Restructuring China’s finances

In its quest to build a low-carbon economy, China is seeking ways to channel cash towards green schemes. Zeng Gang outlines the latest developments.

History teaches us that financial support is an essential ingredient in technological innovation and economic transformation. Finance – be it the funds required to facilitate technological invention or the rewards reaped by that invention – spurs the changes on. Meeting China’s emissions-reduction targets and developing a low-carbon economy will be no different. Recent data indicates that financial institutions are involving themselves in the development of sustainable technology. Meanwhile, the growth of carbon markets has provided some incentive for the development and application of that technology and attracted numerous businesses and financial institutions. This financial innovation is playing an increasingly important role in efforts to build a low-carbon economy.

Broadly speaking, financial innovation in the low-carbon sector is concentrated in two areas – green credit in existing markets and innovation based on the new carbon markets.

Let’s take the first of these. Many energy-saving projects and research and development activities – in renewable energy, for instance – are in line with national industrial policy and have a certain potential for profit, at least in the presence of mechanisms for distributing risk. Financial institutions are therefore happy to participate by providing financial backing. Commercial banks are currently the main participants in this sector, giving rise to the concept of “green credit”. The commercial nature of this kind of credit – it carries an expectation of profit – makes it more sustainable.

The second is linked to the emergence of carbon markets. These markets have been designed so that cutting carbon emissions (while leaving the scope of production unchanged) is no longer just a company’s duty to society – it is a profit-generating capability. This provides an incentive for firms to use low-carbon technology for manufacturing, and has therefore created demand for a range of related financial services.

This, in turn, has attracted financial institutions. Currently, carbon exchanges, government funds, investment banks, private-equity firms, commercial banks and insurance companies are active in the sector, thereby promoting innovation in financial products and services (such as trade in carbon derivatives and institutional financial products linked to carbon markets). As of the end of 2008, carbon markets globally were worth US$120 billion (814 billion yuan). Within just a few years, this has become a major commercial sector.

Meanwhile, in China, energy saving, emissions cutting and carbon–intensity reduction have been identified as future strategic choices, and good progress has already been made – including in financial-sector innovation. Some institutions have explicitly recognised the responsibility of corporations to save energy and cut emissions, while actively participating in lending to and investment in environmentally friendly projects.

There has also been substantial progress in the development of financial structures related to carbon trading. First, some cities have set up environmental exchanges as trial carbon-trading platforms – helping existing firms to participate and set prices in international carbon markets as well as acting as early trials for a localised carbon-trading system.

Second, many investment banks and private-equity firms are involved in financial and intermediary services related to clean-energy mechanisms, an area that has advanced significantly in the past few years. In 2008, Certified Emission Reductions (credits issued for emissions cuts achieved by projects under the clean development mechanism) originating from China accounted for 84% of the global total – demonstrating the huge potential and competitive advantages China has in the development of the low-carbon economy. Third, some banks have started to experiment with “green credit” and structured products linked to carbon markets, making it easier for individuals to invest.

Despite this progress, it should be noted that development of this sector is still at an early stage, and further improvement is needed. First, there is a lack of specific norms from the government for funding energy-saving and emissions-reducing projects. There are blank spots in the definition of these projects, guidance on management of loans and policy support. This limits the ability of commercial banks to develop related services. Currently, the authorities are working on a list of eligible industries and developing policy on credit for these – and this will play a major role in the development of green-credit offerings by Chinese commercial banks.

Second, in many sectors, green credit is not yet capable of creating sustainable profit – and so solely relying on commercial loans will not work. That is why, despite strong calls for the development of green credit, this type of finance still only accounts for a tiny proportion of the overall market. In the long term, there is a need for policy finance, non-banking finance and other methods to complement the existing commercial channels and distribute risk, creating a layered green-credit system.

Third, the inherent complexities of emissions trading mean that its implementation involves adjustments in overall national strategic policies, and is therefore unlikely to take place on a large scale in the near term. It is more likely that it will remain restricted to voluntary reductions. This means that, for some time into the future, innovation in carbon trading in China will be mainly aimed at overseas trading systems (currently that of the European Union, and the proposed cap-and-trade system in the United States). International financial institutions, including different international investment banks and private equity investors will continue to dominate the sector.

Climate change is one of the biggest challenges humanity faces – and perhaps also the biggest opportunity for development. The technological innovation and structural economic changes it is triggering may provide a route out of the global economic slump and act as a motivating force for a return to sustainable growth. And the financial system has both the duty and ability to play a major role in this. In China, the banking sector is by far and away the biggest player in the financial system. Therefore, guiding commercial banks towards participation in green credit, and building a layered and sustainable green financing system around that core, should be the focus of future development of green financing in China.

Zeng Gang is head of the Banking Research Office at the Chinese Academy of Social Science’s Institute of Finance and Banking

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