Sustainability has become a universal buzzword in recent years. It appears just about everywhere – in corporate boardrooms, political discourse, and dinner table discussions. People are sending a clear signal: sustainability matters, and it matters now. As environmentally-focused regulation and stakeholder demands accelerate, organizations will be expected to make public climate-related targets, including setting sustainable finance commitments. Companies face a precarious predicament—adopt sustainable finance initiatives and potentially misclassify or greenwash information—or avoid changes to business paradigms and run the risk of financial, regulatory, and reputational damages. This blog attempts to make that choice easier by demystifying sustainable finance, revealing insights into its relevance, component parts, product types, market development and outlook.
Contents
- 1 Sustainable finance
- 2 Why is sustainable finance relevant?
- 3 What is sustainable finance?
- 4 What are sustainable finance product types?
- 5 How can KPMG help?
- 6 Learning Objectives
- 7 Terminology
- 8 International Initiative
- 9 Sustainable Finance and China
- 10 Promotion of Green Finance Policies in China
- 11 International Collaboration
- 12 Sustainable Finance and The European Union
- 13 Next Generation EU
Sustainable finance
Sustainable finance is the set of practices, standards, norms, regulations and products that pursue financial returns alongside environmental and/or social objectives. It is sometimes used interchangeably with Environmental, Social & Governance (ESG) investing. However, many distinguish between ESG integration for better risk-adjusted returns and a broader field of sustainable finance that also includes impact investing, social finance and ethical investing.
A key idea is that sustainable finance allows the financial system to connect with the economy and its populations by financing its agents in seeking a growth objective. The long-standing concept was promoted with the adoption of the Paris Climate Agreement, which stipulates that parties must make “finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.” In addition, sustainable finance has a key role to play in the European Green Deal and in other EU International agreements, and its popularity continues to grow in financial markets.
In 2015, the United Nations adopted the 2030 Agenda to steer the transition towards a sustainable and inclusive economy. This commitment involves 193 member states and comprises 17 goals and 169 targets. The SDGs aim to tackle current global challenges, including protecting the planet. Sustainable finance has become a key cornerstone for the achievement of these goals.
Various government programs and incentives support green and sustainable initiatives. For instance, the U.S. Environmental Protection Agency (EPA) provides grants and low-interest loans through its Clean Water State Revolving Fund for projects that improve water quality or address water infrastructure needs. The Small Business Administration (SBA) also offers loans and grants for green businesses. Research and utilize these programs to secure necessary financing.
Why is sustainable finance relevant?
Mounting regulatory and financing pressures are placing sustainability at the forefront of the investment world. Climate regulation has propelled the finance revolution. In the US, enhanced SEC climate-related disclosure requirements expected in April 2023 will push organizations to formally adopt sustainability principles. In the EU, new CSRD standards supported by the Green New Deal enforce adherence to strict climate-related rules and targets. Globally, the 2015 Paris Agreement underscored the plethora of countries ready to commit to a greener, cleaner future.
The investment required to support a decarbonized world is immense. The UN estimates that global investment needed to achieve UN Sustainable Development Goals is between $5T and $7T annually1. The capital demanded dwarfs the capital supplied toward sustainable development2. Given this looming financing gap, coupled with national decrees to achieve climate goals and minimize climate risks, sustainable financing confers an alluring and timely set of solutions.
What is sustainable finance?
Sustainable finance is an overarching term referring to the investment process accounting for and promoting environmental and social factors, as illustrated in the image above. While covering a broad swath of activities, we will focus on a subset of sustainable development: environmental or green finance. Environmental finance represents financing focused solely on environmental issues, such as decarbonization and biodiversity loss. It includes an array of financing vehicles that channel capital into green-labeled projects, climate-change mitigation or adaptation efforts. These investment activities are often grouped within socio-environmental financing, which directs financing toward social and environmental issues. The various types of environmental finance are explained below3:
I . Socioenvironmental finance: Under this type of finance, projects that harm or potentially damage the environment are prohibited from funding. This concept is broader than green finance in that it focuses on economic growth which may not contribute to environmental outcomes.
II. Environmental/Green finance: This encompasses all types of projects that are concerned with either optimizing environmental benefits or reducing and/adapting to environmental risks.
a. Climate finance: refers to financing methods that catalyze low-carbon and climate resilient development
What are sustainable finance product types?
Sustainable finance comes in many shapes and forms. Despite the myriad of financing options, the predominant financial instruments are in the form of debt and equity, detailed below:
I. Green equities: shares of equities/stocks invested in companies and/or funds promoting positive environmental outcomes
a. Green companies: investments in shares of companies advancing positive environmental goals, such as renewable energy or electric vehicle firms
b. Green funds (mutual and/or exchange traded funds): investments in funds indexed or selected for companies with positive environment footprints, such as funds with only peer leading companies in terms of carbon reduction
II. Green debt: debt instruments aimed at projects and/or companies combating climate change and environmental degradation.
a. Bonds: credit issued in public markets to finance projects aimed at positive environmental change.
i. Green and sustainable bonds: bonds invested in projects with intended environment goals, such as bonds directed for energy building retrofits
ii. Sustainability-backed bonds: bonds invested in projects where funding is based on achieving certain sustainable linked goals by a certain deadline, such as bonds directed towards renewable energy infrastructure to meet energy consumption reduction goals
b. Loans: credit issued in private markets aimed at positive environmental change.
i. Green and sustainable loans: loans invested to stimulate development of environmentally-friendly services and products, such as energy-saving home-improvement loans
ii. Sustainability-backed loans: loans invested in projects where funding is based on achieving certain sustainable linked goals by a certain deadline, such as energy-saving home improvement loans with covenants based on meeting energy reduction goals.
Sustainable finance market developments and outlook
The global sustainable finance market is growing rapidly. Global borrowing by issuing green bonds and loans, and equity funding through initial public offerings targeting green projects ballooned to $540.6 billion in 2021, a 100X increase since 20124. Overall, sustainable assets under management surged from $30.7 trillion in 2018 to $35.3 trillion in 20205. There are no signs of slowing down. sustainability assets may surpass $41 trillion by 2022 and $50 trillion by 2025, constituting one-third of projected total assets under management globally6. As markets continue to grow and evolve, financial institutions and investors alike need guidance to best position themselves for success.
How can KPMG help?
Numerous sustainable finance products and services have emerged to serve disparate segments within the financial sector, including asset and wealth management, corporate and commercial banking, investment banking, capital markets, and everyday consumers. Given this widespread market expansion and adoption, financial institutions are increasingly offering sustainable financing products to their customers. With multiple investment options available, the landscape can appear daunting. Partner with KPMG to navigate the murky waters of sustainable finance. With countless areas of expertise, including sustainability reporting, climate risk management, and emissions calculations, we can illuminate the best path forward for your sustainability journey.
Learning Objectives
Explains the potential contribution of sustainable finance to achieving the Sustainable Development Goals and the goals of the Paris Agreement on Climate Change;
Explains the core concepts of sustainable finance and the relevance of sustainability considerations for the key actors in the financial system;
Describes the role that regulation and industry initiatives (self-regulation) play in shaping sustainable finance;
Describes different sustainable finance products, such as bonds and loans, that may be available to provide the capital needed to support the delivery of the Sustainable Development Goals and the goals of the Paris Agreement on Climate Change.
Terminology
The terminology is essential to understand the different concepts around sustainable finance and the differences. The United Nations Environment Programme (UNEP) defines three concepts that are different but often used as synonyms, namely: climate, green and sustainable finance. First, climate finance is a subset of environmental finance, it mainly refers to funds which are addressing climate change adaptation and mitigation.[6] Then, green finance has a broader scope because it also covers other environmental issues such as biodiversity protection. Lastly, sustainable finance includes Environmental, Social and Corporate Governance (ESG) factors in its scope. Sustainable finance extends its domain to the three components of ESG; it is therefore the broadest term, covering all financing activities that contribute to sustainable development.
International Initiative
By signing the Paris Agreement, more than 190 countries have committed to fighting climate change and reducing environmental degradation. To reach the target of a maximum temperature increase of 2 °C, we need billions of green investments each year in key sectors of the global economy. Public finance will continue to play a key role, but a significant share of the funding will have to come from the private sector. Because financial markets are global, they offer a great opportunity, but this potential is largely untapped. Indeed, to mobilize international investors, it is necessary to promote integrated markets for environmentally sustainable finance at the global level.
The UNFCCC and Paris Agreement’s collective goal of mobilizing USD 100 billion per year by 2020 in the context of meaningful mitigation action and transparency on implementation fell short in 2018.[8] Therefore, this requires a high degree of coherence between the different capital market frameworks and tools that are essential for investors to identify and seize green investment opportunities. This means working together to ensure the potential of financial markets, and it is in this context that the International Platform on Sustainable Finance has been created.
Sustainable Finance and China
Development of Sustainable Finance in China
China, as one of the world’s largest economies and a global leader in environmental challenges, has taken significant strides in the development of sustainable finance. The country’s journey toward integrating environmental, social, and governance (ESG) criteria into its financial system is characterized by a commitment to addressing climate change, promoting green investment, and adopting international best practices.
Promotion of Green Finance Policies in China
China’s commitment to sustainable finance is reinforced by its strategic policy decisions. In 2016, the People’s Bank of China launched a green finance pilot program in five provinces, followed by the Green Credit Issuance Guidelines, encouraging financial institutions to support green projects and integrate ESG criteria into their lending practices.
In June 2022, China’s National Development and Reform Commission released its 14th 5 year plan on renewable energy development (2021-2025), to accelerate renewable energy expansion. The plan looks to increase renewable energy generation by 50% and looks for a target of 3.3 trillion kWh as compared to 2020’s 2.2 trillion kWh and hopes to reduce emissions by 2.6 gigatons annually.China’s National Energy Administration has also furthered this goal by introducing policies supporting renewable energy development, facilitating investments in wind, solar, and hydroelectric power.
International Collaboration
China recognizes the importance of international collaboration in sustainable finance. In 2015, China established the Green Finance Committee (GFC) to promote the development of green finance and align with international green finance principles. This platform was created in response to China hosting the G20 and has only grown since its founding. The GFC has actively engaged with global organizations such as the Green Finance Initiative (GFI) in the United Kingdom, contributing to a greater understanding of green finance’s international dynamics.
Sustainable Finance and The European Union
European Green Deal
The European Green Deal is a proposal by the European Commission, approved in 2020, to put in place a series of policies to make Europe climate neutral by 2050 and to cut at least half of its CO2 emissions by 2030.[26] Within it, the Commission has promised to raise no less than €1 trillion in order to achieve the objectives of the European Green Deal by making sustainable investments. Part of this money has been raised to finance the Next Generation EU. Sustainable finance is therefore one of the pillars on which the EU Green Deal focuses and in addition to its own investments, the Commission would also like to promote private investments by introducing taxonomy regulation.
Next Generation EU
More recently, the European Commission, on behalf of its 27 member states, is also making greater use of green finance, especially green bond (see green bonds section) to finance part of Next Generation EU. The aim of this initiative is to relaunch the economy following COVID-19 pandemic and aims to improve the European Union on several levels including; making it greener, accelerating its digitalisation, improving the health system and preparing it for future challenges or supporting young people and making Europe more inclusive.
The main project under this initiative is the Recovery and Resilience Facility (RRF) which provides grants and loan funding to EU member states to support reform and investment. In order to access these funds, each EU Member State must propose a plan which must be approved by the European Commission and then by the Council. One of the most important criteria of this plan is that at least 37% is dedicated to the green aspect and 20% to digitalisation. Disbursement is gradual, with 13% received after the contract is signed, and the remainder on the basis of a bi-annual evaluation based on a report submitted and a payment request.
Green Central Banking legitimacy
Another concern worth debating in sustainable finance is the legitimacy of Green Central Banking.
First, in response to the recent global financial crisis, which started with the outbreak of the pandemic, there has been a strong reliance on central banks to intervene not only for their traditional prudential motives of ensuring price and financial stability but also for more promotional purposes as a means of supporting other policy objectives such as promoting a low-carbon economy (Baer et al. 2021).However, according to many researchers, the pursuit of such promotional goals in monetary policy decisions raises serious questions about the legitimacy of independent central banks (Fontan et al. 2016).By way of illustration, Greenpeace protestors claimed in March 2021 that the European Central Bank’s (ECB) monetary policies subsidise fossil fuel companies (Trick, 2021).
Furthermore, the Central Bank Independence (CBI) framework says that central banks should be permitted to operate independently within a limited mandate (Deitch et al., 2018),although other writers feel that changing the central bank’s mandate is insufficient (Fontan et al. 2022).
Central banks are rarely tasked with advancing environmental or climate change mitigation objectives. When it comes to these environmental policies, central banks must deal with arbitrary issues, and there is no agreement on who should bear the burden. Neither conservative nor progressive central bankers defend this dilemma (Fontan et al. 2022).As a result, according to the previous authors, their pursuit of green monetary policies puts central banks in a tough spot, casting doubt on their legitimacy.