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Asian Development Outlook, April 2021
Financing a Green and Inclusive Recovery
A great reset: COVID-19 highlights the need for developing Asia to build back better, and this requires mobilizing large amounts of capital from both public and private sources.
Summary
- Green and inclusive recovery requires both public and private capital.
Building back better and greener from COVID-19 will demand large investments that are often beyond the means of the public sector alone. Promisingly, green and social finance from private sources has grown rapidly in recent years.
- Private green and social finance is becoming financially driven.
While it was investors’ environmental and social goals that initially drove global growth in sustainable investment, financial motives are increasingly coming to the fore. After Australia’s ratification of the Kyoto Protocol restricted its emissions, to cite one illustration, the debt costs of high-emitting Australian companies increased by an average of 5.4%, and their equity costs by 2.5%, relative to low-emitting companies. Tapping green and social finance helps meet the preferences of various stakeholders, hedge and mitigate sustainability risks, and generate resilience under shocks. Green and social finance also fosters positive recognition among investors, thus broadening the financing base.
- Sustainable finance offers real environmental and social benefits.
Asian firms that issue green bonds typically improve their environmental performance by 17% after 1 year and 30% after 2 years, as measured by corporate environmental ratings. At the market level, green bond issuance is associated with reduced carbon dioxide (CO2) emissions as market participants become more aware of the Sustainable Development Goals (SDGs) and committed to achieving them. Social impacts are more varied, but innovative financing instruments such as impact bonds show potential.
- Engaged public policy is central to nurturing social and green finance.
Governments can use a range of policy options both to shape markets and to participate in them. Regulation that enforces common standards of information disclosure and impact measurement is the most powerful policy option to support the development of green and social finance. Policy makers can align finance with the SDGs by incorporating sustainability risks into the micro- and macroprudential framework to safeguard financial stability, strengthen market infrastructure and ecosystems, and expand fiscal revenue available for development along a green, resilient, and inclusive pathway.
Mobilizing resources for green and inclusive recovery
Asia must build back better as it emerges from the pandemic.
Society now has an opportunity to build back better. Green and inclusive recovery would strengthen resilience under future shocks.
The region has turned its attention in recent years to more sustainable and inclusive growth. Both economic growth and the quality of life face threats from environmental challenges such as climate change, biodiversity loss, and environmental pollution. Growth that empowers and benefits the entire population remains a work in progress. The pandemic set back these efforts and imposed disproportionate burdens on the poor and vulnerable. It also clearly demonstrated that abnormal risks can and do become reality, driving home the need to prepare for future risks, the most dire of which is worsening climate change. Society now has an opportunity to build back better. Green and inclusive recovery would strengthen resilience under future shocks.
Building back better requires mobilizing capital both public and private.
Dubbed the Great Reset, building back better after COVID-19 will require mobilizing capital to fund green investments such as clean energy and social investments such as public health, education, and job training.
The vast financial resources needed are often beyond the means of the public purse alone. Especially after suffering sharp contractions in fiscal revenue during the pandemic, Asian governments must close the funding gap by catalyzing more private capital and mobilizing resources from a much broader funding base. As a bonus, the participation of private capital fosters risk sharing on green and social projects across a broad coalition of public and private investors.
Green and social finance specifically targets sustainability goals.
Such capital is deployed in a range of investments designed to achieve specific and measurable environmental or social objectives.
Comprising all financing instruments, investments, and mechanisms that contribute to the SDGs, the spectrum of green and social finance includes blended or catalytic finance, debt, equity, funds, and grants. This diversity offers the opportunity to create innovative financing models and new financial instruments to expand the supply of capital for sustainability goals.
This area of finance has grown rapidly in recent years.
Developing Asia leads all other emerging regions in the issuance of green, social, and sustainability bonds.
Growth in green and social finance has been particularly strong in private capital. Financially sophisticated advanced economies, where environmental and social issues have long been high priority, still dominate the global green and social finance landscape. Meanwhile, developing Asia leads all other emerging regions in the issuance of green, social, and sustainability bonds. The region also leads the developing world in regulation and policy guidance on green and social finance. Rapid global growth in green and social finance has continued since the COVID-19 outbreak. The trend is consistent with heightened awareness in the financial industry of the importance of green and inclusive recovery from COVID-19.
Drivers of green and social finance
Economic and noneconomic factors alike drive green and social finance.
While it was investors’ environmental and social goals that initially impelled global growth in sustainable investment, financial motives are increasingly coming to the fore.
Evidence shows various factors driving incentives for the finance industry to channel capital into investments with environmental and social impacts: staying aligned with changing stakeholder preferences and social norms, hedging and mitigating sustainability risks, and fostering greater resilience in the wake of shocks to particular firms or entire markets.
Evidence shows that sustainability risks increase firms’ financing costs.
Developments demonstrate that investors weigh firms’ exposure to sustainability risk when making portfolio decisions.
In the first 5 years after the 2007 ratification of the Kyoto Protocol initiated restrictions on annual CO2 emissions in Australia, the debt costs of high-emitting Australian companies increased by 5.4%, and their equity costs by 2.5%, relative to Australian firms with lower carbon footprints. Two probable channels for higher financing costs are worsened cash-flow risk and investor recognition. High emitters had increased default probability, financial distress risk and market risk. In addition, they faced declines in institutional ownership and greater difficulty in obtaining finance from major banks. These developments demonstrate that investors weigh firms’ exposure to sustainability risk when making portfolio decisions.
Green and social finance engenders positive investor recognition.
Tapping green and social finance signals a firm’s awareness of environmental and social issues and its commitment to positive outcomes.
This is well received by investors, as evidenced by Asian stock markets responding positively to the issuance of corporate green bonds. During a 16-day period encompassing the announcement of green bond issuance, issuing firms’ common stocks post an average cumulative abnormal return of 0.5%, or an annualized gain of 7.9%. Such positive reaction indicates that investors see green and social finance creating value. Recent evidence from global markets shows firms distinguished by their green bond issuance enjoying superior stock price performance and greater resilience during the pandemic. Further, such positive investor recognition helps to broaden the investor base for green and social investment.
Targeted impacts from green and social finance
Social and green finance requires better impact measurement.
Accurate impact measurement informs assessment of funding and investment proposals, enhances credibility, facilitates decision making, guides future resource allocation, and creates models and benchmarks.
However, there are currently no commonly agreed reporting standards or impact metrics for green and social finance. This failing exacerbates information asymmetry and raises concerns about green- or social-washing—inaccurate, self-serving claims that undermine investor confidence. In response, some progress has been achieved toward consolidating the many competing models for impact measurement.
Green finance credibly signals commitment to environmental impact.
Evidence suggests that green finance signals increased awareness of and commitment to the SDGs and thus indicates positive environmental outcomes.
Asian firms that issue green bonds typically improve their environmental performance by 17% within a year after issuance and by 30% within 2 years, as measured by corporate environmental ratings. Evidence further suggests that cities using more green bond finance enjoy significantly improved local air quality. An increase by one standard deviation in green bond financing is associated with a 0.6% improvement in the air quality index. Countries similarly record lower carbon emissions after the first green bond issuance in national bond markets.
Private capital makes social programs more efficient and effective.
Innovative social finance instruments like impact bonds connect private capital to investment that addresses social and development challenges.
These mechanisms facilitate risk transfer from the government and service providers to private investors, who earn returns only when desired social outcomes are achieved. Development impact bonds enable results-based private finance to participate in development programs in low- and middle-income economies. Notable examples include the Educate Girls Development Impact Bond, which improved education outcomes for marginalized school-age girls in India.
Multilateral development banks catalyze green and social finance.
The challenge of unlocking green and social finance created a role for multilateral financial institutions.
They provide direct financing and catalyze capital from public and private sources through blended finance, credit enhancement, and loan guarantees. They innovate novel financing solutions and further facilitate the development of green and social finance by strengthening market infrastructure and ecosystems, as well as government policy, knowledge, and capacity in developing economies.
Complementary financing for green and inclusive recovery
Public sector capital remains a vital pillar of finance for the SDGs.
Public spending oriented toward the SDGs remains important for developing economies’ green and inclusive recovery.
Evidence shows that fiscal measures with environmental goals contribute to green development. The pandemic underscores the need for investment in basic public services such as health care and education to address worsening inequality. Even as the COVID-19 crisis suppresses tax revenue in Asian economies, some Asian governments are investing to ensure sustainable recovery after the pandemic. Examples include the Green New Deal in the Republic of Korea, green components in Japan’s economic stimulus packages, and the issuance in Thailand of sovereign sustainable bonds.
Microfinance has potential for achieving positive social outcomes.
Whether commercially oriented or not for profit, microfinance institutions provide a wide range of financial services to vulnerable groups.
Microfinance aims to promote positive development outcomes toward the major socioeconomic imperatives of poverty reduction, equitable health care and education, job creation, women’s empowerment, and disaster resilience. However, evidence is mixed on the impact that microfinance has on poverty reduction and some other social outcomes, leaving it subject to debate.
Carbon pricing narrows the funding gap during a low-carbon transition.
Asian economies can build on regional experience with carbon-pricing schemes to realize the benefits of a broad toolkit of available carbon-pricing instruments.
Carbon pricing through emission trading, carbon taxes, and other mechanisms aims to internalize the external costs of carbon emissions by making polluters pay for their CO2 emissions. While carbon-pricing instruments are still in their infancy, momentum is growing in Asia and the Pacific for their use to facilitate a low-carbon transition. Asian economies can build on regional experience with carbon-pricing schemes to realize the benefits of a broad toolkit of available carbon-pricing instruments.
Nurturing green and social finance in Asia
Engaged public policy is central to nurturing social and green finance.
Governments can use a range of policy options both to shape green and social finance markets and to participate in them.
Policy options include fiscal measures such as grants, direct and indirect investment, tax incentives and subsidies, and legislation and regulation. While a range of policy innovations already exists worldwide, the market would benefit significantly from legislation and regulation that enforce common standards of impact measurement and information disclosure. Governments can reshape existing policies and contribute to green and inclusive recovery through investment, catalysis, innovation, advocacy, and research in green and social finance.
Finance should align with the SDGs while safeguarding financial stability.
Sustainability risks pose challenges to individual financial institutions and to the whole financial system.
Policy makers have started to incorporate sustainability risks into micro- and macroprudential frameworks, charting the way forward for safeguarding financial stability while supporting the transition to sustainable development. Financing sustainable recovery can be facilitated by sound financial market infrastructure and a viable market ecosystem. Asian policy makers need to work together to develop standards of impact measurement and information disclosure that align with international standards and promote sustainable finance as a regional agenda.
Strengthened public finance can support green and inclusive recovery.
Domestic resource mobilization provides more resources for sustainable recovery.
Effective tax policy measures can increase tax revenue by (i) broadening and protecting the domestic tax base; (ii) enhancing tax compliance through better taxpayer services and strengthened risk management, audit, and enforcement; (iii) developing more transparent and efficient tax administration with streamlined business processes and digital technology; (iv) striking a balance between raising tax revenue and promoting investment; (v) and strengthening international tax cooperation. Finally, tax policy measures that offer well-designed tax incentives can improve development outcomes by, for example, promoting clean energy investment.