Section three | Transforming the Financial System
This section focuses on cross-cutting reforms and institutional changes that could improve how the financial system works to support private finance and investment in sustainable infrastructure, including by scaling up and targeting public finance through development finance institutions (DFIs) to better leverage private finance. Building on the work of the UNEP Inquiry into the Design of a Sustainable Financial System1, among others, the first part of this section highlights policy innovations in developing and developed countries that are starting to show how to better align the financial system with sustainable development, as well as international collaborations that are supporting national action to achieve that goal. The second part then examines some of the recent developments and innovations in Multilateral Development Banks (MDBs) and other DFIs that are helping to increase their direct financing for sustainable infrastructure, and to crowd in private investment.
Transforming the financial system and its intermediaries is essential to scaling up sustainable infrastructure finance. Although public finance and investment will continue to play a critical role, particularly in low-income countries, large amounts of private capital are needed as well – and this will only flow if the right market signals are present within the financial system. Private financing of infrastructure that is high-carbon, not climate-resilient, or generally unsustainable still significantly outweighs private flows to sustainable infrastructure. Actions by regulators and policy-makers in the financial system can reorient incentives and reframe how investors view risks and potential returns. Reforms in the financial regulatory system and in the practices of central banks, combined with other policy reforms (e.g. to price carbon and support innovation and to use sustainability criteria when screening projects), can level the playing field between sustainable and unsustainable options and thus give a powerful boost to private investment in sustainable infrastructure.
Mark Carney, Governor of the Bank of England, has said climate change is a “tragedy of the horizon”, because its worst impacts “will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no direct incentive to fix”.2 Although some climate change impacts are already being felt, the most serious impacts – and the benefits of mitigation and even some adaptation today – may be several decades away. That is far longer than the timeframes for most decision-makers looking ahead: beyond the business cycle, the political cycle, and even the horizon for most regulators, including central banks. The horizon for monetary policy, for example, is two to three years – a decade if we consider the credit cycle. Addressing climate change and other sustainability issues, including the financial risks they pose, requires a shift away from the tyranny of “short-termism” to take a longer view.
Tackling climate risks now is preferable to a “wait and see” approach, as greenhouse gas concentrations in the atmosphere will continue to rise, as will the associated total costs of action in terms of emission reductions and adapting to the climate change that is locked-in.3 This is particularly true when financing infrastructure, which is relatively expensive and long-lasting. Yet investors focused on short-term gains might be discouraged by the fact that the upfront capital requirements for sustainable options can be higher relative to “brown” alternatives, with the benefits accruing over several years. Even energy efficiency investments may take five years or more to recover first costs. Infrastructure investments, by their nature, require patient capital, and sustainable infrastructure, even more so – but the benefits over time can be substantial.
Broadly, there are five policy priorities to transform the financial system to mobilise private finance for more sustainable investment – called the “5 R’s” in the UNEP Inquiry work:4
- Reallocation: Mobilising and reallocating private finance to green investments, including through green bonds and green banking. In the case of emerging economies and other developing countries, where local financial institutions and capital markets are weak, strategic use of resources garnered by MDBs and other DFIs will be needed, working with leadership from host country governments.
- Risk: Enhancing frameworks for systemic risk management to take into account macro-prudential or systemic risks in the financial system related to climate change, including from the physical risk of climate change, and from climate policies.
- Responsibility: Clarifying the core responsibilities of financial institutions under fiduciary duty or legal liability definitions to assess and take into consideration environmental, social, and governance factors.
- Reporting: Better reporting and disclosure across the three actions above.
- Roadmaps to a strategic reset: Harmonising and linking initiatives across countries to achieve coherence at the systems level, which will increase the capacity of increasingly global financial systems to support renewed economic competitiveness and improved sustainability performance.5
As part of the overarching architecture to mobilise private finance and investment for sustainable infrastructure, DFIs play a very important role. They are particularly important for those projects that do not otherwise offer risk-return profiles matching the appetite of private investors. DFIs can participate in a number of ways, from being an investment partner to offering to mitigate financial risk, such as through guarantees, in turn, making it possible to bring in private investors. DFIs have also played a pioneering role in launching some of the instruments discussed in this section – such as green bonds – helping to prove a concept or establish the track record necessary to mainstream widespread replication and use. There is an urgent need to scale up DFI investments in sustainable infrastructure, focussed on approaches that can help “crowd in” private finance.
The actions outlined above aim to regulate and better use financial institutions for sustainable development. To be effective, the reforms must also be supported by strong environmental policies, which are key drivers of demand for green finance. The attractiveness of green investments is influenced by the risks in the real economy associated with highly polluting or resource-intensive alternative investments. It is only through setting the right broader policy frameworks that environmental costs become real in financial terms.