Aligning Finance with the Green Transition

This paper proposes an allocative “green credit policy” approach, whereby incentives and targets are deployed to align the financial sector with governments’ decarbonisation plans.

It distinguishes this approach from the risk-based framework that currently dominates financial policy related to the green transition. It offers a critique of the existing approach, highlighting that it has not succeeded in shifting financial flows from transition-incompatible activities – particularly given bank credit to carbon-intensive sectors has continued to increase in the nearly seven years since the Paris Agreement.

The authors characterise the risk-based approach as being primarily focused on policies such as disclosure, taxonomies, scenario analysis and stress testing, which they say amount to outsourcing the pace and nature of decarbonisation to private finance.

They say such policies are vulnerable to regulatory capture and poorly equipped to deal with the shift towards market-based finance. They also argue that they fail to account for the radically uncertain nature of climate risks.

Instead, the paper advocates an allocative credit policy regime which places greater emphasis on environmental outcomes as a justification for policy intervention. It proposes a framework that includes both incentive tools – like climate-adjusted capital requirements – and coercive tools such as outright bans on financing certain sectors.

Such policies would target both the banking system and market-based finance to ensure the entire financial system is aligned with green transition objectives. They would be dictated by the green industrial strategy, the need to develop green infrastructure, and the need to downsize transition-incompatible sectors as defined by a public taxonomy.