China's pivot to green finance

The country regards it as a central part of financial market reform rather than as an afterthought

Much has been said about the state of China's natural environment. Estimates of at least $5 trillion, or about half of China's annual GDP, needed to repair the environmental damage done over recent decades gives a sense of the magnitude of the challenge.

The international impact of China's environmental mess is equally worrying. Those focused on Africa and other parts of the developing world understand that China's rapidly growing outward investment may well bring jobs and income in the short term but will only contribute to sustainable development if both China, and the investment, is greened.

Fortunately, China's climate agreement with the United States is the start of efforts to curb environmental pollution on many fronts. It is welcome news that China's coal consumption fell by more than 2 percent last year, signaling what may be the most important fossil fuel peak in modern times. Clean energy investment in China jumped 32 percent in 2014 to a record $89.5 billion (79.5 billion euros), as compared to US growth of 8 percent to $51.8 billion, Japanese growth of 12 percent to $41.3 billion, and meager 1 percent growth across Europe. Even Beijing's infamous smog levels fell last year, according to the municipal Environmental Protection Agency, though pollutants remained far above acceptable levels. Ambitiously, Beijing's municipal authorities hope to get PM2.5 levels down to 60 by 2017, still above safe levels according to the World Health Organization, but not dissimilar to urban air pollution levels in some major European cities.

Such advances provide ground for optimism, but it will take far more to pivot China's massive economy to green. China's much-heralded, new environmental protection law is a step forward. However, there are concerns that it may be ineffective in the face of fragmented environmental governance arrangements, vested interests and inadequate local capacities. More is needed, but more channeled through China's creaking administrative routes is unlikely to be effective.

Finance may offer part of the answer. Financial market reform is central to China's overall economic reform efforts. Today's financial sector, dominated by state-owned banks, remains underdeveloped in its core task of mobilizing savings and channeling capital to productive, financially rewarding use, and in advancing China's development. Familiar reforms are underway, which if successful will deliver better governed and more extensive and diversified financial and capital markets. Until recently, however, such reform plans have not explicitly embraced the policy goal of greening China's development.

Green finance has risen up China's policy agenda. In 2007, the China Banking Regulatory Commission established its Green Credit Guidelines as an innovative attempt to raise awareness and action on the environment. More recently, there have been signs of a mainstreaming of green finance. Since early 2013, the Finance Institute of the Development Research Center of the State Council (DRCFI) has been working with the International Institute for Sustainable Development, in association with the UNEP inquiry into design options for a sustainable financial system, in developing policy recommendations to advance green finance across China's financial system. Further evidence of this mainstreaming has been the initiative of the People's Bank of China to establish a Green Finance Task Force, co-convened by the UNEP Inquiry, to identify practical steps to green China's financial market reform.

Green financing, according to the DRCFI-led research launched at the China Development Forum, increased at an annual growth of 23 percent in the five years to 2012, to about $260 billion, equivalent to more than 2 percent of GDP. Investment needs across key green sectors in China, the study estimates, will be about $460 billion a year from 2015 to 2020, or about $2.8 trillion from now until 2020, probably an underestimate, according to the authors. The research estimates that two thirds of this will need to come from domestic and international financial and capital markets, given fiscal limitations and priorities.

Major barriers need to be overcome in unlocking this level of green finance from financial and capital markets, including perverse price signals resulting from absent or inappropriate policies; an unwillingness of short-term focused investors to finance green development projects; and a lack of clear definitions and frameworks that limits enabling policies, regulations and standards. In addition, progress is constrained by divergent interests and approaches between central and local government, as well as between government and market institutions.

Interventions in the financial system are essential to an effective green economic and industrial strategy and associated policy measures. The DRCFI-led report sets out wide-ranging recommendations to advance green finance in China, covering banking, investment, insurance and monetary policy. In the all-important banking sector, for example, recommendations include allowing eligible green loans to be excluded from the loan-to-deposit ratio indicators in banking risk management, offering preferential treatment for green assets in use as collateral against loans, introducing environmental stress tests as part of banking regulations, and building up securitization channels for green credit. Building on international experience in green bonds, the report recommends a government-endorsed system or third-party assurance system for the green claims of corporate bond issuers, providing a price differential for green compared to brown loans to create more deal flow for green bonds, and offering tax credits for green bonds.

Notably, the recommendations covering the broader role of central banks extend beyond international practice. Pointing out that monetary policies affect investment decisions through their effects on interest rate levels, inflation targeting and exchange rates, the report proposes the establishment of green refinancing facilities, consideration of green steering of asset purchases in the context of quantitative easing, including environment-related risks in the models for stress testing in relation to financial stability, and more broadly eliminating sector biases in current monetary policy that are misaligned with the objectives for a green economy.

These and other policy recommendations by the DRCFI, strengthened and extended further by the report by the PBoC-led Green Finance Task Force could represent the world's most ambitious experiment in systematically greening a major financial system. China's ambitious thinking sees green finance as central, not additional to the financial market reform agenda. From this perspective, a lack of green financing delivers poor allocation of capital, mispriced risks and weaker long-term economic growth, creating stresses that ultimately lead to financial market instability and underperformance. Greening the financial system, on the other hand, would improve its efficiency, effectiveness and resilience, making it fit for purpose in serving the needs of China's economic development in the 21st century, as well as that of the world.

The author is a co-director of the UNEP Inquiry into Design Options for a Sustainable Financial System, the international project lead in the DRCFI-led study into China's green finance, and the international co-convener of the Green Finance Task Force initiated by the People's Bank of China. The views do not necessarily reflect those of China Daily.