Innovative finance for climate action: is it more than a “green bubble”?

Climate change remains one of the world’s most pressing issues, and the financial community has started developing innovative solutions to support climate adaptation.

Some estimates indicate that assets integrating environmental, social and governance (ESG) considerations have reached $35 trillion in 2020 or no less than 36% of total professionally managed assets. Especially, green, social, and sustainability (GSS) bonds have flourished, thus mobilizing billions of dollars for climate-related projects. In August 2021, the Climate Bond Initiative reported that the issuance of GSS bonds reached a record-breaking milestone of half a trillion dollars during the first half of 2021, a very encouraging result when compared to the full 2020 total of “only” US$297 billion. Such data evidence tends to demonstrate that the “green revolution” is underway in the financial markets.

However, some voices have raised concerns about a potential “green bubble”. A few months ago, the Bank for International Settlements (BIS), which is the central bank of the world’s central banks, warned about the current risks of a green bubble, highlighting that “historical lessons (…) could be relevant for ESG securities. Assets related to social changes tend to undergo large price corrections after an initial investment boom”.

Indeed, the financial markets have seen many innovations turn into financial turmoil, also called “bubbles”, whereby the price of stocks, assets, or even industries, far more exceeds its actual value. These financial crises generally follow the same patterns again and again – financial history often repeats itself. Bubbles start with some great innovation, while prices rise slowly at first. Then the markets enter rapidly a stage of euphoria, with more investors experiencing the fear of missing out (also known as “FOMO”). Thereafter, the panic gets to investors after they realize that the underlying assets cannot deliver magical returns. Therefore, asset prices reverse course as rapidly as they had increased, and some investors lose it all. This same scenario has been repeating itself for centuries. One of the first historical speculative bubbles was the Tulip Mania in Holland in the early 1600s, when individuals started buying tulip bulbs, recently introduced in Europe via the spice trading routes. The market became euphoric, with tulip bulbs reaching sky-high values, before falling apart suddenly in 1637.

While climate change is a much more serious issue than this tulip bulb mania, are we experiencing some degree of euphoria in the climate finance markets? Could it be counterproductive for climate action?

Some strong fundamentals tend to demonstrate that climate finance is here to stay. First, the world is undergoing a massive multi-trillion-dollar wealth transfer as baby boomers pass on their resources to upcoming generations, especially the millennials who are more focused on climate action. In addition, data evidence shows that climate finance can deliver both financial returns and positive environmental outcomes. Finally, technology innovations are expected to reduce project transaction costs, as has already happened in the clean energy sector.

However, these market fundamentals might not be enough to avoid a green bubble. Additional action is needed from governments, regulators, and private investors to ensure the climate finance industry delivers its promise of transformation in the next decade. First, the market suffers from the lack of global standards for climate-related disclosures that should be mandatory for organizations. Therefore, the risk of greenwashing remains too high. While G7 recently supported “moving towards mandatory climate-related financial disclosures”, such policy initiative might materialize too late compared to the speed of innovation in the financial markets. Secondly, private investors can also play a key role by transparently integrating climate considerations in their investment strategies, by investing responsibly in ventures that will help bring the transformations needed for climate adaptation. These elements will be a sine qua non for capital markets to help achieve a true transformation for climate adaptation.