Fiscal policy – reorient flows
The Ministry of Finance (MoF) is a key player in a country’s decarbonisation pathway due to its central and powerful position in government. The MoF allocates and controls government spending, funding expenditure through taxation and borrowing. It also provides financial oversight and determines financial strategy. Embedding climate change in the MoF mandate and enacting key legislation such as climate laws are key to mainstreaming climate action in all functions of the MoF.
Guide sustainable finance
The strategic role of the MoF is key to coordinating whole government action on climate change. This coordination is important to prevent inefficiencies and ensure sufficient speed of action. While cross-government alignment will stem from top-level decisionmakers, the MoF can ensure day-to-day coordination, for example through oversight of ministerial and sub-national government budgets.
The MoF, with the support of the central bank and regulators can create a sustainable finance roadmap. Such a roadmap can provide clear market signals on introduction of policies, while ensuring coordination – see for example, the EU Action Plan on Financing Sustainable Growth (now Renewed Sustainable Finance Strategy); which aimed to coordinate the introduction of the Green Taxonomy and corporate and financial disclosure regulations. The Green Finance Platform and UNDP Financial Center for Sustainability’s Sustainable Finance Diagnostic Toolkit could be used to kickstart roadmap development. NGOs and consultancy firms are often enlisted to develop roadmaps.
Roadmaps can be highly complex, for example the UK’s Green Finance Strategy which aims to not only green the financial system but also increase financing flows to green technology, incorporating the Industrial Strategy and international commitments. However, they can also have a more narrow focus, such as Brazil’s Roadmap for implementation of TCFD recommendations. EM governments’ sustainable finance roadmaps are often developed with MDB or foreign government support, such as the Philippines Roadmap. Such a roadmap can help all stakeholders to see the bigger picture and can also galvanise action, helping to overcome inertia and short-termism that can stifle government action on climate change.
The Coalition of Finance Ministers for Climate Change emphasise the importance of long-term strategies to mainstream climate into economic and financial policy. Sovereign issuance can also enable ministry coordination, due to the need to collaborate on green expenditure identification. A key element of many sustainable finance strategies, and a central tool for governments to drive sustainable finance is the development of taxonomies and standards. A taxonomy is a classification system identifying activities and investments that deliver key sustainability objectives. Taxonomies aim to direct finance flows towards activities that reduce GHG emissions and other environmental damage, as well as improve transparency for investors and inform financial supervision.
Taxonomies’ environmental objectives will be informed by national environmental policy and priorities. Including other objectives such as biodiversity, circular economy and pollution prevention widens the scope of activities that can be included, and ensures that these other environmental objectives are not disadvantaged in terms of financial flows. For their criteria to best meet the needs of the sustainable transition, these need to be science-based, usable and aligned with both global and local standards. For example, in China, different types of green bonds had to reference different guidelines from the corresponding regulators. In 2021, the People’s Bank of China (PBOC), the National Development and Reform Commission, and the China Securities Regulatory Commission jointly revised and released the Green Bond Endorsed Project Catalogue. The updated Catalogue was a crucial step in developing a standardised green bond market because it unified domestic standards.
Global alignment will enable international flows of capital and prevent market fragmentation, particularly vital for countries without a strong local investment base. It will also reduce the burden on international investors who will likely be working with several different taxonomies. Taxonomy developers can use the IPSF’s EU-China Common Ground Taxonomy (CGT) as a basis for taxonomy development. For example, Hong Kong has adopted the CGT and it will be operationalised by the Green and Sustainable Finance Cross-Agency Steering Group.
The MoF is also well positioned to overcome a major constraint to sustainable investment, which is a lack of investible projects. Identifying/creating a pipeline of green investments is important for sovereign green bond issuance, but can also be done strategically for blended finance, MDB or private investors. The MoF ca coordinate with other government departments to establish this pipeline. The MoF is also in a position to negotiate cost efficient financing from MDBs which can kick start blended financing solutions for the market.
Facilitate central bank action
The Ministry of Finance tends to also set the mandate and remit of the central bank. Most central bank mandates are to maintain price or financial stability, and this can be seen as limiting their ability to address climate risks. The Ministry of Finance can clarify the mandate, to make clear that climate-related risks are in a central bank’s remit and impact financial stability. In 2021, the UK Treasury clarified the Bank of England’s role in supporting the transition to a net zero economy. In response, the Bank committed to greening its Corporate Bond Purchase Facility, reducing carbon intensity 25% by 2025 and aligning it with net zero by 2050, stating that the remit change enabled this monetary policy update.
The MoF could also set a secondary mandate, of sustainable development or other such climate-aligned objective. Such secondary mandates are common among EM CBs. There is precedent for mandate change in the face of huge financial risk. Before the GFC, very few G20 CBs had a financial stability mandate. Most had a singular, price stability mandate. By 2020, most had a double or multiple mandate, with a significant uptake of financial stability objectives.
Leverage the power of government asset holdings
The MoF also have some control over government asset holdings, such as sovereign wealth funds. Tilting these investments to green will not only increase financing of the sustainable transition, but also improve resilience of these funds to climate-related risks. Increasing green and sustainable investment allocation of these funds can also provide an example to private investors, helping to overcome hesitancy about ‘new’ financial products. Sovereign wealth funds are created to facilitate intergenerational transfer of wealth. The negative climate impacts on future generations gives these funds a clear motive to green their portfolios.
Governments are increasingly diversifying the revenues of these funds away from oil and gas assets. New Zealand’s sovereign wealth fund has reduced its emissions intensity 50%, and in 2022 shifted 40% of its holdings to Paris-aligned indices, committing to a 7% annual CO2e reduction. Norway’s sovereign wealth fund, which owns 1.5% of the world’s listed assets, introduced an environmental mandate program investing in green bonds, but has since removed it, instead committing to reduce climate-risk of the entire fund. As 3/4 of the International Forum of Sustainable Wealth Funds have only 10% holdings in climate-related strategies, introducing net zero targets for their sovereign wealth funds is a clear opportunity for governments to help fund their net-zero transition.
Beyond reducing carbon intensity of sovereign wealth funds, they can be leveraged for strategic long term investment in the net zero transition. Such funds could be partially dedicated to or fully transformed into environmental trust funds, dedicated to providing long term investment in net zero-aligned projects. These funds could be used to finance PPPs, discounted loans, tax exemptions, blended finance or other government expenditures for the transition outlined in this report.
The MoF can also establish new funds to encourage action. In 2005, Korea’s MoF established the Korea Fund of Funds. This provides seed funding to local fund managers to boost SME and venture capital investments. A MoF could set up a similar fund to prioritise sustainable investments.
Issue thematic sovereign debt to fund green government expenditure and signal intent
Sovereign bond issuance is an important function of the MoF, providing long-dated funding, particularly well-suited to the infrastructure and other long-term capital investments needed for transition.
Green sovereign issuance allow governments to leverage private finance, to overcome the substantial finance gap to meet net zero. In addition, proceeds often fund expenditures linked to policy measures such as grants, subsidies, and tax credits which leverage even more private investment. Green bonds attract a wider investor base than standard issuance (i.e., vanilla). This can also lead to tighter primary market pricing, also known as a greenium, which can offer issuers lower borrowing costs.
The Climate Bonds Sovereign GSS Bond Survey found most countries’ key motivation for issuance was to catalyse a local green bond market. Sovereign green bonds provide benchmark pricing and liquidity for corporate issuers, enabling them to estimate demand and pricing for their bonds, and inform size of issuance. For example, in 2021, the UK issued its debut green gilt and saw 79% growth in non-sovereign green bond issuance that same year. Another key motivation was to diversify the investor base, while many investors reported reputational and visibility benefits. Issuers from both developed and emerging markets (DM/EM) found the benefits to outweigh the challenges of issuance.
Sovereign issuance also increases transparency, as it involves processes of green budget tagging. This process can also reveal gaps in policy, for example, Chile’s issuance demonstrated need for better information on government policy and prompted an improvement in building codes.
Sovereign issuance has also shown diversification into social, sustainable and sustainability-linked issuance, particularly from EM. Sustainable bonds combine green and social expenditures, helping to tackle the perception that green transition could hinder economic development. For example, Thailand’s TBH50bn (USD1.6bn) Certified sustainability bond funded both the construction of an electrified rail line of the Bangkok metro (THB30bn) and social projects, including the COVID-19 Rehabilitation Package which aims to support employment generation (THB20bn). Sustainability bonds can not only ensure funding of important social infrastructure but also enable communication of the developmental benefits of green investment and transition.
Countries without sufficient green expenditure could issue a sustainability-linked bond (SLB). Rather than funding specific expenditures, SLBs are linked to a set of KPIs, penalised by a coupon step up if those KPIs are not met. The World Bank has issued guidance on designing sovereign SLBs. Chile issued the first ever sovereign SLB in March 2022. The USD2bn issuance used the KPIs recommended by the World Bank. The KPIs target emissions reduction of 15.4% and peak by 2030 and a 60% renewable energy (RE) installed capacity by 2032. These KPIs are attached to a coupon step up of 6.25bp and 12.5bp from 2030/2032. However, while the emissions reduction targets are aligned with its Nationally Determined Contribution (NDC) and a below 2°C scenario, they require an increase in ambition to align with a 1.5°C pathway. All SLB issuers must ensure they use meaningful KPIs to give credibility to the ambition of the investment.
MDBs and other actors can also support sovereign issuance at all stages of the process. For example, Climate Bonds Initiative supported development of Italy’s and Chile’s green bond frameworks and eligible expenditure identification. The World Bank’s support of the 2018 USD15m Seychelles blue bond issuance included a partial credit guarantee of USD5m and arranged a loan to cover most of the transaction costs. It also connected Seychelles with banks and investors.
Fund resilience spending with green or sustainable bond issuance
Resilience investments tend not to directly generate income but result in significant saving due to avoided damage from climate hazards. Therefore, they tend to be publicly funded. Sovereign green bonds can dedicate significant levels to adaptation and resilience. 90.6% of proceeds from Fiji’s 2017 green bond were dedicated to adaptation, with climate resilience cited as the driving cause of the issuance. Use of proceeds (UoP) included reconstruction of schools damaged by 2016’s Tropical Cyclone Winston, agricultural resilience to drought and flood and adaptation research. A sovereign could issue a resilience bond, a green bond dedicated exclusively to resilience funding. The EBRD issued the first resilience bond in 2019, although no sovereign has labelled a bond as such.
Sovereign issuance could also fund ecosystem protection. Similarly to resilience investments, these efforts do not often generate direct income streams but provide important benefits of enhanced carbon sinks, natural hazard protection and economic co-benefits. See Environmental protection to safeguard climate action for more.
Resilience investments and green bond UoP can be guided by the Climate Bonds Climate Resilience Principles, as used by the EBRD for their 2019 bond. These high-level Principles will soon be followed by a Resilience Taxonomy, providing granular guidance on what is a credible resilient investment for green issuance.
The CCRI has also developed the Jamaica Systemic Risk Assessment Tool, enabling analysis of climate risks and future impacts, to establish future economic losses. This quantification can help make the case for investment in resilient infrastructure and resilient activities and encourage private investment in resilience.
Address indebtedness through climate action
A highly indebted MoF may be unwilling to issue more government debt and further increase their debt to GDP ratio and associated risks. They could instead restructure existing debt as an SLB, bringing clear accountability and transparency to a country’s progress towards the achievement of its NDCs, and possibly securing more favourable interest rates.
MoF could also investigate the possibility of debt for nature swaps, to reduce their debt to GDP ratio, while also meeting their climate goals. A creditor country agrees to write of a portion of debt on the condition that the debtor country carries out conservation activities. These transactions have taken place in countries across the world. The idea first emerged in recognition of the environmental damage occurring in debtor countries as they increased exports of natural resources to pay off their debt. Debt-for-nature swaps can also be multilateral or can involve participation from an NGO. For example, Belize made a debt for nature swap in 2021, buying back its debt at a significant discount in exchange for increasing marine conservation efforts. This reduced its external debt by 10% of GDP and was financed by a blue bond insured by the US International Development Finance Corporation.
Tilt government expenditure to green
The government budget is controlled by the MoF. Greening expenditure requires aligning all elements of the budget with the decarbonisation pathway, not simply increasing spending on green projects. Embedding climate considerations within development plans and communicating the economic benefits of environmental expenditure is important to justify these to the electorate and prevent environmental expenditure from being seen as in contention with developmental expenditure.
Increasing levels of green public investment will be needed to deliver climate mitigation and adaptation goals. Green public investment management (GPIM) ensures investment is best targeted to climate change needs. This requires five key elements:
1. Climate-focused national planning: aligning sectoral plans and associated portfolios with climate objectives,
2. Public sector coordination: across all public sector institutions and any joint ventures with private actors.
3. Ensuring climate adaptation and mitigation assessments are included in project appraisal and selection, including in the PPP framework
4. Budgeting for and reporting on green investment and infrastructure maintenance in the annual budget: tagging climate expenditures, ex post reviews of climate outcomes
5. Incorporating climate risks in natural disaster risk management strategies and fiscal risk analysis.
These elements are covered by many of the policies outlined in this report. Taking a GPIM approach ensures climate action is consistent and aligned. Such coordinated action can also help governments identify where public investment is most needed, i.e., where private finance cannot be leveraged due to lack of returns or level of risk.
Green budget tagging can be used to assess budget alignment with climate commitments. It can also be carried out as part of the process of sovereign green bond issuance, to identify eligible use of proceeds for the bond. In 2020, France was the first country to carry out green budget tagging, as part of the OECD Paris Collaborative on Green Budgeting. The expenditures with an environmental impact came to €52.8bn, out of a total of €574.2bn budget and tax expenditures. While tagging can inform policymakers and monitor action, it does not drive action. Green budgeting can use the results of this assessment to improve alignment of expenditure with environmental goals. Of the 40% of OECD countries that use some form of green budgeting, most use environmental impact assessments (EIA), while the UK and Ireland adopt a green perspective in performance budgeting. Green budget tagging can also be used for ex post reviews of climate outcomes of government expenditure.
Green public financial management adapts existing public financial management (PFM) practices to support climate-sensitive policies. It is similar to green budgeting but has a wider scope as it covers all elements of PFM, gradually promoting climate-sensitive fiscal policies throughout and beyond the budget cycle. Lessons can be learnt from other priority-based budgeting approaches such as gender budgeting and SDG budgeting. For example, OECD gender budgeting analysis found the need to embed gender-responsiveness within the annual budgeting routines and be linked with the substance of policymaking rather than be adopted as a compliance process. By looking to green all elements of financial policymaking, green PFM can also help ensure fiscal efficiency, ensuring greatest environmental returns of policies. It could also highlight fiscal inefficiencies, such as continuing fossil fuel subsidies which reduce RE competitiveness, while implementing measures such as carbon pricing, as seen in the UK.
Effective implementation of green PFM requires political backing for the reform and communication to ensure buy-in. The MoF needs to take on a strong stewardship role. Basic PFM practices should already be in place, with the strategy integrated into the existing PFM reform agenda and appropriately sequenced. These approaches have strong complementarity and overlap. Governments will likely select either green PIM, green PFM or green budgeting, depending on their public investment needs and institutional strengths.
Phaseout of fossil fuel subsidies not only disincentivises fossil fuel investment, it also frees up budgetary space for other investments. Government support for fossil fuels (budgetary transfers and tax breaks linked to production and use) in 51 countries almost doubled in 2021, to USD697.2bn. This was largely driven by a surge in consumer subsidies, to USD531bn, more than triple their 2020 level, driven by the surge in energy prices. Given continued increases in energy prices in 2022, this year is likely to show similar levels of support. A clear phaseout plan, including reallocation and transition support, is important to prevent economic shocks from removal of subsidies, and ensure buy-in from the population.
Additional support may be required for the most vulnerable, as low-income households spend a larger proportion of their income on fuel. Kazakhstan’s sudden halting of liquified petroleum gas subsidies was met with mass protests, with the government resigning three days later. In contrast, Singapore eliminated petrol subsidies in 2015, at a time of low fuel prices and reallocated the spending to social development. This demonstrates the need for clear communication of timelines of phase out and of its social benefits and reallocation of spending. Given current and likely sustained elevated fuel prices, phase out plans require mitigatory measures to minimise adverse social impacts.
Policy risk insurance can also be provided to improve investibility of projects. Policy supports such as feed-in-tariffs carry a removal risk. As this risk is posed by the public sector, the public sector is well placed to insure against it.
One green expenditure which is often coordinated by the MoF are green sovereign guarantees. These can de-risk private sector green bond issuance and improve their credit rating. Partial risk guarantees, or “wrappers”, lend the government credit rating to the issuance while liquidity guarantees allow extension of debt tenor. By providing credit enhancement to private sector green bond issuance, it enables access to institutional investors and lowers the cost of borrowing, thereby encouraging private sector green bond issuance over vanilla issuance.
However, guarantees hold a liability risk, and require sufficient balance sheet liquidity to ensure MoF ability to fulfil the guarantee if called upon. The MoF will need to minimize the potential large liabilities of such guarantees, particularly in EM countries. Robust monitoring mechanisms can ensure that guarantees and other blending mechanisms do not exceed balance sheet capacity.[xxxix]
The government can also provide subsidies to green bond issuers. Interest rate subsidies, or stamp duty exemptions could be applied to green bond issuance. However, such a policy faces a risk of subsidy allocation being dominated by large corporates which do not require subsidies. If such a policy is used, it needs to be reserved for where it is most needed, i.e., SMEs, to ensure efficacy of such spending.
Subsidies can also cover the cost of verification and external review. While these costs are a small portion of issuance for large issuers, these might be a barrier to smaller issuers. Several local governments in China have introduced green bond subsidies, as part of the PBOC green finance pilot zones.
Singapore’s Sustainable Bond Grant Scheme covers the costs of external sustainability review, assessment and verification services for issuers of green, social and sustainability-linked bonds (up to SGD100,000 for a minimum bond issuance of SGD200m). The Scheme’s scope was expanded with the launch of the Green and Sustainability-Linked Loan Grant Scheme, which covers the cost of assessment and verification and up to 60% of the cost of framework development.
Under HKMA’s Hong Kong Green and Sustainable Finance Grant Scheme, the authority co-funds half of eligible expenses (up to HKD2.5m) for a first-time issuer, and 100% (up to HKD800,000) for green loan borrowers or repeat issuers.
There is also potential for sovereign-to-sovereign green guarantees. These could be provided by DM governments on EM green sovereign issuance. These could follow the model of MDB guarantees to sovereign issuance, as outlined below. DM sovereigns could leverage their own balance sheet and credit score to de-risk investment in EM sovereign green bonds. A guarantee from a sovereign with a strong balance sheet and credit score would increase investor confidence, enabling institutional investors to purchase the EM green bond. This would optimise balance sheet capacity, as capital would be tied up for shorter amount of time than with a standard loan. This would also decrease the cost of capital for the EM sovereign, as such bonds would likely receive higher valuations.
Guarantees can also be accompanied by capacity building. Guarantors can share their own experience in developing green bond frameworks and provide assurance to international investors.
The US government has provided guarantees on sovereign bond issuance. For example, in 2017 it provided a 100% guarantee of the repayment of principal and interest for a USD1bn Iraqi sovereign bond, as part of a wider international assistance package. Such guarantees have historically included conditionality, therefore a green sovereign guarantee program could be very similar to this precedent.
Incentivise sustainable investments through climate-aligned tax policy
Taxation can be altered to incentivise green activities and discourage high-carbon activities. This will improve the risk-return profile of sustainable investment and enable its growth.
Tax incentives can be used to increase green investment. For example, by making the interest from green bond holdings tax-exempt. This could follow the model of tax exemption for US municipal bonds. Tax Credit Bonds could also be used; bond investors receive tax credits instead of interest payments so issuers do not have to pay interest on their green bond issuances. These incentives can help tilt investment to green and the resulting increase in investor interest and demand will encourage issuers to issue green bonds. Luxembourg reduces the subscription tax rate for investment funds according to their level of EU Taxonomy alignment.
Carbon pricing, through a carbon tax or emissions trading scheme is implemented to capture the external cost of GHG emissions and charge this to emitters. This can improve the business case for green technologies and incentivise emissions reductions. The OECD has calculated that introducing a EUR10/tCO2 carbon price could reduce a country’s emissions by 7%.
When introducing a carbon price, there are several important considerations. It is important to ensure it covers all emissions, so as to incentivise action across the economy. Design of the pricing instrument will impact price stability and value. For the carbon price to encourage clean investment it must be both high enough to prompt action but also stable. Carbon price volatility will discourage green investment. Therefore, a hybrid approach to carbon pricing, such as an ETS with a fixed price floor, emissions cap and price ceiling, can increase emissions reduction certainty and provide predictable prices.
Concerns over carbon leakage, the relocation of carbon-intensive industries to avoid pricing, have been a barrier to carbon price introduction. While many jurisdictions have provided free emissions credits to certain industries, this weakens the price signal. Instead of issuing free allowances or exempting certain industries from pricing, governments can address carbon leakage through carbon border adjustment mechanisms, see Trade.
An international carbon price floor has also been proposed by IMF staff, suggesting a floor of USD25-75/tCO2 by 2030, depending on their level of economic development. This would provide long term green investment certainty globally and help to address carbon leakage concerns.
However, carbon pricing cannot be relied on to drive transition alone. Other policies are required to overcome market failures and problems of inertia, increase the green asset pipeline and channel funding to transition the whole economy. Accompanying carbon pricing with policies such as fossil fuel phaseout strategies will also prevent incremental change in response to the carbon price, and provide a clear signal on the future of the carbon price.
Particularly for EM, carbon pricing may not be appropriate as the main element of the policy package due to greater political economy restraints. Non-price instruments such as standards, regulations and subsidies may be more effective in overcoming EM economies’ greater market failures and in developing infrastructure. They can also overcome EM political economy constraints as costs to citizens are less visible and less regressive than pricing. An exclusive focus on carbon pricing may also even delay the deployment of other mitigation policies, increasing cost of transition.
Environmental tax reform (ETR) is closely related to carbon pricing. It involves the introduction of environmental taxes on pollution, energy and/or resources, and the introduction of expenditure policies. This both discourages environmentally damaging activities and raises revenue for public investment. ETR is particularly well suited to developing countries as it can have a “triple bottom line” effect: cutting pollution, generating and funding development and raising economic activity. It can be used to facilitate a Just Transition, mitigating climate impact whilst raising welfare.