How green financial sector reform can help drive decarbonization

Green Financial Sector Interventions (GFSIs) are financial policies, regulations, and instruments that governments can use to direct private finance away from high-carbon investments and toward more climate-smart — or green — investment. This shift provides needed funding for climate action and protects financial institutions and systems against climate risk.

GFSIs are part of a trend toward green financial sector reform that countries are increasingly utilizing in their climate change strategies. GFSIs address several barriers to scaling green finance flows, including failure of investors to internalize greenhouse gas (GHG) emissions, financial markets not properly accounting for climate risks, low institutional capacity, and the lack of an enabling environment.

By addressing these barriers, GFSIs can adjust the availability and price of capital for both low- and high-carbon activities. This fosters demand for green investments with implications on sectors’ performance, output, and GHG emissions. Many commercial investors have stated their intention to shift to greener portfolios, and countries that proactively pursue green financial sector reform will be well-positioned to attract this financing.

To maximize the impacts of GFSIs, however, we must better understand how and to what extent GFSIs increase green investments and reduce emissions while avoiding unintended effects on macroeconomic and financial stability.  This understanding is still incomplete, particularly for emerging markets and developing economies, which impedes GFSI implementation and – as explained in more detail below – the deployment of climate finance to support them.

A new paper, funded by the World Bank’s Carbon Partnership Facility, The Role of Green Financial Sector Initiatives in the Low-Carbon Transition, presents a theory of change that maps the impact channels of GFSIs on investments and, ultimately, the volume of emission reductions that result.

The paper covers a range of high-potential GFSIs:

• Green macroprudential policies: Green supporting factors and dirty/high-carbon penalizing factors¹
• Green monetary policies: Green collateral factors and green quantitative easing
• Green public co-funding and incentives: Soft loans and green portfolio rewards.²

The paper qualitatively investigates the transmission channels of these GFSIs and how they influence the availability and cost of capital for high- and low-carbon assets.

Next to their direct impacts, GFSIs could also stimulate economic activity, with implications for investments, output, and GHG emissions that would need to be considered for climate and development policy. If green conditionality and climate risk assessment are not included with GFSI, they could also benefit high-carbon activities and lead to unintended higher GHG emission intensity in the economy. Building on these insights, the paper develops a theory of change about the role of GFSIs in climate mitigation and the low-carbon transition, identifying levers to maximize impact.

We highlight here the transmission channels for two of the GFSIs covered: a soft loan program that directly targets a specific sector with a fixed amount of advantageous financing (Figure 1) and a green supporting factor that influences the relative cost of capital for high- or low-carbon investments (Figure 2).

Figure 1: Transmission Channels of Soft Loans and Credit Guarantees³

Figure 2: Transmission Channels of a Green Supporting Factor

Understanding the transmission channels and resulting emission reductions has two primary benefits. First, it allows policy makers to understand how much the GFSIs will in fact reduce emissions. This can help them decide between different GFSIs and assess the emission reduction volumes to expect as part of national climate mitigation plans and targets such as those in countries’ Nationally Determined Contributions (NDCs) under the Paris Agreement.

The second benefit to estimating GHG emission reductions from GFSIs is the ability to attract appropriate international public climate finance. The majority of such climate finance is activity based. That is, it is provided upfront, usually with some degree of concessionality, to buy down the capital cost of large infrastructure projects. However, such climate finance is not always well-suited for GFSIs, which tend not to have the upfront capital costs of infrastructure but instead incur costs throughout implementation. This makes results-based climate finance a more appropriate support for GFSIs. Since GFSIs are paid based on the emission reductions achieved, it is essential that rigorous means of assessing emissions reductions are in place.

An ongoing World Bank project with the Climate Change Group; Finance, Competitiveness, & Innovation Global Practice; and Macroeconomics, Trade, & Investment Global Practice is using the theory of change to develop a quantitative model to project emission reductions from various GFSIs. This model is now being piloted and tested for Türkiye and other selected countries.

When fully developed, the model will be available to emerging market and developing economies (EMDEs) to understand how GFSIs can influence finance flows and reduce emissions.  The model can also be used to pursue relevant results-based climate finance to support the GFSIs, such as through the World Bank’s Transformative Climate Asset Facility and the new Scaling Climate Action by Lowering Emissions (SCALE), which has a pillar devoted to supporting countries with green financial sector reform.