101 Sustainable Finance Policies for 1.5°C

A Green Taxonomy is a crucial mechanism to give all actors guidance on what is green. Including transition in the taxonomy provides guidance on how to decarbonise high-carbon activities, and enables financing of these activities’ transitions. Aligning with international taxonomies and standards will enable international private finance flows. Adapting an international taxonomy to the national context also requires less capacity than developing a taxonomy from scratch.

Many policies will tilt investment flows away from high-risk carbon-intensive and towards green investments. These can insulate economies from climate-related risks and open up green development opportunities.  

Scale junior capital to increase investment flows

• Government guarantees de-risk green bond issuance, allowing institutional investor participation. This encourages green bond issuance over vanilla. Sovereign-to-sovereign guarantees will work in the same way and decrease cost of capital for EM sovereigns. 
• DFI guarantees and credit enhancement can channel investment to EM and higher-risk projects by clearing a path for investors to reach senior tranches of debt. Isolating and funding junior tranches can overcome the challenge of matching conservative risk appetite with available investment opportunities.  As much of the capital available for transition is highly risk averse, guarantees are crucial to meet senior debt appetite and overcome the challenges posed by lack of junior capital. 
• Increase blended finance provision. This leverages concessional financing to reduce a project’s credit risk, allowing for greater mobilisation of private capital. The Development Bank of South Africa’s Climate Finance Facility enables long-term renewables financing.[i] Including other de-risking facilities such as risk hedging can provide protection from negative market fluctuations and can further increase financing flows, especially important in EM where access to long-term capital is limited.

Mitigating risk to ensure rapid green capital flows   

• Require investors and corporates to publish transition plans, as required in UK sustainability disclosures.[ii] This step can prompt immediate action. The government can then introduce risk tools for long-term assessment of transition plans and their impact on exposure. Basing these on robust standards such as the Climate Bonds transition and entity criteria will ensure credibility and speed of transition.[iii]  
• Encourage the use of green financial instruments through subsidies and incentives which reduce cost of green capital and ensure attractive returns. E.g., Singapore’s Sustainable Bond Grant Scheme covers additional costs of labelled issuance.[iv]  
• Targeted subsidies are crucial to enable cost competitivity of specific green technologies and to enable industrial transitions, for example, the US subsidies for low-carbon hydrogen production.[v]
• Remove perverse subsidies (on fossil fuels, damaging ecosystem practices etc.) which distort perceptions of climate-related risk. This also immediately frees up a significant level of government spending, which can be reoriented to fund transition investments. 
• Central banks (CB) recognise climate risk as a risk to financial stability and address it across prudential and monetary policy. Many policies can be, and have been, adapted to incorporate climate risk considerations without waiting for disclosure and stress testing evidence.
• The CB can adjust risk weightings for capital and reserve requirements and collateral frameworks to incorporate climate risks.[vi] This will help insulate the CB balance sheet from climate-related risk and encourage FIs to green their capital allocation. Hungary’s CB established preferential capital requirements for green mortgages, based on their lower default risk.[vii]

Strengthen carbon pricing to drive change 

• Carbon prices need to be high and stable to ensure investor confidence in the price signal. Carbon pricing reform is needed, removing free allowances and limiting purchase of carbon credits, so that pricing can force change. 
• Carbon credit trade threatens the transition if purchased to offset avoidable emissions. Market reform can identify qualified offset purchasers. This can ensure credits are reserved for residual emissions and focus on preserving high carbon stocks.
• Carbon border adjustment mechanisms (CBAMs), whereby imports are also subject to local carbon pricing, are important to avoid relocation of high-carbon activities to countries without pricing schemes.^[viii]  
• Overreliance on carbon pricing could hinder transition if it delays implementation of other mitigation policies.^[ix] Particularly in EM, non-price instruments may better overcome political economy restraints and avoid regressive impacts on consumers.[x]

Capture the opportunities of transition 

• Establish green trade windows, with low tariffs for low-carbon trade. This can compensate for CBAM limitations and facilitate the flow of capital to EM, crucial to the success of the global transition. 
• Establish energy transition mechanisms to fund early retirement of fossil fuel assets, and their replacement with renewables installations. ADB’s pilot mechanism uses blended financing to buy and retire or repurpose coal plants in Indonesia, Philippines and Viet Nam.[xi] Energy transition mechanisms can address the financial risks of continued fossil fuel asset operation and create social just transition opportunities.