Governing finance to support the net-zero transition
By Olga Mikheeva and Josh Ryan-Collins
The Net-Zero carbon (NZC) transition requires a massive structural change to the economy, including greening our energy systems, building stock and transport infrastructure as well as decarbonising industrial production systems. To do so will require huge investment: clean energy-related investment alone will need to reach $4 trillion annually by 2030 from around $1 trillion now, according to the International Energy Agency (IEA). Simultaneously, financing of unsustainable activities needs to be rapidly phased out.
Financial policy bodies — central banks, financial regulators and ministries of finance — have a key role to play in supporting this tectonic shift in financial flows. The emerging policy consensus is that they should play primarily an ‘enabling’ role to help private finance lead the transition.
Under this approach, financial supervisors and central banks have pushed for greater disclosure of climate-related financial risks by banks and asset managers, alongside developing scenario analysis and climate-stress tests, to correct the perceived failure of markets to price in such risk. For example, the Network for Greening Financial System (NGFS) comprised of over 100 national financial regulators and the Task Force for Climate-related Financial Disclosures (TCFD) have developed various related methodologies.
This emerging consensus also favours introducing carbon taxes to adjust prices in favour of green investment and de-risking green investments by leveraging pubic funding and ‘blending’ public grants and subsidies with private co-investors. Further, creating green financial markets means ‘greening’ financial instruments such as green bonds, Environmental Social and Governance indicators and derivatives and designing green taxonomies to attract private capital.
As yet, whilst there has been some spectacular pledges by financial institutions to support green finance, the results of this market-led, ‘price-correcting’ and ‘de-risking’ strategy have been disappointing. Climate-related financial disclosures are yet to materially affect investment decisions for the majority of investors and bank lenders. Commercial banks, large investment banks and asset managers have significantly increased their financing of fossil fuel companies since the 2015 Paris Agreement and TCFD came into being. A recent analysis found that commercial banks channelled $1.5 trillion to the coal industry between January 2019 and November last year and the major European banks provided $33bn to oil and gas sector despite signing net-zero pledges.
“Climate-related financial disclosures are yet to materially affect investment decisions for the majority of investors and bank lenders”
Recently research points to two major challenges for this private-finance led strategy to the NZC transition. One is the need for ‘patient’, high risk finance to support technological innovation in a wide range of low-carbon sectors — something the private sector has not been very good at. A second, related problem, is that of the fundamental uncertainty that is associated with green transition — and indeed any major economic transformation — rendering attempts to quantify the financial ‘risks’ associated with it and enhance ‘price discovery’ problematic. This heightens the ‘carbon-lock in’ problem, making existing financing of fossil fuel activity continue to appear less risky and more profitable than switching to low-carbon financing.
In the light of these challenges, what lessons can we learn from history from countries that achieved rapid structural economic transformation? In a new IIPP working paper — ‘Governing finance to support the Net-Zero transition: Lessons from successful industrialisations’ — we examine the financial policy regimes and institutions that enabled Mexico, Canada, Norway, Japan, Korea and China to successfully industrialise at different periods between the 1930–1980s.
In all our case studies, ministries of finance and central banks played a more direct and coordinated role in industrial and economic development than under the market-enabling strategy being pursued to support today’s NZC transition.
Policymakers addressed the problem of uncertainty of investing in new economic sectors via the active use of a range of credit policies These involved the directing of credit towards strategic industrial priority sectors such as manufacturing and value-added export industries and the suppression of credit to less desirable sectors such as real estate and consumption, freeing up resources (at times through forced savings) for industry and helping to control inflation. Usually, central banks lead on the implementation of these policies. In addition, there were controls on corporate and government bond markets (including foreign capital controls) to support fiscal policy objectives. These interventions ranged from ‘corporatist’ negotiation arrangements between financial firms/banks and financial policy makers in Norway, to the ‘lender of last resort’ role and targeted refinancing schemes in Korea and Mexico to extraordinarily detailed window guidance policy by the central bank of Japan. the central bank of Japan.
Secondly, all our case studies established specialised public finance institutions — state investment banks — to help provide patient, long-term finance, often at a promotional interest rates to support industrial development and technological innovation. These institutions coordinated closely with ministries of finance and central banks, in some cases being financed directly or even owned by them. For example, the Industrial Development Bank of Canada was a subsidiary of the Bank of Canada until the mid-1970s; and, in Mexico, Nasional Financiera was assisted by the Banco de Mexico by requiring private banks to purchase Nasional Financiera’s bonds as part of liquidity requirements.
Notably, these institutions were financed from various non-tax channels and thus somewhat protected from short-term political interference: either government savings instruments and postal savings (Japan), or central bank loans and funds raised on domestic and foreign markets (Korea, Mexico, Canada), including foreign multilateral institutions, or from bond or equity purchases by central banks and domestic financial institutions (Mexico, Canada, China).
Thirdly, our case studies suggest that steering finance towards a shared policy goal (be it industrialisation or green transition) involves close and ongoing coordination between key financial governance bodies — particularly central banks, ministries of finance and ministries of industry and trade. This contrasts with today’s more fragmented mandates for economic governance institutions (e.g. the strict division of fiscal and monetary policy) and the emphasis of financial policy on financial stability rather than economic development or green transition. This fragmentation implies an even stronger importance of strategic coordination between central banks and ministries of finance on the one hand and with ministries of economy development or industry on the other hand.
This is not to say such high levels of coordination and policy deliberation are easy. Our case studies demonstrated several tensions with governance agencies prioritising different policy tools. For example, the purpose of credit controls in Mexico during 1940s-1950s was seen in terms of price stability by Mexico’s Central Bank and Ministry of Finance whereas other ministries saw it as part of sectoral policies. Japan’s Ministry of Finance and the ‘mighty’ Ministry of International Trade and Industry (MITI) had jurisdictional conflicts over industrial policy whilst the Bank of Japan was running a covert policy of credit control from 1940s well into 1980s. Norway’s Ministry of Finance tended to advocate for more regulatory approaches to credit control whereas Norway’s Central Bank was in favour of more market-based approaches during 1950s-1970s.
In all cases, the governance institutions played a key role in directing — rather than de-risking — financial capital to priority sectors via a range of institutional innovations. More explicit and more strategic intervention and coordination is needed among key financial governance bodies today to support the NZC transition. Examples of institutional innovations discussed in Europe — the revision of the European Central Bank’s secondary mandate to support economic development and enhanced coordination between investments (European Investment Bank and National Promotional Institutions), monetary policy (European Central Bank) and fiscal space (European Commission, Recovery and Resilience Facility) are promising steps in that direction. A further step can include more strategic alignment of financial policy and net-zero policy targets whereby financial governance shifts its focus from correcting carbon prices and markets towards actual financing of the net-zero economy.
No doubt other factors beyond financial governance also played a part in these successful late state-led industrialisations. Nevertheless, financial policy makers today can surely take note of the alternative and deliberately created institutional coordination mechanisms and innovations that created financial sector dynamics conducive to structural change. There are obvious limitations in translating historical successes (and failures) into present day context and we hope this paper stimulates further research on strategic governance of finance for economic and particularly low-carbon transition.
