Getting green finance right to win the net-zero fight
By now, we all know the headline.
In September 2020, Xi Jinping pledged that China will peak carbon emissions before 2030 and become carbon neutral before 2060.
But reaching net zero won’t come cheap.
- In fact, it’s going to be eye-wateringly expensive.
According to the head of the central bank (PBoC), Yi Gang:
- China will need to come up with RMB 2.2 trillion (USD 352 billion) per year to reach the 2030 goal.
- This outlay will grow to RMB 3.9 trillion (USD 624 billion) annually from 2030 to get to net zero by 2060.
That’s almost RMB 140 trillion (USD 22.4 trillion) – about five times the size of the current German economy – needed over the next thirty years to fund Xi’s climate pledge.
Looking at those kinds of numbers, it’s clear the government can’t fund this mega-transformation of the economy alone.
- That’s where green finance comes in.
What is green finance? And how is China supporting it? We’re glad you asked – because answering those questions is the very reason we put this latest Trivium China Deep Dive together.
- Green finance is a set of policy and bureaucratic arrangements and incentives meant to channel non-state (aka private sector) capital into green projects and industries.
- Green financial products are primarily loans and bonds.
- And as with just about everything, China has its own approach to setting up a green finance system.
If you’re keen to understand that unique approach, well by all means, keep reading.
The lay of the land
China got serious about green finance in 2016 when the government prioritized the “holistic development of a green financial system” in the 13th Five-Year Plan.
- This priority reflected heightened government attention on addressing serious domestic pollution concerns and, more recently, staking China’s claims to global leadership in tackling climate change.
Since then, key Chinese government entities have been trying to set up the basics of the domestic green financing system, with some success.
By the numbers:
- By 2020, green bond issuance in China had skyrocketed to RMB 813 billion – up from just RMB 238 billion in 2016.
- And in the same year, green lending by 21 major financial institutions – which account for over 80% of Chinese banking assets – reached RMB 11 trillion, up from RMB 7.5 trillion in 2016.
But as always in China – while the absolute numbers are large, the proportions tell a different story.
- In 2020, green loans only accounted for less than 7% of the credit market, and green bonds less than 1%.
Even before Xi’s climate pledge, these numbers were nowhere near high enough to fund China’s green commitments.
So how to spur growth in green financing? There are two main issues at the center of policymakers’ attention:
- Ensuring green investments are financially attractive
- Ensuring funded projects are environmentally impactful
Those are two pretty fundamental challenges that are still being thought through – which tells us how far there is to go. But the increased political will to address these challenges is palpable.
Beyond the numbers
As the green finance issue moves up the priority chain, however, sheer political will won’t be enough – policymakers realize the need to focus on the economics.
- While there is plenty of political pressure on banks and companies to get behind green finance, the financial incentives are just not there yet to attract the vast levels of investment needed.
Indeed, for now, green finance often comes at a net economic cost for borrowers and lenders.
- Banks say the material incentives for green lending are not enough to make such products cheaper than “regular financing” products.
- What’s more, even if interest rates on green finance products are competitive, borrowers and lenders need to comply with a list of complex requirements and produce all the paperwork documenting how they meet those requirements, to boot – creating significant additional compliance burdens.
- And importantly, green funds aren’t fungible – by definition, they have to be used for specific activities, which further dents their attractiveness.
So with all these headwinds, why are the numbers up at all?
- Participating in green finance often makes political and reputational (if not economic) sense for borrowers.
- Lenders often approve green lending to demonstrate they’re on board with the government’s plan.
- And quelle surprise: State banks have to support the goals of the state. So there’s that.
The bottom line: The political incentives for green finance are firmly in place – getting the economics right is now the key challenge for policymakers.
Flipping the switch
The PBoC has recently upped its policy game to address the persistent lack of financial incentives for lenders.
- Stay with us for a minute because we are about to go all Party-speak.
The PBoC’s efforts will be guided by the “three major functions” and the “five pillars.”
The “three major functions” refer to the main types of policy support for green finance, including:
- Resource allocation: Guiding financial resources into green investments through tools including monetary policy, credit policy, regulatory policy, and project evaluation.
- Risk management: Improving the financial system’s ability to manage risks related to climate change through tools such as climate-risk stress tests, environmental analysis, and green-asset risk weightings.
- Market pricing: Building a national carbon emissions trading market, developing derivative trading products, and setting a reasonable price for carbon emissions through the market trading system.
The “five pillars” refer to activities that support the development of China’s green finance ecosystem:
- Improving the green finance standards system by unifying domestic standards and aligning them with international ones
- Strengthening oversight of financial institutions and their information disclosures
- Improving incentive and restraint mechanisms – through policies like performance evaluations and interest-rate subsidies
- Encouraging innovation in green financial products and markets
- Increasing international cooperation
But the PBoC’s challenge isn’t just about increasing the volume of green finance. It’s also about ensuring funds are spent on genuinely impactful projects – and preventing “greenwashing.”
The toolkit: As we lay out below, financial officials are primarily employing three main tools to boost financial incentives for green lending and investment.
Tool #1: Making green finance more attractive to banks
In recent years, the PBoC has pursued a range of measures to make green finance more attractive for lenders, including:
- Re-financing funds designated for green financial products
- Allowing green bonds to be used as collateral for PBoC lending facilities
What’s more, in August, the PBoC said it plans to develop more financial instruments that offer preferential interest rates for green financing – as well as providing targeted and direct support for green development.
Translation: The PBoC will boost subsidies for green investment to get more banks on board.
Subsidizing a portion of investments is cheaper than putting the entirety of project financing on the public books. But, ultimately, the entire point of developing a green finance system is to make green investments financially attractive – without the need for direct government subsidization.
To do that, officials will need to entice a wider array of players into the green financing market.
What to watch: That will take time, so for now, direct subsidies will remain the order of the day.
Our question: Once investors bake subsidies into their financial models for green investment, will the government be able to pull back?
- That’s easier said than done, as shown by the painful extraction of subsidies from the solar sector.
Tool #2: Increasing the weight of green finance in bank assessments
The PBoC already considers green credit and green bond performance in its macroprudential assessment (MPA) framework – which policymakers employ to give banks quarterly performance and risk evaluations.
- But the weighting of these metrics in evaluating bank performance is set to increase.
How does that work? The increased weighting of green finance within the MPA framework should incentivize banks to boost capital allocation to green projects – because it will boost the overall MPA score, which brings a broad range of benefits to lenders.
As an example: Higher MPA scores lead to increased access to central bank facilities and lower interbank borrowing costs.
The roadmap: In early February, Wang Xin, director of the PBoC’s research bureau, announced that the central bank would incorporate more and more forms of green finance – including green trusts and green equity investments – into the MPA.
The upshot: Using indirect incentives, like lower wholesale funding costs tied to intermediary evaluations, could be one key way for the PBoC to avoid leaning too heavily on direct subsidies in boosting green finance.
- That’s what we call a market-forces win-win.
Mark your calendars: Wang expects the revised MPA framework to drop before the end of 2021.
Tool #3: Getting more investors involved
Policymakers know that when it comes to green finance, the more the merrier.
That’s why they are looking to harmonize green finance standards with international best practices – to help foreign and local investors identify, screen, and (hopefully) fund green assets in China.
- In February, the PBoC’s Research Bureau noted they were on track to publish the China-EU Shared Classification Catalogue for Green Finance.
- And in April, the PBoC, CSRC, and National Reform and Development Commission updated their green bond endorsed-project catalog, harmonizing standards across the three regulatory bodies.
Beijing is also keen to tap into the growing interest in ESG to speed up green investments.
- The number of ESG indices in China doubled in 2020 from 2019.
- The scale of ESG funds grew by more than 60% in the same period.
But folks in the know tend to agree that ESG investing suffers from some significant issues, particularly in China, including:
- Domestic investors’ general lack of practical experience with ESG investing
- The lack of unified ESG standards, which drives vast variability in rating agencies’ ESG scores
To address these long-term challenges, the PBoC is looking to get strategic-minded funds – such as pension funds and social security funds – to lead the way in thinking through proper ESG investment.
- In the meantime, the securities regulator (CSRC) has signaled that it’s also working to align domestic ESG disclosure standards with international ones, to make it easier for investors to assess the ESG-ness of companies.
Get smart: Bringing domestic ESG and green finance standards and best practices closer to international ones will make it easier for investors to make informed decisions regarding the Chinese market.
But, but, but: These standards will still be a far cry from what you might see in other countries.
- The overarching idea in aligning standards is to entice foreign capital to support domestic green requirements – not necessarily to fit domestic green projects and financial instruments into international investors’ frameworks.
Proper assessment mechanisms will be crucial to success
Banks, financial institutions, and investors are all eager to be seen supporting China’s green drive.
But the last thing the PBoC wants is to see money gushing into ineffective projects that do little or nothing to reduce emissions and end up as non-performing assets a few years down the road.
- Getting this right will require ongoing assessment and information disclosure mechanisms to enable all stakeholders to assess the quality and impact of investments along the way.
To this end, the PBoC has emphasized that green finance should be “workable, measurable, and verifiable.”
What does that mean?
- Workable – Investments should support sectors that can achieve clear, significant reductions in carbon emissions
- Measurable – Financial institutions must be able to calculate the carbon emission reductions stemming from green funds directly – and must publicly disclose that information
- Verifiable – Officials will establish a network of third-party professional institutions to verify the integrity of information disclosures
That may seem like a heavy lift. But the PBoC’s recently launched environmental information disclosure pilot in the Greater Bay Area (GBA) gives us a good idea of how all this might eventually look.
- Thirteen banks in Guangzhou, Zhuhai, Huizhou, Zhongshan, Dongguan, Foshan, Jiangmen, and Zhaoqing are participating in the pilot.
The selected banks must include details on the following in mandatory annual reports:
- Overall project governance structures
- Objective analyses of the financial institution’s environmental risks and opportunities
- Environmental risk management and processes
- Impacts of business activities on the environment
- Impacts of investment and financing activities on the environment
What to watch: Given that the government is setting up the GBA as a key zone for innovating financial reform, we’ll be keeping close tabs on how well these environmental information disclosures work – or don’t.
The bottom line: Green finance can’t not work
Despite some enormous challenges, China’s financial officials must find a way to make green finance work – to fund China’s lofty carbon neutrality goals.
- Indeed, given the domestic political imperatives, they simply have to find a way.
- And that’s not to mention what it would mean for the world if China’s attempt to set up a workable green financing system fell flat.
For those of us on the outside, keeping tabs on these developments will be critical. Apart from the obvious life-or-death benefits of China achieving carbon neutrality, there are many other reasons to root for policymakers’ success.
Our take on the stakes:
- China’s bid to achieve net zero is not just about reducing emissions – it’s about transforming the country’s entire economic model, with ramifications across all sectors.
- Most of the technology required to reach net zero doesn’t even really exist yet, or is only in its infancy. These discoveries will likely drive transformations across industries (even in some not directly related to the green enterprise) – and ensuring proper funding behind these technologies will be vital.
- Environmental protection will also likely be incorporated as a core element of the latest incarnation of “common prosperity.” Smart companies and investors will strategically dovetail their corporate and portfolio positioning – and messaging – with this new reality.
- China is not the only country trying to make green finance work. China’s approach, and failures and successes, could help inform solutions globally as other countries struggle to fund their own green transformations.
- Green development is a long-term, large-scale enterprise. Given the sheer scale of the outlay required, investors can’t afford to sit this one out.
In conclusion: Chinese financial regulators are moving from a crawl to a walk in building out a viable system of green financing. They will soon be running, and the rest of us need to be ready to keep up.
KNOW CHINA BETTER.
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