Green Financing and ESG Risk: The Necessity of Regulation

Global warming and climate change, along with other environmental issues, are concerns for the entire world. However, the road to the green transition requires huge investments by the private sector, which primarily seeks profit, and which investments the states want to regulate and direct, but do not have complete control over.

In this article we will try to define green projects and green financing and present an overview of green financing instruments, which will allow us to talk about the influencing factors and problems that have been observed with green financing and proposed ways to solve those problems.

In general, green projects refer to projects that create products or develop technologies that are primarily aimed at reducing greenhouse gas emissions or supporting the use of clean energy. Green finance implies financial investments flowing into sustainable development projects and initiatives, environmental products, and policies that encourage the development of a more sustainable economy.

A green loan is a special type of short- or medium-term financial support from banks to start-ups, small businesses, and multinational corporations for research and development of innovative products. Green traded stocks and bonds generally refers to bank securities that are mainly used to support green industry projects, including green indices and green exchange-traded funds. There is already an EU standard for green bonds, but changes to it are expected. The proposed alterations aim at better regulating the entire green bond market, improving transparency, establishing European green bond labels and combating greenwashing.

The willingness of banks to take action on the demands of environmental responsibility largely stems from increasingly strict global and regional policies and agreements concerning the environment and climate change. Central banks have begun to require banks to obtain green certification, award green credit scores, and engage in environmental innovation and social inclusion efforts. Banks that adhere to these green finance requirements receive tax breaks and other incentives from central banks. Also, intense competition to gain an advantage over others are driving banks to come under intense mimetic pressure in banking sectors resulting in the growth of green finance.

Furthermore, green project financing poses new risks. While traditional risk is known and predictable, the same traditional projects now carry greater risks, primarily of reduced profit due to rising prices of carbon in the European Trading System (ETS), as well as due to other levies payable by greenhouse gas (GHG) emitters. The risks and risk control measures implemented by the banks influence decision-making on green credit and investment in green projects.

The study of risk is especially necessary in the context of an environmental disaster (such as the recent spill of hazardous materials after a train accident in Serbia), where a growing understanding of the interplay between hazard, vulnerability, and exposure has led to more comprehensive and sophisticated risk models and assessment methods. A company’s non-financial reporting is extremely important in trading ESG securities.

Green financing is aimed at projects that should have a clear profit and less risk than “dirty” projects – green projects are not burdened by the EU Emissions Trading System (ETS), the Carbon Border Adjustment Mechanism (CBAM), or other environmental taxes, as well as not being subject to strict regulations and prohibitions, and the like.

As such, it is quite clear that finance providers (governments and banks) should direct money towards green projects, which have high profit and low risk. However, we run into two related problems here. The first problem is unclear regulation, which enables and leads to the second problem: greenwashing.

Observing the European Central Bank (ECB), which, in mid-2022, took steps to include climate change considerations in its monetary policy framework, in the future, states and international institutions are expected to adopt clearer and more precise norms that define the procedure for investing in green projects, as well as the way to monitor the functionality of those projects. The expectations we can have from green investments this year are conditioned by the energy crisis, inflation, rising interest rates and general uncertainty, but future regulatory developments, increasing ESG expertise in the industry and improvements in the availability of resulting data should lead to an increase in companies’ ability to manage ESG risk, especially considering the development of reporting on environmental parameters as required by the CSRD.

Expecting the further development of the control and verification mechanisms of green projects, as well as the further development of non-financial reporting criteria, we hope that Serbia will also benefit from such projects in the future, and that the state authorities, together with the National Bank of Serbia, will recognize the need for more detailed regulation of this area.

Author: Danica Jankovic, Trainee Lawyer at Vukovic & Partners Law Firm

VP advokatska kancelarija Beograd

Vuković and Partners Law Firm

Danica Janković

green finance

ESG risk

CSR Directive

global warming

climate change

green projects

green loans

green credits

green traded stocks and bonds

ETS

European Trading System

risk control

investing in green projects

greenwashing

green transition