There are primarily two parts to the international experience in financing carbon neutrality: first is how to mobilise private finance to low-carbon investment, and second is the prevention of climate risks. Both are very important and require mobilising more green finance as well as guiding finance out of high-carbon industries in an orderly manner. Below are eight aspects of the international experience that may be relevant for China.

Learning extensively from international standards and methods

First is the formulation of the standards defining green and sustainable finance. The EU has recently enacted the EU taxonomy for sustainable activities after three years, in which a very important principle is put forward: the Do No Significant Harm principle. The principle demands that any of the sustainable objectives supported by sustainable-finance projects, such as environment, climate and biodiversity, may not be harmed.

China’s first edition of the Catalogue of Projects Supported by Green Bonds was drafted by the Green Finance Committee of the China Society for Finance and Banking and published in 2015. In the new green bond catalogue published by the People’s Bank of China (PBOC) this year, we have learnt from the EU’s Do No Significant Harm principle and removed high-carbon projects such as clean-coal technology. The previous green catalogue has included some green projects that would damage the climate objectives, including the clean-coal projects. However, the circumstances were different and the smog issue dominated between 2014 and 2015, so the focus of environmental policies was smog control, regardless of the methods adopted, as long as they reduce smog they were considered to be “green”. Some projects, especially the clean-coal technology, have also been included in the green projects and the catalogue of projects supported by green finance, even though they are only able to reduce sulphur dioxide, nitrogen oxides and dust and not carbon dioxide.

But the times are different now. The mean value of Beijing’s particulate matter (PM) 2.5 has dropped from 90 to 38 between 2013 and 2020. The PM 2.5 target that China’s environmental departments have set for Chinese cities is 35 by 2030, so the current value is very close to the target.

Meanwhile, senior government departments have proposed carbon-neutrality targets, which have become the most critical breakthrough point for future green development and the building of a circular economy. As a result, the focus of environmental policies has also shifted dramatically, allowing the enforcement of the internationally advocated Do No Significant Harm principle. In other words, our future green standards may not harm major objectives such as the tackling of climate change. If harm will be done, even if other environmental objectives will enjoy positive effects, the standards should not be included.

Currently, we are still learning from the Do No Significant Harm principle. The catalogue for green bonds has been revised, but the current Statistical Standards for Green Credit and Guiding Catalogue for Green Industries still contain high-carbon projects such as fossil fuel. That is why these green catalogues should also observe the Do No Significant Harm principle in their next revision. 

Second is the performance of environmental- and climate-risk analysis. The so-called environmental- and climate-risk analysis is the use of methods such as stress testing and scenario analysis to evaluate how environmental and climate factors impact the asset quality and financial risks of financial institutions. 

China has explored this aspect. Industrial and Commercial Bank of China (ICBC) performed environmental stress testing back in 2015, primarily focusing on the impact that air-pollution-control policies had on credit risks. Air pollution-control policies may crackdown on high-pollution industries, which will have to pay more taxes and receive more penalties, leading to the risk of rising default rates. ICBC later also performed environmental and climate stress testing related to carbon.

Currently, only about three banks in China have explored this aspect, whereas most major financial institutions in Europe and the U.S. are already conducting stress testing and scenario analysis on environmental and climate risks; China, therefore, lags in popularising the practice.

So what exactly is being analysed? My research team released a report last year that calculated the possible rise in default rates among sampled Chinese coal businesses using the model of climate-transition risk analysis. The report concludes that during the transition towards carbon neutrality, the default rate of sampled Chinese coal businesses may rise from 3% in 2020 to 22% in 2030.

Internationally, such a conclusion is nothing new. Similar cases were seen over the last few years. For instance, Vivid Economics, a British company specialised in environmental- and climate-risk analysis estimated that the valuation of coal-power companies would drop by 80% during the process of achieving carbon neutrality, while that of petroleum-related companies would drop by 40%. Meanwhile, the 2° Investing Initiative from Europe also released a report stating in a two-degree scenario, the valuation of coal-power companies would drop by about 80% while default rates related to coal power would rise four-fold.

Despite such conclusion has already been reached internationally, it is only just starting to draw attention in China and has triggered the expected market changes, with Chinese regulators worrying the expected sudden changes will lead to a volatile market. These risks indeed demand attention and response.

I believe that a single prediction alone for such risks does not suffice and everyone should be encouraged to carry out the research. The results may be extreme predictive values from both ends with predictions forming a probability distribution. However, with a mean value, the predictions will stabilise over time.

Furthermore, regulators should establish a set of standardised means and frameworks for the analysis of environmental and climate risks, so financial institutions may conduct research using comparable frameworks, means and hypotheses in the future.

In this respect, notable attempts have been made internationally. The Network of Central Banks and Supervisors for Greening the Financial System was established by eight central banks and supervisors, including the PBOC, European Central Bank and Bank of England, in 2017. Today, the network has grown into a mechanism with 89 members that coordinates global central banks and regulators and has put forward four scenarios for future environmental and climate stress testing and economic analysis. China’s regulators should focus on the standard frameworks proposed by international organisations, which may serve as good lessons for the regulation of environmental risk analysis in China.

Strengthening the disclosure of carbon-footprint and brown-asset information

Third is the strengthening of disclosure of information related to climate. Europe has long regarded climate change as most critical to green development. As a result, businesses and financial institutions were early to begin the disclosure of information related to climate, such as the carbon emissions produced by the investment and loan projects of banks or asset management institutions

Currently, no Chinese financial institution has begun such work, whereas it is already happening abroad. For example, Aviva, which is launching pilot programmes under UK-China Green Finance Taskforce, calculates the carbon emissions, known as carbon footprints, produced by its equity- and debt-investment projects. Data show that carbon footprints are decreasing each year. Take, for example, the carbon footprints were 175 last year, which decreased to 165 this year and further decreases to 150 next year. This shows a trajectory of moving towards carbon neutrality. If we do not know the carbon footprints of loans or investments, we cannot plan for carbon neutrality. The objective of carbon neutrality is to achieve net-zero emissions, which requires advanced calculation and disclosure. 

Fourth is the calculation and disclosure of the exposure of brown assets. Apart from Chinese financial institutions, particularly banks, that disclose green assets and credit, foreign financial institutions are also disclosing the exposure of brown assets, and this is important. Brown assets refer chiefly to high-carbon assets, including fields that China’s carbon market will cover, such as the thermal-power, iron-and-steel, building-material, non-ferrous metal, petrochemicals and paper-making industries, which will certainly be included in the definition of brown assets. It is likely that a few other industries that do pollute but are not large producers of carbon emissions may also be included. I estimate that a dozen industries will be included in the definition of brown assets. 

Exposure of brown assets must be calculated and disclosed, the theoretical foundation of which is that green finance policies must be policies that prevent environmental and climate risks. Without knowing the exposure of brown assets, the risks may not be assessed, prevented and managed. It is therefore necessary to first define the scope of brown assets and calculate their proportion, based on which their impact on the environment and climate may be calculated and the potential financial risks as a result of asset default or impairment assessed.

Giving full play to the role of market mechanisms in driving the innovation of green products

Fifth is the innovation of carbon products. A few fields have currently drawn wide attention, and one of them is financial products that are linked to carbon footprints. Banks and bond markets may respectively offer loans and issue bonds linked to carbon footprints, and the interest rates may be linked to the carbon footprints of the financed businesses or projects. If businesses can reduce carbon footprints to below the expected level, then interest rates may be lowered. If they are unable to reduce carbon footprints to the promised target and they are higher than expected, then interest rates will go up. The extent and direction of the interest rate change all depend on the level of carbon footprints.

Such financial products place projects or businesses under pressure to reduce carbon emissions during the agreed terms. They are constantly driving businesses to reduce carbon emissions to cut interest rates. There is no shortage of good such examples abroad, and I believe China should also take a leaf out of their book.

Sixth is the great importance of transformational financial products. In the overall economy, the majority of the GDP comes from carbon-emitting and high-carbon industries, whose funding we are unable to immediately cut off. We may, however, attach green requirements for new loans and support the low-carbon transformation of these industries. Such transformational financial support will become increasingly important, perhaps even more than pure green finance. Its proportion may increase but so are the challenges. 

So how to achieve it? I have been discussing with the Asian Development Bank (ADB) whether a transformational-financial pilot programme may be launched in China. The initial consideration is that an international development institution such as the ADB provides low-cost finance to, for example, China’s coal-power projects, so they may within the next five to seven years transform into new-energy businesses. This will prevent these businesses from defaulting or dramatically retrenching while ensuring an uninterrupted power supply. Not only does this ensure production, economic and social stability, but also prevents financial risks.

If a transformational financial product may be paired with other resources, such as resources from local governments, benefits from talent introduction and the policy of grids powered by new energy, then the likelihood of its success will be increased and the application highly extensive.

Major financial institutions should actively play a leading role

Seventh is that asset owners should become the driver. In the asset-management industry in China, many asset managers are selecting their investments based on the principles of green investment and the environmental, social and governance (ESG) criteria. In the West, it is mostly asset owners who play a leading and guiding role. So who are the asset owners? Sovereign wealth funds, pension schemes and insurance companies for instance. When assigning their wealth to asset-management institutions, these wealthy institutions should communicate to the managers to follow the ESG criteria and the principle of responsibility and give preference to low-carbon, green and sustainable assets.

Following such a lead, the entire asset-management industry may soon turn green. For example, the Social Security Fund or the State Administration of Foreign Exchange needs to invest a certain amount of funds into ESG products. If 5% of the funds managed by a certain asset-management company come from these green funds, then the remaining 95% of its funds will optimise automatically. Its overall processes, methods and adopted data will become green, which will rapidly drive other funds to become green.

For example, Norges Bank, manager of the largest sovereign wealth fund in Norway, is a powerful driver of the greening of asset management. It has assigned many green funds to asset managers, even asset managers in China are under its influence. It actively adopts an active shareholder strategy to influence the invested businesses. Over 1,000 of the invested businesses are influenced and formulate strategies and plans according to ESG criteria proposed by shareholders, so as to develop more sustainably. The international experience of asset owners influencing the asset-management industry and the greening of the invested businesses are something worth learning from.

Eighth is the issue of carbon neutrality facing the operation of financial institutions. Many good approaches are currently available, and 30 major international financial institutions have achieved carbon neutrality in their operations, while more have announced their plans for carbon neutrality in their operations. So what does such carbon neutrality mean? It means these institutions achieve carbon neutrality in their offices and with their vehicles. The carbon emissions generated by their employees on business trips must also be neutralized. Among the Chinese-funded institutions, Haitong International is perhaps the first financial institution to set forth its carbon-neutrality plan; it announced at the end of 2020 to achieve carbon neutrality in five years. 

So what exactly should be done? Specifically, first is the renovation of buildings to reduce energy consumption. If not, then purchase green power while reducing employee travel, such as always using videoconference where possible instead of flying around. This may still not help achieve the carbon-neutrality target, then carbon sinks may be purchased or trees planted in Inner Mongolia, so as to strive to achieve carbon neutrality in five years.

According to calculation, the target may not be costly but will produce tremendous exemplary effects. While trying to achieve carbon neutrality, employees will widely spread the concepts and methods of carbon neutrality, and the tens of thousands of businesses and clients they come across will also be influenced, so I see such a mechanism as being very effective.