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Over the past few decades, China has become the world’s largest emitter of greenhouse gasses. The process of rapidly becoming a global economic engine has led to extreme conditions in air pollution. It is estimated that 1.6 million people die from air pollution in China annually, representing nearly one in every four deaths in the country. Cities are becoming so engulfed in smog that there are days where you see nothing but white clouds in the sky. Middle-class uproars have given leadership a reason to push forward efforts to drastically reduce air pollution.
Why is the Chinese government willing to go to extreme lengths to combat pollution? How does their situation differ from ours domestically?
In China, pollution has become visible. Visibility of a problem makes it tangible, and tangibility makes it real. If extreme air quality conditions are occurring in China where it can be visually experienced, does that mean that climate change issues don’t exist at home because it is more abstract?
From late November to early December of 2019, I had the honor to be selected as a Canadian delegate representing United Nations Association in Canada at the UNFCCC’s annual climate change conference, COP25, in Madrid, Spain. During my time at the conference, I had the pleasure of learning everything I could about climate science, international policy, and initiatives other countries are taking within agriculture, infrastructure, energy, health, and transportation, among other topics.
In order to deliver the Paris Agreement commitment to limit global warming to 1.5°C compared to pre-industrial levels, carbon emissions would have to decline by 45% by 2030 and reach net zero by 2050. It is estimated that this will take US$6.9 trillion annually to finance. The amount of investment needed in infrastructure will require not only public financing and NGOs, but an activation of the private sector as well.
With the information I have, I believe there are two key ways to do so. First, making businesses pay for the true costs of production by adding externalities into the price of goods. Second, making it easier for those businesses to invest in green production methods by mobilizing climate finance.
Adding Externalities into The Cost of Goods
H&M is a global brand and a leader in the fast fashion movement. You may have purchased a shirt from H&M for $10 or a blazer for $20. In the moment of purchase, have you ever thought of all the additional costs you aren’t paying for but someone else is? The workers in a developing nation killed in factory fires, the massive environmental pollution from textile production, and the piles of waste from the low-utilized fast fashion pieces. What if the true costs of those goods were reflected in the price?
There is a price tag attached to the low price.
Theoretically, if companies that produced cheap products were forced to add the costs of these externalities into the price of the product, consumers would have to pay more for the goods in order for the businesses to maintain profitability. In this scenario, there is the potential for innovators and entrepreneurs to develop green manufacturing facilities that have less external costs associated with production. If these costs were less than traditional methods, there is a logical case for businesses to switch to sustainable production to then have a competitive edge and offer a lower price to consumers. Not only will it make sense socially, but financially as well.
Generally, consumers don’t make purchase decisions because of sustainability, they make them based on value (usually as a factor of quality and price). If the value of sustainable products overtime outweighs the value of unsustainable production, it is much easier to influence business decisions which ultimately impact consumer decisions. This change is possible when the sustainable business opportunities becomes more profitable. That starts with including the costs of externalities in the production of goods.
Mobilizing Climate Finance and The Greening of Portfolios
In September of 2019, the furniture giant Ikea (specifically Ingka Group) announced that it will produce as much renewable energy as the energy it consumes. Ikea has spent $2.5 billion euros over the past decade investing in renewable energy infrastructure. Though this may seem like an added cost and a marketing play, CEO Jesper Brodin believes otherwise:
“Being climate smart is not an added cost. It’s actually smart business and what the business model of the future will look like ... Everything around fossil fuels and daft use of resources will be expensive.”
Ikea has a highly profitable business to finance the green infrastructure and support the long-term business case. But for many companies, it’s much more difficult to justify the investment when short-term profitability is prioritized over long-term sustainability and when financial institutions view the green economy as ‘still in pilot’ and therefore a risky investment.
Though green economy initiatives may seem riskier, climate change exposes financial institutions to a lot of risk. This is a result of having a large portion of capital tied up in brown economy (fossil fuel based) investments. There are physical risks from infrastructure damage, transition risks with the reassessment of asset prices as changing costs become apparent, and asset risks where embedded valuation of fossil fuel reserves under new emissions targets may never be allowed to be used.
The question then becomes, how do we de-risk green economy projects for a more sustainable financial future?
I believe this lies in three areas:
- Improving the risk assessment of investments
- Making green projects more ‘bankable’
- Incentivizing financial institutions to invest in green projects.
1. Improving the Risk Assessment of Investments
Climate-related risk disclosures can be challenging. At COP25, I learned how complex the interaction of climate science, public policy, economics, and financial markets really is. The interconnected global supply chains and intersecting regulatory and operating environments makes matters even more difficult. In addition, standards for what constitutes “green finance” are high-level, fragmented, and voluntary. When coupled with economic incentives, loosely constructed standards and definitions that are unenforceable can lead to greenwashing.
Regardless of these challenges, better disclosure of climate-related risks is necessary to steer investment towards initiatives that reduce the world’s dependency on fossil fuels. Not only is this important to improve the environment, but also to reduce the real risks that financial institutions own but have yet to disclose. In addition, standardized measures of carbon intensity for specific assets is key to properly assess the long-term risks of brown investments. This will comparatively reduce the perceived riskiness of green investments.
2. Making Green Projects More ‘Bankable’
High level, financial institutions will go towards reliable assets and a low risk of return on their capital. Essentially, too few projects are meeting the “risk-return” profile that traditional investors are interested in. There is not a lack of financing, only a lack of ‘bankable’ projects.
Preparation is an essential step in achieving project bankability and meeting market risk-adjusted return requirements. As a result, there must be a bridging of the gap between information and capacity to mobilize technical expertise. Without this information, it is difficult for financial institutions to price climate-related risks and opportunities effectively.
3. Incentivizing Financial Institutions to Invest in Green Projects
In addition to increased information, incentives are an important driver. Traditional financial institutions are primarily regulated through risk-weighted assets, which are based on historical information and expert analysis. They rarely take into account longer-horizon, hard to measure risks such as climate change. As a result, the public sector should leverage its toolkit of incentives (i.e. interest subsidies, different rates of discounting, guarantees, capital grants, etc.) to nudge financial institutions to allocate capital into green investments. As a result, this will align short-term incentives with the long-term horizon.
The Path Forward
Climate change is a global problem. Not only because every country is contributing to it and experiencing its effects (inequitably), but because of how carbon dioxide mixes into the air and is distributed across the globe over a few years. Production in China is affecting the air at home and vice versa.
Achieving the 1.5°C goal of the Paris Agreement will require significant public policy interventions, changes in individual lifestyles, and companies adapting their business models and investment choices. This presents an unprecedented collective action problem with many risks and opportunities that will shape the new economy. Between public institutions, development banks, traditional financial institutions, and private companies, climate financing capacity and mechanisms will be critical in the private sector's shift to green investments.
We live in a world where you cannot rely on morality for people to make the right decision. You must make it easy for them to make the right choice through value creation. The faster we as a society can internalize this, the faster we can implement structural changes to mobilize the private sector in the right direction along a greener path forward.
We have tackled major climate risks as a society before. Look no further than the ozone crisis for evidence. If we have done it in the past, we can mobilize as a collective to do it again.