This article first appeared on the website OMFIF on 11 January 2023.

Marcus Pratsch, Head of Sustainable Bonds and Finance.

Frank Scheidig, Global Head of Senior Executive Banking, DZ BANK.

Many countries are looking to carbon markets and SLBs to address climate change

Without fast and deep emission reductions in all sectors, limiting global warming to 1.5 degrees Celsius is not achievable. Effective action requires concerted and sufficient investment, knowing that the costs of inaction will be far higher. The good news is we have all the tools and the knowledge required to limit warming. However, we need to speed up. This also means that market instruments must be expanded and applied more broadly and equitably to support immediate emissions reduction and encourage innovation.

Nationally determined contributions are at the core of the Paris agreement and key to the achievement of its long-term goals. According to the Intergovernmental Panel on Climate Change, developing countries alone require up to $6tn by 2030 to finance not even half of their climate action goals. While financial flows are three to six times lower than levels needed by 2030 to limit warming to below 2 degrees Celsius, there is sufficient global capital and liquidity to close investment gaps.

Many countries are looking to carbon markets as part of the answer. Issuing green bonds is another solution for financing climate change mitigation and adaptation. So far, Europe has been the first (and the only) continent to promote the use of carbon markets to reduce emissions and of the green bond segment to finance the transition to low-carbon economies.

During COP27, Mike Bloomberg, founder and CEO of Bloomberg, said ‘Carbon markets were perceived like the wild west in the past. But now they [will] become the new sheriff in town.’

This underscores that carbon finance will be crucial for the implementation of NDCs. Carbon pricing provides mitigation incentives and indirectly reduces the vulnerability of the economy to climate change. According to a report from the World Resources Institute, interest in carbon markets is growing around the globe: 83% of countries intend to make use of international market mechanisms to reduce greenhouse gas emissions.

To support climate action on a large scale, building integrity into carbon markets is key. Emissions reduction and removal must be real and consistent with a country’s NDC. The institutional and financial infrastructure for carbon market transactions must be transparent. And there must be adequate social and environmental safeguards to mitigate adverse effects as well as protect positive project impacts, including the respect of human rights.

A vibrant sustainable bond market can be instrumental to monetise sustainable policies and national commitments such as the NDCs.

Climate-related projects often require long-term financing which cannot be channelled by the banking industry alone. This is where green bonds can be an effective solution. They can finance renewable energy and energy efficiency projects at lower costs for a long tenure. In addition, funds raised through green bonds usually have fewer restricting covenants, compared to bank loans, and are therefore a much more attractive source of climate-related finance.

Another way to link sustainable sovereign financing with NDCs could be through sovereign sustainability-linked bonds. These bonds are for general budget spending like any other government debt, but with a link to a refinancing mechanism if NDCs or other targets are met. By issuing the world’s first sovereign SLB in March 2022, Chile successfully demonstrated that sustainable bonds could monetise not just sustainable public expenditure and infrastructure but also sustainable policies and national commitments such as the NDCs.

Transition bonds are another promising instrument in the sustainable bond market. Both as a use-of-proceeds and as a target-linked variant, they offer issuers the opportunity to raise capital for the funding of projects that will help them align with their local country’s NDCs.

The need for transition financing to successfully implement the Paris agreement is undisputed. We cannot achieve a decarbonised and more sustainable world by focusing exclusively on economic activities, business models and sectors that are already ‘dark green’. We can have a much greater positive impact on the global sustainability agenda by helping to make ‘brown’ economic activities, business models and industries ‘light brown’ or ‘light green’, rather than painting already ‘dark green’ activities, models and sectors one shade greener.

Both carbon market instruments and sustainable bonds are effective financial instruments for the implementation of NDCs. They are complementary, as we can only create a green and low-carbon economy by allocating large amounts of capital towards a more sustainable future. As we are running out of time, this can only be done by using different instruments in parallel.