What is green finance and why is it important?
In this series, NUS News explores how NUS is accelerating sustainability research and education in response to climate change challenges, and harnessing the knowledge and creativity of our people to pave the way to a greener future for all.
By Prof Sumit Agarwal and Assoc Prof Zhang Weina
“Green finance” is one of the hottest buzz words in town. The massive amount of information from different sources, however, could be misleading and potentially crowd out the holistic understanding of this crucial topic. There is now an urgent need to present a clear message of what green finance is, why it is important, and how everyone can play a role in this development.
As a part of the frontier research movement in green finance, and with funding support from the Monetary Authority of Singapore, NUS established the Sustainable and Green Finance Institute (SGFIN) in September 2021. The new institute aims to dive deep into the key questions of how businesses and various stakeholders in Singapore and Asia Pacific can transition into a greener economy through rigorous evidence-based research.
There are no clear defining boundaries of “green finance”, similar to how the concept of “finance” has been seamlessly adopted as an integral part of economic developments, businesses, consumers, households, regulators, and governments in the world. Broadly speaking, anything in the finance sector that is related to environmental issues, activities, targets, performance, and impacts can be considered a part of green finance.
In practical terms, it is much easier to understand the boundaries of green finance by exploring existing financial products that are labelled as “green”. To name a few, they include green bonds, climate bonds, transition bonds, sustainability-linked bonds or loans, green equity funds, green Exchange-Traded Funds, and green Asset-Backed Securities. In addition, practitioners in the financial industry observe that customised and structured green financial services are also growing fast in Asia. This is due to the increased demand from firms in various sectors aiming to transit into greener technology and business models, as well as the increased supply of green capital from environmentally-conscious investors.
Environmental challenges such as climate change, global warming, excessive waste generation, and rapid depletion of natural resources continue to increase. What role can green finance play to make real changes to the environment, such as achieving carbon neutrality goals?
To answer this question, we need to return to the very core function of finance—to provide the capital that businesses need to engage in productive activities so that the capital providers can share the profits generated without participating directly in the production activities. To put it simply, finance functions to direct money to the right party so that it can perform the right activities, generating more money so that everyone is better off.
In order for this process to work effectively and efficiently, accurate and clear information is key. Hence, many finance researchers consider academic research in finance as playing the crucial role of establishing a clear causal relationship between relevant information and the direction and allocation of capital flows. Indeed, the “efficient market hypothesis” is a famous finance theory that builds upon efficient information dissemination processes so that investors can invest fruitfully. In this hypothesis, the prices of financial products constitute a useful reflection of market participants’ demand and supply for the underlying payoff of these products. Relevant information about these products drives the formation of the demand and supply forces. For example, stocks are traded at the price where the demand and supply for the stocks reach a consensus. The arrival of new information related to these stocks would drive the fluctuations of stock prices because the new information affects the demand and supply of the stocks.
Precisely because of such an economic mechanism, “green finance” is much more complicated than traditional finance. The lack of transparent and consistent information disclosures related to the environmental activities and performance of green financial products hampers the ability of financial markets and institutions to price these products efficiently.
Green bonds are among the oldest and most well-established green financial products in the market. The awareness of green bonds as investment vehicles has been growing exponentially, as evidenced by the double-digit growth rate of green bond issuances in the past five years. The Climate Bonds Initiative (CBI) recently reported that issuances of green bonds have totalled more than US$500 billion in 2021, and forecasted that the market will continue to grow to reach US$5 trillion by 2025. As part of this big wave, many Asian companies and governments have actively issued green bonds in the past few years to finance the transition into greener technology and infrastructure.
NUS is part of this frontier development with its inaugural S$300 million green bond issued in May 2020, and a similarly-sized second offering in May 2021. The proceeds are allocated towards financing various green projects, including research facilities for green-related topics as well as energy-related initiatives.
Nevertheless, the public criticism of “greenwashing” has also become louder amid positive market sentiments toward green bonds. The European Union Taxonomy Regulation defines “greenwashing” as the practice of gaining an unfair competitive advantage by marketing a financial product as environmentally-friendly, when in fact basic environmental standards have not been met. According to this definition, many issuers of green securities would not be guilty on the “greenwashing” charge, primarily because they did not even set any clear environmental goals and metrics in the first place.
When financial institutions or firms label their bond issues as “green” bonds, they need to meet the eligibility criteria defined by various green bond principles. A few examples include the European Green Bond Standard, the United Nations Sustainable Development Goals, the International Capital Market Association’s and CBI’s green bond principles. Unfortunately, there is no current global standard on the definition and certification of green bonds. Indeed, many issuers would even try to set their own definition in order to manage their green bonds.
To validate the issuers’ compliance with their chosen green bond principles, a third-party assurance entity would evaluate the project allocations and impact reports of each green bond issue. However, assurance is not a guarantee of the complete environmental results and impact, particularly beyond the scope of the chosen green bond principles.
For example, an issuer can be reporting a positive environmental performance under the chosen principles, but the project could still result in negative environmental impacts in other dimensions. This may be even worse than “greenwashing” because the issuer is truthful in what it discloses and may even believe that it is doing good for the environment, but an absent holistic environmental impact assessment muddies the picture. Moreover, a green project financed by an issuer may overshadow other environmentally-damaging activities performed by the same issuer elsewhere.
In traditional finance, the definition of fraud is the inconsistency between the self-declared and real accounting numbers. Auditors serve as gatekeepers to prevent cheating and mis-reporting by the firms. In the case of green bonds, auditors are largely missing, and the assurance party is used in place of auditing.
For green finance to play its core function in improving environmental sustainability, the quality of information around green financial products has to be dramatically improved. Many governments and international organisations have been working hard to standardise the disclosure requirements for the environmental performance of green products. The private financial sector, as well as the non-profit and academic sectors, can also contribute to improve the transparency and completeness of sustainability.
SGFIN has set one of its core objectives in creating a transparent and holistic impact measurement generated based on various information sources. One of the institute’s goals is to contribute to a higher-quality information network around each green project to help green capital flow more productively and investors to have a more complete and holistic understanding of the environmental impacts of the green financial products in their portfolios.
Rigorous learning and training are key to equipping participants in the green sector to integrate the total impact of corporate activities into the environment, people, and the economy. These impacts have to be measured and evaluated using a rigorous process with reliable data rather than merely anecdotal evidence and story-telling. Researchers in SGFIN and the NUS academia are also working to curate new modules and courses in the green finance field to disseminate relevant and holistic knowledge to key stakeholders. These include students at the undergraduate and graduate levels, and participants in executive and lifelong learning. Indeed, the very first intake of students pursuing the Master of Science in Sustainable and Green Finance will soon embark on their exciting learning journey through classroom and capstone projects in August 2022.
About the authors
Sumit Agarwal is the Low Tuck Kwong Distinguished Professor of Finance, Economics, and Real Estate at National University of Singapore (NUS) Business School and Managing Director of the Sustainable and Green Finance Institute (SGFIN) at NUS.
Zhang Weina is Associate Professor of Finance at NUS Business School, Deputy Director of SGFIN and Academic Director of the NUS MSc in Sustainable and Green Finance programme.
This is the fourth instalment of the Greening the Future series on sustainability and climate change.
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Read NUS President Prof Tan Eng Chye's commentary on the role that universities play in driving climate change action.