Every year, leaders from politics and business come together with economists, investors and even celebrities at the World Economic Forum in the Swiss resort of Davos. One of the five key themes of this year’s event was safeguarding the planet. The forum’s own figures suggest that human-caused climate change has cost the planet US$3.6 trillion (£2.9 trillion) in damage since 2000 alone.
Many of the sessions at Davos focused on climate change, which was especially pertinent after US president Donald Trump’s decision to abandon for a second time the Paris Agreement – a framework to keep the warming of the planet to 1.5°C above pre-industrial levels by the end of the century.
In an online address to Davos delegates, Trump even argued that the oil-producers’ group Opec should reduce the price of oil. This is in stark contrast to the views of many other governments – exemplified by UK energy and climate change secretary Ed Miliband’s assertion that net zero is “unstoppable”.
But one of the less discussed elements of the path to net-zero by the year 2050 (a key target to keep the Paris Agreement on track) is the role of the financial sector.
As economists, we believe that banks and financial institutions should play a key role in making the green transition happen. Companies that produce goods and services will need to invest in equipment and technology – either to make new greener products or to ensure that they pollute less.
But this will cost money – likely money that firms do not actually have on their balance sheet or under their mattress. When banks assist in providing funding for this type of investment, it is known as green finance.
Green finance from banks can take two forms. Either the banks underwrite corporate bonds, which means they sell bonds to investors in exchange for a fee. Or they become involved in the provision of a syndicated loan, which is when they collaborate with other banks to lend money.
But both options are constrained by the rule that a bank will only provide finance out of self-interest. This means they act only when the profit they earn is proportional to the credit risk they take on. But this was in contrast to the message from Davos that businesses should take the lead, with the aid of finance from banks, in mitigating the risks of climate change.
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Sources of credit for businesses to make green investments include philanthropists, public finance and the private sector (that is, commercial banks). However, it is arguable that charity and public money are best used in partnership with private banks, to finance projects that are perceived high risk and low return. Banks alone would not support these because of their promotion of self-interest.
However, philanthropy can be limited and inconsistent in providing funds for green projects. And the public sector has so many demands on its purse that its ability to support is also limited. This is where the private sector plays a key role in mitigating climate change and where partnerships between these three sectors could offer a way forward.
This pathway was discussed at Davos but the speakers were not clear on what effective partnerships would look like. As academics who have researched the factors that influence green finance provision across multiple European countries, we would suggest a partnership structure between the public sector and the private sector, based on risk-sharing.
In these cases where banks perceive the risk to be unbearable (and therefore not in their self-interest), governments could partner with banks in offering finance and so share the consequences of a bad project outcome. In other words, they would form a partnership with the bank to share the downside risk.
A bank may consider an investment to be higher risk where a project has less certain outcomes, or requires funding for a longer period of time. Both of these factors are comparatively common in green financing deals. This could be because a firm is investing in new or untested tech or production methods – for example car manufacturers exploring new electric vehicle battery technologies.
The struggle for smaller businesses
This partnership approach could especially benefit small and medium-sized enterprises (SMEs), which make up 99% of Europe’s companies. But these businesses can struggle to access finance from banks due to their lack of capital, which can make banks see them as a high risk. And this of course is challenging for SMEs, which mostly have no other sources of external finance.
Research shows that medium-sized firms often rely on loans for finance. Our work focuses on how companies in Europe and the UK source green financing. It has highlighted that larger companies, as well as more liquid and more profitable firms, tend to raise finance via bonds (issued by banks and bought by investors) rather than loans (from a bank or other financial institution).
In fact, our research shows that in some European countries (including Latvia, Malta and Romania), domestic banks have no record whatsoever of providing green finance to companies.
This means it is much easier for larger businesses to get green finance compared to their smaller peers. And smaller companies tend to obtain relatively lower amounts of green financing, creating a real risk that SMEs may not get what they need in order to play their part in reducing their emissions.
Without a significant shift in allowing SMEs to get the finance they need to become greener, governments will struggle to get close to their net-zero goals. But, along with financial regulators, governments could lead the way to create partnerships with banks and other financial institutions to overcome the barriers that SMEs face.
Sharing the risk would ensure banks continue their green lending activities and accelerate progress toward meeting government climate targets.
