economy

 

Budgetary guidelines for a low-carbon economy

Climate change, climate hazards, and climate disasters are happening more frequently and have the potential to put economies on a path of slower growth, more financial instability, budgetary restrictions, and even poverty traps. For developing nations that are more susceptible, this is especially true. Fiscal Policies for a Low-Carbon Economy, our recent report, explores how a combination of carbon pricing and green bonds might manage climate-related risks, enhance economic recovery strategies, and enable a just transition to a low-carbon economy.

According to studies on climate economics, green bonds can help advance renewable energy technology, better address the issue of fair transition, and act as a stabilizing force on the financial market when compared to conventional assets, particularly those based on fossil fuels. They can also accelerate the low-carbon transition. Our research backs up these conclusions.

Global green bond issuance increased to nearly $250 billion in 2019, up from roughly $30 billion in 2014, and surpassed investments in renewable energy (Figure 1). Since the World Bank issued its first green bond in 2008, the number and variety of issuances have grown dramatically, providing further evidence of this instrument's potential to assist in supplying the funding necessary for the low-carbon transition. Many nations have a significant demand for these assets; oversubscriptions, for instance, were recorded in 2020 for German, Egyptian, and Chilean green sovereign bonds as well as in 2019.

Green bonds can both help and speed the low-carbon transition by helping to meet its financial needs.  Green bonds can really collect private money and act as project-level bridge financing to increase the variety of low-carbon technologies that are readily available, bridging the gap until carbon pricing systems can be appropriately scaled up. One of the largest solar energy installations in the world is in Noor-Ouarzazate.

By generating 2624 GWh of clean energy, this project will significantly assist Morocco in meeting its climate goals by raising the proportion of renewable energy in the overall energy mix to more than 40%. Green bonds are able to hasten the mitigation process by adding to the financial resources. The green bond market in China, which has quadrupled in size over the past four years to reach roughly $120 billion, has experienced the most spectacular mobilization to date.

Additionally, green bonds have a number of qualities that appeal to both investors and issuers in the financial market. In comparison to traditional (such as fossil fuel) assets, green bonds in particular can operate as a stabilizing effect on the financial market. The report provides preliminary evidence that the issuance of green bonds may benefit risk management for asset and portfolio holdings as well as increase investor diversity and scalability.

For instance, Figure 2 demonstrates that a higher proportion of green bonds reduces the variance in portfolio returns during recessions (or shocks to the price of oil), demonstrating the value of these securities as a hedging tool, particularly during recessions or periods when the price of fossil fuels is dropping.

The green bond market is relatively tiny and developing, thus results should be carefully analyzed. Despite the fact that green bond issuance has grown alongside investments in renewable energy in recent decades, as shown in Figure 1 above, green bonds still make up a small portion of the financial market's assets.

Green financial policies include carbon taxes and green bonds.

Carbon pricing has been widely advocated as a way to quicken the shift to a low-carbon economy, and many experts and policymakers agree with this strategy. By increasing the cost of fossil fuel energy and supporting the development and use of renewable energy, carbon pricing aids in the transition to a low-carbon economy. In reality, carbon pricing has taken on a variety of shapes, including a carbon tax and an emissions trading scheme (ETS).

                            image source- image

In order to meet climate goals, financial market tools have also been utilized to promote the expansion of renewable energy. Through alternative energy Exchange Traded capital (ETFs), for instance, there has been a significant flow of financial equity capital directed toward climate mitigation and adaptation strategies (Engle et al. 2020). According to data (Figure 3), green investments recently beat carbon-intensive assets. The research explores the interaction between carbon taxes (such as a Pigouvian tax levied on carbon-intensive commodities and services) and green bonds (a market debt instrument to fund low-carbon investments), adding data to support the advantages of issuing green bonds.

Why combine green bonds and carbon taxes?

Combining a carbon price with climate bonds as tools for speeding climate mitigation and adaptation initiatives has four primary advantages:

Although replacement effects are a key component of carbon pricing, it's possible that substitutes are now unavailable and must be generated through private or public-private partnership investments. Green bonds can be used as interim financing for low-carbon alternatives;

Green bonds produce good externality effects while carbon taxes can lessen negative externalities (and encourage investments to do so); both seem to be necessary.

In the transition to a low-carbon economy, green bonds enable inclusive growth strategies with greater environmental justice and fairness within and across generations; and lowers the issue with "stranded assets," or financial liabilities.

Market education continues.

Market players are diverse and still in the learning process, and the green bond segment of the asset market is still modest. Although the performance of green bonds depends on a variety of variables (the issuer, rating, currency, bond maturity, and sector), our analysis suggests the following preliminary findings:

Compared to traditional bonds and assets, particularly those based on fossil fuel energy, green bonds seem to be less volatile. According to Kapraun and Scheins (2019), green bonds likewise appear to sell at a (negative) premium, and their Sharpe Ratio (the return-risk trade-off) appears to be comparable to or even higher than that of conventional or fossil fuel-based bonds.

A high correlation between changes in the price of oil and the returns on carbon-intensive securities is also demonstrated by the literature and our early research. Green bonds are a suitable hedge for investors since they have lower volatility and minimal correlation with the prices and returns of assets based on fossil fuels.

cheaper volatility and yields could offer both individual and institutional investors better options for asset diversification, steadier returns for investors, and cheaper capital costs for issuers. Contrarily, co-movement with oil price swings makes the revenue of carbon-dependent countries sensitive and raises financial volatility in specific industries and nations when it comes to assets backed by fossil fuels.

Cycles of the economy and green recovery

Given the potential advantages of green fiscal tools, decision-makers ought to think about including these measures into plans for economic recovery.  Carbon taxes and green bonds work together to fully address long-term climate externalities, and may even encourage the formation of beneficial externalities. However, a carbon tax levy may be less prudent during business cycle downturns, while green bonds (and green assets generally) seem to be an effective macroeconomic stabilizer and addition to portfolios.

How to balance green bonds, carbon taxes, and other instruments presents a difficulty in this situation. Some nations have limited access to the credit market, limited budgetary room, and other limitations. These nations are already more badly impacted by the COVID-19 situation and more susceptible to climate concerns. There is a need for early debt forgiveness, debt restructuring, and innovative financial instruments like green convertible bonds or climate-to-debt swaps because they must have access to funds for rescue and recovery initiatives.

image source- https://blogs.worldbank.org/climatechange/fiscal-policies-low-carbon-economy