Chapter 6: Green finance and carbon markets

According to the United Nations’ financing roadmap to net zero, the lion’s share of the USD32 trillion of funding needed for decarbonisation efforts in the next decade must come from the private sector. Some experts, like UN Special Envoy for Climate Action and Finance Mark Carney, predict two to three times that amount is needed between now and 2050 to reach the requisite scale.

Public funding is vital for the transition, but it will not be enough. For China, the UN estimates that government financial resources can only meet 10-15% of the country’s green investment needs.

This presents an enormous opportunity for Australian and Chinese private sector investors and borrowers. Green finance markets are developing at a dramatic pace. In China, the green loans market is already at USD2.5 trillion, the largest globally.

China’s ability to achieve carbon neutrality by 2060 relies on (among other things) the continued growth of the domestic green bond and green loan markets, as well as the expansion of cross-border investment structures and access to private capital in the international capital market.

Green investment is firmly embedded within China’s 14^th Five-Year Plan (2021 – 2025) which has propelled China as a leading force within green financial markets.

But the funding challenge (and opportunity) is broader than debt markets and carbon trading. An OECD report led by Secretary-General Mathias Cormann points out that net zero goals will also require “international progress to support an effective carbon price” to ensure the efficient allocation of resources in financial markets. In his foreword, Cormann flags the opportunity for market participants to encourage greater transparency and support the “reallocation of capital towards greener alternatives, while discouraging capital flows to carbon intensive projects”.

Many countries have started developing financial products and mechanisms to mobilise their financial sectors. Government authorities, regulators, corporates and consumers are playing a significant role – including by developing carbon trading markets. Yet given the enormous funding deficit, much more is needed providing opportunities for greater collaboration between financial market operators and participants in Australia and China.

The year 2021 was a landmark one in the international green finance arena, with the finalisation of the Article 6 rulebook for the development of carbon markets (see below). There is now a clear roadmap to guide financial institutions, companies and governments over the next few years. Priorities include improving the interoperability and consistency of sustainable finance standards (including developing common taxonomies), building a robust transition finance framework, embedding sustainability into credit risk assessments, and adopting green finance tools and instruments to achieve net zero emission goals.

Financial institutions are forming and joining global alliances to find solutions in increasing numbers. There are more than 450 financial sector members of the Glasgow Financial Alliance for Net Zero working on common approaches to sustainability infrastructure and best practice guidelines. 

The UN-convened Net Zero Banking Alliance (NZBA), which aims to provide a structured forum to support banks and financial institutions to achieve 2030 emissions targets and transition to net zero by 2050, was launched by 43 founding members in April 2021. It has since grown to 110 members including Australian banks National Australia Bank Limited, Australia and New Zealand Banking Group Limited, Commonwealth Bank of Australia and Macquarie Bank Limited. These NZBA-aligned banks represent about 40% of global banking assets.

As of August 2022, no Chinese banks were members of NZBA. This presents an opportunity for further collaboration. Chinese banks are, however, involved in the Alliance for Green Commercial Banks, a 2019 initiative of the World Bank’s International Finance Corporation and the Hong Kong Monetary Authority. The alliance brings together institutions to develop and build capacity for climate-related investments. The first regional chapter is in Asia with cornerstone members including the Bank of China and HSBC. The alliance aims to bring in non-financial institution ‘green’ industry companies in the future.

China also participates in a range of multilateral green finance initiatives including the Central Banks and Regulators Network for Greening the Financial System, the Common Ground Taxonomy with the EU, and the World Bank’s Sustainable Banking Network which facilitates dialogue and knowledge sharing with leading authorities on the development of the global green financial industry.

There remains an opportunity for greater collaboration between Australia and China, building on these forums.

Building tomorrow’s taxonomies

The reason ‘taxonomy’ matters, and why it has become something of a buzz word, is that it helps establish standards that allow financiers and investors to assess the sustainability credentials of projects and financial products on a consistent basis.

Greater standardisation of green-related financing terms and criteria to assess performance against green metrics will build the confidence of borrowers, financiers and the broader public that financial markets play a key role in delivering green outcomes. Green taxonomy is designed to help minimise greenwashing, where green credentials are misleading, inaccurate, inflated or unsubstantiated.

In July 2020, the European Union (EU) and China initiated and co-chaired a working group on sustainability-related taxonomies. Referred to as the ‘Common Ground Taxonomy’, its objective is to comprehensively compare existing taxonomies for sustainable investments and identify the commonalities and differences in their respective approaches, criteria and outcomes.  

The first green bond issued under the Common Ground Taxonomy, published jointly by the People’s Republic of China (PRC) and the EU in November 2021, marked a milestone in identifying the similarities and differences between the green taxonomies of each.

By contrast, Australia’s participation at the international level on sustainable finance taxonomies remains limited. Australia’s Council of Financial Regulators has indicated it is considering global taxonomies but expressed concern that they do not differentiate between the impact that climate change has in different parts of the world or take into account the different structures of national economies or other local considerations.

Much of this private capital will need to be competed for and won in the international capital market. China is aware of the importance that international green financial markets place on transparent and regular disclosure as well as third-party opinions and is moving from self-assessment towards independent verification of green credentials and mandatory disclosure relating to emissions and other key environmental metrics by 2025.^[1]

Green loans

The development of green loans - steady since the PBOC’s inaugural green policy publication in 1995 – has accelerated in recent years.

This presents an enormous opportunity for Australian and Chinese private sector investors and borrowers. Green finance markets are developing at a dramatic pace. In China, the green loans market is already at(approximately USD2.5 trillion) by the end of 2021 according to the PBOC; a 33% increase from 2020 levels. The utility, transport, warehouse and renewable energy sectors were among the principal beneficiaries.

The market-based tools for the macro-regulation of onshore loan capital at all levels are the Green Credit Policy issued by the PBOC and China Banking and Insurance Regulatory Commission (CBIRC), and the Green Credit Guidelines of the CBIRC.

Chinese banks have access to low-cost funds via a carbon emission reduction facility launched by the PBOC in 2021. This requires financial institutions to promote the flow of funds towards green projects and away from environmentally harmful projects. There are disclosure requirements and green incentives, including PBOC preferential rates which could help 2,817 companies cut carbon emissions by approximately 28.76 million metric tonnes.

The Green Credit Guidelines identify how Chinese banks should address sustainability related issues at board and senior management levels and integrate environmental and social considerations into lending policies. Chinese banks that have a higher proportion of green loans and have issued green bonds receive higher scores which are linked to performance evaluation of senior bank executives. 

Together, these tools allow Chinese authorities to track the green performance of individual banks and assess the level of green loan provision to the Chinese economy. They drive the development of a unified green finance system that incorporates enhanced incentives for lending to green and transition projects, harmonised standards, and reporting and disclosure requirements.

From 1 June 2022, the Green Finance Guidelines require Chinese banking and insurance institutions to support a low-carbon economy in a material way. The guidelines impose obligations to mobilise green capital, improve their own as well as their respective clients’ ESG performance, and decarbonise asset portfolios. Innovation is encouraged.

In China, green loans have generally performed better than conventional loans with a default rate over the past five years in the region of 0.7% lower than non-performing loans as a whole. This is driven in part by the financial market’s perception that green loans are intrinsically lower risk. Contributing to this trend is that much of this green lending relates to infrastructure projects, which are generally considered stable and lower risk.

Green bonds

Chinese green bond issuances aggregated some USD94.8 billion in 2021. Growth in 2022 is projected to reach as high as 80% from 2021 levels as more issuers enter the market following government initiatives to expand investment in green and transition projects.

Significantly, the current edition of China’s Green Bond Catalogue no longer includes ‘clean coal’ projects as eligible for finance through the issue of green bonds. Published by the key regulatory bodies for green bonds - the PBOC, the China Securities Regulatory Commission and the National Development and Reform Commission (NDRC) – the catalogue was last updated in May 2021 and contains an exhaustive list of eligible projects and eligibility criteria for the issuance of green bonds.

In the past five years, China’s green bond indexes have outperformed fixed income and submarket indexes by a range of 50 - 120 basis points, in part driven by the PBOC’s relaxation of monetary policy and the financial market’s perception that issuers of green bonds have greater credit strength.

As market capitalisation of green bonds grows, Chinese issuers are becoming increasingly sophisticated, with instruments incorporating both green and sustainability linked features.

In Australia, the green bond market has experienced exponential growth since the World Bank in 2014 issued its first green Kangaroo bond (Australian-dollar bond issued in a domestic market by a foreign issuer).

In 2021, Australia was the world’s ninth largest market in terms of the total number of loan and bond issuances with green and sustainability-linked terms (40 in total and trending up). Recent green bond issuers include Fortescue Metals Group, NSW Treasury Corporation, Lend Lease and the University of Tasmania demonstrating the depth and diversity of the market.

Hong Kong’s role in China’s green finance market

Hong Kong’s role as one of world’s top international financial cities, and a key city in China’s Greater Bay Area, is well known. Perhaps less well known is Hong Kong’s ambition to capitalise on its unique position in driving global capital flows with a view to developing into a regional carbon trading centre and green finance hub.

Hong Kong is using its financial and legal frameworks to develop green finance regulations, reporting and disclosure standards, and certifications. Supported by government investment, public sector resources and private sector expertise (including from many Australian firms and businesses based in the city), Hong Kong is developing a fast-growing suite of green products and services. These include green and sustainability-linked bonds, loans and funds, buoyed by market appetite from retail and institutional investors in the local, Chinese Mainland and regional markets.

A Green and Sustainable Finance Cross-Agency Steering Group was set up in May 2020 to co-ordinate the management of climate and environmental risks to the financial sector, accelerate the growth of green and sustainable finance in Hong Kong and support the government’s climate strategies.

Hong Kong creates a corridor for investment opportunities into China. Various ‘connect’ schemes such as the Shanghai-Hong Kong Stock Connect initiative, introduced in 2014, have enhanced trading and clearing fluidity between the mainland and Hong Kong. This presents an opportunity for Australian funds and asset managers, wealth and professional advisers.

In addition, the GBA Green Finance Alliance was established in September 2020 by Hong Kong and the Mainland of China. The alliance supports investments that capitalise on the demand for green finance in Guangdong and Shenzhen along with the capabilities and talent in Hong Kong and Macau.

Projects backed by the alliance include one seeking to establish a cross-border carbon marketplace, akin to the Shanghai-Hong Kong Stock Connect. A feasibility study conducted by the Securities and Futures Commission in 2022 highlighted the need for Hong Kong to “develop market structure and regulatory models to link up international investors with the mainland’s carbon markets”.

The complexity of solutions and portfolios that banks and advisors must offer will demand expertise – including from Australia.

Carbon markets offer a way for companies to meet their compliance obligations and manage climate risk in a cost-effective way. Companies that can reduce their emissions beneath their compliance limit can sell their remaining carbon credits (subject to the rules of the applicable scheme). Companies that exceed their emissions limit can buy credits by way of offset (again, subject to applicable rules).

The same principle applies to the voluntary carbon markets. Companies that can reduce or remove emissions cost-effectively earn credits to sell to companies that wish to achieve a lower carbon footprint than they would be otherwise able to readily or cost-effectively achieve.  

Australia’s carbon exchange

By contrast, Australia has had a rocky political road when it comes to managing carbon emissions. The ERF is a voluntary scheme administered by the Clean Energy Regulator, supplying Australian Carbon Credit Units (ACCUs). Similar to other carbon credits, ACCUs represent one tonne of CO₂ equivalent stored or avoided by a carbon reduction project, such as revegetation, plantation forestry and capture and combustion technologies. 

The Clean Energy Regulator is developing an Australian Carbon Exchange to make trading ACCUs and potentially other carbon units simpler. Expected to launch some time in 2023, the exchange is anticipated to cut transaction costs and support increasing supply and demand across the corporate sector.