How the green financial sector reform can drive decarbonization

Green Financial Sector Interventions are financial policies, regulations, and instruments that governments can use to redirect private finance away from high-carbon investments in favor of more climate-smart or green investments. This shift provides the necessary funding for climate action and protects financial systems and institutions from climate risk.

GFSIs are part of a growing trend towards green financial sector reform, which countries are more likely to use in their climate change plans. GFSIs are designed to address many barriers to green finance flows. These include failures of investors to internalize greenhouse gases (GHG), financial markets that need to account for climate risks adequately, and low institutional capacity.

GFSIs can address these obstacles and adjust the price and availability of capital for low- and high-carbon activities. This increases the demand for green investments, which affects sectors’ output, performance, and GHG emissions. Commercial investors have clarified that they intend to move to greener portfolios. Countries actively pursuing reforms in the financial sector will be well-placed to attract this funding.

GFSIs can have a significant impact on financial stability and macroeconomic stability. However, it is essential to understand how and in what ways GFSIs reduce emissions and increase green investment. This knowledge must be completed for emerging markets and developing countries, which can impede GFSI implementation and – as discussed 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 for change that maps the effect channels of GFSIs and, ultimately, the number of emission reductions that result.

This paper discusses a variety of GFSIs with high potential:

• Green macroprudential policy: Green supporting factors, dirty/high-carbon penalizing elements
• Green monetary policies: green collateral factors and green quantitative ease
• Incentives and public co-funding for green projects: Soft loans and green portfolio incentives.

Figure 1: Transmission Channels for Soft Loans and Credit Garanties

This paper qualitatively examines the transmission channels of GFSIs and their impact on capital availability and costs for low- and high-carbon assets.

GFSIs can have direct effects on economic activity. This could have implications for output, investments, and GHG emissions. These impacts need to be taken into account for climate and development policy. Green conditionality and climate risk assessment should not be included in GFSI. They could benefit high-carbon activities and unintendedly increase GHG emissions intensity in the economy. The paper builds on these insights and develops a theory for change about GFSIs’ role in climate mitigation and low-carbon transition. It also identifies levers that can maximize their impact.

Here we highlight the transmission channels for two GFSIs: a soft lending program that targets a particular sector and provides a fixed amount (Figure 1) and a green support factor that impacts the relative cost capital for low- or high-carbon investments (Figure 2).

Figure 2: Transmission channels of a green supporting factor

There are two main benefits to understanding the transmission channels and how they affect emission reductions. It allows policymakers to see how the GFSIs reduce emissions. This will enable them to decide between GFSIs, and determine the emission reduction volumes they can expect in national climate mitigation plans.

GHG emission reductions through GFSIs are also a benefit. This is because it allows for international climate finance. Most climate finance is activity-based. It is usually provided upfront and often with concessional to help lower the capital costs of large infrastructure projects. GFSIs are not suited to such climate finance. They do not have upfront capital costs for infrastructure but incur costs during implementation. GFSIs will benefit from results-based climate financing. GFSIs are paid on the emissions reductions achieved. Therefore, it is essential to have rigorous methods of evaluating emission reductions.

A World Bank project is ongoing with the Climate Change Group, Finance, Competitiveness & Innovation Global Practice, and Macroeconomics, Trade & Investment Global Practice. This project uses the theory of change to create a quantitative model that projects emission reductions from different GFSIs. The model is currently being piloted in Turkiye and other select countries.

The model will eventually be made available to emerging markets and developing economies (EMDEs), allowing them to see how GFSIs influence finance flows and reduce emissions. You can use the model to seek relevant results-based climate financing to support GFSIs such as the World Bank’s Transformative Climate Asset Facility or the new Scaling Climate Action by Lowering Emissions program (SCALE), which includes a pillar dedicated to countries that have implemented green financial sector reform.