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Can the international financial market contribute to the urgency of fighting climate change? The green finance boom suggests it’s possible, a lot.
Never before has so much money for sustainable development been raised in the capital markets as this year; the total world volume is approaching the two trillion euro mark.
Discussions at COP26 in recent weeks have drawn even more attention to the potential role that finance could have.
It is becoming more and more obvious that it is enough to give the “green” label to financial products to be inundated with investment money. Not only are businesses riding this wave, but governments are too.
How do governments react?
In international comparison, Europe has clearly taken the lead, followed far behind by the United States and Asia.
Some are already jubilant that Europe is the big winner from green funding. The particularly large amount of green capital available, they say, will transform the economy faster than in the United States and China.
However, such a view fundamentally fails to recognize the interdependencies of capital markets.
The first critical question is: what is green finance anyway?
Opinions on this matter differ from country to country and there is no uniform classification. For example, if nuclear energy is considered environmentally friendly in France, the reverse is true in Germany.
Due to this uncertainty, some financial institutions are increasingly accused of not taking the classification of green investments too seriously and of prioritizing marketing at the core.
This accusation is summarized under the keyword “greenwashing”. But even if there was a uniform and generally accepted classification of green investment opportunities, that wouldn’t change much.
The second critical question is: does green finance provide additional funds for the sustainable transformation of the economy?
In many cases, the answer to this question is clearly no.
An example is the case of “green” sovereign bonds issued for the first time in September 2020 in Germany. The German federal budget was only examined to see what spending already planned could be classified as green.
Once the amount was determined, the government sold green bonds for exactly that amount – so nothing changed.
How are banks tackling climate change?
Banks, on the other hand, may refuse funds to their borrowers, or only offer funds on very unfavorable terms, if they expect more commitment from a company to climate protection.
This results in the seemingly paradoxical situation that climate-conscious investors can achieve the most when they invest in companies that were previously known as climate sinners.
With these companies, they can reduce CO2 emissions considerably more through their intervention than with companies that are already climate-friendly.
However, investors should not mistakenly believe that investing in “greening” businesses will automatically lead to higher returns.
This may be the case if they realize earlier than others that a company is on a climate-damaging path with its production technology, and that a rapid change of course can increase earning opportunities.
But this is not the rule. Investments in exclusively green asset classes deprive investors of the possibility of diversifying their capital as widely as possible.
What effective steps can we take?
In competition with the United States and China, Europe would do well not to rejoice too soon in its current pioneering role.
On the contrary, Europe should seize the momentum and create the conditions for investors to really contribute to a green shift in companies through their actions.
There are a number of good starting points for this. For example, corporate governance rules should be strengthened.
The trend towards passive index investments, observed for many years in all major international capital markets, is expected to reverse and soon, if the great importance of donor interventions in the green transformation of the economy is recognized.
A thriving market for venture capital would be another key element. As Europe lags behind the United States and China in many technological developments, there is an opportunity to create the next crop of climate tech ‘unicorns’ on the old continent through a tight mesh of science and practice.
And what about European companies?
It is often said that Europe contributes only 10% of global CO2 emissions anyway.
But European companies could, thanks to their innovative power, not only significantly reduce emissions caused by Europe, but also become the benchmark and the sought-after supplier for CO2 reductions around the world.
This would reverse the distortion of the market values of European companies, compared to American and Chinese competitors.
The fight against climate change is too important to follow only seemingly plausible arguments. It is high time to move from a naïve to an informed approach to sustainable financing – in the interests of investors and the environment.
Jörg Rocholl is President of ESMT Berlin and Vice-President of the Scientific Advisory Board of the German Federal Ministry of Finance.