Climate finance: Money at better use

Editor's note: Zhu Xiaoyu, a special commentator on current affairs for CGTN, is an assistant professor at Lingnan College, Sun Yat-sen University in China. His research focuses on environmental, social and governance (ESG) and corporate finance. The article reflects the author's opinions and not necessarily the views of CGTN.

It is now widely accepted that global temperatures are rising – a narrative that many suspected several decades ago. This year, we have witnessed more evidence of this phenomenon: the wildfires in Hawaii, the drought in Africa, the orange sky in New York City, and the typhoon duo, Saola and Haikui, in southern China. Climate-related incidents impact our economy and society so frequently that we now have a specific term for them: climate risk.

While some still harbor doubts, the majority of us recognize that ignoring these issues may lead to devastating consequences for our human race in the foreseeable future and for generations to come.

So, how do we address and mitigate such risks? One crucial avenue is through finance. While not the sole solution, it is undeniably a necessary one. The 28th session of the Conference of the Parties (COP28) to the UN Framework Convention on Climate Change, held in Dubai from November 30 to December 12 this year, emphasized once again that climate finance plays a pivotal role in mitigating climate risks.

In summary, the key conclusions reached at COP28 are as follows: First, there still exists a non-trivial gap between the expected and realized amounts of carbon emissions, and financial investments in mitigating climate risks are insufficient. Besides, cooperation between countries across the globe should be strengthened.

Moreover, while previous documentation such as the Kyoto Agreement, the Paris Agreement, the loss and damage deal at COP27, and the Glasgow Climate Pact at COP26 should be sustained, new agendas are expected to have stricter terms and conditions.

Fourth, public entities, such as the Ministry of Finance, the member state governments of the EU, the European Investment Bank, etc., should lead the reform. Private parties and investments should play complementary roles to public actions.

Furthermore, investment from related parties, such as the multilateral development banks and the development finance institutions, should be directed toward greener energy resource companies rather than conventional fossil fuel companies.

Observations from the meeting's bullet points highlight that COP28 places a high emphasis on the role of finance in coping with climate risks. Can the finance industry serve such an important role? The answer is yes, and it lies within a few key aspects.

Participants in the finance industry are increasingly attentive to climate risks. Regulators worldwide have established principles for firms to disclose their environmental, social and governance (ESG) reports, social impact reports, and sustainability reports.

Compliance with various standard boards, such as the International Sustainability Standards Board, the European Sustainability Reporting Standards, the Global Reporting Initiative, and the Sustainability Accounting Standards Board, has been developed and adopted by multiple entities. While regulations are advocated at different stages across the world, there are observable steps toward shaping market-wise principles that better regulate climate risks.

For market participants, swift and aggressive action is evident. Studies indicate that investors systematically respond to climate risks, and climate risk factors are becoming significant in asset pricing models. Extreme weather, as outlined in academic literature, hits stock and option prices. Among different market participants, institutional investors are quick to diversify climate risks in their portfolios.

The Big Three, namely BlackRock, State Street, and Vanguard, signed the Principles for Responsible Investment in 2008, 2012, and 2014, respectively. In 2020, Larry Fink, the CEO of BlackRock, highlighted climate risk as the "top issue" that clients raise with BlackRock, predicting a significant reallocation of capital sooner than anticipated.

Studies show that incorporating climate risk-avoiding measures can reduce portfolio risks for institutional investors. On the firm side, exposure to higher climate risks leads to lower earnings, higher costs of capital, and lower firm leverage. Firms, especially publicly listed ones, seek consulting on how to address climate issues, often with high service fees. The finance industry seems to function as a well-organized mechanism for reducing climate risk and creating positive externalities for society.

However, in this market against climate risks, enthusiastic investors are sometimes disillusioned by firms' false "green" behavior, known as greenwashing. As actual wrongdoings are nearly impossible to detect, the green market can sour. Some firms engage in arbitrage by falsely claiming noble activities.

Financial institutions and firms benefit from higher ESG ratings by issuing such financial instruments, while society is misled into thinking the finance industry is shaping the world for the better. Investors will lose hope once again, disappointed by the profit-driven nature of the finance industry.

Is it legitimate to ask whether the finance industry can mitigate climate risk, and if so, how? It is a two-sided sword, and our job is to sharpen the right side. Fortunately, there are visionary efforts. The EU introduced the Non-Financial Reporting Directive in 2014 and the Corporate Sustainability Reporting Directive in 2023, mandating companies to ensure ESG reporting, especially regarding carbon emission reduction numbers.

As the EU channels investments into achieving climate goals, as seen in COP 28, they also enforce truthful reporting by firms. Industry norms for non-financial reporting are approaching financial reporting, converging towards reliability and relevance. Public regulations play a critical role in this game.

Are private parties useful? Obviously yes. An example is a new instrument called ESG-linked securities, which tie the cost of the security to firms' green key performance indicators. If a firm performs well in dimensions such as reducing carbon emissions, the cost of the securities can be lowered (e.g., interest rates). These securities generally impose fewer restrictions on how firms use the proceeds. Under the guidance of market unions and associations, such instruments are effective in inducing better behavior from firms in curbing climate risks.

In conclusion, the finance industry can play a prominent role in reducing climate risks. Climate finance has the potential to do well by doing good. By creating the right foundation with a well-regulated market, climate finance should pave the way for a better future for our offspring – with cleaner air, fresher water, and cooler temperatures.

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