For green finance, climate policy is the new monetary policy

Since the landmark Paris Agreement was struck in 2015, a growing movement of investors has begun to question the profit-above-all orthodoxy of traditional investing.

Many of them now eschew that approach, instead opting for sustainable, responsible, and impact (SRI) investing, which prioritizes social welfare while yielding financial returns.

Investors worldwide are starting to care about climate change, and the global boom in issuances of green bonds — used to fund climate-friendly projects — is evidence of this.

While the proceeds of some green bonds do finance green innovation and production, others are increasingly used for general-purpose, or even carbon-intensive, activities inconsistent with the bonds’ initial claims. Many firms even exaggerate or falsify their environmental commitments in order to access SRI capital — a phenomenon known as “greenwashing.”

Greenwashing has made it hard to identify truly green assets, discouraging SRI investment and preventing green capital from flowing into the most effective carbon-reduction activities. Effective climate policy can tackle this issue and ultimately improve the efficiency of green capital allocation.

By compelling firms to internalize the social cost of their carbon emissions, climate policy can motivate them to turn the proceeds of green bonds into actual green practices, such as clean technology and renewable energy, to save on emissions costs.

But profit-seeking firms will only engage in truly climate-friendly activities — rather than greenwashing — if there is a financial incentive to do so. Investing in green technology and clean production both on save emission costs when climate policy is in position. Indeed, companies in countries that have already adopted progressive climate policies raise more funds from the green debt market than those that have not.

Climate policy that reflects and acts upon the public’s commitment to combat climate change can promote SRI investments in four ways.

First, effective climate policy imposes and regulates information disclosure on carbon emissions, enabling SRI investors to better identify green assets and track their impact on climate change mitigation.

Second, it mandates that national agencies and capital such as pension funds and sovereign wealth funds support the pursuit of climate goals, directly boosting SRI investments.

Third, it provides policy support and financial rewards for green technology and production, which attracts SRI investors seeking to optimize their social impact.

Finally, good climate policy grows the demand, and therefore the price, of green assets, which improves the profitability of SRI investments and enhances their sustainability in turn.

Rising concern about climate change has accelerated the adoption of climate policy globally. By April 2021, 45 nations had already implemented or were scheduled to implement a nationwide carbon tax or Emission Trading System (ETS). But it is clear that these efforts do not go far enough to reach net-zero emissions by 2050, a key tenet of the Paris Agreement.

Many governments are still hesitant to adopt climate policy. A key concern is the perception that climate policy could slow economic growth by increasing the cost of production, thereby discouraging corporate investment.

Firms are, after all, profit seeking in nature. So, to reduce their resistance to climate policies, it must be demonstrated that they actually benefit from their introduction.

A recent study by the Institute of Global Economics and Finance (IGEF) found that climate policy reduces corporate financing risk, which in turn strengthens corporate balance sheets. While small and medium enterprises largely borrow from domestic markets, large firms borrow substantially from foreign markets. Historically, large firms outside the US have had to borrow foreign capital in international investors’ currency to secure funds, rather than their own.

But borrowing in a foreign currency while generating most of their income in the local currency exposes firms to currency mismatch risk. If the foreign currency they borrowed in appreciates substantially relative to their local currency, they can face a in spike debt burden, threatening a default or bankruptcy — even if the firms are fundamentally solid.

This currency mismatch risk is not an abstract concern — there are a host of very real examples of this happening, including the 1994 Latin American Crisis and the 1997 Asian Financial Crisis. More than two decades on from these crises, companies are still grappling with the risk of borrowing in foreign currencies, but climate policy could mitigate that risk.

IGEF's report found that climate policy actually mitigates the currency mismatch risk by attracting SRI investors, who are largely willing to tolerate the higher risk associated with green assets, and who do so in their local currency.

When firms issue corporate green bonds in their local currency, they essentially offload the currency mismatch risk to SRI investors’ — a relief for firms that rely heavily on international financing, exposing them to exchange rate volatility.

So, climate policy is to green bonds as credible monetary policy is to regular bonds. Credible monetary policy reduces the chances of money being printed to inflate debt denominated in local currency, which improves firms’ capacity to issue local currency bonds and mitigate currency mismatch risk.

Climate policy achieves that same goal by reducing the probability of greenwashing, thereby directing SRI investment toward green bonds that enable firms to borrow in their local currency. Climate policy is, thus, the new monetary policy for green financing.