How policymakers can redirect financial flows towards sustainability

A large proportion of global capital still flows into climate-damaging activities. Financing the green transition is a decisive factor in whether the climate targets are achieved. A research project conducted by Witten/Herdecke University and the Institute for Ecological Economy Research (IÖW) has investigated how the financing gap can be closed and what policymakers and the financial sector can do to achieve this.

Today, the project team presented its findings and addressed three key recommendations for a more sustainable financial policy in the policy brief titled “Financing the green transition.”

First, the bankability of green investments should be strengthened in a targeted manner. Second, the financing of fossil and emission-intensive activities should be actively reduced. And third, more public funds should be made available for green activities that are necessary but generate little or no private return.

Huge funding gap for green transition

There is a huge global funding gap: According to the Climate Policy Initiative, about 7 trillion U.S. dollars a year are needed worldwide to achieve the climate targets. In Germany, the additional investment required is between 60 and 100 billion euros annually. At the same time, fossil fuel projects are still considered particularly profitable and low-risk—with serious consequences for the environment and society.

Strengthening the bankability of green investments

The research team identified key levers for redirecting capital flows in a sustainable manner. One of these is to strengthen the bankability of green investments. Policymakers can use financial incentives, guarantees and regulatory measures to achieve this.

Joscha Wullweber, head of the project at Witten/Herdecke University, explains, “In simple terms, bankability means: What is the risk-return ratio of an investment in the productive economy or in financial assets? In other words, what is the probability that I will not get back the money I invest, and will I receive a return on this risk that meets my expectations? The lower the risk and the higher the return, the greater the bankability.”

However, the bankability of many green projects is far too low for the financial sector to invest in them, the researchers’ analysis shows. In contrast, the bankability of numerous climate-damaging projects remains high. This is despite the fact that the European Sustainable Finance Regulation aimed to strengthen sustainability criteria for investments.

Making climate-damaging investments unattractive and strengthening public investment

In addition to policy recommendations also known as “de-risking,” the team developed financial policy measures to phase out climate-damaging investments. These measures should make it more difficult to finance fossil and emissions-intensive activities and regulate not only banks, but also non-banks or “shadow banks.” One promising measure would be the exclusion of climate-damaging assets from the collateral framework of the European Central Bank (ECB).

The project also identified areas that are essential for a decarbonized economy and the green transition and in which the state would have to play a stronger role in financing them. These include peatland protection, infrastructure for non-motorized mobility and flood protection, which cannot or can hardly be financed by private funds. Public funds can be mobilized through various instruments, such as an EU climate fund; a “Green Golden Rule,” which states that green investments are not included in the EU debt rules; or through targeted taxes.

Recognizing the limits of financial policy

The authors emphasize that an integrative policy mix is needed. Transition researcher Florian Kern from the IÖW comments, “Financial and monetary policy alone are, of course, not enough. They must be flanked by coherent innovation, industrial, fiscal and sectoral policies in order to advance the green transition in a socially just and ecologically sound way. Financial policy must effectively complement other policies in the area of environmental and economic policy, such as measures for the energy transition, resource protection or the circular economy.”

Silke Stremlau, chairwoman of the Sustainable Finance Advisory Committee of the previous German government, praised the project’s approach, stating, “The team’s researchers have succeeded in using their analytical lens to focus on the gaps in the current sustainable finance discourse. The question of whether the current measures are sufficient and what we can do if this is not the case is essential for the progress of the green transition. With the policy recommendations, a consistent set of measures is now on the table.”