Financing the Green Transformation

How to Make Green Finance Work in Indonesia

U. Volz,Judith Böhnke,Laura Knierim,Katharina Richert,Greta-Maria Roeber,Vanessa Eidt

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137486127
• Topic: Economía
• Subtopic: Economía medioambiental

Explores challenges for developing and emerging economies for enhancing green financing for sustainable, low-carbon investment, looking at Indonesia. Based on surveys in the Indonesian banking and corporate sectors and expert interviews, it devises innovative policy recommendations to develop a framework conducive to fostering green investments.

1

Introduction

Planetary boundaries and a scarcity of natural resources require a significant boost of investment into clean and renewable energy and a more efficient use of resources in developing, emerging and advanced economies alike. Addressing climate change globally requires the mobilisation of unprecedented financial resources. Developing and emerging economies face a particular challenge, since they not only need to mobilise resources for climate change adaptation and mitigation, but also have to address more imminent challenges such as infrastructure investments and poverty reduction. The development needs of societies and environmental sustainability need to be reconciled by moving towards a “green transformation” which puts “green growth at the heart of development” (OECD 2013).¹ Green growth can be defined as the “improvement of ecological quality of growth that simultaneously realizes economic expansion, improvement of welfare, poverty reduction and environmental protection, and emphasizes eco-efficiency of consumption as well as production” (Mori 2013: 5).

Despite varying amounts of financial commitments from national governments and international donors to finance a green transformation in developing and emerging economies, public finance alone will never suffice. To mobilise the necessary financial resources it is elementary that both private and public players combine forces in their financing efforts. According to the World Bank (2012a: 10) approximately 85% of the needed financial resources must come from private investors. In this context, the financial sector will have to play a key role in allocating “green finance” into sustainable investment and development. The concept of green finance, although still in its infancy, has attracted considerable interest in recent years, not least in the development community. Green finance comprises all forms of investment or lending that consider environmental effect and enhance environmental sustainability. An important element of green finance is sustainable investment and banking, where investment and lending decisions are taken based on environmental screening and risk assessment to meet environmental sustainability standards.

To foster green investments, not only the willingness of the financial sector to supply sufficient finance is crucial, but also the attractiveness of green investments for the private sector, thus generating the demand for green finance. By nature, the greatest attractiveness of green finance is seen in those sectors where resource saving is economically profitable and where abatement measures have only limited implications on consumer lifestyles (Vattenfall 2007). However, in addition it is crucial to focus on those sectors that will face increasing emissions caused through economic development. Key sectors, in this regard, are the energy and the industry sector where emissions are sharply on the rise in developing countries (Nyboer and Sharp 2007; Moomaw 2007). As a result, the industry and the energy sector offer large potential for the development of green finance in developing and emerging economies. The United Nations Framework Convention on Climate Change (UNFCCC) has calculated that total mitigation to keep industrial emissions in 2030 on a 2004 level will cause USD 205.5 bn of incremental costs (Nyboer and Sharp 2007: 8, 16). In addition, total investment for mitigations in the energy sector has been estimated by UNFCCC to be more than USD 20 trillion, up to 2030 (Moomaw 2007: 7).

Against this backdrop, this book investigates the challenges for developing and emerging economies for enhancing green financing for sustainable and resource- and energy-efficient investment, using Indonesia as a case study. Indonesia, a lower middle income country with a per capita income of approximately $3,500 in 2013 and the world’s fourth most populous country with almost 250 million people, is an interesting case study. The country, in which growth has followed a very carbon-intensive path, faces vast financing needs for green investment in clean and renewable energy, wastewater treatment and sanitation, as well as transport and infrastructure, both in rural areas and in urban areas such as Greater Jakarta with approximately 33 million people. Indonesia also needs to invest in a more efficient use of natural resources. At the G20 Summit in Pittsburgh in September 2009, then President Susilo Bambang Yudhoyono pledged to reduce Indonesia’s emissions by 26% by 2020 compared to a “business as usual” (BAU) trajectory. With international assistance, the emission reduction target is even higher with 41%. This is the highest commitment in absolute terms made by any country. At the same time, however, the government emphasises that the environmental goal should not come at the expense of other political dimensions: policies should be “pro-growth, pro-jobs, pro-poor and pro-environment”, allowing Indonesia to sustain growth at more than 6.5% a year as well as to halve poverty. As a result, the country faces vast financing needs for a green transformation of its industry and energy sector.

The study looks at three different levels to identify approaches for enhancing green finance: (1) the regulatory framework, (2) the potential supply of green finance through financial institutions and (3) the potential demand for green finance from the corporate sector. It also analyses the role that international development cooperation can play in supporting developing and emerging economies in designing a regulatory framework geared at increasing green investment. The book provides an in-depth analysis of the challenges facing developing and emerging economies in financing the green transformation. It includes the results of two surveys that were conducted in the Indonesian banking and corporate sector, respectively. Based on the empirical analysis, the book devises innovative policy recommendations for the Indonesian government to develop a regulatory framework that will increase incentives for a more efficient use of resources and increased investment in sustainable and energy-efficient ventures. The Indonesian case study is interesting in its own right, given that Indonesia is one of the largest emitters of greenhouse gases worldwide, but it also provides important insights for other developing and emerging economies so that the book should be of interest to a wider audience in scholarly as well as policy and business circles.

The book is organised as follows. Chapter 2 elaborates on the challenge of financing the green transformation that societies and economies worldwide are confronted with, and the particular challenges for developing and emerging economies. It examines the reasons for underinvestment in green projects from the corporate sector as well as the reasons why financial institutions have been hesitant to provide green finance. Private investments in the green transformation are obstructed by a combination of market and government failures. These failures prevent the allocation of capital into green investments to a socially optimal degree. The chapter dissects these failures and establishes the rationale for public intervention. Subsequently, it defines a set of criteria that should guide public intervention to facilitate private green investment and discusses different instruments to overcome the failures. It also spells out the potential pitfalls of such intervention. Despite the dangers of government failures, it is clear that the public sector ought to play a key role in catalysing and leveraging green investments.

Chapter 3 turns to Indonesia, where the government has set out an ambitious agenda for a green transformation. The chapter discusses the need for a green transformation of the Indonesian economy and analyses the Indonesian policy goals for significantly reducing carbon emissions and the resulting investment needs. It also provides an overview of the existing institutional and regulatory framework and investigates which of the challenges discussed in the previous chapter apply in the Indonesian context. Finally, it delineates the necessary action to achieve the set goals and discusses the relevance of and potential for green finance in Indonesia.

While the Indonesian financial sector ought to play a pivotal role in channelling the required resources to finance the green transformation, so far green financing is hardly existent in Indonesia, and beyond theoretical considerations there is very little empirical evidence to explain this underperformance. Moreover, there is only limited knowledge about the potential demand for green finance from Indonesian companies. To shed light on this, Chapter 4 presents an empirical analysis of the supply and demand side of green finance in Indonesia, based on comprehensive surveys in the banking and corporate sectors, respectively, as well as qualitative interviews with Indonesian government officials, representatives of banks and corporations, and numerous experts from business associations, international organisations, development agencies, academia and non-governmental organisations (NGOs). The surveys and the interviews were carried out in Indonesia in 2013. The analysis focuses on the following two research questions: (1) What are the bottlenecks for banks to provide green finance and for companies to invest in green projects? (2) Which policies or instruments could help enhance green investments? Section 4.1 examines the supply side of green finance. In order to test various working hypotheses, two questionnaires were developed for the banking sector. First, a questionnaire comprising 10 questions was sent to all 127 banks in Indonesia through Bank Indonesia, the central bank. Second, semi-structured qualitative interviews, comprising 30 questions, were conducted with 15 banks together with Bank Indonesia. The section introduces the hypotheses, discusses methodological issues, and presents and interprets the empirical findings of the survey and the interviews. Subsequently, Section 4.2 analyses the demand for green finance. To get a better understanding of firms’ environmental awareness, their views on resource efficiency, their interest in undertaking energy efficiency and other green investments, and their access to finance, an online firm survey was conducted, comprising 29 questions along with 10 specifications of company characteristics. Based on the theoretical analysis in the second chapter, the survey tests a number of hypotheses regarding the most important obstacles for corporations in undertaking green investments as well as the effectiveness of instruments which could help to facilitate such investments and enhance the demand for green finance. Similar to the bank survey, the firm survey was complemented by qualitative, semi-structured interviews with firms, which were asked 24 questions in total. Section 4.2 outlines the hypotheses, discusses the methodology, and presents and interprets the empirical findings of the company survey and interviews. Section 4.3 summarises the main findings from the bank and firm surveys.

Based on the preceding empirical analysis of the bottlenecks to furthering green finance and investment and of the suitability of various instruments to address these hurdles, Chapter 5 develops policy recommendations for Indonesian policy makers as well as for international development cooperation committed to supporting the green transformation in Indonesia (or elsewhere). Drawing on the insights gained from the financial and the corporate sector surveys and the interviews with relevant ministries, business associations, international development agencies and other stakeholders, the chapter develops a three-phased approach for introducing a green finance framework in Indonesia aimed at developing the capacities for green lending in the banking sector that match the demands from the corporate sector. To this end, the chapter also reviews the approaches to fostering green finance that were recently taken by Bangladesh, China and Thailand and analyses the first experiences with these countries’ green finance policies. Although the proposed framework is tailored to the Indonesian context, the approach can be adopted also by other developing or emerging economies, considering the specific country context.

Finally, Chapter 6 summarises the main findings and policy proposals of this study. Using the Indonesian example as an illustration, it draws lessons that are relevant also for other developing and emerging economies that seek to engage the financial sector in the transition towards a green and sustainable economy. Developing green finance, it argues, is not only crucial for successfully managing a green transformation, and hence desirable from a societal perspective, but also provides lucrative business opportunities for the financial sector. At the same time, a better access to green finance will facilitate corporate investments in energy and resource efficiency and hence raise the overall competiveness of the economy.

2

Financing the Green Transformation – Market Failures, Government Failures and the Role of the State

Green investments are obstructed by a combination of both market and government failures. These failures prevent the allocation of capital into green investments to a socially optimal degree. However, although government failures cannot be ruled out per se, most experts would agree that the public sector ought to play a vital role in catalysing and leveraging green investments. This chapter introduces these failures and establishes the rationale for public intervention. Subsequently, it defines a set of criteria that should guide public intervention and discusses different instruments to overcome the failures.

2.1 The economic rationale for public intervention – addressing the obstacles to green finance

The under-provision of green finance is due to a combination of market and government failures. As a result, a gap emerges between what would be economically desirable from a societal perspective and what seems profitable from the microeconomic perspective of decision makers at the bank and company level.

2.1.1 Market failures

Bator (1958: 351) defines market failure as “the failure of a more or less idealized system of price-market institutions to sustain ‘desirable’ activities or to estop ‘undesirable’ activities”, where “[t]he desirability of an activity ... is evaluated relative to the solution values of some explicit or implied maximum-welfare problem.” There are different reasons why an allocation of resources may not be optimal, including the non-internalisation of externalities into decision making; insufficient incentives for the private provision of public goods because their consumption is non-excludable and non-rival; imperfect information and transaction barriers; imperfect competition because of monopolistic or oligopolistic market structures, collusion or barriers to entry; and capital market imperfections.

In environmental economics, one of the most important market failures is due to negative externalities which arise when the marginal social cost (i.e., the sum of marginal private costs and the marginal external costs) of production and/or consumption of goods and services are higher than the marginal private cost. That is, the negative effects of economic activity on the welfare of others or the society at large are not considered by individual action because the welfare of others is not reflected in market prices. Since companies in many cases do not have to pay for the pollution they cause, investments in pollution reductions are much rarer than would be optimal for the society as a whole. In other words, companies’ marginal costs differ from societal marginal costs, which also include environmental costs. Negative externalities also occur when the environmental costs of production are not borne by the producer but are rather imposed on future generations (World Bank 2012a; Bowen et al 2009; Stern 2007).

Since the true costs of greenhouse gas (GHG) emissions are not included in the market mechanism, the market for relevant goods (energy, innovation, land use, etc.) cannot be considered socially optimal (Stern 2007). Examples for negative externalities that are not reflected in market prices are the environmental damages caused by conventional electrical energy generation from fossil fuels (i.e., coal, oil and gas). The comparison of costs of conventional and renewable energy generation looks very different when the damage costs caused by the combustion of fossil fuels are taken account of and incorporated in electricity prices. Owen (2006: 632) points to important “market failure constraints on the adoption of renewable energy technologies” and highlights that “renewable technologies would possess a significant social cost advantage if the externalities of power production were to be ‘internalised’. Incorporating environmental externalities explicitly into the electricity tariff today would serve to hasten this transition process” (ibid.: 642). Table 2.1 provides an overview of different market barriers that can prevent new and superior technologies to penetrate the market.

Positive externalities can similarly hold back green investments. Positive externalities occur for instance when companies that invent green technologies unwillingly have to share their innovation with free-riders. In many cases, green projects heavily rely on new technologies and unproven business models. Thus, an inventor has to cover relatively high readiness costs (learning and early transactions costs) (Ritchie 2010). Followers benefit from the effort of the first mover using the innovation without adequately rewarding the first mover (Vivid Economics 2011). Hence, incentives for first movers to invest in green projects are relatively low. The low incentives for first movers create a severe shortage of needed innovations and development of green business models and technologies – consequently leading to a slower green sector development than desired optimal (Ritchie 2010).

Green investments, especially first mover projects, are often held back because investors face imperfect information (Schleich 2011). Investors lack information of green investment opportunities, or cost saving potentials, thus making investment decisions which are optimal from neither a microeconomic nor societal perspective. With imperfect information, firms might be reluctant to incur risks related to relatively new technologies and often unproven business models, especially when investments require a long planning horizon. Thus, investors tend to invest less than the optimal amount in upgrading machinery and buildings (World Bank 2012a). In the case of asymmetric information between landlord and tenant, a situation may emerge which is commonly known as the “split-incentive”: investments made by the landlord in the energy efficiency of a building reduce the energy costs of the tenant, but can only be recovered by the landlord through an increase in rent. If one of the two actors is not well informed about the cost saving potential, the investment will possibly not take place (IPCC 2001).

Information also plays a crucial role in the financial sector. Due to the relatively “newness” of many green investments, financiers often lack the necessary experience and information to adequately assess technical and market risks of green projects as w...