2022IFCII | Tzu Kuan Chiu: green finance should be guided by an optimal top-down design and a comprehensive framework

"2022 International Forum for China Impact Investing (IFCII): from Beliefs to Action" was held online from June 30 to July 1. This article is based on the presentation by Professor Tzu Kuan Chiu at Shanghai Advanced Institute of Finance (SAIF), Shanghai Jiao Tong University (SJTU) and Academic Director of the Sustainable Finance Discipline Development Fund.

Both green finance and transition finance are goal-oriented, which aim to support the sustainable development of the real economy. Sustainable Development Goals (SDGs) cover environmental protection as well as social development. Environmental sustainability is adopted by China’s carbon neutrality goal and the Paris Agreement-aligned target, which aims to hold global average temperature increase to “well below 2°C above pre-industrial levels and pursue to limit the temperature increase to 1.5°C above pre-industrial levels”[张1] . Both goals involve the net-zero target. Put simply, net zero means cutting greenhouse gas emissions to as close to zero as possible, with any remaining emissions re-absorbed from the atmosphere, by oceans and forests for instance. ESG is usually based on the framework of the UN's 17 SDGs, including No Poverty, Zero Hunger, Good Health and Well-being, Quality Education, Decent Work and Economic Growth, etc.

How is the goal-oriented financial system different from traditional finance? Simply put, traditional finance involves two dimensions: investment returns and risks. When we shift to goal-oriented finance, a third dimension must be added to reflect goal attainment, i.e., the social and environmental benefits. For example, it should be able to tell whether the green fund has promoted common prosperity and carbon neutrality. The performance assessment needs to set appropriate KPIs, such as the reduction of CO2 emissions, water conservation, and narrowing urban-rural disparity. The results need to be released to investors, government, stakeholders, and the public.

The top priority for green finance and transition finance is to build a framework. This framework has several layers from top to bottom; each layer has several interdependent elements.

Real economy is the first layer of this framework. Once the goal is set, next is to establish a green taxonomy and standard. The green taxonomy will help identify economic activities that meet green standards so that funds can be channeled to promote sustainable goals. "Green economic activities" includes not only near zero activities, but also high emission activities engaged in the "pathway to zero" campaign, and enabling activities.

Globally, China and the European Union (EU) are two major players in the green finance ecosystem, but the two have different taxonomies that suit their respective conditions. The EU adopts a principle-based taxonomy to establish a list of environmentally sustainable economic activities. This top-down methodology focuses on the macro level but may not be practical. China adopts experience-based taxonomy that generalizes qualified green activities based on experience; this bottom-up taxonomy is practical but may not be very comprehensive.

If we hope to establish a green taxonomy that can be adopted globally, two key elements need to be considered: a macro-level framework and a top-down design. This framework should focus on the macro level and be ambitious, stand-alone, and forward-looking. The principles should fit all scenes; therefore, they should be abstract and not be based on the rules of thumb. Of course, abstract principles will eventually be applied to specific contexts, which vary from country to country and region to region, so the selected green activities, projects, and enterprises may not be the same.

As countries move toward carbon neutrality, initially they have more brown economy than green one. However, in the end, when carbon neutrality is achieved, all activities and assets will become green. Therefore, green finance or brown transition finance, they are both goal-oriented finance based on China’s macro goals.