Final Project - Sustainable Finance

Evaluating the Impact of Green Financing on Carbon Emissions Reduction

Introduction:

Since the European Investment Bank (EIB) introduced the first climate awareness bond in 2007, the green bond market has seen remarkable growth. One major change that has taken place in recent years is the emergence of a deep green bond market. Green bonds, which are self-labeled fixed-income securities designed to raise funds solely for green projects, are viewed as instruments for both climate change mitigation and adaptation. The expansion of the green bonds market not only promotes the development of green finance and brings diversification benefits, but also has significant implications for the environmental impact of green bonds and their liquidity. Addressing climate change necessitates cutting carbon emissions, and a key component of this effort is the financing of carbon reduction measures. Therefore, a forward-looking analysis could focus on the effectiveness of such financing in actually reducing emissions.

A fundamental question is whether green bonds bring clear environmental benefits, specifically whether they contribute to a reduction in global greenhouse gas (GHG) emissions, including carbon dioxide (CO2). Assessing this remains a challenge for several reasons: granular information on the projects being financed or their impact is scant. Despite the scarcity of data, it’s possible for us to obtain some basic understanding by developing some simple models that assess the interplay between green debt issuance (in billions of USD) and carbon emission data (in millions of tons).

Dive into the Trend:

Figure 1.1 presents an interesting juxtaposition of two distinct trends related to environmental finance and emissions from 2007 to 2020 on a global scale. The bar graph indicates a general upward trend in green debt issuance, with a notable increase beginning around 2014. Particularly, the year 2020 stands out with a significantly higher amount of green debt issuance compared to previous years. The red line, which indicates the average percentage change in emissions, fluctuates over the years. Theoretically, it should move in the opposite direction to green debt issuance; however, the graph does not show a clear upward or downward trend, nor does it present an obvious correlation between the two trends. While green debt issuance has increased, especially in the latter half of the observed timeframe, the change in emissions does not demonstrate a consistent pattern in response. This inconsistency could imply that the impact of green debt on emissions is not immediate, or that other factors are influencing changes in emissions.

Figure 1.1

To further discover the nexus between the two indicators, Figure 1.2 introduces a metric that accounts for the influence of GDP growth by presenting a weighted green debt issuance. This adjustment is crucial because if the rate of green debt issuance does not exceed GDP growth, then the relative impact of green investments on the overall economy might be too weak to incur a noticeable change in emissions. Essentially, the green projects financed by the green debt may be too small to counterbalance emissions from the rest of the economic activities.

Presenting the amount of green debt issuance as a percentage of the total GDP of the country allows us to observe some level of correlation. This normalization allows for a more meaningful comparison, especially when considering the variability in economic sizes and growth rates among different countries. We now find an inverse relationship between the trend of the percentage change in emissions and the green debt proportion in 2016-2017. Though such a correlation does not necessarily indicate causation, the apparent inverse relationship could be an encouraging sign that potentially points toward the benefits associated with green bond issuance.

Figure 1.2

Comparative Analysis by Country:

Although the figures above suggest a certain degree of relationship between green debt and GHG reduction, a closer examination of each country is necessary to determine whether the magnitude of this relationship is underestimated. It is plausible that outliers exist—countries that have issued a small amount of green bonds but contribute disproportionately to GHG emissions, or vice versa. This could distort the overall picture if the emissions data are not weighted by the size of the green debt or the economic output of the issuing entities. Therefore, world maps are utilized to reflect the average carbon emissions, as well as average green debt issuance, from the year 2018 to 2022 at the macro level, with a color gradient ranging from yellow to dark purple, indicating rising levels of carbon emissions and green bond issuance, respectively.

From Figure 2.1, we notice that typically large industrialized nations or those with high fossil fuel consumption have the highest levels of GHG emissions. The US, India, and Russia are among the top countries with the highest levels of carbon emissions from 2018 to 2022. The United States, with its large and diverse industrial base, substantial transportation sector, and high per capita energy consumption, has historically been one of the largest emitters. India’s position as a top emitter is closely linked to its rapid industrialization, growing energy sector, and increasing urbanization, which have naturally resulted in significant carbon emissions. Meanwhile, the high emission rate in Russian is primarily due to its energy production sectors.

Figure 2.1

*Note that some of the countries are not shown on the map due to unreported data in OECD/IMF database

Being among the largest carbon emitters in the world, the countries show varying levels of commitment to green financing, as expressed through the issuance of green bonds. From Figure 2.2, we observe that India, as well as some European countries, do not exhibit strong engagement in sustainable finance, as reflected by their yellow coloring indicating a low level of green debt. In contrast, countries like the US and China are demonstrating a strong commitment to green financing. This result is intriguing, especially considering that Europe is often perceived to be proactive in environmental finance. The discrepancy could be the result of different data scales; if the scale is not adjusted for the size of the economy or the population of the countries, the absolute amounts might be significant but may appear small relative to the country’s GDP or total bond market.

In addition, the green bond market’s maturity can vary across different regions in Europe. Some European countries may have well-established green bond markets, and the relative issuance might reflect market saturation or a shift towards other forms of sustainable finance, while in others, the market could be nascent. Furthermore, since the economic context of each country differs, their focus on sustainability can also vary. It is worth noting that India, despite having a large economy, is still an emerging market with different financial and environmental challenges compared to European countries. The country’s focus might be on addressing immediate economic development needs, with green financing being a growing but still developing area. Overall, these snapshots may provide some indication of the geographical distribution of green financing levels, but a deeper analysis is indeed required to fully understand the nuances of green debt issuance in each country.

Figure 2.2

Regression Analysis:

Last but not least, a simple method is used to examine the percentage change in carbon emissions as a dependent variable, based on the percentage change in green debt issuance, taking into account GDP weighted by the producer price index. This approach yields linear regression results. As shown in the graph below, the distribution of data points is quite dense at the lower end of debt issuance, indicating that most of the green debt issuance corresponds to a small proportion of total domestic production, perhaps due to the relatively new and emerging nature of the market. The cluster of points centered around the zero line for percentage change in emissions suggests that, in many cases, the change in emissions is minimal. The second graph provided offers a more detailed scatter plot with the addition of color-coded best-fit lines corresponding to the effect of green debt issuance on carbon emissions for each year. The colored trend lines for individual years illustrate that the impact of green debt issuance on emission changes is not consistent over time and may be influenced by other factors not captured in this two-dimensional analysis. However, in both figures, there are indications that with higher debt issuance, the variability in emission changes increases; as the proportion of debt issuance rises, the spread of percentage change in emissions also seems to widen.

Figure 3.1

Figure 3.2

So far, however, green bond projects have not necessarily translated into significantly lower or falling carbon emissions at the country level. Thus, current labels for green bonds do not signal that issuers have lower or decreasing overall carbon emissions relative to overall production. However, this does not repudiate the usefulness of the instrument. Indeed, an inverse relationship between the trend of the percentage change in emissions and the green debt proportion is presented in our trend analysis and the linear regression model. Through this model, we can also identify factors that hinder a country from effectively adopting green financing instruments and reaping their benefits. In particular, the growth of the green bond market varies over time and depends on the expansion of the overall bond market and the economic health of the country. This is especially true in the context of emerging economies, where the priority often lies in addressing urgent developmental needs.

Conclusion:

Given the challenges the green bonds market is facing, we may consider tapering the market by allowing for greater standardization of the instruments to reduce the cost of issuing and to improve the reporting and tracking system. The goal would be to reduce the costs associated with issuing green bonds and to improve how we report and track their outcomes. If we integrate climate-focused financing into the broader financial market, rather than confining it to a niche area, it could have a more significant effect on reducing carbon emissions. This would happen as these financial tools become more widely available and used by a greater number of participants. Additionally, integrating green financing with broader economic policies and incentives could encourage a more holistic approach to reducing emissions. Projects financed by green bonds should be clearly linked to specific environmental outcomes, such as measurable reductions in carbon emissions. This alignment would make the impact of green bonds stronger. Moreover, engaging a diverse array of investors and educating the public on the potential of green bonds could stimulate further growth and acceptance of these instruments. As green financing matures and evolves, it has the potential to play a pivotal role in transitioning towards a low-carbon economy, provided it is part of a comprehensive strategy that includes robust environmental governance and enforcement mechanisms.