The weight of research shows that businesses and households with good environmental credentials are also better borrowers. They are less likely to default on their loans and less likely to be late on their repayments.
In a well-functioning market where these broader social and economic benefits were properly priced, these borrowers would get lower interest rates. When these loans were securitised and sold on, the bonds would be more favourably priced because the underlying asset was stronger and safer.
This is not what we are seeing. While some banks and financial institutions are increasingly taking environmental credentials into account, we are not seeing it on the scale that the evidence would recommend, particularly in developing countries.
The regulations inhibiting sustainable investment globally are the Basel III global capital rules and national financial regulations that seek to implement them. Among other things, these rules require that banks hold high-quality assets on their balance sheets as a buffer to shocks. But the rules around the quality of these assets don’t account for the fact that environmentally friendly loans are safer than the unfriendly ones. The result is that the world’s banks aren’t holding or issuing enough green debt, resulting in less sustainable investment.
It gets worse. The failure of these rules to properly price environmental risks undermines the stability of the financial system, as it means there are unaccounted-for risks endemic in bank balance sheets. A borrower who is forced to undertake a costly environmental clean-up, for example, could quickly find themselves in financial trouble – a shock which is then transmitted through to the lender and any financial assets that are underpinned by that original loan.
Another factor constraining sustainable investment is a lack of data. There is a range of organisations providing ratings on the environmental credentials of firms. These data are vital for markets to price environmental risks properly. But the same organisations often provide different environmental ratings for the same businesses. This makes such pricing difficult.
In a world of digital and remote sensing technologies, the collection of high-quality data on land management and the environmental impact of firms has never been easier. But in countries where such technologies are unavailable and where firms are not yet providing comprehensive environmental ratings, it becomes very difficult for markets to price these risks.
Global solution vital
How do we begin to get national financial authorities to work towards a global financial regime that properly prices natural capital (reduced carbon emission, environmental sustainability)? In China, Europe and elsewhere authorities have begun actively framing national approaches to the problem, but the global nature of capital markets and environmental challenges requires a global solution.
China’s central bank governor, Yi Gang, has announced that the People’s Bank of China (PBoC) is co-operating with the European Union to achieve convergence of green investment taxonomies across the two markets, aiming to implement a jointly recognised classification system for business environmental credentials by the end of this year.
The Asia-Pacific Economic Co-operation forum (APEC) is a platform from which to work through these issues. As a co-operation framework, it can support finding practical areas to work together – especially between the US and China – and build broader consensus for mutual benefit.
APEC also brings a practical, private-sector led way of getting action on climate change that supports agriculture, boosts investment and bolsters financial stability; something which can help bring more recalcitrant governments into the tent.
Sustainable investment is a practical area in which China and the US can share a common priority. The PBoC has been working on it for some years, it has political appeal across the partisan divide in the US and is something that resonates with APEC governments that prefer technology and private-sector led approaches to climate change.
One challenge is in making sure that loans are provided for the right amount of time. The economic payoffs that come from sustainable investments can take decades to materialise. There’s a role for government in ensuring there are institutions in place to encourage and regulate markets in natural capital.
With government budgets in tatters and the threat of climate change real, boosting the role of private finance has gone from being preferable to being essential.
Adam Triggs is a director within Accenture Strategy, a visiting fellow at the ANU Crawford School of Public Policy, and a non-resident fellow at the Brookings Institution. This article is part of a series from East Asia Forum (eastasiaforum.org) at the Crawford School in the ANU’s College of Asia and the Pacific.