Through China, a green financing leader emerges

MANILA — Within the past 15 years, almost every sector imaginable has been reconceived within the context of sustainable development with the notable exception of one: finance. For years, there has been a debate over how to finance sustainable development, and how to do so in a manner that reflects the principles of sustainable development. Last year, that discussion took a major step forward when China embraced the concept of “green finance” and championed it both domestically and internationally during its presidency of the G-20.

There is no universally accepted definition of green financial activities, mainly because different countries have different priorities in their environmental policy and approaches to implementation. On a conceptual level, it can be thought of as financing environmentally sustainable growth. And China is leading the push for “green finance” to be at the heart of economic development strategies.

The world is taking notice. Germany under its current presidency of the G-20 is building upon what China started last year. Several developing countries are looking at China for lessons on how to develop their own green finance systems. And many of the world’s leading financial centers, including London, New York and Singapore, have also started developing green finance initiatives and plans partly inspired by the market that China offers.

And yet that leadership appears somewhat serendipitous. “China doesn’t mean to be a green finance leader. But our government authorities have the awareness that we should have green finance,” said Wang Yao, director general of the International Institute of Green Finance at the Central University of Finance and Economics in Beijing.

How China came to embrace green finance

So why did one of the dirtiest countries in the world choose to embrace a development model that emphasizes environmental sustainability, runs counter to traditional economic thought and up until recently was confined to a fringe of academics and policymakers?

After almost 40 years of astonishing growth built on the backbone of exploiting its natural resources and cheap labor, the world’s second largest economy reached a turning point and had to design a new development pathway forward. Beset with domestic pushback on its rampant pollution and aware of the economic benefits of clean energy, China started working on green finance in 2006. But, for many years, such financing was purely conceptual and lacked actionable plans.

Then in 2014, roughly 40 local and international banking, finance and development experts joined the Green Finance Task Force to come up with policy recommendations to the Chinese government on “greening” the country’s financial system. The task force published a more comprehensive reform plan the following year. In 2016, the highest levels of the Chinese government formally recognized the importance of green finance in the country’s 13th Five-Year Plan and seven government ministries jointly released “Guidelines for Establishing the Green Financial System,” laying out action points on how China can green its financial system. This involves not just spurring more private sector investment in green industries, but also entails more effectively controlling investments in polluting projects.

“China's green finance reform plan seeks to mobilize green investment flows through changing the rules of the financial system itself, the underlying regulatory and market incentives that shape flows of finance across the whole economy,” said Shantanu Mitra, a senior climate and environment adviser for the U.K.’s Department of International Development. “Whilst ambitious, such an approach clearly has high transformational potential in terms of the sheer volume of financial flows affected.”

China estimates that it needs an additional $600 billion each year for what it defines as green finance, which among many things includes renewable energy and sustainable construction. At least 85 percent of that amount will have to come directly from the private sector due to fiscal constraints. One of the most oft-cited examples of how China plans to mobilize the capital is through issuing green bonds, which tie the proceeds of bond issues to environmentally friendly investments. The speed at which China has embraced green bonds is staggering. At the end of 2015, China had no footprint on the global market. One year later, it commanded nearly 40 percent.

“What was understood by key actors in China was that the country needed a financial system that would be part of the solution in addressing environmental and climate challenges, and one that could appreciate and so resource the next generation of global industries that would be green” said Simon Zadek, co-director of the United Nations Environment Program Inquiry into Design Options for a Sustainable Financial System and one of the leading experts on green finance. “Uniquely at the time, China’s insight translated into a systematic treatment of how its financial system needed to evolve, a lesson that is now increasingly appreciated by the very people and institutions around the world whose earlier view was that shaping an inclusive, sustainable global economy is not the business of finance.”

Traditionally, economists viewed the environment as a “luxury” that countries can only afford to consider once they have developed. Income and employment were prioritized over Mother Nature. But the international development community has increasingly come to understand that natural assets are not some theoretical construct. The environment provides jobs and enhances prosperity. Heavy pollution, natural resource depletion and the realities of climate change, meanwhile, bring with them hefty economic burdens.

As climate science, modeling and epidemiology become more precise, the measurements bear that out. For instance, due to human pressure on the Earth’s resources, natural capital has declined in 116 out of 140 countries around the world. That includes the deterioration of natural resources, such as freshwater and arable land, according to the 2014 Inclusive Wealth Report. Over 7 million deaths are now attributable to ambient and household air pollution, says the World Health Organization. And 750 of the world’s top economists agree that a catastrophe caused by climate change is the single biggest potential threat to the global economy, according to a 2016 World Economic Forum survey. Last year marked the first time in over a decade of Global Risks reports that the environment ranked first — above the spread of weapons of mass destruction and mass involuntary migration. Green finance is one way to reduce all of these threats and in the process support the Sustainable Development Goals, as well as the Paris climate accord.

It is worth noting, however, that not all countries have the same standards for what constitutes climate and environmentally friendly investments. China, for example, considers clean coal projects that reduce emissions relative to existing generation methods to be green. But clean coal is not in line with international green definitions, such as the Climate Bonds Taxonomy. That’s mainly because rather than moving away from coal dependency, clean coal technology could increase the life cycle of existing retrofitted plants or the construction of new plants. Moreover, even if the most advanced technologies are used, coal fired power plants still emit about twice the amount of carbon dioxide compared to gas-fired power and 15 times that of renewable energy over the full lifecycle.

But, while countries have differing approaches, China has to date gone further than any other nation in terms of identifying what needs to be implemented or changed to green a financial system. That includes defining policies, regulations, standards and market practices in finance. UNEP’s Zadek said that there are two reasons why China has been able to move in a way that other countries can’t.

First, the highest levels of the Chinese State Council are prioritizing green finance and China’s economy responds strongly to policy signals. Second, the fact that China’s markets are underdeveloped means that in some ways, it has less incumbent interests, which makes it easier to push forward new concepts. “It’s incredibly hard to make change in the United States’ financial system because it’s very developed with corporate and other interests not wanting change,” said Zadek. “In China and other developing countries, financial markets are far less developed and that allows for some leapfrogging.”

Given its stated commitment to the environment, China is also incorporating green finance into its foreign policy. “Green finance is one of the main topics of One Belt, One Road,” said Wang, referring to China’s goal of creating a modern version of the Silk Road, a network of trading routes linking China to Africa and Europe. “The initiative will mean more investment, and that investment should be green investment that takes into account environmental risks.”

Some developing countries are eager to gain insight from the pioneer. Wang recently attended a high-level summit on green bonds where an official from the Moroccan central bank told her that the African country is “very interested” in China’s policy framework. Indonesia is also keeping an eye on China. “We are learning from China because they are more advanced than any other country in green finance,” Edi Setijawan, sustainable finance director of Indonesia’s financial services authority, the Otoritas Jasa Keuangan, told Devex.

OJK was the first financial regulator to establish what is a roadmap for sustainable finance. But, moving forward, Setijawan said that his country is looking to China for lessons on how financial authorities such as the People’s Bank of China are involved in green finance.

“Our situation is similar to China’s; we are also doing a top-down approach to green finance. While we cannot adopt exactly what they have done, we are adapting some lessons from them, particularly their green credit guidelines and green bonds.” To ensure relevance and compatibility within and outside the national context, China based its guidelines on international good practice, but also tailored it to the national context. This is an important lesson for other developing countries.

Global lessons and implications

Learning is not a one-way street. Developing countries are also innovating at home, and influencing China. For instance, Brazil’s central bank has developed unusually comprehensive and advanced environmental regulations, independent of the country’s Environment Ministry. And Bangladesh’s central bank offers refinancing lines to commercial banks at reduced interest rates for loans given to priority areas of the economy, such as agriculture. When Bangladesh started doing that in 2009, it hadn’t been done before. Now China wants to do the same thing.

In 2012, regulators, including central banks and banking associations from China, Indonesia, Brazil, Bangladesh and a handful of other countries came together to form the Sustainable Banking Network. Facilitated by the International Financial Corporation, the private sector arm of the World Bank, the SBN was created to advance sustainable finance practices in emerging markets. It now has 32 member countries and covers over 85 percent of the total $50 trillion banking assets in emerging markets. The platform has played a key role in advancing green finance through sharing best practices and creating capacity building opportunities for financial regulators.

Marcos Brujis, global director of the IFC’s Financial Institutions Group, told Devex that some valuable lessons from China’s experience are being utilized to support other SBN member countries on their green finance journey. For one, China has highlighted the business case and opportunities in green lending by actively encouraging banks to move away from polluting businesses and toward lending to the green economy. “Green finance should be viewed as a core business, not as a corporate social responsibility or CSR,” said Brujis.

China has also increased awareness about the risks to banks’ portfolios if they don’t manage environmental and social risks. The China Banking Regulatory Commission has integrated sustainability risk considerations into the regular bank supervision process. Lastly, a crucial success factor is measuring adoption and impact. China has done this through a comprehensive measurement framework and key performance indicators that track how well banks are responding. This requires implementing effective systems and measuring the actual benefit that sustainable finance is having on the environment, for instance through improved air and water quality.

“We see significant innovations coming from developing countries, partly inspired by China, but also partly as proof of the innovative nature of developing countries in what people have historically assumed they are really weak, which is finance,” said Zadek.

Central banks have never been thought of as agents of change. And yet, China’s central bank, the PBOC, and the CBRC have shown that central banks and regulators can be engaged in these broader policy objectives, albeit within their mandate of financial market development. Unsurprisingly the PBOC and the Bank of England co-chaired the Green Finance Study Group, which was created last year under the G-20. The group’s objective is to identify institutional and market barriers to green finance. Based on country experiences and best practices, they analyze options on how to enhance the ability of the financial system to mobilize green private investment. If successful, this could facilitate the green transformation of the global economy. The GFSG outlined their findings in the G-20 Green Finance Synthesis Report released last year.

“GFSG’s synthesis report lays down the common understanding among G-20 countries on the need for scaling up green finance,” said a spokesperson for the German ministry. “The German government decided to continue the work of the GFSG during its G-20 presidency in 2017, putting particular emphasis on the application of environmental risk analysis in the financial industry and on the use of publicly available environmental data for financial risk analysis and informing decision-making.”

The German Corporation for International Cooperation or GIZ, acting on behalf of the country’s Federal Ministry for Economic Cooperation and Development or BMZ, and the U.K.’s DfID are at the forefront of a small group of development agencies that provide support for the way in which various countries in the global south develop their domestic financial market. This goes beyond greening development aid, which has been going on for a long time, to supporting the greening of financial markets in certain developing countries.

DfID, and the U.K. government more broadly, support work on green finance in developing countries through a range of initiatives, particularly through its 5.8 billion pound International Climate Fund. Some of their approaches use public resources to leverage private finance for green investment, for instance through risk sharing. Others focus on mobilizing public finance, for example through integrating climate or environmental policy considerations into public expenditure planning and execution.

Meanwhile, GIZ has a fairly sophisticated technical cooperation program that supports developing countries in their financial market development and is increasingly linking it to environmental issues. In 2016, the German federal government dedicated 4.8 billion euros in financial sector development to climate and environment projects through both GIZ and its KfW development bank. To help implement these projects, KfW has provided a wide range of instruments, such as credit lines, funds and insurance.

“The German government will continue to exchange and collaborate with China and other international partners in order to disseminate international good practices and advance the development of green financial markets globally,” said a spokesperson for the German ministry.

Challenges ahead

The transition to a green economy in any country will be difficult, but in a country as large and complex as China it is bound to be painful. Moving forward, China’s main challenge is effectively implementing its green finance plan and in particular, trying to internalize externalities. For example, factoring into the price of a solar power system, its contribution to clean air. Or factoring into the price of a chemical plant, the damage it causes to the environment. The key challenge with attracting private investments toward green sectors and away from polluting industries is distorted price signals.

China will also have to contend with a number of other issues. Leonardo Martinez-Diaz, global director of the Sustainable Finance Center at the World Resources Institute, said that the country will have to increase the number of bankable projects available, which is a constraint in almost every country, including China. And it has to deal with the questionable risk appetite of local financial institutions. “Many of the banks are still quite conservative and often not comfortable operating with new technologies or sectors that they may not have operated in before,” said Martinez-Diaz. “That may be slowing down, to some extent, their willingness to put money on the table.”

Over time, the banks will ideally get more comfortable and hopefully more willing to take risks in green sectors. They have no choice. The Chinese government is determined to drive the environment into the very fabric of the way the global financial system works. And if any country can do it, the world’s second largest economy is in the best position to.

In this six-week special series, Devex examines China's expanding role in aid and development across the globe. From tensions in Ghana to projects in Pakistan, from climate financing to donor partnerships, from individual philanthropy to state-financed investment, this series traces the past, present and future of Chinese aid and development. Join the conversation on our Facebook discussion forum.