The Role of Financial Markets in a Green Transformation

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With respect to the balance between private and public funding, on the one hand many – such as John Kerry at COP26[1] – argue that we need private financing to fund a green transformation, and that the role of the state is to support financiers in doing so by providing guarantees to green projects or by “de-risking”. Financiers such as Larry Fink of Blackrock concur.[2] On the other hand, Adam Tooze has argued that the financing needs for a climate transformation are really not so large – nothing like the scale of financing needed for the Second World War – and there is no reason that the transformation should be viewed as lying beyond the capacity of developed countries to issue debt.[3] Tooze finds that the problem is fundamentally one of politics, not financial constraints.[4]

The fact that private financing proposals are treated as – quite obviously – only being possible with state support, which is designed to bear a significant portion of the risks of the projects being financed, is a red flag for critical finance scholars such as Daniela Gabor.[5] De-risking proposals often draw from the structure of the 2008 financial crisis bailouts: When the Federal Reserve took over the management of bad assets in its Maiden Lane conduits, for example, the losses were divided into a first loss “equity” tranche (which was retained by the private sector) and a much larger, but less risky, second loss tranche, or “senior loan” (which was provided by the Fed). Now proposals such as Blackrock’s would have public entities such as the International Monetary Fund and the World Bank bear the equity risk of projects to “green” the developing world.[6] In fact, we should question whether private financing that is made possible because public bodies agree to bear the “equity” risk of the project should really be considered private financing at all. Indeed, the very concept of bearing first loss “equity” risk would normally indicate ownership of the project, as on the stock market. In short, proposals such as Blackrock’s would have financial markets fund the green transformation in name only.

As we learnt in 2008, public guarantees are rarely as limited as the legislatures that enacted them intended them to be. Instead, private finance excels at exploiting such guarantees in ways that come as a shock to the public servants who must honour them. Examples in 2008 abound, including: the expansion of deposit insurance in the United States (US), Ireland, the United Kingdom (UK), Germany, etc.; the temporary guarantee of money market funds in the US; and the conversion on a shotgun basis of US investment banks Goldman Sachs and Morgan Stanley into bank holding companies – with direct access to Federal Reserve support. There is no reason to believe that these dynamics – whereby large private-sector financial firms are able to socialise their losses by expanding narrow guarantees beyond what legislators intended – will be any different when it comes to the guarantees that support a green transformation. In short, when private funding is supported by public “de-risking”, the effect is almost certainly a form of off-balance-sheet rather than on-balance-sheet public funding of the activity. Needless to say, this off-balance-sheet public funding is likely to be much more expensive than direct public funding of the same activity, which would be supervised by the standard rules of public procurement. Indeed, public de-risking can be viewed as a form of regulatory arbitrage designed to circumvent public procurement regulations.

Overall, current proposals for so-called private funding of the green transformation should be met with robust scepticism as long as they depend on de-risking by public entities. That said, there is surely a role for private finance in the form of purchases of publicly issued debt dedicated to the finance of the green transformation, as well as in the finance of projects that meet state-designated standards and may be granted certain benefits, such as tax preferences or lower fees for the use of public property and services.

This then leads to the second issue: What are the dangers that our modern financial market structure poses to a successful green transformation? In particular, the coronavirus crisis has revealed that fundamental instability lies at the heart of our public debt markets, so that the markets that have for most of the past century been described as “the most liquid in the world” are now subject to dramatic liquidity crises.[7] These liquid public debt markets are a cornerstone of modern finance, as banks, pension funds, as well as financial and non-financial businesses all rely on them as a means of transferring funds with a measure of safety from today into the future. Financial markets are not equipped to deal with the possibility that these assets which sit at the heart of the financial system can be “illiquid”, and markets are at risk of collapse when forced to adapt to unstable, illiquid values in these assets.

This growth of fundamental instability in the core of modern financial markets has already altered the traditional relationship between monetary and fiscal authorities, as central banks have had to step in to support the value of government debt on a scale and at a speed that is unprecedented. Monetary policy-makers are now regularly taking actions that have clear fiscal implications, and the issue of public debt by fiscal authorities can interfere with the traditional channels of monetary policy transmission in novel ways.[8] Indeed, Gabor argues that financial markets are now so completely dominated by central bank policy that we need to protect against the likelihood that central banks could derail a green transformation.[9] She argues that a commitment to green coordination between the central bank and fiscal authorities is essential. This is certainly true, and the long-standing tradition of coordination between monetary and fiscal authorities in countries such as the US and the UK means that it should not be difficult for them. While the European Central Bank faces a more complicated situation, recent history indicates that, when necessary, it can demonstrate creativity in “muddling through” to reach an effective solution, such as Mario Draghi’s “whatever it takes” approach to the 2012 debt crisis.

Another pressing issue that is raised by the ever-increasing frequency in advanced economies of episodes of financial instability is what can be done to ensure that a green transformation is not derailed either by instability originating in financial markets, or by the political repercussions deriving from increasing inequality that is both created and perpetuated by solutions to instability.

Our current financial markets are characterised not just by unreliable liquidity in sovereign debt markets, but also by a zeitgeist that favours what is best described as crony capitalism in advanced economies, when structural financial instability is transformed into a reason to socialise losses and bail out unsuccessful companies.[10] The discussion of the “de-risking state” above is part of this phenomenon, and we have seen this in the responses to financial crises in 2007-2009 and in 2020, when the central banks stepped in to provide price support for private contracts. There is a pretense of public purpose for bailouts that support the wealthy far more than they support the real economy and the general public. Reform must address not just the liquidity problem, but also the policy bias towards bailouts for the wealthy.

On the one hand, there is a consensus among progressives that instability is associated with private-sector money creation. However, there is little consensus on what to do about it. As in the past, proposals range from regulatory reform of banking to calls to get the private sector out of banking entirely. A taxonomy of the range of proposals to address the problem of financial stability includes:

1. Ring-fencing. This involves housing the different banking activities in different financial holding company subsidiaries. An example is the Vickers Commission, whose policy recommendations were in fact adopted in the UK. This policy proposal is closely targeted to averting bank solvency issues and does not do much to address the problem of market instability.
2. An updated Glass-Steagall Act. These policy proposals are related to ring-fencing, but they involve a more dramatic separation between the different financing activities. In particular, commercial or retail banks are prohibited from engaging in market trading activities or being affiliated with companies that do so. Thus, a single corporate entity – measured at the holding company level – cannot engage in both activities. An example of this is the 21st century Glass-Steagall Act, which was a bill proposed (but not adopted) in the US in 2017.
3. An asset-based approach. This focusses on putting in place regulation that will forestall bank finance of long-term assets such as real estate, public debt, and corporate bonds or securitisations. This approach can also be viewed as one of structural separation, similar to that which characterised the US and the UK prior to the 1980s. Under this approach, mortgages would be mostly financed by dedicated financial institutions that are not directly tied into the monetary system.[11]  
4. The market maker of last resort. This is a central bank purchase facility for public debt that can have the effect of targeting yields on long-term public debt. Gabor builds on the importance of this central bank function to the operation of modern markets to conclude that we need to focus attention on central banks when discussing implementation of a green transformation.[12] The market maker of last resort is related to proposals for the central clearing of sovereign debt.[13]
5. The expansion of central bank services to the public as a substitute for private bank services. Proposals include central bank deposit accounts,[14] central bank digital currencies,[15] and narrow banking proposals that seek to get banks out of money creation entirely.[16]
6. Government direction of credit and/or credit guidance.[17]

Key areas of contention include clearly defining (or redefining) the parameters of banking – and of private-sector money creation (items 1-3) – as well as the role of both central banks and government more generally in supporting or displacing such private money creation (items 4-6).

Ring-fencing and Glass-Steagall take an entity-based approach to redefining banking, whereas Sissoko has argued that it is important to take an asset-based approach and to restrict the flow of bank money into specific categories of assets (as in fact the original Glass-Steagall Act did[18]). The aforementioned liquidity problems in sovereign debt markets during the coronavirus crisis stand as an example of why such regulation is necessary.

Others argue that perhaps central banks acting as market makers of last resort can successfully target the yields of long-term sovereign debt, not just over the short term, but over a long-term horizon.[19] If so, then government-bond financed investment in, for example, a green transformation is a free lunch, as government debt can be issued without any risk that interest rates will rise over the long run and ultimately make the policy expensive. Two problems arise with this approach. First, financial markets have developed in an environment where there is a market price for sovereign debt, so the shift to a central bank-supported price creates windfall gains for the current owners of sovereign debt – and to the degree that these owners are the wealthy, this exacerbates inequality. Second, the market-based approach to pricing sovereign debt has the advantage that the market indicates quickly when there are concerns about the sovereign repayment (though it may be manipulated and do so too quickly). Eliminate this and sovereign debt problems may grow unnoticed until they are irrecoverable. In short, the policy creates a danger of cliff risk.

Perhaps, then, financial stability is best supported by a strategy of structural reform of sovereign debt markets that relies on regulation to limit the practice of borrowing against longer-term government debt in order to obtain leverage in financial markets, as this practice creates liquidity crises. Such limitations would mitigate the need for central bank intervention. After all, this central bank intervention is necessarily most immediately beneficial to the – wealthy – owners of the debt and may undermine support for all policies associated with it, including a green transformation. Ensuring a robust market structure will arguably provide a better foundation for the debt issuance that is needed to fund a green transformation than one that is founded on periodic or persistent central bank support for bond prices.

In this environment, there is still a need for a reform of the banking system to ensure that everyone can benefit from it. These reforms include (i) the provision of some kind of very low-fee public bank account – provided by, for example, the post office, the central bank, or even a central bank digital currency – to ensure that even the least-advantaged have access to the payments system, and (ii) credit guidance and/or regulation that ensures that bank-created money flows into real activity and not into financial engineering or asset price bubbles that exacerbate inequality.

To summarise, the question “What is the role of financial markets in a green transformation?” needs to be restated: What is the role of the state in making sure that our financial markets can support a green transformation? Proposals for the state to play a “de-risking” role are ill-advised, because they are designed to bail out wealthy investors. However, there is an important role for the state in financial markets. First, the state should issue public debt to fund its own green agenda, and thus supply financial markets with tradable assets. Second, the state should reform sovereign debt markets to limit the practice of borrowing against longer-term debt in order to avoid the impetus for central bank bailouts of the private sector. Making financial markets more robust in this way will support the long-term liquidity of sovereign debt and not harm it, as is often claimed. Third, the state should set green and “dirty” or equivalent standards with the explicit expectation that the central bank will be governed by these standards and not invest in “dirty” assets or support them in other ways. Fourth, the state should certify projects that are designed to explore and develop future green technologies and consider providing preferential treatment for such projects, such as advantageous tax rates. Two additional policies that are not specific to the green transformation but are necessary to address growing problems of finance-driven inequality are publicly provided, low-fee universal access to the payments system, and credit policies that direct financing into real activities.

Financial markets have an important supporting role to play in a green transformation, and we can only expect them to be successful in playing this role if the state carefully designs the rules of engagement for financial market players with the green transformation. In this situation, we can expect the central bank to play an important role in following the rules for a green transformation laid out by the state.[20]