental Protection, the National Development and Reform Commission (NDRC)), and the banking, insurance, and securities commissions, all emphasize the importance of establishing a green financial system, including “financial instruments such as green credit, green bonds, green stock indices and related products, green development funds, green insurance, and carbon finance, as well as relevant policy incentives to support the green transformation of the economy” (People’s Bank of China 2016). The PRC’s growth in activity in the green bond market has propelled the country into a leadership position, and green bond issuance from this country represents one of the largest sources of issuance in the global green bond market (Climate Bonds Initiative 2017).

Green Fintech in the PRC In the PRC, the ANT Financial Services Group, formerly known as Alipay and a leading fintech company, launched a large-scale pilot to engage with consumers in shaping their behavior in ways aligned with green finance at scale. Chen et al. (2017, pp. 6–7) have explained the design of the pilot and have highlighted its immediate impact and long-term potential: The “Ant Forest” encourages Ant’s users to reduce their carbon footprint through a three-part approach: (a) providing individualized carbon savings data to peoples’ smartphone, (b) connecting their virtual identity and status to their earnings of “green energy” for reduced carbon emissions, and (c) providing carbon offset rewards through a physical tree planting programme. The Ant Forest pilot has far exceeded expectations in attracting large numbers of users in a short period of time, and has elicited significant behavioral change. Over the first six months from August 2016 to January 2017, 200 million people across China have voluntarily joined the programme, about 44% of Ant’s user base in China, or about 20% of China’s adult population or 3% of the world’s total population. Behavioral change over the period has resulted in an estimated 150,000 tons of cumulative avoided carbon emissions and over 1 million trees planted by January 2017. ... The Ant Forest pilot could be extended in collaboration with other digital financial companies to encourage billions of people to reduce their carbon footprint.

As a recent study on the future of blockchain technology in the Asia and the Pacific region has noted: “Asia could become a dynamic testing ground for the new

330

D. Nassiry

business models promised by blockchain, as the region has high demand for financial inclusion and the need for more efficient, convenient, and affordable products and services” (Cognizant 2017, p. 8). For the Asia-Pacific region, blockchain represents the most significant technological opportunity of the next decade, and is likely to be a wellspring of innovative ideas for leaders across the globe. Thoughtful observers of the blockchain phenomenon already recognize that they cannot ignore the cost efficiency and business effectiveness promises of distributed ledger technology. ...Blockchain offers a once-in-a-lifetime opportunity for firms and leaders in the Asia-Pacific region to provide an example to the rest of the world of how the blockchain revolution will unfold. (Cognizant 2017, p. 22)

According to recent statistics, the PRC was the most active filer of patent applications related to blockchain technology, with 56% (226) of the 406 blockchain related patent applications filed in 2017 (Desouza et al. 2018; Noonan 2018; Thomson Reuters 2018). As Desouza et al. (2018) argue: Despite a spate of enthusiasm for blockchain business, many companies are keeping low profiles for their involvements in blockchain-related products owing to policy uncertainty. The central government’s policy toward cryptocurrency is very explicit, as it banned initial coin offerings (ICOs)) in September 2017 and later prohibited all cryptocurrency exchanges from operating in China. Yet the regulation on blockchain, the technology behind cryptocurrencies, remains unclear. Business operators must be cautious, given the difficulty of determining if blockchain products are fully compliant with government rules, even when no cryptocurrencies are involved. ... Sorting out the regulatory uncertainty with blockchain is key to the future innovation trajectory.

Conclusions and Preliminary Recommendations The future development and adoption of blockchain, IoT, big data and other related technologies offers the promise of systemic transformation: a radically different financial and capital allocation system geared toward inclusive and sustainable development. These new technologies are at an early stage of development and their future trajectories are difficult to predict with confidence. However, the net effect of applications of fintech and blockchain technology to the wide range of potential use-cases described above will be to substantially improve reliability (such as identity and financial inclusion), increase access to services (such as energy, banking and property ownership) and importantly, lower overall system costs. The aggregate impact of lower costs in each individual organization or service-provider, given sufficient competition and market dynamics, may have the positive effect of lowering the costs of achieving the goals connected to these services. Of course, there will be growing pains, particularly as the system takes shape. According to Tapscott (2016), “[t]he biggest problems...have to do with governance. Any controversy that you read about today is going to revolve around these

14

The Role of Fintech in Unlocking Green Finance

331

governance issues. This new community is in its infancy. Unlike the Internet, which has a sophisticated governance ecosystem, the whole world of blockchain and digital currencies is the Wild West.” The significant energy use of blockchain consensus algorithms relying on proof-of-work, as compared to the more efficient proof-ofstake approach, will also need to be resolved. However, even critics such as Roubini and Byrne (2018) who labeled blockchain “one of the most overhyped technologies ever” due to its inefficiency compared to existing databases and its superior demand for storage space and computing power, among other limitations, have conceded that blockchain could have “potentially far-reaching implications” if combined with “secure, remote automation of financial and machine processes” and in “specific, well-defined, and complex applications” such as in interaction with self-driving cars or drones.

Preliminary Recommendations for Policy Makers Policy makers responsible for finance for climate change and sustainable development should pay attention to developments in fintech and blockchain. The sector is rapidly evolving with a proliferation of different initiatives that have either direct or indirect relevance to green finance and sustainable development. Many initiatives are at an early stage and, if supported by appropriate policy and regulation, have the potential to develop into business models that can both reduce the cost and improve the prospects of achieving the objectives of the Paris Agreement and the SDGs, particularly with respect to the areas described in this chapter, including supply chain transparency, identity and financial inclusion, property rights, expansion of renewable energy, decentralization of electrical power systems, carbon credit trading and improved access to climate finance. Policy makers can draw inspiration from a wide range of current and ongoing initiatives led by committed, dynamic fintech entrepreneurs who are focused on developing and implementing their particular technologies with a view to an application or set of applications that often have material direct or indirect bearing on our ability to fulfill the SDGs and the Paris Agreement. However, it is often the case that the deeper opportunity set rather than the agreements themselves are at the forefront of people’s thinking and business models. Finally, policy makers should engage more closely with the fintech and blockchain sector, in part because it is developing quickly, in parallel with and to some extent separately from the “real” economy. For policy makers who can keep up with the pace of change, engagement with the fintech and blockchain sector will create new opportunities for countries that wish to reach the next stage of development in terms of financial, economic, and technological performance in a global economy that is increasingly dependent on complex, decentralized networks. Recognition of this potential will create opportunities for approaches that provide significant long-term advantages in strengthening green finance for low-carbon, climate-resilient investment and achieving the sustainable development goals.

332

D. Nassiry

References Asian Development Bank (ADB) (2017) Meeting Asia’s infrastructure needs. Asian Development Bank, Manila. https://www.adb.org/sites/default/files/publication/227496/special-report-infra structure.pdf. Accessed 1 Aug 2018 BanQu (2018) Website. https://banqu.co/our-purpose/ Basden J, Cottrell M (2017) How utilities are using blockchain to modernize the grid. Harvard Business Review, 23 March and updated 27 March. https://hbr.org/2017/03/how-utilities-areusing-blockchain-to-modernize-the-grid. Accessed 1 Aug 2018 Besnainou J (2018) Blockchain in energy & industry raises $1 Billion – and heads into challenging times. Cleantech Group. https://www.cleantech.com/blockchain-in-energy-industry-raises-1-bil lion-and-heads-into-challenging-times/. Accessed 1 Aug 2018 Bhattacharya A et al (2016) Delivering on sustainable infrastructure for better development and better climate. Brookings Institution, Washington DC. https://www.brookings.edu/wp-content/ uploads/2016/12/global_122316_delivering-on-sustainable-infrastructure.pdf. Accessed 1 Aug 2018 Bielenberg A et al (2016) Financing change: how to mobilize private-sector financing for sustainable infrastructure. McKinsey & Co., New York. https://www.mckinsey.com/industries/capitalprojects-and-infrastructure/our-insights/next-generation-of-infrastructure. Accessed 1 Aug 2018 Blakstad S, Allen R (2018) Fintech revolution, universal inclusion in the new financial ecosystem. Palgrave Macmillan, Cham. http://www.springer.com/fr/book/9783319760131 Blockchain Trust Accelerator (2017) What is blockchain? https://trustaccelerator.org/whatblockchain. Accessed 1 Aug 2018 Buterin V (2015) On public and private blockchains. Ethereum blog, 7 August. https://blog. ethereum.org/2015/08/07/on-public-and-private-blockchains/. Accessed 1 Aug 2018 Center for International Climate Research (CICERO) (2018) Scaling green investments through blockchain. https://www.cicero.oslo.no/en/posts/prosjekter/scaling-green-investments-throughblockchain. Accessed 1 Aug 2018 Central Committee of the Communist Party of China (CPC) (2016) The 13th five-year plan for economic and social development of the People’s Republic of China. http://en.ndrc.gov.cn/ newsrelease/201612/P020161207645765233498.pdf. Accessed 1 Aug 2018 Chapron G (2017) The environment needs cryptogovernance. Nature 545:403–405. https://doi.org/ 10.1038/545403a. https://www.nature.com/news/the-environment-needs-cryptogovernance-1. 22023 and www.nature.com/polopoly_fs/1.22023!/menu/main/topColumns/topLeftColumn/ pdf/545403a.pdf. Accessed 1 Aug 2018 Chen L et al (2017) Scaling citizen action on climate. ANT Financial’s efforts towards a digital finance solution. United Nations Environment Program, Geneva. https://www.sustainabledigi talfinance.org/initiatives-publications?lightbox=dataItem-jdg0t378 and https://docs.wixstatic. com/ugd/3d4f2c_109c450486544f6da883689ccaabe9b3.pdf Climate Bonds Initiative (2017) China green bond market 2017. https://www.climatebonds.net/ files/files/China_Annual_Report_2017_EN_Final_14_02_2018%281%29.pdf. Accessed 1 Aug 2018 Climate Bonds Initiative (2018) Nordic and Baltic public sector green bonds. https://www. Accessed climatebonds.net/resources/reports/nordic-and-baltic-public-sector-green-bonds. 1 Aug 2018 Climate Chain Coalition (2018). https://www.climatechaincoalition.io/ and https://www. climatechaincoalition.io/charter. Accessed 1 Aug 2018 Cognizant (2017) The future of blockchain in Asia-Pacific. https://www.cognizant.com/ whitepapers/the-future-of-blockchain-in-asia-pacific-codex3240.pdf.Accessed 1 Aug 2018 Crosby M et al (2015) Blockchain technology beyond bitcoin. University of California, Berkeley. http://scet.berkeley.edu/wp-content/uploads/BlockchainPaper.pdf. Accessed 1 Aug 2018

14

The Role of Fintech in Unlocking Green Finance

333

DeCaprio A, Beck S (2017) Blockchain pilots making waves in developing Asia. Asia Pathways, 20 July. Asian Development Bank Institute, Tokyo. https://www.asiapathways-adbi.org/2017/ 07/blockchain-pilots-making-waves-in-developing-asia/ Accessed 1 Aug 2018 Desouza KC et al (2018) Is China leading the blockchain innovation race? https://www.brookings. edu/blog/techtank/2018/07/19/is-china-leading-the-blockchain-innovation-race/. Accessed 1 Aug 2018 Dorfleitner G et al (2017) Fintech in Germany. Springer International Publishing. https://doi.org/ 10.1007/978-3-319-54666-7. https://www.springer.com/cda/content/document/cda_down loaddocument/9783319546650-c2.pdf?SGWID=0-0-45-1602368-p180682637. Accessed 1 Aug 2018 FMDV–Global fund for cities development (2017) The potential catalytic role of subnational pooled financing mechanisms. July. FMDV/AFD, Paris. http://www.agence-france-locale.fr/ sites/afl/files/base_documentaire/2017-09/FMDV_Policy-Paper_%20SPFM_ENG.pdf. Accessed 1 Aug 2018 Global Commission on the Economy and Climate (2014) Better Growth, Better Climate. https:// newclimateeconomy.report/2014/ Golden SLM, Price A (2018) Sustainable supply chains, better global outcomes with blockchain. https://www.newamerica.org/bretton-woods-ii/policy-papers/sustainable-supply-chains/. Accessed 1 Aug 2018 Gupta V (2017a) A brief history of blockchain. Harvard Business Review, 28 February. https://hbr. org/2017/02/a-brief-history-of-blockchain. Accessed 1 Aug 2018 Gupta V (2017b) The promise of blockchain is a world without middleman. Harvard Business Review, 6 March. https://hbr.org/2017/03/the-promise-of-blockchain-is-a-world-without-mid dlemen. Accessed 1 Aug 2018 Gupta V, Knight R (2017) How blockchain could help emerging markets leap ahead. Harvard Business Review, 17 May. https://hbr.org/2017/05/how-blockchain-could-help-emerging-mar kets-leap-ahead. Accessed 1 Aug 2018 International Energy Agency (IEA) (2017) Digitalization & energy. IEA, Paris. https://webstore.iea. org/digitalization-and-energy. Accessed 1 Aug 2018 International Institute for Sustainable Development (IISD) (2018) Subnational pooled financing mechanisms for funding infrastructure projects. https://infrastructure.iisd.org/research-andreports/subnational-pooled-financing-mechanisms-funding-infrastructure-projects. Accessed 1 Aug 2018 Johnson S (2018) Beyond the bitcoin bubble. The New York Times Magazine. https://www. nytimes.com/2018/01/16/magazine/beyond-the-bitcoin-bubble.html. Accessed 1 Aug 2018 Kairos Future (2017) The land registry in the blockchain – testbed. A development project with Lantmäteriet, Landshypotek Bank, SBAB, Telia company, ChromaWay and Kairos Future. March. https://chromaway.com/papers/Blockchain_Landregistry_Report_2017.pdf. Accessed 1 Aug 2018 Kyriakou S (2017) Green bond investors demand transparency. Financial Times, 14 June. https:// www.ftadviser.com/investments/2017/06/14/green-bond-investors-demand-transparency/. Accessed 1 Aug 2018 Lee G (2018) Life beyond cryptocurrencies – Hong Kong and China fintech firms show there is more to blockchain. South China Morning Post, 24 February. http://www.scmp.com/business/ companies/article/2134488/life-beyond-cryptocurrencies-hong-kong-and-china-fintech-firms. Accessed 1 Aug 2018 Liebriech M (2017) Six design principles for the power markets of the future – a personal view. Bloomberg New Energy Finance, 24 May. https://about.bnef.com/blog/liebreich-six-designprinciples-power-markets-future/ and http://www.liebreich.com/news/white-paper-six-designprinciples-power-markets-future/. Accessed 1 Aug 2018 Lindenberg N (2014) Definition of green finance. German Development Institute (DIE), Bonn. https://www.die-gdi.de/uploads/media/Lindenberg_Definition_green_finance.pdf and https:// www.cbd.int/financial/gcf/definition-greenfinance.pdf. Accessed 1 Aug 2018

334

D. Nassiry

Linsell K (2017) The $123 billion question hanging over renewable energy. Bloomberg, 22 June. https://www.bloomberg.com/news/articles/2017-06-22/green-bond-mania-spurs-demand-toback-up-climate-saving-promises. Accessed 1 Aug 2018 Livingston D et al (2018) Applying blockchain technology to electric power systems. https://www. cfr.org/report/applying-blockchain-technology-electric-power-systems and https://cfrd8-files. cfr.org/sites/default/files/report_pdf/Discussion_Paper_Livingston_et_al_Blockchain_OR_0. pdf. Accessed 1 Aug 2018 Marke A (ed) (2018) Transforming climate finance and green investment with blockchains, 1st edn. Elsevier, London. https://doi.org/10.1016/C2017-0-01389-7 Marke A, Sylvester B (2018) Decoding the current global climate finance architecture. In: Marke A (ed) (2018) Transforming climate finance and green investment with blockchains, 1st ed. Elsevier, London, pp 35–59 Marr B (2017) The complete beginner's guide to fintech everyone can understand. Forbes, 10 February. https://www.forbes.com/sites/bernardmarr/2017/02/10/a-complete-beginnersguide-to-fintech-in-2017/#5e4e9d7b3340. Accessed 1 Aug 2018 McCormick K et al (2015) Greening the economy compendium. Lund University. http://portal. research.lu.se/ws/files/7509153/201604_Course_Compendium.pdf. Accessed 1 Aug 2018 Medium (2018) Blockchain – hero of the energy transition or climate policy enemy number one? https://medium.com/climate-policy-initiative-energy-finance/blockchain-hero-of-the-energytransition-or-climate-policy-enemy-number-one-a2a03150cb29. Accessed 1 Aug 2018 Merz M (2018) Enerchain project overview and key insights. PONTON GmbH, Hamburg. https:// ponton.de/downloads/enerchain/EnerchainKeyInsights_2018-03-29_final.pdf. Accessed 1 Aug 2018 Metlelitsa C (2018) 4 predictions for blockchain in energy in 2018. Greentech Media. https://www. greentechmedia.com/articles/read/four-predictions-for-blockchain-in-energy-in-2018#gs.tIZhA_8. Accessed 1 Aug 2018 Meunier S (2018) Blockchain 101: What is blockchain and how does this revolutionary technology work? In: Marke A (ed) Transforming climate finance and green investment with blockchains, 1st edn. Elsevier, London, pp 23–44. https://doi.org/10.1016/B978-0-12-814447-3.00003-3 Moody’s (2018) Global green bond issuance rises in second quarter of 2018, but growth continues to moderate. https://www.moodys.com/research/Moodys-Global-green-bond-issuance-rises-insecond-quarter-of%2D%2DPR_387338. Accessed 1 Aug 2018 Nakamoto S (2008) Bitcoin: A peer-to-peer electronic cash system. https://bitcoin.org/bitcoin.pdf. Accessed 1 Aug 2018 Noonan L (2018) China leads blockchain patent applications. Financial Times, 25 March. https:// www.ft.com/content/197db4c8-2e92-11e8-9b4b-bc4b9f08f381. Accessed 1 Aug 2018 OECD (2017) Investing in climate, investing in growth. OECD Publishing, Paris. https://doi.org/ 10.1787/9789264273528-en. Accessed 1 Aug 2018 Outlier Ventures (2016) Blockchain-enabled convergence, understanding the web 3.0 economy https://outlierventures.io/convergence-wp. Accessed 1 Aug 2018 Outlier Ventures (2018) The convergence ecosystem, convergence 2.0, building the decentralised future. https://outlierventures.io/wp-content/uploads/2018/03/The_Convergence_Ecosystem_ Report_Outlier_Ventures_2018.pdf. Accessed 1 Aug 2018 People’s Bank of China (2016) Guidelines for establishing the green financial system. http://www. pbc.gov.cn/english/130721/3133045/index.html and http://usa.chinadaily.com.cn/business/ 2016-09/04/content_26692956.htm. Accessed 1 Aug 2018 Pisa M, Juden M (2017) Blockchain and economic development: Hype vs. reality. Center for Global Development, Washington DC. https://www.cgdev.org/sites/default/files/blockchain-and-eco nomic-development-hype-vs-reality_0.pdf. Accessed 1 Aug 2018 PwC (2017) Blockchain – an opportunity for energy producers and consumers? https://www.pwc. com/gx/en/industries/assets/pwc-blockchain-opportunity-for-energy-producers-and-consumers. pdf. Accessed 1 Aug 2018 PwC (2018) Blockchain – an opportunity for energy producers and consumers? PwC global power & utilities. https://www.pwc.com/gx/en/industries/assets/pwc-blockchain-opportunity-for-energyproducers-and-consumers.pdf

14

The Role of Fintech in Unlocking Green Finance

335

Repinski C (2017) Unlocking the potential of green fintech. Stockholm Green Digital Finance. https:// static1.squarespace.com/static/59b29215c027d84ada066d3b/t/5a4f73e6e4966b7a764114ba/ 1515156458061/stockholm-green-digital-finance-insight-brief-no1-2017.pdf. Accessed 1 Aug 2018 Roubini N, Byrne P (2018) The blockchain pipe dream. Project Syndicate, 5 March. https://www. project-syndicate.org/commentary/blockchain-technology-limited-applications-by-nourielroubini-and-preston-byrne-2018-03. Accessed 1 Aug 2018 Santibanez M et al (2015) Transparency the key for burgeoning green bond market. Reuters, 30 March. https://www.reuters.com/article/green-bonds/transparency-the-key-for-burgeoninggreen-bond-market-idUSL6N0WW16120150330. Accessed 1 Aug 2018 Schmidt-Traub G (2015) Investment needs to achieve the sustainable development goals, understanding the billions and trillions. SDSN working Paper, version 2. Sustainable Development Solutions Network, New York. http://unsdsn.org/wp-content/uploads/2015/09/151112-SDGFinancing-Needs.pdf. Accessed 1 Aug 2018 Schmidt-Traub G, Sachs J (2015) Financing sustainable development: implementing the SDGs through effective investment strategies and partnerships. Sustainable Development Solutions Network, New York. http://unsdsn.org/wp-content/uploads/2015/04/150408-SDSN-FinancingSustainable-Development-Paper.pdf. Accessed 1 Aug 2018 Solarplaza (2018) A comprehensive guide for companies involved in blockchain and energy. https://www.blockchain2business.eu/request-blockchain-company-guide/. Accessed 1 Aug 2018 Statkraft (2018) Renewable energy generators and industrial consumers connected via blockchain. https://www.statkraft.com/media/news/2018/blockchain-test-trade/. Accessed 1 Aug 2018 Tapscott D (2016) How blockchains could change the world. McKinsey & Company https://www. mckinsey.com/industries/high-tech/our-insights/how-blockchains-could-change-the-world. Accessed 1 Aug 2018 Tapscott D (2018) Ten cryptocurrency predictions for 2018 from the co-founder of the Blockchain Research Institute. Available via Quartz. https://qz.com/1171977/ten-2018-predictions-fromthe-founder-of-the-blockchain-research-institute/. Accessed 1 Aug 2018 Tapscott D, Tapscott A (2016) blockchain revolution: How the technology behind bitcoin Is changing money, business, and the world. Penguin Random House, New York Tapscott D, Tapscott A (2017) Realizing the potential of blockchain: A multistakeholder approach to the stewardship of blockchain and cryptocurrencies. World Economic Forum, Geneva. http:// www3.weforum.org/docs/WEF_Realizing_Potential_Blockchain.pdf. Accessed 1 Aug 2018 The Economist (2015) The trust machine. October 31, 2015 https://www.economist.com/leaders/ 2015/10/31/the-trust-machine Thomason J et al (2018) Blockchain – powering and empowering the poor in developing countries. In: Marke A (ed) Transforming climate finance and green investment with blockchains, 1st edn. Elsevier, London, pp 137–152 Thompson Reuters (2018) In rush for blockchain patents, China pulls ahead. 18 March. https:// blogs.thomsonreuters.com/answerson/in-rush-for-blockchain-patents-china-pulls-ahead/. Accessed 1 Aug 2018 UNCTAD (2014) World Investment Report. Investing in the SDGs: An Action Plan. https://unctad. org/en/PublicationsLibrary/wir2014_en.pdf United Nations Climate Change News (2018) UN supports blockchain technology for climate action. UNFCCC, Bonn. https://unfccc.int/news/un-supports-blockchain-technology-for-cli mate-action. Accessed 1 Aug 2018 United Nations Framework Convention on Climate Change (UNFCCC) (2015) Paris Agreement. http://unfccc.int/files/meetings/paris_nov_2015/application/pdf/paris_agreement_english_.pdf and https://treaties.un.org/doc/Treaties/2016/02/20160215%2006-03%20PM/Ch_XXVII-7-d. pdf. Accessed 1 Aug 2018 United States Agency for International Development (USAID) (2017) Identity in a digital age: Infrastructure for inclusive development. US Agency for International Development, Washington DC. https://www.usaid.gov/digital-development/digital-id/report. Accessed 1 Aug 2018

336

D. Nassiry

White M (2018) Digitizing global trade with Maersk and IBM. https://www.ibm.com/blogs/ blockchain/2018/01/digitizing-global-trade-maersk-ibm/. Accessed 1 Aug 2018 World Bank (2017) Distributed ledger technology (DLT) and blockchain, Fintech Note No. 1. World Bank, Washington DC. http://documents.worldbank.org/curated/en/177911513714062215/pdf/ 122140-WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf. Accessed 1 Aug 2018 World Bank (2018) Blockchain and emerging digital technologies for enhancing post-2020 climate markets. World Bank, Washington DC. http://documents.worldbank.org/curated/en/ 942981521464296927/Blockchain-and-emerging-digital-technologies-for-enhancing-post2020-climate-markets. Accessed 1 Aug 2018 World Economic Forum (2013) The green investment report. http://reports.weforum.org/greeninvesting-2013/ and http://reports.weforum.org/green-investing-2013/required-infrastructureneeds/#read. Accessed 1 Aug 2018 World Energy Council (2017) The Developing Role of Blockchain. https://www.worldenergy.org/ publications/2017/the-developing-role-of-blockchain/ Zadek S, Robins N (2018) Making waves: aligning the financial system with sustainable development. United Nations Environment Program, Geneva/Nairobi. http://unepinquiry.org/makingwaves/. Accessed 1 Aug 2018

Part IX Green Technology Financing

Use of Innovative Public Policy Instruments to Establish and Enhance the Linkage Between Green Technology and Finance

15

KyungJin Hyung and Prajwal Baral

Contents Introduction: Green Technology Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Technology Financing and National Public Policy Instruments . . . . . . . . . . . . . . . . . . . . . . . . Green Technology Financing Scheme (Malaysia) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Green Funds Scheme (the Netherlands) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Financing Based on National Green Certification Scheme (the Republic of Korea) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Comparative Analysis of National Green Technology Financing Schemes in the Netherlands, Malaysia, and the Republic of Korea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . An Institutional Case of Green Technology Financing in the Republic of Korea: Easing SME Access to Private Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Green Technology Financing Using KTRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Issues with Green Technology Bankability and Evolution of KOTEC’s Green Technology Business Certificate (GTBC) Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Learning from KOTEC’s Green Technology Business Certificate (GTBC) Program . . . . . Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

340 341 342 344 347 350 352 354 356 358 359 361

Abstract

The risks pertaining to the applicability and profitability of green technologies have discouraged the participation of private financial institutions in green space, and investment is mostly limited to a handful of proven green technologies. It is therefore imperative to explore how appropriately designed public policy

K. Hyung (*) Korea Technology Finance Corporation (KOTEC), Busan, Republic of Korea e-mail: [email protected] P. Baral Hornfels Group Ltd., Moscow, Russian Federation e-mail: [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_28

339

340

K. Hyung and P. Baral

instruments could unlock private investment in green technologies. The first part of the chapter introduces the term “green technology financing”, after which it introduces three national green technology financing schemes, one each in Malaysia, the Netherlands, and the Republic of Korea, and each layered with an appropriately designed certification scheme. Next, the chapter discusses innovative aspects of these schemes, and introduces an institutional case from the Republic of Korea that has addressed some of the limitations of those schemes and that has largely helped mitigate real and/or perceived risk associated with green technology projects on the part of private financiers. Finally, the chapter makes policy recommendations specific to developing countries for attracting private finance to green technologies. Keywords

Green technology · Cleantech · Green technology financing · Green finance · Green certification JEL Codes

G23 · G24 · O31 · Q28 · Q55

Introduction: Green Technology Financing The term “green finance” has already gained global prominence. UN Environment (2016) has mapped a broad convergence of various existing definitions of green finance, as well as some divergences, as illustrated in Figure 1. While some areas of divergence are uncontroversial, others such as clean coal, nuclear, and large-scale hydropower have serious disagreements among various stakeholders. In this chapter, we define green technology financing as the one geared toward one or more of these areas. We neither intend to prescribe areas that are covered by green technology financing, nor do we recommend any particular area that should or should not be covered. Each country has its own development priority and set of policy instruments to promote nationally appropriate green technologies. There have been various estimates of global green finance opportunities. For instance, a study by UN Environment and DBS (2017) revealed that demand for additional green investment in Southeast Asia from 2016 to 2030 will be $3 trillion, spread across four sectors: infrastructure, renewable energy, energy efficiency and food, and agriculture and land use. Most of these demands require huge investments in technologies. Similarly, the Research Bureau of the People’s Bank of China has estimated that the People’s Republic of China’s (PRC) green investment needs will be roughly $450 billion–$600 billion per year and this annual need will grow in line with the PRC’s GDP in the short term (Xinhua 2017). Green technology has thus emerged as a new alternative financing space because of rising global demand. There are, however, only a handful of financing mechanisms or schemes that have been able to influence both a positive market disruption and the stimulation of a domestic green technology industry.

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

341

Clean energy

Clean coal CCs Low-carbon infrastructure Low-carbon base stations broadband General grid efficiency

Large hydropower Nuclear Bioenergy, Marine Wind, Solar, Geothermal, Small hydropower

Smart/Mini grid

Efficiency Fossil fuel power efficiency Advanced materials Green building Lighting

Grid integration Industrial energy Storage efficiency Most commonly included Afforestation Reforestation Metro Non-diesel trains Energy and Water Efficiency Electric cars, Alternative Pollution fuel vehicles Prevention, Green agriculture Recycling Logistics Protected areas Wastewater Biodiversity treatment Land Waste systems

Transport

Water supply Least commonly included Pollution, waste, and water

Figure 1: Sectors or Areas Covered by Various Green Finance Definitions. (BRT bus rapid transit, CCS carbon capture and storage. Source: UN Environment (2016))

Green Technology Financing and National Public Policy Instruments Governments can promote and scale up green technology markets by directly financing projects and by cultivating local enterprises and industry through appropriate laws, regulations, and public policy instruments. A combination of both is also possible. While the first method is quite straightforward and mostly done in the form of project financing with or without the participation of private sector institutions, there is only so much a government can do with its limited spending. That is where

342

K. Hyung and P. Baral

the second approach seems more sustainable. The cultivation of local green enterprises, often small and medium-sized enterprises (SMEs), is, however, inherently more challenging and complicated despite being sustainable in the long run. This is because most SME financing is corporate; in order to avoid on-balance sheet exposure to credit risks, most financial institutions are hesitant to lend money to SMEs with a limited credit history. In addition, this approach requires a medium- to long-term policy focus and takes a longer time to drive enterprises from innovation to a market-ready stage. This chapter analyzes some green technology financing schemes that have successfully used innovative public policy instruments and incentives. These schemes have been drawn from Malaysia, the Netherlands, and the Republic of Korea.

Green Technology Financing Scheme (Malaysia) The Green Technology Financing Scheme (GTFS) was launched by the Malaysian government in 2010 under the 2009 National Green Technology Policy, with an initial funding of nearly $850 million. The scheme has been extended to 2022, with the second round (GTFS 2.0) starting in 2018 with an additional funding of $1.2 billion (GreenTech Malaysia 2016). GTFS is administered by the Malaysian Green Technology Corporation (GreenTech Malaysia), which is part of the Ministry of Energy, Green Technology and Water. Apart from administering GTFS, GreenTech Malaysia has also introduced other alternative financing schemes such as the Energy Efficiency Financing Scheme. GTFS, in particular, provides funding to technology products, equipment, and systems that have proven business models and fall under one of the following areas: minimal degradation of the environment; zero or low greenhouse gas emission; public environmental improvement; conservation; and renewable energy resources. The four key sectors targeted by this scheme are energy, water and waste management, buildings, and transport. The renewable energy ongrid developers must receive prior approval from the Sustainable Energy Development Authority for feed-in approval before applying for the GTFS. All companies that intend to be either users or producers of green technologies are eligible to apply for financing under this scheme. Foreign producer companies with at least 51% Malaysian shareholding, and foreign user companies with at least 70% Malaysian shareholding can also apply for financing. However, the project must be located within Malaysia. Research and Development (R&D) does not qualify for financing. GTFS consists of two distinct processes: technical evaluation and financing. These two processes are captured by Figure 2.

Technical Evaluation All eligible projects, after being evaluated by the technical evaluation team at GreenTech Malaysia, are presented to the GTFS Technical Committee for their consideration and approval. On average, it takes 21 working days for technical

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

343

)4''06'%*/#.#;5+#  )TGGP%GTVKHKECVG

3URPRWLRQV*UHHQ&HUWLILFDWLRQ 0RQLWRULQJ

%QQTFKPCVQT4GIWNCVQT  .QCP 241,'%6%1/2#0; 2TQFWEGT  /CZ 75 OKN HQT [GCTUOCZ



4GDCVG

(+0#0%+#. +056+676+105 &UHGLWDVVHVVPHQW ILQDQFLQJ



 &5(',7 *8$5$17 &25325$7,21

$GPLQLVWHUJXDUDQWHH UHEDWH

7UGT/CZ75OKNHQT[GCTU OCZ

Figure 2: Implementation Mechanism and Key Agencies. (Source: GreenTech Malaysia (2015))

evaluation. The successful producer and user companies are awarded a Green Project Financing Recommendation Certificate that is valid for 6 months from the date of issuance. The applicants are also trained in green technology.

Financing There are 52 financial institutions that participate in GTFS. Only 28 are active as of the end of 2017. A successful applicant submits an application along with the Green Project Financing Recommendation Certificate to a financial institution of its choice. After a careful evaluation, the financial institution issues a Letter of Offer to the applicant. The Malaysian government bears 2% of the total interest rate or profit charged by the participating financial institution on the soft loan issued. The type and value of security or collateral required depends on individual participating financial institutions. The length of loan tenure is 15 years for producers and 10 years for users. The maximum amount of financing offered to an individual company is $25.5 million for producers (effective from June 2016; it was half of that earlier) and $2.5 million for users (to be increased to $12 million per group of companies in GTFS 2.0). There is also a provision for working capital financing, which is limited to purchase of raw materials only and is capped at $1.2 million for both producers and users. The tenure of a working capital loan is limited to 5 years. For producers, GTFS 2.0 will have a provision of up to $70 million bond/sukuk per group of companies. GTFS 2.0 will also provide financing of up to $6 million per group of companies to energy service companies (ESCOs) with a loan tenure of 5 years. One important aspect of financing is a government guarantee. Credit Guarantee Corporation Malaysia Berhad (CGC) guarantees 60% of the approved loan, and a fee of 0.5% per year on the amount charged to the borrowing company. In GTFS 2.0, the bond/sukuk issuance will be 100% guaranteed by Danajamin Nasional Berhad (a financial guarantee company jointly owned by the Ministry of Finance and

344

K. Hyung and P. Baral

CGC). The Letter of Guarantee issued by CGC is sent to the applicant, participating financial institutions, and GreenTech Malaysia. It is impossible for the borrower to obtain financing from the participating financial institutions without a government guarantee because most environmental projects proposed are high-risk. The entire process of financial approval (including guarantee issuance) takes 30–60 working days.

Results In fewer than 10 years since its launch (as of October 2017), GTFS has approved a total of 319 projects with a total cost of nearly $1.7 billion (GBN 2017). The total amount of loans approved under this scheme stands at $829 million. Most approved projects are in renewable energy sector. A total of 3.7 million tons of CO2 equivalent are expected to be avoided every year through the approved projects, along with a creation of more than 5,000 jobs (ibid).

The Green Funds Scheme (the Netherlands) Written into Dutch law in 1994, and launched by the government in 1995, the “Green Funds Scheme (GFS)” is a tax incentive that offers a reduction in income taxes and a capital gains exemption on green savings and investment by private individuals and households. GFS is supported by three other related fiscal promotion schemes: VAMIL (accelerated depreciation of environmental investments), MIA (environmental investment allowance) and EIA (energy investment allowance). While GFS concentrates on projects in the early phase of technological development and their market introduction, the three supporting schemes (VAMIL, MIA, and EIA) focus on expansion and saturation phases (RVO 2002). This section discusses only GFS. GFS is operated by four ministries working closely together: Housing, Spatial Planning and the Environment (VROM); Finance (FIN); Agriculture, Nature and Food Quality (LNV), and Transport, Public Works and Water Management (VenW). VROM is responsible for coordinating implementation (NL Agency 2010). GFS comprises three individual schemes: Green Projects Scheme, Green Institutions Scheme, and Tax Incentive Scheme, each of which is discussed below.

Green Projects Scheme This scheme determines projects, as opposed to companies that are eligible for GFS. Broadly, any projects covering forests and landscape, organic farming, green label greenhouses, agrification, renewable energy, sustainable building, cycle-track infrastructure, soil decontamination, and others providing significant and immediate environmental benefit are eligible. The Ministry of Housing, Spatial Planning and the Environment, by agreement with the Ministry of Finance and after consultation with the Ministry of Agriculture, Nature and Food Quality and the Ministry of Transport, Public Works and Water Management, has developed a comprehensive

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

345

list of types of projects eligible under each of these sectors, the elaboration of which is beyond the scope of this chapter. These criteria are updated every few years to reflect technological progress, changing environmental regulations, and evolving customer preference. Any green financial institution (described below) that receives a financing request from a company applies for a green certificate to the government. The National Service for the Implementation of Regulations (Dienst Regelingen) at LNV and NL Agency (Agentschap NL) are authorized by VROM to issue green certificates on behalf of the ministry (NL Agency 2010). Once a certificate is obtained, that project is officially eligible for green financing. The certificate remains valid for 10 years.

Green Institutions Scheme As of 2017, nine major Dutch banks operate under this scheme as green financial institutions offering deposits and issuing bonds with a fixed value, term, and interest rate, or shares in a green investment fund (Scholtens 2011). To qualify as a green institution, they must put at least 70% of their funds into certified projects. They will lose their green status otherwise, and individuals saving or investing with these institutions will receive no further tax incentives. Green institutions are insured under the Dutch deposit insurance guarantee mechanism and are supervised by the financial authorities (i.e., Autoriteit Financiële Markten and De Nederlandsche Bank) (ibid). The green institutions offer loans to companies with green projects that are 0.5% lower than market rate, and which were previously 1% when interest rate levels were high. Even this 0.5% differential sometimes could prove to be a make-or-break deal for many green projects. Tax Incentive Scheme In the Netherlands, individuals normally pay 1.2% capital gains taxes on any investment that results in profit. (All individuals with liquid assets [savings, stocks] are required to pay capital gains taxes. The tax is 1.2% above a threshold of €25,000.) Under GFS, they are exempt up to a maximum of $65,457 (Google currency exchange used as of December 2017) (€55,145) per person as of 2010 (which is set to increase over time to account for inflation). In addition, money placed in a Green Fund in one of the nine participating financial institutions generates an income tax deduction of 0.7% as of 2017 (the Dutch government gradually reduced income tax incentives from 1.3% in 2010 to 1% in 2011 and to 0.7% in 2012). This is the reason individuals are willing to accept a lower interest rate on their savings with green financial institutions (0% as opposed to 0.5% for non-green deposits as of 2016) or a lower dividend. The net tax advantage comes out to 1.9% (1.2% capital gains tax + 0.7% reduction in income tax), which is still more lucrative than 0.5% interest on a normal savings account. Figure 3 summarizes these three individual schemes and how they are interrelated.

346

K. Hyung and P. Baral

 %QORCP[ JUHHQSURMHFW

NQYEQUVNQCPU GEQPQOKE CUUGUUOGPV

$CPMU JUHHQIXQGV



 ITGGP CUUGUUOGPV

)QXGTPOGPV OHJLVODWLRQ

UWRGTXKUKQP DGNQY CXGTCIG TGVWTPU

EQORGPUCVKPI VCZFGFWEVKQP

UCXKPIU



%QPUWOGT SULYDWHFDSLWDO

Figure 3: The Dutch Green Funds Scheme. (Source: Rabobank (2010) (undated))

Results GFS financed 6,066 projects between 1995 and 2009 (an average of more than 400 per year), most of which could not have been realized without the scheme. The total financing offered by green institutions to companies with green projects stood at $17 billion (€12 billion) as of 2011, with an average investment size of $631,484 (€ 532,000). The European Commission (2012), citing a 2010 report by the Dutch Ministry of Housing, Spatial Planning and the Environment, reported that every euro of public funds spent generated a private investment of 40 euros (i.e., 40 euros of private investment for every euro of tax incentive offered to individuals), which is an extremely effective leverage of private investment using limited public resources. Most of these investments went to greenhouse gas-reducing projects and energy projects (40.7% and 26% respectively as of 2011) (Scholtens 2011). The number of individuals participating in this scheme also rose nearly 250,000 by 2009 with an average individual investment of $35,610 (€30,000) (European Commission 2012). The assessment of projects financed is only ex-ante, which is done by the Netherlands Enterprise Agency (RVO). The RVO does random checks of these projects to make sure they are implemented as intended. It is ultimately the responsibility of green banks to confirm that the projects are appropriately implemented. In case there is any change in project implementation, the banks are required to report that to the RVO. If the projects fail to meet desired objectives during the implementation, the banks are required to change the status of green finance to normal finance. This check and balance mechanism has turned out to be a win-win for all four parties–government, individuals/citizens, banks, and companies with green projects. The Netherlands, in addition to promoting green technology innovation and development, also achieved an average CO2-emission reduction of 0.5 MT per year since 2001 through green projects funded under this scheme (NL Agency 2010).

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

347

Green Financing Based on National Green Certification Scheme (the Republic of Korea) Quite a few organizations in the Republic of Korea sought to advertise their existing products and services in a manner linked with the word “green” rather than actually understanding what it could mean and what they should change. As a result, the government looked for a sensible incentive system to guide the growth of green technology-based enterprises. The Korea Technology Finance Corporation (KOTEC), a policy financial institution that specializes in financing technology-driven SMEs and innovative business ventures through its own proprietary technology/business rating system, had a chance to discuss with the Presidential Committee an early idea of establishing green certification to identify, incentivize, and signal true green technologies and businesses to the market. The idea was further enhanced through numerous cross-ministerial efforts and went into effect in April 2010. The certification scheme is designed in four sections “Green Technology”, Green Technology Product”, “Green Project”, and “Specialized Green Enterprise”.

Green Technology The 358 strategic items and 1,745 core technologies are selected based on 61 main areas in 10 green growth fields (1. Renewable Energy, 2. Carbon Reduction, 3. HighTech Water Resources, 4. Green IT, 5. Green Vehicles and Ships, 6. High-Tech Green House/City, 7. Advanced Materials, 8. Clean Production, 9. Eco-Friendly Agricultural and Fishery Food, 10. Environmental Protection and Preservation). The certification is given after the two rounds of evaluation. Entities with green technologies can make an application on the portal site (http://www.greencertif.or.kr) managed by the Korea Institute for Advancement of Technology (KIAT) and apply to one of 11 specialized institutions including KOTEC, the only financial institution. The applying entity can first check whether its technology meets the pre-condition (benchmark capacity) and choose the evaluation institute by referring to the guideline. The guideline tells which institutions are designated for which technology field and also available for the selected or desired time schedule of the applicant. Each institution has qualified areas for evaluation with some overlap. The first round of evaluation is conducted by the institution to which the entity has applied. The evaluating institution first attests whether the technology satisfies the pre-determined benchmark capacity, and then evaluates the qualification using a small committee method based on technological excellence (60 points) and green efficiency (40 points). When the application passes through the first round, the outcome is reported by the evaluating institution through the portal site for the second round of evaluation. The application that scores a total of 70 points or higher gets to the second round of evaluation. A cross-functional committee that represents all 11 institutions convened by KIAT makes the final confirmation of whether the first round of the evaluation was conducted properly, after which KIAT issues the certification in accordance with the final outcome.

348

K. Hyung and P. Baral

Green Technology Product If the product in application is already commercialized, entities can apply for the certification of the green technology product. The evaluation process is the same as for green technology with the same 11 institutions. The products have to satisfy three confirmation criteria: possession of a green technology certificate, verification that the certified green technology contributes to the product function’s manifestation, and availability of applied product (model). The evaluation criteria for certification are product manufacturing possibility, quality management, and product capacity. Green Project The certification object for this category is economic activities related to green growth, such as installing facilities and infrastructures, applying, propagating and spreading technologies that have a significant economic and technical ripple effect. More specifically, there are 105 predefined projects in nine fields (1. Propagating and Spreading Renewable Energy, 2. Building carbon reduction plants, systems, 3. Developing, handling and managing high-tech water resources, 4. Using and Propagating green IT, 5. Propagating and spreading green cars, green vehicles and systems, 6. Propagating and spreading high-tech green houses, cities and infrastructure, 7. Establishing the infrastructure for clean production, 8. Supporting and supplying eco-friendly agricultural foods, 9. Environmental protection and preservation). The application is evaluated based on three criteria using the same process as described above with the same 11 institutions: feasibility of green technology (30 points), environmental expectancy effect (50 points), and policy compatibility (40 points). Specialized Green Enterprise The enterprises for whom 30% or above of the prior year’s total sales comes from certified green technologies are eligible to get certified as specialized green enterprises. Results By the end of 2016, the cumulative total of certifications in the aforementioned four categories was 4,160 cases. Among the 11 institutions, the Korea Environmental Industry & Technology Institute (KEITI), an agency under the Ministry of Environment, took the largest share with 1,309 cases (31.47%) followed by KOTEC with 1,053 cases (25.31%) as represented in Table 1. Table 2 illustrates how many certifications were awarded in each green category to the institutions that chose KOTEC as the evaluating institution. By no surprise, green technology took the largest share, followed by green product. Certified entities receive benefits in the form of various financial and human resources support, and favors in national R&D participation and government procurement system in addition to image promotion. The certification is effective for 2 years, and cross-functional committee raises a new bar continuously by reviewing the existing benchmark capacities for green technologies. The committee ensures that the bar is sufficiently high to continuously companies’ abilities to catch up with the rapid evolvement of technology.

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

349

Table 1: Cumulative Total of Evaluation (Certified Ones) by Different Institutions from 2010 to 2016 Evaluating Institution Korea Environmental Industry & Technology Institute (KEITI) Korea Technology Finance Corporation (KOTEC) Korea Agency for Infrastructure Technology Advancement (KAIA) Korea Energy Technology Evaluation and Planning (KETEP) Korea Evaluation Institute of Industrial Technology (KEIT) Korea Institute of Planning and Evaluation for Technology in Food, Agriculture & Forestry (IPET) Korea Industrial Technology Association (KOITA) Korea Communication Agency (KCA) Korea Institute of Marine Science & Technology Promotion (KIMST) Korea Creative Content Agency (KOCCA) Korea Culture & Tourism Institute (KCTI) Total

Cases 1,309 1,053 397 350 307 294 266 127 52 5 – 4,160

Source: Personal communication with Korea Institute for Advancement of Technology, compiled by authors. Table 2: Cumulative Total of Evaluation by KOTEC from 2010 to 2016 by categories

KOTEC Total

Green Technology Applied Certified 1,091 639 4,806 2,650

Green Product Applied Certified 453 328 1,738 1,148

Green Project Applied Certified 21 6 143 42

Green Enterprise Applied Certified 99 80 402 320

Sum Applied Certified 1,664 1,053 7,089 4,160

KOTEC Korea Technology Finance Corporation. Source: Compiled by authors.

The purpose of certification in its design was to signal the legitimacy of green technologies, products, projects, and enterprises to stakeholders including financers. The Republic of Korea government encouraged both public and private sector financial institutions to favor green-certified enterprises. The government launched a Green Financing Portal (http://www.green-finance.or.kr) to alert financial institutions about the certification, expecting spontaneous positive response from the market. The government also showed strong willingness to support R&D-stage green financing for the technologies in 10 designated green growth fields as well as the widespread use of commoditized green technologies, particularly in public procurement. Such green financing was primarily done through public institutions, especially the Korea Development Bank (KDB), Industrial Bank of Korea (IBK), Korea Credit Guarantee Fund (KODIT), Korea Technology Finance Corporation (KOTEC), and Korea Finance Corporation (KoFC). The government financing to these five institutions in 10 green growth fields, not limited to enterprises with green certifications, increased from $5.58 billion (Google currency exchange as of December 2017) in 2009 to $15.93 billion and stagnated thereafter with $14.76 billion in 2013 and $14.67 billion in 2014 (National Assembly Budget Office 2016) without

350

K. Hyung and P. Baral

significant sign of private sector engagement. The scheme succeeded to a large degree in setting up a predesigned pathway for green technology development and prevent green washing by companies. However, it still did not crowd in sufficient private finance providers to green technology development and deployment.

Comparative Analysis of National Green Technology Financing Schemes in the Netherlands, Malaysia, and the Republic of Korea Asia is heavily dominated by a bank-centered financial system, with non-bank finance being negligible in most Asian countries. A study conducted by the Asian Development Bank (ADB 2015) indicates that despite SMEs accounting for an average of 96% of all enterprises, particularly in 20 Asia SME Finance Monitor (ASM) countries, including the Republic of Korea and Malaysia, bank loans to SMEs make up an average of only 18.7% of the regional total, with a decreasing trend since the 2008–2009 global financial crisis. Most SMEs thus have difficulty accessing finance, and rely on informal sources of financing. The green technology financing schemes discussed in this chapter could thus provide some guidance on easing SME access to finance and also on how to unleash private finance for innovative technology-based enterprises. The Dutch Green Funds Scheme (GFS) is a very successful case despite its reach to a limited Dutch population. Its success could largely be attributed to the Dutch history of social and environmental awareness (Thornley et al. 2011) and the design of an incentive structure that is favorable to banks, borrowers, and investors alike, the last one being bank customers in this case. The scheme also benefited from a competent engagement of Senter Novem, now the Netherlands Enterprise Agency (RVO), that simplified the green investment decision-making process by issuing certificates to bankable green projects, thus increasing the risk appetite of banks. In recent years, however, the credit portfolio of green banks has been shrinking because of difficulty of finding bankable projects that meet the criteria of the GFS. An informal correspondence with the RVO representative revealed that the RVO has been receiving requests from the banks to lower the bar for green projects. The RVO said it is reluctant to do so fearing government expenditure on non-risky projects that would otherwise be easily financed by the private sector without government support. It has resulted in many bigger green banks refusing to accept any more deposits from individual investors under this particular scheme. One noteworthy aspect of the Dutch scheme is its focus on projects that are still in the initial phase of their technological development with the certificate valid for up to 10 years unlike the Malaysian Green Technology Financing Scheme (GTFS) that provides funding to only those products, systems, and equipment that have proven business model with the certificate valid for only 6 months. The Dutch scheme is, however, narrowly constructed, limited to individual investors, soft loans, and projects that can self-support over time (ibid). Some bigger and beneficial projects might not find it feasible to just use one particular financial

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

351

instrument despite it being 1% below the market interest rate. Most importantly, the Dutch scheme would be difficult to replicate in countries where the tax system is not transparent and where general awareness of environmental conservation and green growth is low. It would also be challenging to pilot this scheme in countries where the government institutional capacity is weak, unlike in the Netherlands, where RVO has a long history of promoting both environmental solutions and innovative technologies, and engaging private sector effectively. Despite these challenges, the Dutch government policy is more amenable to green business cases through the provision of corresponding laws/regulations, subsidies, etc. A successful replication to another country or a region would require a highly scrutinized local adaptation. The Green Technology Financing Scheme (GTFS) of Malaysia is unique in that it supports both producers and users of green technologies, hence taking a value chain approach–encouraging both supply and demand at the same time. As mentioned, GTFS does not provide financing to technologies that are at an early stage of development, thus creating a vacuum in a market that is still not mature enough in the green space. The scheme could nevertheless be replicated in countries with favorable green policy. One particular area in GTFS that could be improved is the capacity of financial institutions in evaluating green projects. EcoClub Malaysia (2015) has reported that less than 50% of the certified projects have received financing so far because the “financial institutions face difficulties in evaluating green projects due to lack of knowledge on the subject, lack of documentation of successful projects’ track records, lack of awareness on technological effectiveness, and payment uncertainty, often resulting in delayed lending for green technology projects”. On the one hand, there is an upward trend in the number of green projects being certified, while on the other hand, financial institutions remain behind this trend by providing inadequate capital. One more improvement that could be made in GTFS is the design of a variable credit guarantee framework as opposed to the current practice of providing a flat guarantee of 60%. Although flat guarantee systems are simple to design and easy to implement, adaptation of guarantee ratios to loan default risk could help allocate limited public finance to additional green technology ventures. The National Green Certification Scheme of the Republic of Korea was successful in raising awareness of legitimate green technologies and products. The scheme, however, lacked a deep engagement with the banking sector. Since the certified technologies were all beyond the stage of prototype, the government had assumed that private financial institutions would readily pick them up for financing. On the contrary, the banking sector did not have full trust in the bankability of certified technologies, technology products, and enterprises because of perceived risk. In addition, unlike the Dutch and the Malaysian case that took a project-financing orientation by funding projects where green technologies were applied, the Republic of Korea scheme was mostly limited to corporate financing and hence was limited in scope. The following section highlights an institutional case from the Republic of Korea that is much wider in scope and has been quite successful in easing green technology SME access to finance.

352

K. Hyung and P. Baral

An Institutional Case of Green Technology Financing in the Republic of Korea: Easing SME Access to Private Finance KOTEC, currently operating under the Ministry of SMEs and Startups, has developed a proprietary technology rating system called KOTEC Technology Rating System (KTRS) that was first conceived in 1999 and developed in 2005 based on the understanding that technology ventures do not have sufficient past track record and need to be evaluated based on future potential rather than past performance. KTRS is composed of 33 evaluation criteria that fall into one of four modules: management capability, technological excellence, market potential, and commercialization prospect. Each criterion is given to the evaluators with detailed and highly standardized guidelines for the rating to secure objective outcomes no matter who evaluates the technology business using KTRS. KTRS covers most of the same evaluation criteria as used by venture capital firms. The difference is that KTRS was designed not for equity investment, but for loan guarantee purposes where the estimation of default probability is as important as forecasting the success potential. The system is unique in that it produces two grades using a single evaluation process: technology-level grade and risk-level grade. The technology-level grade signifies success potential. Each of 33 criteria used to determine technology level is assigned a different weight driven by Analytic Hierarchy Process (AHP). AHP determines a particular set of criteria out of hundreds in consultation with technology experts and business analysis experts with sufficiently long experience of evaluating various business ventures driven by a diverse array of commercial innovations. The fact that KOTEC is roughly composed of half its staff having engineering and science background, and the other half having a business, economics or law background since its establishment in 1989 has enabled the organization to accumulate distinguished insights into technology-based SMEs. The AHP process formalized such tacit knowledge. On the other hand, 13 out of the same 33 criteria, in conjunction with macroeconomic variables such as Small Business Health Index and Business Survey Index that are updated into the system, separately calculate risk level, i.e., default probability. None of these 13 criteria uses financial indicators. These 13 criteria were chosen out of a statistical test (logit regression) for default estimation, and have different weightings from those used to determine technology level. As Figure 4 indicates, the weighted summation of technology level and risk level produces the final grade ranging from AAA to D as with conventional rating systems. This rating and grading system has been successful for many years in determining the right technology businesses as well as forecasting their default probabilities. This system, unlike conventional credit rating system, also measures default risk—hence, allowing the institution to preplan risk management. The rating system was put into full force in January 2007 after a series of pilot uses and statistical tests. Figure 5 illustrates how KOTEC’s technology appraisal and credit guarantee works in the banking mechanism.

'PXKTQPOGPVTKUM

4KUMUKP VGEJPQNQIKECN HGCUKDKNKV[

2QUUKDKNKV[QH DWUKPGUUITQYVJ

6GEJPQNQIKECN ECRCDKNKV[

#PCN[UKU

4KUM.GXGN

4`4

6GEJPQNQI[.GXGN

8`8

Figure 4: Assessment of Technology Level and Risk Level. (Source: Authors)

%QTRQTCVG KPVGTPCNGZVGTPCN 'PXKTQPOGPV8CTKCDNGU

-645



6GEJPQNQI[ CRRTCKUCN KPFKEGU

+PRWV

9GKIJVGF 5WO

1WVRWV

6GEJPQNQI[ $K\)TCFG

###&

15 Use of Innovative Public Policy Instruments to Establish and Enhance. . . 353

354

K. Hyung and P. Baral

#RRNKECVKQPHQT.QCP 

 #RRNKECVKQPHQT%TGFKV  +UUWCPEG QH.QCP

6GEJPQNQI[  #RRTCKUCN

 +UUWCPEGQH%TGFKV )WCTCPVGG%GTVKHKECVG

Figure 5: Overview of KOTEC’s Technology Guarantee Support. SME small and medium-sized enterprises. (Source: Authors)

KOTEC’s guarantee amount ranges from $30,000 to $3 million (assuming $1 is KRW 1,000). It is $7 million in case of trade guarantee and $5 million in case the value of technology itself is more than $5 million. In exceptional cases, KOTEC awards guarantee of $10 million, particularly when the company must purchase expensive equipment, in which case the guarantee will be short-term as it will be converted into mortgage later. The average tenor of a loan guarantee is up to 10 years, given as 1- to 3-year term loan and can be rolled over up to 10 years. The guarantee fee ranges from 1.2% to 1.3%. For young startups, however, the fee is reduced to 0.3%. Assuming market interest rate is 4% to 7%, if a company applies for loans with KOTEC’s guarantee certificate, the interest rate is lowered to 2% to 5%, which is still profitable after adding guarantee fees. The guarantee certificate is issued within 2–7 days from the date of filing an application. In case of intellectual property guarantee, it takes up to a month.

Green Technology Financing Using KTRS Using its unique KTRS, KOTEC established a green-growth loan guarantee program that provides loan guarantees to SMEs for both R&D and commercialization of green technologies that belong to one or more of 10 green growth areas (1. Renewable Energy, 2. Carbon Reduction, 3. High-Tech Water Resources, 4. Green IT, 5. Green Vehicles and Ships, 6. High-Tech Green House/City, 7. Advanced Materials,

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

355

Table 3: Total Outstanding Credit Guarantees as of 2016—Breakdown by Green Growth Areas Green growth field SMEs with National Green Certificationa Renewable Energy Carbon Reduction High-tech Water Resources Green IT Green Vehicles & Ships High-tech Green House/City Advanced Materials Clean Production Eco-friendly Agricultural and Fishery Foods Environmental Protection & Preservation Total

Number of SMEs 415

Total amount supported (US$ million) 300.8

418 280 304 1,459 286 238 408 125 476

192.3 134.6 121.5 747.3 229.5 124.7 214.6 73.5 198.7

1,261

529.1

5,670

2,866.6

IT information technology, SMEs small and medium-sized enterprises. a National Green Certification discussed separately in the next section. Source: Compiled by authors based on KOTEC’s internal data.

8. Clean Production, 9. Eco-Friendly Agricultural and Fishery Food, 10. Environmental Protection and Preservation) prioritized by the Republic of Korea government. By the end of 2016, KOTEC has maintained approximately $2.9 billion (KRW 3.2 trillion) worth of loan guarantee balances for green technology SMEs as illustrated in Table 3. Compared with KOTEC’s total guarantee outstanding of approximately $17.1 billion (KRW 19 trillion) at the end of 2016, the green technology specific guarantee significant. Table 4 illustrates yearly provision of guarantee in green growth areas for the last 8 years. The average default rate of KOTEC’s loan guarantees for green growth areas in 2016 was 5.04%, while the same for overall loan guarantee portfolios in 2017 was 4.47%. To specifically enhance private sector participation, KOTEC together with Korea Credit Guarantee Fund (KODIT) also mobilize financial resources from some of the biggest companies in Korea. For instance, 18 power and utility companies along with other big companies including Korean Electric Power Corporation (KEPCO), Korea East-West Power, Samsung Electronics, SK Energy, Hyundai Motor Company entered into an agreement with KOTEC and KODIT by contributing $92.7 million (KRW 103,000 million) in March 2011. KOTEC and KODIT multiplied (12 times) that resource to supply a loan guarantee of $1.1 billion (KRW1.2 trillion) to renewable energy technology SMEs upon recommendation of Korea New & Renewable Energy Association. In addition, commercial banks also give favor to the SMEs in terms of interest rates under some special agreement.

356

K. Hyung and P. Baral

Table 4: Yearly Provision of Loan Guarantee to Green Growth Areas by KOTEC (2009–2016) Year 2009 2010 2011 2012 2013 2014 2015 2016 Cumulative Total

Amount in US$ million 1,151.1 788.4 797.4 1,152.0 914.4 700.2 731.7 633.6 6,868.8

Source: Compiled by authors based on KOTEC’s internal data.

Issues with Green Technology Bankability and Evolution of KOTEC’s Green Technology Business Certificate (GTBC) Program The loan guarantee program of KOTEC using KTRS along with various other efforts made by other policy institutions in the Republic of Korea was not enough to raise the required capital to achieve the SME-propelled green growth envisioned by the government. One of the major barriers was that banks were unable to understand the excellence of green technologies that have either been certified under the National Green Certification Scheme or assessed using KOTEC’s proprietary rating system, i.e., KTRS. In consultation with major commercial banks in the Republic of Korea, KOTEC found out that the perceived risk of green technologies, whether certified or not, was far larger than the real risk, primarily because of the unfamiliarity of banks with green technologies. KOTEC saw a real need of some kind of illustrative mechanism with which the bankers could be trained to understand the nuances of green technologies and their bankability. In 2012, KOTEC conceived the idea of sharing its green technology evaluation information in the form of a certificate, particularly taking into consideration the challenges that banks encountered in making loan decisions for green technology SMEs. KOTEC developed the Green Technology Rating System (GTRS), a derivative model of KTRS. GTRS is not used for loan guarantee purposes and was solely developed to help banks understand both the real and perceived risk of green technologies. To better suit the purpose of enhancing the understanding of bankers on green technology specific uncertainty, a green effectiveness module was added to the original four modules of KTRS. The criteria under the green effectiveness module helped evaluate and demonstrate the functions of green technologies in relative scale with descriptive guidelines. In addition, the original criteria that belonged to four modules of KTRS were also largely streamlined and amended to produce better analysis of green technology ventures. The certificate was designed in the form of 9- to 11-page-long analysis including grade, definition of the grade in terms of default probability, and analysis of five modules in a way that bankers could

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

357

easily understand and gauge the excellence of the enterprise relative to peers in the same green industry. The certificate was designed to be valid for 6 months considering rapidly evolving nature of the technology business. The certificate began to be issued in 2013. The certificate was issued in two ways. The first is when banks ask KOTEC to evaluate the incumbent and issue a certificate that could be used as a reference for their lending decision without KOTEC’s guarantee service. The second is when KOTEC recommends banks to ask for certificate issuance when KOTEC believes that a certain green business has enough excellence and market could comfortably finance in addition to KOTEC’s loan guarantee. Table 5 shows the record of the usage of the certificate in the past. KOTEC understood that it would take time for banks to accept and widely use such certification, and planned to continuously enhance the system through close monitoring and sound feedback loop. In July 2014, however, KOTEC decided to stop issuing Green Technology Business Certificate in order to fully support the new government initiative called Technology Credit Bureau (TCB) introduced in June 2014 (see Box 1). Box 1: Technology Credit Bureau (TCB)

Low Carbon, Green Growth initiative under the preceding President lost its original steam after the new President Park declared “Creative Economy” as the new direction of the economy in 2013. TCB was introduced by the Financial Services Commission (FSC) of the Republic of Korea to propel the “Creative Economy” through widespread use of technology business rating by commercial banks. Under TCB, designated private sector institutions provide reports of a broad range of innovative business ventures and technology SMEs. The FSC hoped that the banks would make lending decisions by referring to such report. The major feature of the TCB scheme was to blend credit analysis with technology business analysis and to conduct sector-agnostic analysis aiming at the larger target group of innovation-driven SMEs. The idea of mixing technology ratings with credit ratings was thought to be helpful to make banks more comfortable to lend to non-conventional business ventures. The final report contains a grade calculated as a weighted sum of a conventional credit rating and a technology business rating, unlike the Green Technology Business Certificate, which produces a grade solely from GTRS. The TCB’s goal was to get banks familiarized with innovation-driven business ventures and thus, mixing of credit rating with technology rating was thought to be helpful in making banks more comfortable to deal with the new concept. The remaining format that includes the definition of grade and analysis based on management, technology, market, and commercialization, is similar to that of KOTEC’s Green Technology Business Certificate except that sector-specific modules such as Green Effectiveness are not used. The certificate is effective for a year.

358

K. Hyung and P. Baral

Table 5: Issuance of KOTEC’s Green Technology Business Certificate from 2013 to 2014 to Help Bank Lending to SMEs in 10 Green Growth Areas Items Issuance (cases) Lending (cases) Total Loan Amount (US$ million)

2013 209 119 37.0

First half of 2014 48 43 15.8

Total 257 162 52.8

Source: Compiled by authors based on KOTEC’s internal data.

Table 6: Cumulative Total Issuance of Technology Credit Certificate from 2014 to Oct 2017 for Bank Lending Institution (designated date) Issuance

KOTEC (June 2014) 37,112

KED (June 2014) 105,489

NICE (July 2014) 121,479

eCredible (April 2015) 40,857

Sum 304,937

Source: Financial Service Commission Statistics (Nov 2017).

The Financial Services Commission (FSC) requested KOTEC to share with designated private institutions (the three designated private institutions are Korea Enterprise Data (KED), Nice Information Service (NICE) and eCredible), the KTRS system, and the know-how of building and using such technology business rating system. The FSC also asked KOTEC to remain in the TCB scheme to issue analysis reports together with other private sector institutions until the practice gets well rooted in the banking sector. (In the second half of 2014, KOTEC’s issuance of Technology Credit certificate took 32.43% share. In the same period for 2016, it dropped to 8.2%, indicating an enhanced capacity of designated private institutions.) Since the TCB scheme is for the entire spectrum of innovation-driven SMEs, KOTEC uses the combination of KTRS and the credit rating system while issuing a Technology Credit certificate. In addition, because the FSC’s market orientation was clear, it was irrelevant to pursue KOTEC’s own green-sector-specific certificate program separately. The TCB scheme was successful in increasing the total cumulative bank lending toward innovative (sector-agnostic) SMEs from $8.0 billion (KRW 8.9 trillion) at the end of 2014, the year the scheme was first introduced, to $114.6 billion (KRW 127.4 trillion) at the end of October 2017. $21.9 billion out of this was rendered purely by banks without collateral or credit supplementation. Table 6 illustrates the issuance of Technology Credit certificate by four institutions as of October 2017.

Learning from KOTEC’s Green Technology Business Certificate (GTBC) Program KOTEC was able to contribute towards building capacity of financial institutions to some extent by using both credit guarantee program and the Green Technology Business Certificate (GTBC) program. The GTBC distinguished itself from National

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

359

Green Certification Program by communicating comprehensive evaluation results in a way that is appropriate for decision making of financial institutions. This certificate provided comprehensive technology, business, market and green effectiveness analysis that helped the banks make informed financial decisions. KOTEC, however, failed to take advantage of GTBC program to support green technology SMEs. Instead of only relying on banks to finance technologies certified under GTBC program, KOTEC could have effectively linked GTBC program with its regular guarantee scheme to fund some of those certified green technologies. As opposed to its fixed guarantee coverage of between 85% and 100% for technology SMEs, KOTEC could have used flexible guarantee coverage such as in the Malaysian GTFS for green technologies certified under GTBC program. This was definitely a missed opportunity despite challenges in negotiating flexible guarantee coverage with commercial banks unfamiliar with such approach. The GTBC program in combination with KOTEC’s loan guarantee program would have helped design small-scale green technology projects, contributing towards enabling green technology innovation ecosystem in the Republic of Korea. Although the GTBC program had to be discontinued because of change in policy direction and introduction of the TCB initiative, the GTBC concept could still be applicable in many developing countries where access to bank financing is limited because of real or perceived risk of green technologies. The success of the TCB scheme in the Republic of Korea also signifies such potential. KOTEC has not completely abandoned GTRS. It has recently been internally testing a pilot upgrade version of Climate Technology Evaluation System that has climate-smart evaluation modules replacing green effectiveness module in GTRS. This new system is more suitable for evaluating climate technology-based SMEs, particularly in response to the Republic of Korea government’s strong commitment to the Paris Climate Agreement. When the upgrade is completed, after a couple of years of experiment and exploration, the system will be enhanced to evaluate both smaller climate businesses and larger scale climate projects in terms of both economic viability and positive climate impact.

Conclusion The greatest barrier to SME financing for green technology projects is the real and/or perceived risk on part of the financial institutions and capital markets. The stringent lending and investment criteria of financial players that are primarily based on conventional credit assessments might not be applicable to evolving green technologies that have limited or no credit history albeit strong market potential, business models that require innovative metrics and methodologies, and generate returns over a relatively longer period of time as compared to that by conventional technologies. The green certificate schemes introduced by three countries in this study could be used as pilot benchmarks by countries looking to evaluate technologies for their green potential. In addition to this, countries could learn from how Malaysia, the Netherlands, and the Republic of Korea have structured innovative

360

K. Hyung and P. Baral

public policy-driven financial incentives around green certificate schemes. These incentives could be interest/tax rate deduction scheme implemented by the Dutch government or loan guarantee scheme of the Republic of Korea government or a combination of soft loans and loan guarantee schemes by the Malaysian government. Each scheme could be improved further as discussed in the preceding sections, but should not be directly replicated without first laying the necessary cushion. The cushion includes, but is not limited to, favorable green technology policy and relevant regulations along with enforcement mechanisms, strong technical institutions for evaluating green technologies and awarding certificates, and financial institutions that are willing to work closely with certification agencies. The cross-functional coordination among different ministries and institutions is also crucial from a very early stage before rolling out any innovative scheme like the ones discussed in this chapter. This is particularly important when the new scheme requires linkage between green technology and finance because the institutions that govern financial institutions, technology innovation and green growth policy are mostly different. The success of three case studies discussed in this chapter can largely be attributed to such cross-functional cooperation and coordination among several government agencies with varying degree. When Viet Nam built and piloted its version of KTRS through the Official Development Assistance (ODA) of the Republic of Korea government, although beneficiary institutions, i.e., the State Agency for Technology Innovation (SATI) and National Technology Innovation Fund, both under the Ministry of Science and Technology were deeply involved, the lack of early engagement of financial institutions led to difficulty persuading the banks to accept this new system. On the other hand, in Thailand, where the Thai version of KTRS is being piloted with an early engagement of Thai Credit Guarantee Cooperation (TCG) under the Ministry of Finance along with National Science and Technology Development Agency (NSTDA) under the Ministry of Science and Technology and other government agencies, the buy-in of this new system has been expected to be easier. The nurturing of green enterprises and development of green industry base requires long-term policy focus. It also requires revision and update of existing policies, laws and regulations in accordance with both evolving pace of technological development and new national/international green commitments of the country. For instance, the green growth policy in the Republic of Korea lost momentum when President Ms. Park replaced it with a new agenda called Creative Economy. Although the national green certification scheme of the Republic of Korea still exists, such unexpected policy changes without integrating the existing policy into the new one diluted to certain extent the integration of green technology innovation and financing. Under the new President Mr. Moon, the National Assembly is reviewing existing legal frameworks for the necessary revision of existing policies and comprehensive adjustments of relevant laws including the Framework Act on Green Growth to steer the country toward a climate-smart growth trajectory, also in accordance with Paris Climate Agreement. The nations of the world are at different development crossroads. It might be difficult for a country to completely replicate one or a combination of the schemes

15

Use of Innovative Public Policy Instruments to Establish and Enhance. . .

361

discussed in this chapter, in which case a part of one of the schemes could be pilottested to evaluate its applicability, feasibility, and potential effectiveness in that country. It is hard to develop the entire value chain of green industry overnight; hence, a step-by-step approach is recommended. To start with, green technology certification schemes already successfully implemented by credible institutions like those discussed in this chapter could be a good start for countries with favorable green technology policies and regulations. The certification process helps build effective stakeholder engagement and, when designed by taking financial institutions into consideration, could contribute toward crowding in private finance for certified technologies and projects, hence furthering the linkage between green technology and private finance. In addition, the existing certification schemes could also be used for cross-border green technology transfer where technologies developed in a country with rigorous certification could be either simply transferred to another country through sales or franchising agreement or further developed in the recipient country through a joint venture. For example, Bhutan has already started exploring certified green technologies (Traffic ITS system) from the Republic of Korea for potential technology transfer. It is important to understand that most developing countries are at very early stage of industrial development and hence a total leapfrogging to greener industrial base is possible provided these countries embrace the learning from successful case studies like the ones discussed in this chapter. Technical assistance and capacity building support from multilateral banks and international development institutions will certainly play a critical role in this regard. Disclaimer The views expressed herein are those of the authors and do not necessarily reflect the views of Korea Technology Finance Corporation.

References Asian Development Bank (ADB) (2015) Asia SME finance monitor 2014. https://www.adb.org/ sites/default/files/publication/173205/asia-sme-finance-monitor2014.pdf. Accessed 1 Oct 2018 EcoClub Malaysia (2015) Malaysia’s green technology financing scheme promotes green investment by providing easier access to financing, at lower costs. http://www.ecoclubmalaysia.org/ malaysias-green-technology-financing-scheme/. Accessed 22 Dec 2017 European Commission (2012) Promoting investment in sustainability: green funds. https://ec. europa.eu/environment/ecoap/about-eco-innovation/business-fundings/netherlands/13112012promoting-investment-in-sustainability-green-funds_en. Accessed 1 Oct 2018 Financial Service Commission Statistics (2017) [Data shared internally among TCB institutions, not publicly available.] Green Bank Network (2017) Malaysia green technology corporation. http://greenbanknetwork.org/ malaysia-green-technology-corporation/. Accessed 1 Oct 2018 GreenTech Malaysia (2015) Green technology financing scheme Malaysia. LTF IN-session workshop, UNFCCC climate change conference, Bonn. https://unfccc.int/files/cooperation_support/ financial_mechanism/long-term_finance/application/pdf/t4_syed_ahmad_gtfs.pdf. Accessed 1 Oct 2018 GreenTech Malaysia (2016) Selangor Darul Ehsan, Malaysia. https://www.gtfs.my/. Accessed 1 Oct 2018

362

K. Hyung and P. Baral

Ministry of Housing, Spatial Planning and the Environment (NL Agency) (2010) The Green Funds Scheme – a success story in the making. https://www.rvo.nl/sites/default/files/bijlagen/ SEN040%20DOW%20A4%20Greenfunds_tcm24-119449.pdf. Accessed 1 Oct 2018 National Assembly Budget Office (2016) Public climate finance policy evaluation. https://www. nabo.go.kr/system/download.jsp. Accessed 1 Oct 2018 Netherlands Enterprise Agency (RVO) (2002) Sustainable profit – an overview of the environmental benefits generated by the Green Funds Scheme. https://www.rvo.nl/sites/default/files/ bijlagen/sustainable_profit_tcm24-121095.pdf. Accessed 1 Oct 2018 Rabobank (2010) Dutch Green Funds Scheme. http://thai-german-cooperation.info/download/ 20150318_eedp_05_green_funds_netherlands.pdf. Accessed 1 Oct 2018 Scholtens B (2011) The sustainability of green funds. Nat Res Forum 35:223–232. http:// onlinelibrary.wiley.com/doi/10.1111/j.1477-8947.2011.01387.x/abstract. Accessed 1 Oct 2018 Thornley B, Wood D, Grace K, Sullivant S (2011) Case study 7 – Green Funds Scheme. Impact investing – a framework for policy design and analysis. http://www.woodlandforlife.net/PDFs/ 07-Green_Funds_Scheme%5B1%5D.pdf. Accessed 1 Oct 2018 UN Environment and DBS (2017) Green finance opportunities in ASEAN. https://www.dbs. com/iwov-resources/images/sustainability/img/Green_Finance_Opportunities_in_ASEAN.pdf. Accessed 1 Oct 2018 UN Environment (2016) Definitions and concept – background note. http://unepinquiry.org/wpcontent/uploads/2016/09/1_Definitions_and_Concepts.pdf. Accessed 1 Oct 2018 Xinhua (2017) Green financing piloting part of China’s commitment to Paris Agreement. http://en. people.cn/n3/2017/0615/c90000-9229051.html. Accessed 1 Oct 2018

Part X Community-Based Green Finance

Role of Hometown Investment Trust Funds and Spillover Taxes in Unlocking Private-Sector Investment into Green Projects

16

Naoyuki Yoshino and Farhad Taghizadeh-Hesary

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilization of the Spillover Effects of Green-Energy Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Modeling the Utilization of Spillover Effects of Green Energy and Application of Hometown Investment Trust Funds in Green Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilizing HITs for Green-Energy Projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilizing Spillover Taxes in Development of Green-Energy Projects . . . . . . . . . . . . . . . . . . . . . . Stable Supply of Risk Capital to Renewable-Energy Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fostering Sound Hometown Investment Trust Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

366 369 371 372 375 377 379 379 380

Abstract

In 2016, 88.90% of the Asia and the Pacific region’s energy came from fossil fuel, the consumption of which accounted for almost 40% of global CO2 emissions. To ensure the increasing energy needs of the region are in line with sustainable development goals, addressing the financing gaps of green-energy projects is critical. The major challenge for financing green energy is the lower rate of return on projects compared to fossil fuels. Electricity tariffs are often regulated by governments as prices need to be kept low to serve every household as a necessary good. Green energy’s sources of revenue are only from user charges, making it is not so attractive to investors. This chapter proposes a model for using

N. Yoshino Asian Development Bank Institute (ADBI), Keio University, Tokyo, Japan e-mail: [email protected] F. Taghizadeh-Hesary (*) Faculty of Political Science and Economics, Waseda University, Tokyo, Japan e-mail: [email protected]; [email protected] © Asian Development Bank Institute 2019 J. D. Sachs et al. (eds.), Handbook of Green Finance, Sustainable Development, https://doi.org/10.1007/978-981-13-0227-5_29

365

366

N. Yoshino and F. Taghizadeh-Hesary

the tax spillover from green energy to returning a portion of the revenue to new projects. In addition, the chapter proposes a community-based funding scheme for smaller-scale green projects (e.g., solar and wind). The chapter shows that using this model for funding green-energy projects will increase the rate of return and make them feasible and attractive to private investors. Keywords

Green energy · Green finance · Renewable energy · Hometown investment trust funds · Community-based fund · Spillover effect JEL Classification

Q21 · E62 · G21

Introduction Asia is the leading consumer of oil, coal, hydroelectricity, and, for the first time in 2016, the leading consumer of renewables in power generation, overtaking Europe and Eurasia. Europe and Eurasia remain the leading consumers of natural gas and nuclear power. Asia dominates global coal consumption, accounting for almost three-quarters of global consumption (73.80%). Fossil fuels are the main energy sources for the Asian economies, which has caused serious climate and global warming issues. Figure 1 compares the primary energy consumption in Asia and the Pacific with Africa, the Middle East, Europe and Eurasia, South and Central America, and North America. In 2016, 49.34% of energy consumption in Asia and 5,580 Mtoe

Asia Pacific 440 Mtoe

Africa

895 Mtoe

Middle East

2,867 Mtoe

Europe & Eurasia 705 Mtoe

South & Central America

2,789 Mtoe

North America

0

Oil

Natural Gas

1,000

Coal

2,000 3,000 4,000 Million tons oil equivalent

Nuclear Energy

Hydro-electricity

5,000

6,000

Renewable

Mtoe = million tons oil equivalent.

Figure 1: Regional Consumption of Energy by Fuel, 2016. Mtoe million tons oil equivalent. (Source: BP 2017)

16

Role of Hometown Investment Trust Funds and Spillover Taxes in. . .

367

the Pacific was from coal; their share of oil was 27.90%, and their share of natural gas and liquefied natural gas was 11.65%. This means a total of 88.90% of the energy consumption in Asia and the Pacific was from fossil fuel and less than 12% of energy consumption was from nuclear and renewable-energy resources (BP 2017). Most climate scientists agree that the main cause of global warming is human aggravation of the “greenhouse effect” that is a consequence of the atmosphere trapping heat radiating from earth toward space. Hence, renewable-energy projects, by replacing fossil fuels, would be a sustainable solution for mitigating climate issues. Another reason for the development of renewable projects is diversifying energy resources to promote energy self-sufficiency (Domestic production of primary energy (including nuclear)/domestic supply of primary energy
100 [Yoshino et al. 2017]) and security. Too much reliance on finite resources (coal, oil, or gas) will reduce the resiliency of the economy and make it more prone to energy price fluctuations. Several studies (see, inter alia, Hamilton 1983; Barsky and Kilian 2004; Taghizadeh-Hesary et al. 2013, 2016; Taghizadeh-Hesary and Yoshino 2016) have evaluated the impacts of oil price fluctuations on various macroeconomic indicators and generally found that oil shocks are disruptive to economic growth and create inflation for most importing countries. In a more recent study, Taghizadeh-Hesary et al. (2017) showed that after the Fukushima nuclear disaster in March 2011, which resulted in the shutting down of nuclear plants and the substitution of fossil fuels for nuclear power, energy security in Japan suffered. The authors applied a cointegration analysis and performed a vector error correction variance decomposition by using quarterly data from Q1 1981 to Q4 2010 and from Q1 2011 to Q4 2015. Their findings reveal that the absolute value of elasticities in oil consumption in some economic sectors decreased after the disaster because of an increased dependency, which endangered the country’s energy security. They suggested that to raise energy self-dependency and security, Japan needs to diversify its supplies. As a result of eliminating nuclear power generation and substituting it with fossil fuels, energy self-sufficiency fell from 19.6% in fiscal year 2000 to 8.6% in fiscal year 2013 (MIAC 2015). Before the 2011 earthquake, Japan was the third-largest consumer of nuclear power in the world after the US and France. In 2010, nuclear power accounted for about 13% of Japan’s total energy supply (Taghizadeh-Hesary et al. 2016). In 2012, the nuclear energy share fell to 1% of total energy supply (and contributed at a similar level to primary energy consumption in 2013 because only two reactors were operating for a little more than half of the year). In 2014–2015, Japan did not generate any nuclear power (Taghizadeh-Hesary and Yoshino 2015). Hence, increasing the share of renewable-energy resources in the energy basket is required. One of the obstacles to development of renewable-energy projects is lack of private sector finance. Easing finance for investment in green-energy projects is a key challenge for climate change mitigation (Dangerman and Schellnhuber 2013; Grubb 2014; Stern 2015). In recent years, several new methods for financing green-energy projects have been developed, including green bonds, green banks, and village funds. Green banks

368

N. Yoshino and F. Taghizadeh-Hesary

and green bonds have some potential to help clean-energy financing. The advantages of green banks include improved credit conditions for clean-energy projects, aggregation of small projects to reach a commercially attractive scale, creation of innovative financial products, and market expansion through dissemination of information about the benefits of clean energy. Supporters of green bonds believe that they can provide long-term and reasonably priced capital to refinance a project once it has passed through the construction phase and is operating successfully (NRDC 2016). However, it is necessary to secure a high rate of return to mitigate various risks associated with green energy. Although the aforementioned methods were somewhat helpful for development of green projects, the data suggest they are inadequate. Fossil fuel investments continue to be much larger than those in renewable energy. In 2013, renewable energy received investments of about $260 billion, which is only 16% of the $1.6 trillion in total energy-sector investments (IEA 2014). Meanwhile, investment in fossil fuels in the power sector, where they compete directly with electricity from renewable energy, rose by 7% from 2013 to 2014 (UNEP and BNEF 2015). Clearly, fossil fuels still dominate energy investment. A major concern in the transition to low-carbon energy provision, therefore, is how to obtain sufficient financing to steer investments toward renewable energy (Mazzucato and Semieniuk 2017). Due to the limitations of the Basel capital requirements on lending by financial institutions, and most renewable-energy projects’ reputation for risk, banks are reluctant to finance them. Hence, relying only on bank financing is not a sustainable solution for green-energy projects, and new channels of financing to fill the gap are needed. In line with nonbanking financing solutions, Gouldson et al. (2015) proposed revolving funds as an innovative mechanism that could reduce investment requirements and enhance impacts by recovering and reinvesting some of the savings generated by early investments. Such funds have been created in various contexts. Gouldson et al. (2015) proposed a generic revolving fund model and applied it by using data on the costs and benefits of domestic-sector retrofitting in the UK. They found that a revolving fund could reduce costs by 26%, or £9 billion. They concluded that revolving funds could enable countries with limited resources to invest more heavily and effectively in low-carbon developments, even in contexts of austerity. Ng and Tao (2016) explored the cause of the financing gap in Asia and proposed the use of bonds, specifically, three fixed-income instruments: local currency denominated corporate bonds, asset-backed project bonds, and financial green bonds. In the most recent research examining the potential of the capital market for filling the financing gap of green-energy projects, Monaca et al. (2018) examined whether publicly traded financial products offer investors competitive risk-adjusted returns, or whether renewable-energy investors face a penalty for choosing sustainable assets. They used a traditional portfolio approach to test whether adding renewable-energy exchange-traded funds (ETFs) to a standard portfolio provides diversification benefits over study periods of 2, 6, and 9 years. Their results show that the renewable-energy ETFs provide only minimal diversification benefits.

16

Role of Hometown Investment Trust Funds and Spillover Taxes in. . .

369

This chapter provides two types of innovative financing solutions which involve using spillover taxes originally generated by green-energy supply and returning them to green-energy projects in order to increase their rate of return and make them interesting to private investors. The first solution is more practical for larger green-energy projects (hydropower). The second uses hometown investment trust funds (HITs) for filling the financing gap of smaller-scale green-energy projects (solar and wind). This chapter’s proposed method is the joint utilization of spillover tax payments and HITs to increase the supply of funds to green-energy projects (see Yoshino and Kaji 2013; Yoshino and Taghizadeh-Hesary 2014a). The chapter is structured as follows. In section “Utilization of the Spillover Effects of Green-Energy Supply”, we propose utilization of the spillover effect for the green-energy projects. Section “Modeling the Utilization of Spillover Effects of Green Energy and Application of Hometown Investment Trust Funds in Green Finance” focuses on modeling the utilization of the spillover effects of green-energy supply and application of hometown investment trust funds in green finance. The last section provides concluding remarks.

Utilization of the Spillover Effects of Green-Energy Supply Asian economies are usually characterized as bank-oriented economies, as opposed to the capital market orientation typical of most Western economies. When looking at the financial assets of households in Asian countries, bank deposits and cash account for the largest share, with insurance companies and pension funds accounting for the second-largest share. In Japan in 2013, 55% of the total financial assets of households were in the form of cash and deposits at banks, 28% in the form of insurance and pensions, 12% in the form of securities and stock, and 5% in other forms. For American households, these ratios were 15% (cash and deposits), 28% (insurance and pension funds), 53% (securities and stock), and 4% (others), respectively (Yoshino and Taghizadeh-Hesary 2014b). Even in Japan, which has a developed capital market, the share of cash and deposits is much larger than that of securities and stock. In other Asian economies, the situation is similar to that in Japan, i.e., banks dominate the financial system, pension funds and insurance companies are second, and the share of the capital market is small. This means that banks, insurance companies, and pension funds will be the C for projects and businesses. Loans are suitable for financing short- to medium-term projects because the resources of banks are deposits, which typically are short-term or medium-term resources—usually 1 year, 2 years, and, at most, 5 years (deposits longer than 5 years are very rare). Hence, if banks allocate their resources to long-term infrastructural projects (bridges, highways, ports, airports, etc.) and mega energy projects (such as large hydropower projects), there would be a maturity mismatch. Therefore, because banks’ liabilities (deposits) are short- to medium-term, their assets (loans) also need to be allocated to short- to medium-term projects rather than to long-term projects.

370

N. Yoshino and F. Taghizadeh-Hesary

Non-affected region Private investment

Business development

Electricity Supply Spillover Effect

Employment

Non-affected region

Spillover Effect and increase in sales and property tax revenue Figure 2: Spillover Effects of Green-Energy Projects. (Source: Yoshino and Taghizadeh-Hesary (2018))

Insurance and pensions are alternatives to long-term investments (10, 20, 30 years). Large projects, such as big hydropower, gas-, or coal-based power plants can be financed by insurance companies or pension funds because they are long-term (10–20-year) projects. Having said that, electricity tariffs are often regulated by the government, and this makes it difficult for private institutions such as pension funds or insurance companies to finance energy projects. Hence, to increase the investment incentives, it is necessary to utilize the spillover effects originally created by energy supplies, and refund the tax revenues to investors in the energy projects (Figure 2). Energy supply will bring factories and businesses into the region. New residences will be constructed and property values will rise. Corporate income property, and sales taxes will rise in the area of new energy supply. All these spillover tax revenues were collected by either local or central governments, and they were not returned to investors in energy projects. They relied only on user charges accrued from electricity supply. If part of the spillover tax revenues had been returned to private investors, their rate of return would have increased not only for one period, but also for longer periods, and their maintenance costs could have been supported. It is possible to measure the spillover effect of an energy project based on economic growth in a specific region. To create an incentive for the private sector to invest in a particular energy project, the government should refund all or part of the spillover taxes to the investor. Yoshino and Abidhadjaev (2017) measured the spillover effects of Uzbekistan’s Tashguzar–Baysun–Kumkurgan railway connection (infrastructural project) and Japan’s fast train on Kyushu island. They explained the impact of the project on growth rates of regional gross domestic product and

16

Role of Hometown Investment Trust Funds and Spillover Taxes in. . .

371

sectoral value added by using a difference-in-difference methodology; the same method could be used to calculate the spillover effect of energy projects.

Modeling the Utilization of Spillover Effects of Green Energy and Application of Hometown Investment Trust Funds in Green Finance In Japan, HITs are a newly created source of financing for supporting solar and wind power. The basic objective of HITs is to connect local investors with projects in their own locality where they have personal knowledge and interests. Individual investors choose their preferred projects and make investments via the internet (Yoshino and Kaji 2013). One of the major applications of HITs in Japan relates to wind- and solarpower projects, which have raised money from individuals (about $100 to $5,000 per investor) interested in promoting green energy. Internet marketing companies provide the platforms for investment in these projects and are able to promote them. Local banks have started to make use of the information provided by HITs. If these projects are done properly and are received well by individual investors, banks can then start to grant loans for those projects. In this way, renewable projects can be supported by HITs until they are able to borrow from banks. The use of alternative financing vehicles such as HITs has therefore assisted the growth of solar and wind projects in Japan, where the finance sector is still dominated by banks (Yoshino and Kaji 2013; Yoshino and Taghizadeh-Hesary 2014a). HITs have expanded from Japan to Cambodia, Viet Nam, and Peru. They are also attracting attention from the government of Thailand, Malaysia’s central bank, and Mongolia. Asia’s finance sectors are still dominated by banks, and the venture capital market is generally not well developed. However, internet sales are gradually expanding and the use of alternative financing vehicles such as HITs will help risky sectors in Asia to grow. The Hokkaido Green Fund, established in 2000 to finance wind-power projects in northern Japan, was generated by donations. As banks financed only 20% of the total investments, the other 80% was obtained from individual investors and through donations. The community wind-power corporation sells electricity to the regional power company. In many cases, the price of the power produced by wind is 5% higher than that of other forms of electricity, but users are willing to pay extra to save the environment. More than 19 wind-power projects were constructed in northern Japan using a similar method. There are also examples of solar-power projects in Japan where local governments put money (seed money) into the community fund as an incentive for private investors. Another example is the revitalization of an old hydropower plant in Japan’s Nara prefecture. It was constructed in 1914, but decades later it was abandoned and abolished. The local community and individual investors raised money (one unit of investment was $300) and 274 individuals invested in the revitalization through HITs. The total cost amounted to $500,000, and 184 households received electricity

372

N. Yoshino and F. Taghizadeh-Hesary

from the revitalized dam and money from the surplus electricity sold to the power supply company in the region. Although HITs are a form of crowdfunding, there are significant differences between them and conventional crowdfunds: i) there is a “warm feeling” behind the HITs because investors are sympathetic to the company/project owners, who are not solely in it for profit; ii) investors are ready to receive product or services generated by the project (e.g., the electricity generated by wind power) instead of a share of the profits; iii) the intermediator/assessor of HITs will monitor the project frequently so that the investors will not lose money and instead provide advice when the project faces some difficulty. This is unlike crowdfunding or venture capital where profit is the only purpose of investment.

Utilizing HITs for Green-Energy Projects Investors’ (households) utility function depends on the rate of return and risk. Equation (1) shows the utility function of investors, which is a function of rate of return and risk:
 U ¼ U rt, σ t ¼ rt  βσ 2t

(1)

where rt denotes the rate of return, σ t denotes the risk, and β is the weight for the risk. If an investor gives more weight to the risk, then β will be larger. A smaller β means that the investor is not so concerned about risk. Equation (2) shows the total rate of return of households’ investments. We are assuming that households are putting their money either in bank deposits or in HITs that will be invested into green-energy projects. E rt ¼ αt rD t þ ð1  αt Þrt

(2)

In equation (2), we are assuming that α percent of the households’ assets is going to bank deposits, and the rate of return on bank deposits or the deposit interest rate is E rD t . On the other hand, (1  α) percent of their assets are invested in HITs and rt denotes the rate of return on HITs. E σ t ¼ αt σ D t þ ð1  αt Þσ t

(3)

Equation (3) is the aggregated risk. There are two types  of risk associated with D households’ investments. The first risk is for deposit (σ and the second risk is for t  HITs investment (σ Et . If the deposit interest rate is fixed and not fluctuating, then σ D t is zerois zero. Table 1 shows the risk-return trade-off for the households’ investments. If a household invests in safer assets (here: deposit), the return is rD t and the risk is σD t , which we assume to be zero. If the household invests in green-energy projects

16

Role of Hometown Investment Trust Funds and Spillover Taxes in. . .

373

Table 1: Return-Risk Trade-Off for Households’ Investments Return

Risk

Safer Assets

rD t

σD t

Green-Energy Projects

rEt

σ Et

Source: Authors.

  that have a higher risk (σ Et and expect to make a higher return (rEt , there is a tradeoff between risk and return. Next, in equation (4) we are looking at the dynamic welfare function and two constraints that are presented in equations (4.1) and (4.2): W ¼

ð1

eθt :U ðrt , σ t Þ

(4)

0 E s:t: rt ¼ αt rD t þ ð1  αt Þrt

(4:1)

E σ t ¼ αt σ D t þ ð1  αt Þσ t

(4:2)

In the next step, we develop the Hamiltonian and present it in equation (5) in which the utility function is shown in parentheses:

¼ eθt

h


 H ¼ eθt rt  βσ 2t

(5)

   i E E 2 αt r D  β αt σ D t þ ð1  αt Þrt t þ ð1  αt Þσ t

α is the ratio of allocation between deposits and HITs to green-energy projects. If α = 1, that means households are putting all their money in bank deposits. If α becomes smaller, then the ratio of investment in HITs and green energy is increasing. In the next step, we maximize the Hamiltonian with respect to α, and the results are equations 6 and 6.1: 
  D 
D  @H E E σ t  σ Et ¼ eθt rD t  rt  2β αt σ t þ ð1  αt Þσ t @αt
D 

 E 2 E rt  rEt  2βαt σ D  2βσ Et σ D t  σt t  σt ¼ 0

(6) (6:1)

Equation (7) shows the α that is obtained from Hamiltonian maximization:



D  E E E rD t  r t  2βσ t σ t  σ t αt ¼
 E 2 2β σ D t  σt

(7)

We can rewrite equation (7) by dividing the numerator and denominator by 2β, and we write equation (8):

374

N. Yoshino and F. Taghizadeh-Hesary

is large

is small

Figure 3: Utility Functions with Regard to Different Risk Preferences. (Source: Authors’ compilation)


 1
D E rt  rEt  σ Et σ D t  σt 2β αt ¼
 E 2 σD t  σt

(8)

Equation (9) shows changes of αt with respect to β:
D  rt  rEt @αt 1 ¼  2 :
 >0 @β 2β σ D  σ E 2 t

(9)

t

Equation (9) shows that if the weight of the risk (β) increases, or if the households become more risk-averse and seek safer types of assets, αt, which is the share of bank deposits in total assets, will increase, and households will invest less in HITs for green-energy projects. Figure 3 shows two cases of utility functions with regard to two different levels of risk preferences. On the left side, diagram β is large, which means households are risk-averse. Therefore, they deposit a major part of their assets in banks that have zero risk in this example and a smaller amount in HITs that have higher risk and higher return. On the right side, the diagram shows that β is small, which means these are risk-taking households. Households are ready to take risk, so the utility function becomes flatter compared to the first case. Hence, they are investing a significant portion of their assets in HITs that give them rE return, but are associated with σ E risk.  Equation (10) shows how αt changes when the deposit interest rate (rD t goes up: 1 2β

@αt ¼
 >0 E 2 @rD σD t t  σt

(10)

Equation (10) shows that if the deposit interest rate goes up αt, the share of savings in bank deposits goes up.

16

Role of Hometown Investment Trust Funds and Spillover Taxes in. . .

1  @αt 2β ¼
 0
2 @σ Et σD  σE t

t

(12) Equation (12) shows that if the risk of investment in HITs for green energy goes up, the share of investments in deposits or @αt increases. Figure 4 shows that the higher the rate of return on green energy (rE > rD ), the larger the portion of households’ investments will be in green-energy projects. Figure 4 graphically summarizes all the mathematical equations presented in this subsection by showing the households’ investment preference functions. Households’ utility function depends on the rate of return and risk that are shown by r and σ, which is very typical in finance theory. Figure 4 displays four different cases. The top two diagrams show cases in which α < 1, meaning that households are investing their assets in two forms, bank deposits and HITs for green-energy projects. Case A depicts risk-averse households (β is large) that prefer deposits to green-energy projects. Case B depicts the risk-taker households (β is small) that invest more in HITs for greenenergy projects and ultimately gain higher returns compared to Case A households. On the bottom are two cases (Case C and Case D) in which α = 1, indicating that households keep only deposits without any investment in risky projects (green energy) when the rate of return from green energy is lower than the deposit rate of interest. r ¼ 1:rD þ 0:rE

(13)

σ ¼ 1:σ D þ 0:σ E

(14)

Equations (13) and (14) show Case C and Case D households that invest their assets only in the form of risk-free assets (bank deposits), and their investment in HITs for green-energy projects is zero (shown in Figure 4, Case C, and Case D).

Utilizing Spillover Taxes in Development of Green-Energy Projects As shown in section “Utilizing HITs for Green-Energy Projects”, if the rate of return on green-energy projects increases, households are more interested in investing in

376

N. Yoshino and F. Taghizadeh-Hesary Case A

Case B

is large