The 10-member countries in the Association of Southeast Asian Nations (ASEAN) are among the planet’s most vulnerable to climate change. Yet the region’s ability to meet its green financing needs and mitigate climate change’s worst effects remains significantly underdeveloped.

We estimate that a minimum of US$1 trillion in sustainable investment is required across ASEAN from now through 2030 to decarbonize the regional economy and lessen the impact of climate change. However, according to the May 2023 Climate Bonds Initiative report, “ASEAN Sustainable Finance State Of The Market 2022”, the sustainable finance market of the region currently stands at only $36 billion.

Why scaling sustainable investments remains a major challenge

One of the many challenges preventing the scaling of sustainable investment is that green finance is not cheaper for banks to issue than general purpose finance, and thus it cannot be made materially less expensive for borrowers. According to a 2022 World Bank paper, “Structural Loopholes in Sustainability-Linked Bonds”, around 75% of sustainability-linked bonds have a differential coupon rate of 25 basis points (bps) or less. This provides little financial incentive for companies to fund green projects and meet sustainability targets.

Banks could help to scale up green finance by making it cheaper for companies to access, but it is currently hard to make a financial case to do so. First, on the near-term horizon, on which most finance is priced, green assets are often higher risk than brown ones. Therefore, the economics of risk do not currently create the pricing differential that green finance requires for growth. Second, the cost of funding for banks is not currently materially differentiated between green and brown finance, meaning they cannot pass on structural benefits to their clients. While banks can, and do, charge a lower margin for green loans, the reliance on internal subsidies will always limit the ability to meaningfully differentiate and scale up green finance.

Five game-changing ideas to lower the cost of green finance

To date, most of the focus of banks has been on the asset side of the balance sheet, but we believe innovation on green liabilities and technical solutions to lower funding costs should now be a key priority. Although banks can work on some of these ideas on their own, they can be scaled most effectively if tackled at a system level, including support from regulators and governments. By working together to make it cheaper for banks to issue green finance, we hope that they could in turn price green finance more cheaply.

The five main ideas are:

1. Green guarantee schemes to drive sustainable finance

ASEAN central banks, and perhaps wider governments as well, could establish a green guarantee scheme for banks’ portfolios of green loans. Under the scheme, banks would be able to create a pool of green loans from which they would bear the first losses. Subsequent losses, should they occur, would be borne by the central bank, relevant government departments, or bodies such as national development banks that provide the green guarantee.

Loans accepted into the green loan pool would need to comply with strict criteria. ASEAN central banks or other recognized bodies would need to define these criteria and ensure that the banks partaking in green guarantee schemes have robust processes in place to both apply these criteria and provide transparency as needed. A range of existing systems, such as the ASEAN Sustainable Finance Taxonomy, could be used.

2. Lowering funding costs with green covered bonds

A second option would be the development of legally defined green covered bonds, in which the bank issues a bond collateralized with a pool of green loans. In a covered bond, the bond’s investors have a preferential claim on the pool of loans before then having a claim on the remaining assets of the bank.

We see potential for the covered bond concept to be extended to certain green assets in the form of a legally defined green covered bond. Banks could then pass on the lower cost of financing from the green covered bond versus the funding rates that the green assets would otherwise have received. This would need careful parameterization, both to define the eligible assets and the collateralization requirements. However, we believe it has strong potential to drive down funding costs.

3. Linking green deposits to carbon credits

Several banks have already set up green deposit products in which deposited funds are ringfenced for funding the bank’s other green loans, assets and activities. These products rely upon a set of strictly defined criteria to ensure that the funds are being deployed as advertised in the green deposit terms. However, these deposits are currently not priced lower than standard deposits, so they do not give the banks any funding benefit to pass on in the pricing of green finance.

One option that authorities and financial institutions could consider is linking green deposits to carbon credits, allowing companies that place their money in green deposits to recognize these as offsets to the emissions in the rest of their business. This would tap into both the unmet demand from companies for high-quality offsetting instruments, and the relatively low cost of putting corporate cash to work for sustainability. 

4. Green repurchase agreements to cut green loan costs

Central banks could set up facilities to provide banks with cheap funding for their green loans. For instance, they could set up a green repurchase (repo) facility with a low interest rate in which banks could only repo green loans with specified characteristics, lowering the cost of funding for green loans. Banks could then apply a lower base rate through their funds transfer pricing (FTP) constructs to their green loans which are eligible to be included in the green repos facility, directly passing on pricing benefits to their clients.

5. Green finance gains from regulatory capital adjustments

In many jurisdictions, regulators have inserted support into capital requirement calculations to lower the capital required for lending to small businesses. This is typically achieved by applying different factors into the regulatory formula for small businesses versus other larger companies. While these adjustments were initially applied to limit the disruption of credit to small businesses during the phase-in period of stricter capital requirements after the 2008 global financial crisis, they have been retained since.

Regulators could consider providing regulatory capital relief for strictly defined green loans by making similar adjustments to capital requirement calculations. The degree of relief would require careful calibration to limit any knock-on impacts to financial stability, as it would directly affect bank capitalization. However, if regulators could implement capital relief with care, it would help to lower the cost of funding for eligible green loans.

Uniting banks and regulators to drive affordable green finance

The five financial engineering options for green liabilities and other technical solutions are aimed at the same goal — a meaningful reduction in the cost of funding for banks’ green assets, allowing banks to make it cheaper for companies to access green finance for their green projects, and thus accelerating the transition to a net-zero economy. None are easy to achieve. They require collaboration between financial institutions and authorities, significant innovation, and a degree of courage. However, the end goal is worth the effort and risk.