The entrepreneurial state must lead on climate change

As a much-touted green alliance of financial institutions crumbles, the private sector has once again proved unequal to the task of climate leadership.

In recent weeks, several members of the Glasgow Financial Alliance on Net Zero—a group of 450 financial institutions—have quit over concerns about the cost of delivering on their climate commitments. In dropping out, they have given the lie to the notion that private financial institutions can lead the transition to a carbon-neutral economy. What the transition really needs is more ambitious states that will go beyond market-fixing to become market shapers.

The market-led approach is rooted in the belief that private financial institutions allocate capital more effectively than anyone else. The implication is that states should refrain from ‘picking winners’ or ‘distorting’ market competition, and confine themselves to ‘de-risking’ green investment opportunities to make them more appealing to mainstream private investors.

But modern economic history tells a different story. In many places and on many occasions, it is public actors which have taken the lead in shaping and creating markets that then deliver benefits for both the private sector and society more broadly. Many major technological breakthroughs which we now take for granted happened only because public entities made investments which the private sector found too risky.

Delivering a global transition

The real story is thus quite different from the prevailing myth. We owe many economic successes not to public actors which got out of the way but to an ‘entrepreneurial state’ that took the lead. Moreover, the market-led approach is at odds with the goal of delivering a just, global, green transition in which the costs and risks are shared fairly within and between countries. ‘De-risking’ assumes a strategy that socialises costs and privatises profits.

Private finance still has a crucial role to play, of course. But only the public sector can mobilise and co-ordinate investment on the scale required to decarbonise the global economy. The question, then, is what this approach should include.

First, states should embrace their roles as ‘investors of first resort’, rather than waiting to step in only as ‘lenders of last resort’. Around the world, public financial institutions deploy many billions of dollars each year and, owing to their distinct design and governance structures, they can supply the kind of long-term, patient and mission-oriented finance which the private sector is often unwilling to provide. The evidence shows that direct lending from well-governed public banks can play a powerful market-shaping role by informing perceptions of future investment opportunities.

Secondly, we must rethink the relationship between the public and private sectors, especially when it comes to sharing risks and rewards. When public entities take risks to achieve societal goals, the private sector should not appropriate the financial rewards.

For example, if a government is funding major renewable-energy projects and other green investments, it could take an equity stake in them. Returns can also be socialised by assigning a proportion of intellectual-property rights to the state, allowing profits to be re-invested in new green projects. Importantly, firms benefiting from public finance should be subject to conditions that align their business activities with green industrial-policy objectives, fair labour practices and other priorities.

Strengthening rules and standards

Thirdly, to direct private investment to green activities, and to curtail investment in harmful ones, states must strengthen and update the rules governing financial markets. Such a regime could include central banks introducing allocative green credit policies, and regulators strengthening rules and standards to prevent ‘greenwashing’ and regulatory arbitrage.

Fourthly, policy-makers should recognise that debt finance—whether provided by the public or the private sector—is not necessarily a substitute for direct fiscal expenditure. The logic of repayable financial instruments is not easily reconciled with the public-good features of some climate-related investments. Investments in climate justice and reforestation will yield far-reaching returns but not necessarily of the kind that can be used to repay a loan. Navigating these issues and delivering investment at the necessary scale will require strategic co-ordination across all areas of social, environmental, fiscal, monetary and industrial policy-making.

Finally, more must be done to provide sufficient fiscal space for countries in the global south to pursue their own domestic decarbonisation and adaptation agendas. Many countries, including those that are most exposed to accelerated climate breakdown, are facing significant debt overhangs. It is now imperative that global-north debtor countries—which are responsible for most of the emissions in the atmosphere—help to reduce these burdens through debt write-offs, debt restructuring, loss-and-damage compensation or by replacing climate loans with climate grants.

Dramatically scaled up

To limit catastrophic global warming, the funding for climate mitigation and adaptation must be scaled up dramatically. But the quality of the financing also matters. Rather than holding out hope that private financial institutions will translate their highly publicised trillion-dollar net-zero pledges into credible, accountable action, we should demand that states assume their proper role. That means mobilising and directing finance toward clear and ambitious climate goals, and shaping financial markets to align with those goals. Closing the financing gap requires a radical redesign of the financial architecture and a substantive shift in financial flows. Neither will happen without policy interventions.

To specify the changes that are needed, I moderated an all-women panel today at COP27 with the Barbadian prime inister, Mia Mottley, the World Trade Organization director-general, Ngozi Okonjo-Iweala, the Egyptian minister of planning and economic development, Hala El Said, and the Scottish first minister, Nicola Sturgeon. The challenges are urgent. If states fail to take the lead on climate finance, the green transition will remain out of reach.

Republication forbidden—copyright Project Syndicate 2022, ‘The entrepreneurial state must lead on climate change’