www.ifc.org/ThoughtLeadership Note 27 | December 2016 HOW BANKS CAN SEIZE OPPORTUNITIES IN CLIMATE AND GREEN INVESTMENT Climate change presents risks and opportunities for the financial sector in both emerging and advanced economies. Financial institutions cannot afford to be outside of the transition path to low-carbon economies. Energy subsidies, emission standards, and carbon prices will all have a direct impact on the financial positions of these institutions’ clients, making climate risk an important element of any credit decision. Financial institutions will also need to understand the climate risks associated with their non-green assets and design measures to mitigate them. Yet there are also significant opportunities for financial institutions to provide innovative financing products for energy efficiency upgrades, renewable power generation, green buildings, green transport, and climate-smart agriculture and architecture. And there is a growing community of investors seeking new climate and environment friendly opportunities, which financial institutions can use to diversify their funding base and reduce their funding costs. The Paris Agreement on climate change that took effect in events such as floods and storms that damage property or November 2016 was “an unmistakable signal to business and disrupt trade. Consequences are greatest for the insurance investors that the global transition to a low-carbon economy is sector, but also extend more broadly. urgent, inevitable, and accelerating faster than we ever believed possible,” according to the World Business Council for Liability risks occur when and if parties who have suffered loss Sustainable Development.1 or damage from the effects of climate change seek compensation from those they hold responsible. Such claims Implementation of the landmark agreement is expected to foster could come decades in the future, creating liabilities for carbon policies and technological innovation that will accelerate extractors and emitters and their insurers. investment toward low carbon and climate resilient projects and assets. In addition, as part of the agreement, signatories to the Transition risks are the financial risks that could result from agreement have produced nationally determined commitments the process of adjustment toward a lower-carbon economy. to reduce greenhouse gas emissions that will inevitably Changes in policy, technology, and physical risks could prompt incentivize or discourage certain economic activities. a reassessment of the value of a large range of assets as costs While national commitments submitted so far fall short of the and opportunities become apparent. And a particularly rapid re- agreement’s goal of holding the global temperature increase to pricing could threaten financial stability. less than two degrees Celsius above pre-industrial levels, the agreement incorporated a ratchet mechanism designed to raise When financial institutions are unprepared to assess or respond national commitments every five years. to the climate risks described above, they may face additional legal risks from inaction. For example, a 2016 EU directive These national commitments differ in their level of detail but adopted requires pension funds to assess environmental, social typically require substantial financing and, therefore, imply an and governance risks, including climate risks. expanded role for local banks in emerging market countries. Banks, in addition to governments, are the traditional financiers Transition risks in the financial sector are closely linked to of infrastructure and so are exposed to risks emanating from adjustments in real sectors and can be triggered by: projects that fail to meet sustainability standards.  Mandatory or voluntary changes in emission control Climate Risks in the Financial Sector policies that companies need to comply with, possibly entailing additional costs; The G20’s Financial Stability Board has identified three climate  Declining profitability and cash flows of projects risk categories for the financial sector:2 underwritten by financial institutions resulting from higher Physical risks include the impact on insurance liabilities and financial assets that result from climate and weather-related capital and operating expenditures required to mitigate and  Operating expenses that increase due to changes in the adapt to climate change; price, availability, or quality of inputs;  Low-carbon technologies and innovations that render  Increases in insurance premiums in regions that are prone previous technologies or products financed by financial to climate change; institutions obsolete; and,  Capital expenditure increases that result from asset  A shift by consumers away from high-carbon emitting damage, decreased asset performance, or compliance costs products. associated with emission control regulations;  Accelerated asset depreciation due to climate change Green Finance and Climate Finance conditions, and their impact on projected cash flows;  Loss contingency projections—or reserves required to deal The goals of climate finance are to reduce emissions, with potential disasters or other known risks—which may enhance greenhouse gas sinks, and maintain and increase increase as the risks of climate change become more likely the resilience of human and ecological systems to climate and better quantified; change.1  Intensification of country risk due to climate change. Green finance, by contrast, can be understood as the financing of investments that provide benefits in the Climate Opportunities in the Financial Sector broader context of environmentally sustainable In addition to the many risks enumerated above, the transition development. These benefits include reductions in air, to low-carbon economies also presents an enormous water, and land pollution, reductions in greenhouse gas opportunity for the financial sector. There is increasing demand emissions, improved energy efficiency from existing for capital to finance long-term projects in emerging markets natural resources, and mitigation of and adaptation to where economic growth and lower carbon intensity policies are climate change. intertwined with the urgent need to strengthen climate While green finance refers to a broader set of activities resilience. than climate finance, there is considerable overlap in Governments from 114 countries submitted their national plans terms of environmental externalities, risks to the financial to aggressively reduce carbon emissions under the Paris system and the private sector, and the challenges and Agreement. These plans include renewable energy, low-carbon opportunities in financing both. For that reason, this cities, energy efficiency, sustainable forest management, and document does not distinguish between green finance and climate-smart agriculture. The financing needed to fulfill these climate finance and most of the issues and proposals commitments is enormous and private sector participation is presented here are relevant for both. crucial to ensure that these national commitments materialize. Adjustment to climate change and shifting climate zones IFC’s 2010 study on climate risks for financial institutions creates demand for new and different products and services. highlighted that, for equity investments, climate-driven That will require investment in measures to enhance the deviations from expected results that affect an investment’s resilience of infrastructure, water-intensive industries, and valuation are relevant for projecting returns on equity and agriculture. Climate resilient technologies and practices in planning exit strategies.3 agriculture and food security include drought tolerant seeds, Climate risks are also material to a company’s earnings and improved irrigation systems, and more sustainable land expenses, and so can lead to a deterioration of its financial management practices. Water management to address higher position and its ability to service its debt. rainfall variability ranges from the harvesting of rainwater by households to ecosystem-based adaptation of entire watersheds. Broadly speaking, the financial performance of banks and non- Disaster risk reduction entails the deployment of tools such as bank financial institutions alike can be weakened by: risk and vulnerability assessments, and climate information and early warning systems.4  Supply and demand changes due to climate factors (for example, weather conditions that affect productivity and Currently the vast majority of climate change adaptation is logistics regionally or globally); financed by the public sector. Of a total of $361 billion in  Efficiency, output, and performance of assets and climate financing in 2014, just $25 billion was for climate equipment affected by changing climate conditions, with change adaptation. Of that, a mere $141 million, or less than 0.6 impact on revenues (for instance, hydro power plants are percent, was by the private sector.5 This imbalance between affected by hydrology changes); private and public financing represents a significant opportunity for private enterprises, including financial institutions. 6 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. In 2016, IFC conducted a survey of its emerging market Green Finance in China financial institution clients to understand their strategies and approaches to climate risks and opportunities. Over 60 percent China will require some $600 billion per year to deliver on of the 135 respondents are already active in financing climate- its climate commitments. Available public funds fall far related and green projects. In addition, another 9 percent of short of that amount, so much of the financing will fall to banks expressed interest in pursuing investment opportunities private sources. Policymakers believe that China’s financial in this space. Renewables and energy efficiency topped the list system is key producing this funding and promoting the with 61 percent and 54 percent respectively. shift to a green economy. China approved a set of Green Credit guidelines in 2012, An analysis of the national climate change commitments and and it is the first country to have officially released its Green underlying policies in 21 emerging markets (representing Bond Directives and Green Bond Catalogue, which almost 62 percent of the world’s population and 48 percent of incentivize financial institutions to establish and implement global greenhouse gas emissions) has led IFC to project that environmental and social risk management systems and there will be nearly $23 trillion of climate investment actively engage in green finance. Lending emission opportunities in these markets from 2016 to 2030.7 projects, while the government increased its support for Forward-looking financial institutions in emerging markets energy conservation and emissions reduction. should be able to position themselves to tap into this vast As of June 2016, green credit from China’s 21 largest financing opportunity. In addition to the push from banks (accounting for about 80 percent of China’s banking governments, many private sector initiatives have also been assets) now constitutes roughly 10 percent of their total thriving. According to CDP (formerly the Climate Disclosure loan balance. China also has the fastest-growing green Project), which works with shareholders and corporations to bond market. disclose greenhouse gas emissions:  More than 5600 companies around the world have facilities, a process that requires significant capital expenditure. responded to their carbon disclosure questionnaires;  Some 827 investors with a combined $100 trillion in Green building construction is another area with significant assets have requested climate information from potential for financial institutions.9 Population growth coupled potential investee companies; with urbanization and rising incomes has resulted in a significant increase of new buildings, both residential and  Nearly 90 supply chain corporations representing a commercial, in developing countries, with a concomitant combined purchasing power of over $2 trillion have increase in greenhouse gas emissions. started tracking the carbon footprint of their supply chains, spanning multiple regions. As countries enact building codes with energy efficiency requirements and developers employ green building All of these push and pull actions from the public and certification schemes such as Leadership in Energy & private sectors have begun to effect behavioral changes in Environmental Design (LEED), the demand for green the real sector, resulting in an increase in demand for low- construction finance is expanding. IEA estimates the building carbon investment that financial institutions can support. sector needs an additional investment of up to $296 billion per There are multiple opportunities banks can explore, including: year in addition to the $358 billion flowing to it annually. Energy Efficiency, which has a positive impact on profitability In the white goods sector, energy efficient appliances represent and competitiveness while at the same time reducing or yet another set of opportunities for financial institutions with deferring the pressure of putting additional power generation consumer financing products. Lighting via compact fluorescent capacity on the grid. lamps and light-emitting diodes, space cooling appliances such as air conditioners, and energy efficient household appliances Studies from the International Energy Agency and the World such as washers and dryers are the types of retail assets that Bank Group estimate that about 40 percent of identified energy financial institutions can target with consumer finance efficiency gains have already been achieved. Global investment programs and/or distributor network finance. in energy efficiency in 2015 is estimated at $221 billion and significant economic potential remains for future energy efficiency savings in manufacturing industries. 8 As additional For example, the lighting market is projected to reach a value efficiency standards are introduced, industries in emerging of 110 billion euros by 2020. The United Nations estimates that markets will continue to modernize and upgrade processes and replacing all inefficient lighting worldwide could save 1,044 terawatt hours of electricity annually, equivalent to 530 million This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. metric tons of carbon dioxide emission reduction and $120 Commercial Viability of Rooftop Photo Voltaic Systems billion in electricity bills. There are currently over 250 standards and labeling policies in place in nearly 40 countries Distributed solar has achieved grid parity—its cost is less than or for lighting products, which makes it easy for financial equal to price of electricity from the grid—in many markets with institutions to recognize and target these types of assets. high electricity costs. And in many emerging markets the primary Similarly, energy efficient air-conditioners and heaters in driver of these technologies is the lack of access to grid electricity, developing markets also present immediate demand for or its unreliability. financing that financial institutions can support In contrast to utility-scale solar photovoltaic plants, rooftop solar systems generally displace consumption from the grid or diesel Renewable Energy generated electricity, so they compete either with the price of retail/commercial electricity or the price of diesel fuel. Renewable energy—and solar photovoltaic generation in particular—is poised to disrupt conventional electricity Energy storage improvements will increase the competitiveness of systems worldwide. There are many opportunities for solar photovoltaic systems where there is no grid access or the grid financial institutions to develop innovative financing is not reliable. Photovoltaic solar electricity tends to work well in schemes to either support direct investments by households high temperatures and so correlates with demand for air or businesses, or to provide loans to energy service providers. conditioning. New solar technologies integrate easily with both 2015 was the first year that the amount of added renewable diesel generators and batteries. energy capacity (excluding large hydro) accounted for more Such solar-battery-diesel combinations have been facilitated by the than half of all new energy generation capacity. plummeting cost of batteries and the information technology capability needed to manage them. Going forward, new technologies While renewable energy generation represents a paradigm are expected to drive battery costs down faster. A 2016 study by UBS shift in the power sector globally, distributed solar concluded that investments in solar, electric vehicles, and stationary photovoltaic generation below 1 megawatt is at the forefront battery combinations should pay off in 7 to 11 years, depending on of the transformation in both developed and emerging country-specific economics. markets.10 The market for it in 2015 was $67.4 billion, a quarter of all new renewable generation investment that year. the potential to make solar financing easier while also allowing financial institutions to benefit from mortgage securitization. Rooftop solar systems offer millions of households and companies the potential to produce electricity and, in some The technical risks associated with small-scale distributed solar cases, to inject it into the grid and receive an economic return. systems (up to 1MW) may call into question the viability of Research predicts that distributed solar photovoltaic technology such electricity solutions. While this is a valid concern, these will change the utility landscape in developing countries, risks can be mitigated through innovative energy performance economically outperforming grid-based coal and diesel insurance products provided by insurance companies. Both IFC generation, and will relieve widespread power shortages in and the Inter-American Development Bank are actively regions such as Sub-Saharan Africa and South Asia. working with insurance partners on de-risking tools for developing markets. Partnerships between insurers and With the rapid innovations and steep declining costs of solar financial institutions can make such solutions possible for small panels and battery components, rooftop and captive solar solar systems deployment. photovoltaic systems are becoming commercially viable in many markets. Solar power generation is also an attractive off- Green Bonds—Raising Funding for Climate Finance grid solution for remote communities and households that depend on diesel and kerosene. As financial institutions attempt to seize opportunities in green finance and move to originate more climate-smart assets, access Financing for solar photovoltaic system in the form of loans or to long-term capital will become a larger cause of concern. leases is already well established in the United States and Green bonds are a natural solution. Europe. Financial institutions in developing countries can use the support of development financial institutions such as IFC The European Investment Bank was the first issuer of a climate and team up with solar technology providers and/or energy awareness bond in 2007, followed by the World Bank’s first service companies to quickly penetrate this segment. labelled green bond in 2008. Since then a market for these bonds has emerged. This market was initially dominated by Another interesting financing opportunity exists in combining multilateral development banks, but has grown significantly home mortgage loans with solar home systems loans, which has since then and now includes a much broader universe of issuers. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. The number of green bond issuances in 2014 was triple that of Green bonds help diversify the investor base of bond issuers, 2013. During the first nine months of 2016, green bond attracting new intuitional investors with green or climate issuances reached $60 billion, 150 percent of the total issuance mandates. The bonds can also deliver reputational benefits, of 2015. Green bond issuances of financial institutions enhancing an issuer’s corporate sustainability strategy and its environmentally friendly brand. What Is a Green Bond? Green Bonds are any type of bond instrument where the Emerging Standards Shaping Financial Sector Actions proceeds are applied to finance or re-finance new or existing While innovations continue in the green finance and climate green projects. Such projects generally include renewable finance space, there is general consensus among development energy, energy efficiency, clean transportation, sustainable finance institutions and leading players in the green bond water management, climate change adaptation, sustainable market about the need for harmonized approaches and agriculture and forestry, and pollution prevention and methodologies in certain areas such as: control. - Climate risk (physical, liability, transition) disclosure In 2015, IFC issued a 5-year green Masala bond on the - Measurement of green finance and impact London Stock Exchange, the first green bond issued in the offshore rupee market. The bond raised INR 3.15 billion - Best practices and standards for green finance and bonds. and attracted a broad range of international investors to private sector investments addressing climate change in Inconsistencies in disclosure practices result in reporting that is India. IFC invested the proceeds of the bond in a green bond not comparable, presenting a major challenge to incorporating issued by YES Bank, one of India’s largest private climate-related risks in investment, credit, and underwriting commercial banks. YES Bank will invest the bonds’ decisions. They also make it difficult to assess system-wide proceeds in renewable energy and energy efficiency potential vulnerabilities. In an effort to promote transparency projects, mainly in the solar and wind sectors. and increase awareness of climate risks, the Financial Stability Board has begun an effort to harmonize climate-related In 2016, IFC invested INR 2 billion (about $75.8 million) financial risk disclosures for companies to share with lenders, via subscription to listed, secured INR denominated bonds insurers, investors and other stakeholders. complying with ICMA Green Bond Principles, issued by Punjab National Bank Housing Finance in India. This was In December 2015, the FSB set up a Task Force for Climate- the first green bond issued by an emerging country bank for related Financial Disclosures. In December 201612, the Task the purposes of financing green residential buildings and Force published four recommendations on climate-related facilitating the development of affordable housing. It is also financial disclosures related to: expected to create jobs. Bond proceeds will be exclusively  The organization’s governance around climate-related used for on-lending to developers of green buildings. risks and opportunities  The actual and potential impacts of climate-related risks For more on green bonds see EMCompass note 25, and opportunities on the organization’s businesses, “Mobilizing Private Climate Finance – Green Bonds and strategy, and financial planning. Beyond.”  How the organization identifies, assesses, and manages climate-related risks registered the highest growth, a sevenfold increase from 2014  The metrics and targets used to assess and manage relevant to 2015. climate-related risks and opportunities Despite their impressive growth in recent years, green bonds There is also a critical need for multilateral development banks remain a small and nascent segment of the overall bond market, and donors to harmonize definitions of climate-related assets, which currently stands at almost $100 trillion.11 The momentum as well as what qualifies for development support on both the of demand for green bonds is expected to help drive more climate mitigation and climate adaptation fronts. capital to low-carbon and climate-resilient infrastructure Financial institutions active in the climate finance space also projects, including renewable energy projects. look for reliable tools to track climate finance and the impact of For investors, green bonds can achieve attractive risk-adjusted their green portfolios on greenhouse gas reduction and returns along with environmental benefits, in addition to resilience, as well as other environmental and social co- satisfying green investment mandates, without the need for benefits. The IFC-managed Sustainable Banking Network that time-consuming due diligence. Green bonds also offer a hedge promotes green credit policies in 27 member countries has against carbon transition risks in portfolios that include agreed to set up a working group on green finance emissions-intensive assets. measurement. It will review best practices adopted by its This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. members. China, for example, has put in place a mandatory 12- Those efforts will also help investors to better access and category-reporting system to collect green finance data from its evaluate the environmental impact of their investments. Some local banks. governments, including Morocco, Kenya, Nigeria, Brazil, and China, are already attempting to put in place green bond Climate Bonds by Country policies and guidance for their domestic markets. While all of these efforts are laudable, technical assistance is also required to make local green bond standards compatible with international best practice. Conclusion Greening the financial sector is an integral and inherent part of greening our economies. While the assessment and inclusion of climate risks in financial decisions is becoming more widespread, financial institutions in emerging markets would be well-advised to pay serious attention to them in order to avoid the need for costly amends in future. Proactive financial institutions can position themselves at the forefront of the green/climate finance movement, making conscious decisions to protect their assets, reduce their liabilities, and facilitate the low-carbon, resilient transformation process in real sectors. As the impact from—and awareness of—climate change Source: CBI, HSBC 13 increases, it is important for financial institutions to have a clear strategy for mitigating climate risks and developing climate In addition, green bond investors are concerned about business portfolios. The road ahead is not always reputation risk of ‘green washing’ if proceeds from a green straightforward, but it is already open, with room for additional bond issuance are used for non-green assets. There is currently innovation. a strong push for development of both international and local Wenxin Li, Associate Operations Officer, Climate Business, green bond standards. The Green Bond Principles initiated by Financial Institutions Group, IFC (wenxinli@ifc.org) International Capital Markets Association is the first set of Quyen Thuc Nguyen, Senior Operations Officer, Climate Business, international guidelines designed to shape the process of green Financial Institutions Group, IFC (nquyen@ifc.org) bond issuance for transparency and integrity, and to assist issuers with launching credible green bonds. Meera Narayanaswamy, Senior Investment Officer, Capital Markets, Financial Institutions Group, IFC (mnarayanaswamy@ifc.org)  1 Environmental Finance, Investors and Industry hail entry into force of Paris Agreement , 6 Rehermann, Thomas – Swann, Stacy – Miller, Alan, Private Enterprises Financing Oct 6 2016. Adaptation to Climate Change — Emerging Solutions in Emerging Markets, IFC Medium https://www.environmental-finance.com/content/news/investors-and-industry-hail-entry- Blog Post, Oct 21, 2016. into-force-of-paris-agreement.html https://medium.com/@IFC_org/private-enterprises-financing-adaptation-to-climate-change- 2 FSB Financial Stability Board, Proposal for a Disclosure Task Force on Climate-Related emerging-solutions-in-emerging-markets-ba433b37b96 7 Risks, Nov 9, 2015. https://www.fsb-tcfd.org/wp-ontent/uploads/2016/01/FSB_Disclosure- IFC, Climate Investment Opportunities in Emerging Markets - An IFC Analysis, 2016. task-force-on-climate-related-risks.pdf; see also TCFD Task Force on Climate-Related http://www.ifc.org/wps/wcm/connect/2b169cd5-e5c2-411a-bb71-be1eaff23301/3503-IFC- Financial Disclosures. Climate_Investment_Opportunity-Report-FINAL-11_7_16.pdf?MOD=AJPERES 3 8 IEA, Energy Efficiency Market Report, 2016. Stenek, Vladimir, Amado, Jean Christophe, and Connell, Richenda, Climate Risk and Financial Institutions – Challenges and Opportunities, IFC2010. ifc.org/climaterisks 9 IFC, IFC Climate Implementation Plan, April 2016, p. 14. 4 Swann, Stacy – Miller, Alan, How New Data Tools Can Assess Climate Risks . IFC EM https://www.ifc.org/wps/wcm/connect/5f5402804c60b510b6bbbeaccf53f33d/IFC_Climate_I Compass Note 10, Sept 2016. mplementation_Plan_03152016_WBG_v2.pdf?MOD=AJPERES http://www.ifc.org/wps/wcm/connect/eff61c3e-5172-46fd-8a31-defa84b9f556/Note-10- 10 Rooftop or distributed solar refers to the installation of solar energy production systems on EMCompass-How-New-Data-Tools-Can-Assess-Climate-Risks.pdf?MOD=AJPERES; see residential/commercial rooftops, as opposed to utility-scale solar PV plants or solar farms. also Miller, Alan – Swann, Stacy, Insurance Options for Addressing Climate Change. IFC 11 Bank for International Settlements, Quarterly Review, BIS June 2016. EM Compass Note 13, Sept 2016. http://www.bis.org/publ/qtrpdf/r_qt1606_charts.pdf http://www.ifc.org/wps/wcm/connect/739a5af0-d26c-4ce5-a9ff-d6f49f801bf9/Note-13- 12 TCFD Task Force on Climate-Related Financial Disclosures, Recommendations of the EMCompass-Insurance-Options-for-Addressing-Climate-Change.pdf?MOD=AJPERES Task Force on Climate-related Financial Disclosures, Dec 14, 2016. 5 13 Climate Policy Initiative, The Global Landscape of Climate Finance 2015, November 2015. Climate Bonds Initiative, HSBC, Bonds and Climate Change, the State of the Market in 2016, 2016. https://www.climatebonds.net/files/files/reports/cbi-hsbc-state-of-the-market- 2016.pdf This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.