Green Finance: What it is and what are the key opportunities and challenges for Asian cities
Although green finance holds the promise to promote climate-neutral and nature-positive investments, it remains misunderstood and underutilized by cities. Many urban practitioners lack the financial culture to effectively leverage green finance solutions and meet the infrastructure investment gap.
This post highlights the key takeaways from a recent knowledge sharing session held at the Innovate4Cities conference, curated by Resilient and Inclusive Cities Lab from Nanyang Technological University (NTU), Singapore. The goal of the session was to demystify green finance and highlight key opportunities and challenges for Asian cities.
What is Green Finance?
Simply put, green finance is the financial ecosystem that has been created to improve environmental outcomes. As such, it is one important branch of “sustainable finance”, which includes other facets of sustainability: economic, social, and governance. Under the green finance umbrella, one finds climate change mitigation and adaptation projects or investments as well as other environmental or “nature-positive” investments.
Figure 1. Defining Green Finance (Source: Renard Teipelke, AECOM)
The green finance ecosystem is complex and operates at the intersection of environmental issues, governance, and financial contexts. The public sector alone cannot lead the path to green financing and there is a need to build capacity for key actors of the finance ecosystem:
issuers or borrowers, including municipalities themselves but also private commercial banks, real estate investors, supranational or sovereign entities, etc.
investors, including asset managers, banks, pension funds, insurers, and
numerous actors linking issuers and investors, including accredited external verifiers, advisors, credit rating agencies, stock exchange, etc.
Solving the green finance puzzle means effectively linking the first two classes of actors, providing guidance on the size of the bond or loan, its currency, the credit rating, KPIs, etc., which requires that all stakeholders understand basic principles and can mobilize the required financial and environmental expertise.
What are the new green finance instruments?
There are three (relatively) new instruments at the service of green investments: green loans, green bonds, and sustainability-linked loans. Green loans – where funds come from banks – and green bonds – where funds come from other investors – are used exclusively for financing eligible green projects: renewable energy, green buildings, climate-proof infrastructure, biodiversity conservation, etc. These projects need to follow green loans or green bonds principles and issuers must report annually on the “use of proceeds” and the impact achieved.
Sustainability-Linked Loans, on the contrary, do not focus on the use of proceeds but are general-purpose instruments linked to sustainability-related targets defined by the borrower. Borrowers need to report annually using agreed KPIs or external ratings. An interesting feature is the pricing structure, which may include incentives or penalties depending on the borrower’s ability to meet the targets.
Beyond the broad principles common to all loans and bonds, navigating the green finance ecosystem is becoming easier thanks to the taxonomies created to define sustainable finance instruments, such as those proposed by China, the EU, or the Climate Bonds Initiative. Among them, the EU taxonomy has recently been used to define the European green bond standard, promoting important principles of transparency and a supervision process by the European Securities Markets Authority.
The “green cities agenda”: a huge investment opportunity in Asia
The greater transparency and maturity of the ecosystem lead experts to expect a rush toward green instruments in the next decade. In Asia in particular, cities already facing huge challenges related to water, waste, air quality, or poor infrastructure compounded by the rise in urban population, which leads to the largest infrastructure investment gap in the world.
In a recent analysis, the International Finance Corporation (IFC) found that cities in emerging markets had the potential to attract more than $29.4 trillion in cumulative climate-related investments in six key sectors (waste, renewable energy, public transportation, climate-smart water, electric vehicles, and green buildings) by 2030. The opportunity in East Asia amounted to $17.5 trillion: around 60% of the total climate-related investment potential, and driven by a huge potential for green buildings).
Figure 2. Climate Investment in cities. Source: IFC analysis
Using green finance to address the key infrastructure needs has key advantages for issuers and investors:
Recognition and branding: It provides an opportunity to publicize the loan as a green loan, which shows commitment to the climate change agenda (which also means that financial institutions should help design and supervise transactions to reduce the risk of greenwashing).
Meeting KPIs: companies or cities can implement their climate/green/sustainability strategies
Strengthen competitiveness: borrowers may reduce their operating costs and solve problems or risks in the supply chain.
Diversifying financing resources: borrowers may tap into investors that may not have traditionally invested in cities or infrastructure, so-called “green investors”
Mobilization: green finance projects will become easier to mobilize, e.g., via syndication platforms. For example, climate-related projects can attract blended finance, a mix of traditional financing, and donor funds that make projects more attractive.
Transparency and readiness: Getting ready for transparency and impact reporting that will be needed in the future.
Key challenges for cities to leverage green finance
Despite the opportunities, the rise in green bonds and loans seems hindered by important barriers. First, most city governments have a poor understanding of green finance principles, combined with a lack of technical and financial capacity to be able to structure a framework and design feasible funding instruments. With most documents written in English, language may be the first barrier faced by local governments to accessing green finance flows.
In addition, not all cities or countries are actually able to issue green bonds or use green finance instruments. They may have a limited local budget capacity and insufficient financing facility for large-scale investments, or they may be plagued by issues of rising debt and creditworthiness.
The pandemic has also aggravated many challenges faced by cities and significantly decreased revenues, as cities had to reallocate capital with the rise in social and health expenditures. This has shifted priorities for many cities, and in some cases worsened the environmental baseline, for example with the increase of single-use plastics and associated waste management issues.
Importantly, the institutional and political context within cities and their relationship with the national government can constitute a major barrier. This includes:
Lack of autonomy: not all cities or countries allow their cities to be autonomous in terms of tax revenues, i.e., allowing cities to borrow or spend, especially for climate-related investments or climate action.
Long-term planning: there is often a mismatch between the timing of the long-term development planning, investment, budget cycles, and electoral cycles which is crucial in terms of the decision-maker of the mayor.
Weak participation of stakeholders in decision making: Particularly in countries with very vulnerable populations, climate action should be inclusive, which makes the projects more complex to design and implement when key stakeholders did not participate from the onset.
Looking ahead: What could city governments do to access green finance?
Given the challenges, the national and subnational governments can and should work together to leverage green finance. A key step towards such collaborations is for national and subnational governments to align with international commitments and taxonomies, and to act as an intermediary between multilateral banks and cities. Although many green finance facilities can directly provide finance to cities, cities may need better support for project preparation, data collection, and analysis, which could be provided by the national government.
A step forward for most cities is to create a pipeline of projects that can be financed through green instruments. Not all cities have climate action plans or resilient strategies or climate and vulnerability assessments. Such plans, when developed or revised, should be linked with specific investment plans. Concretely, this may lead to exploring new models for operations and maintenance by examining the revenue generation options or developing city policies for green building and land use planning.
This important step – identifying “finance-ready” green projects – will be facilitated by an increased awareness from all actors, including public, private sector, and environmental experts who can help identify solutions and assess their environmental performance. Most financial institutions, national and supranational, are now considering or actively promoting green finance, which results in the development of new standards adapted to the region. For example, the ADB has recently published new frameworks and guidelines that help localize green finance principles.
Continuing these efforts to raise awareness and build capacity for key stakeholders is key to leveraging the potential of green finance in the region.
Additional sources for more information about Green Finance:
Ctrl-Alt-Delete: A Green Reboot for Emerging Markets
Budgeting for the Sustainable Development Goals
Green Finance Strategies for post COVID-19 economic recovery in Southeast Asia
GCA Integrating Resilience into PPPs Masterclass