With growing public awareness of the urgent need to address environmental challenges such as climate change and pollution, the financial sector is playing an increasingly important role in promoting sustainability. Sustainable finance has emerged as a key tool for aligning financial activities with environmental objectives and supporting the transition to a more sustainable future.
Sustainable vs. Green Finance
Sustainable finance refers to financial instruments, products, and services designed to promote sustainable development and address current environmental challenges. It involves integrating environmental, social, and governance (ESG) factors into financial decision-making and allocating capital to support sustainable projects and businesses. A subset of sustainable finance, green finance targets environmental goals such as biodiversity protection and restoration.
Why is sustainable finance so important?
Sustainable finance is essential to drive innovation across all industries, from renewable energy to circular economy initiatives to green infrastructure. By supporting ingenious projects and businesses, sustainable finance is helping groundbreaking technologies gain the necessary funding to reach their ultimate goal: commercialization.
Investing in environmentally-sustainable projects can help reduce financial risk by mitigating exposure to adverse climate events (greening finance). Indeed, the financial system is increasingly treating climate and environmental risks as financial risks. Integrating ESG considerations into financial decision-making can aid long-term institutional investors with redistributing and rebalancing climate-related risks to maintain financial stability. This can be done with hedging instruments (e.g., catastrophe bonds, indexed insurance) to help insure against increasing natural disaster risk, as well as with other financial instruments (e.g., green stock indices, green bonds, voluntary decarbonization initiatives) to help reallocate investment to “greener” sectors. In order to help investors and financial institutions assess their climate-related exposure, private banks are improving ESG data disclosure, and adopting existing (and proprietary) sustainability frameworks and reporting practices.
The 2018 EU action plan on financing sustainable growth
In March 2018, the European Commission presented an action plan that includes three proposals to connect finance with sustainability: 1) creating an EU sustainable finance taxonomy, 2) improving disclosure requirements, and 3) creating a new category of low-carbon benchmarks.
The EU taxonomy is one of the key proposals in the European Commission's Action Plan on Financing Sustainable Growth, which was published in March 2018. It is aimed at helping investors invest in sustainable projects and assets across the EU. This taxonomy provides details on how ESG factors can be taken into account for investment decisions and establishes low-carbon benchmarks. The aim of this unified EU taxonomy is to facilitate and harmonize investments across national borders by clearly defining what is ‘sustainable’ and what is ‘green’.
In addition, the goal of the action plan is also to increase standardization and disclosure of non-financial information published by companies and used to evaluate risk. It will therefore increase data availability and make data more comparable. In addition, the introduction of labels for sustainable finance also protects private investors from the risks of greenwashing.
To achieve the targets set in the Paris Agreement and the UN 2023 Agenda for Sustainable Development on climate change, the European Commission decided to define appropriate and objective low-carbon indices that could be used as benchmarks for investment portfolios. The Commission, therefore, created a new category of benchmarks divided into two types: 1) low-carbon benchmarks and 2) positive carbon impact benchmarks.
Low-carbon benchmarks are based on 'decarbonising' standard benchmarks and are used for risk diversification. The underlying stocks are to be selected on account of their reduced carbon emissions when compared to stocks constituting a standard benchmark.
Positive-carbon impact benchmarks are a type of benchmark aligned with the Paris Agreement objective of limiting global warming to below 2°C. The underlying stocks are to be selected on account of their carbon emission savings exceeding the stocks' residual carbon footprint.
What are the most common financial instruments in green financing?
Green bonds: any type of bond instrument designed to finance environmental or climate projects. These projects may include investments in renewable energy, energy efficiency, clean transportation, sustainable water management, climate change adaptation, eco-efficient products, production technologies and processes and other environmentally beneficial initiatives.
Sustainability bonds: any type of bond instrument committed to financing a combination of green and social projects. Some bonds may fund environmentally-focused projects with social co-benefits, while others may be primarily social with a green element. The funds are often committed to social or green impact projects that are aligned with the UN sustainable development goals (SDGs). Sustainability bonds include corporate SDG bonds (non-financial), SDG bonds by banks and financial institutions, asset-backed and project SDG bonds, sovereign SDG bonds and municipal SDG bonds(Green and sustainable finance | Think Tank | European Parliament).
Sustainability-linked bonds: any type of bond instrument for which the financial or structural characteristics (e.g., the coupon rate) can fluctuate depending on the achievement of predefined sustainability targets by the issuer. This instrument is relatively new in the market. The first SDG-linked bond was issued in September 2019 by the Italy-based international energy company ENEL. In January 2021, the ECB made sustainability-linked bonds eligible for inclusion in asset-purchase programmes and for use as collateral(Green and sustainable finance | Think Tank | European Parliament).
Green loans: any type of loan instrument whose funds are committed exclusively to green projects addressing key areas of environmental concern, such as climate change, natural resource depletion, biodiversity loss, and air, water and soil pollution. A fundamental part of a green loan is the periodic reporting by the borrower to the lender of the actual use of proceeds, also by using qualitative performance indicators and quantitative performance measures (e.g., electricity production, greenhouse gas emissions avoided)(Green and sustainable finance | Think Tank | European Parliament).
Sustainability-linked loans: any type of loan instrument paid by the borrower where the interest rate is dynamic and linked to some selected sustainability performance indicators, such as carbon emissions or an ESG target. In the case of achieving sustainability targets, the borrower benefits from favourable interest rates, while higher rates are charged in case of failure. This mechanism is a financial incentive linked to the attainment of sustainability objectives(Green and sustainable finance | Think Tank | European Parliament).
Blue bonds: any type of bond instrument committed to financing social projects, including projects aiming at providing food security and developing sustainable food systems, sustaining vulnerable groups in the aftermath of a natural disaster, or alleviating unemployment stemming from a socioeconomic crisis(Green and sustainable finance | Think Tank | European Parliament).
Overall, the increase in green bonds, sustainability-linked loans, and other sustainability-related finance instruments is a clear indication of the growing demand for sustainable finance. These financial instruments offer investors the opportunity to invest in sustainable economic activities while potentially earning financial returns, and the increasing availability of such instruments has helped to drive the growth of sustainable finance. As more companies and financial institutions seek to issue and invest in these types of instruments, it is likely that sustainable finance will continue to grow, contributing to the transition to a more sustainable and environmentally friendly economy.
If you're interested in learning more about sustainable finance, I highly recommend checking out the European Parliament Briefing on Green and Sustainable finance.
Mathilde Noels
References:
www.europarl.europa.eu. (n.d.). Green and sustainable finance | Think Tank | European Parliament. [online] Available at: https://www.europarl.europa.eu/thinktank/en/document/EPRS_BRI(2021)679081.
www.europarl.europa.eu. (n.d.). Sustainable finance – EU taxonomy: A framework to facilitate sustainable investment | Think Tank | European Parliament. [online] Available at: https://www.europarl.europa.eu/thinktank/en/document/EPRS_BRI(2019)635597
www.europarl.europa.eu. (n.d.). Sustainable finance and disclosures: Bringing clarity to investors | Think Tank | Europäisches Parlament. [online] Available at: https://www.europarl.europa.eu/thinktank/de/document/EPRS_BRI(2019)635572
www.europarl.europa.eu. (n.d.). Sustainable finance and benchmarks: Low-carbon benchmarks and positive-carbon-impact benchmarks | Think Tank | European Parliament. [online] Available at: https://www.europarl.europa.eu/thinktank/en/document/EPRS_BRI(2019)640135
Bank, E.C. (2021). Sustainable finance: transforming finance to finance the transformation. www.ecb.europa.eu. [online] Available at: https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp210125_1~2d98c11cf8.en.html.
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