Addressing China’s green finance challenges

THE green finance business is rapidly expanding in China, as regulators are committed to achieving a greener economic transformation on top of the 2060 carbon neutrality goal. Policymaking has been top-down, with high-level directives guiding the overall development of the market.

In 2016, the People’s Bank of China (PBOC), China Banking and Insurance Commission and several ministries issued the Guidelines for Establishing the Green Financial System, which have served as the major policy framework for green finance initiatives in the country.

The multilayer characteristics of China’s green finance system is evident in the high-level guidelines. The system consists of green loans, green bonds, environmental, social and governance (ESG) funds, green insurance, green leasing, green trusts and carbon trading.

According to China’s definition, the green finance business focuses on six green industries, namely energy-saving and environmental protection; cleaner production; clean energy; eco-environment; green infrastructure upgrades; and green services.

Regulatory dynamics

From a supervisory standpoint, banks’ green finance businesses have been included in the macro prudential assessment since May 2021. Twenty-four major banking institutions will be subject to the quarterly assessment, where the total and relative scale of green credit, as well as business growth, will be reflected in the quantitative indicators.

To encourage banks to lend green, the PBOC gave them several direct financial incentives. For example, the PBOC accepted green assets as eligible collateral for its relending facilities, providing low-cost funding to banks for green projects. Green loans are now accepted as part of the standing lending facilities, and green bonds with at least AA ratings are accepted as collateral in medium-term lending facilities.

The PBOC also provided lower cost funding support to projects either facilitating carbon emission reductions or the efficient and cleaner use of coal, through the carbon emission reduction tool or its 200 billion yuan (US$29.9 billion) re-lending facility. Going forward, there may be preferential risk weighting treatment given to green credit in banks’ capital ratio calculation, similar to what the PBOC has done for inclusive loans for micro and small enterprises when it applied a 75 per cent risk weighting.

Growth potential

President Xi Jinping’s recent pledge to achieve carbon neutrality by 2060 will likely be a significant boost to green finance’s development. There will be immense financing demand during China’s greener economic transformation.

UBS estimates that up to US$2 trillion in annual investment will be needed in nine sectors directly linked to the net-zero target in the coming 40 years. Similarly, the National Development and Reform Commission estimated a total of 487 trillion yuan in financing will be needed in green areas during 2020-2050E.

Among all the green finance products, green loans and green bonds are the major forms of green financing, whose balance stood at 15.9 trillion yuan and 1.1 trillion yuan at the end of 2021, accounting for 8.3 per cent and 0.8 per cent of the system’s total. In our base case, we expect the market for green loans and green bonds to reach 62 trillion yuan and 8 trillion yuan by 2031E, growing at a 10-year compound annual growth rate of 14.5 per cent and 22.2 per cent.

Green finance could be a major revenue driver for Chinese banks in the coming decade, generating a potential revenue pool of 1.4 trillion yuan and contributing to 15 per cent of the banking system’s total by 2031E.

The profitability outlook

In our view, green lending is a profitable business, with potential 1.3 per cent return on assets and 16 per cent return on equity, which is higher than the general corporate banking business. The higher margin is mainly boosted by lower credit costs at present.

According to PBOC disclosures, the nonperforming loan ratio for green loans was 0.33 per cent at the end of 2020. However, lower loan yields and deteriorating asset quality may be downside risks for profit margins. The national service risk of lower loan pricing to shore up green industries may weigh on the net loan spread, particularly for the “Big Four” state-owned banks, China’s major green lenders.

Currently, it is common practice for state-owned banks to offer cuts of 30 to 50 basis points (bps) off the interest rates of green loans, from our discussions with banks’ senior management. A potential downside risk is that regulators might continue to guide on banks to lower the loan pricing to support the green industries.

To assess the asset quality risk, we conducted a debt-at-risk analysis. Our results indicated that green bond issuers likely have higher debt repayment capabilities than general corporate bond issuers. However, a list of narrowly defined green companies tended to have higher debt-at-risk ratio than A-share listed companies in general.

At present, almost half of the green loans went to finance green upgrades of infrastructure. These projects are very likely to be backed by the local government. Hence, default risk could be low. That said, credit costs might come up if government no longer provides extensive supports to green industries, such as ending subsidies.

Obstacles to development

To further grow the green finance business in China, we believe some obstacles may need to be addressed. To begin with, to gradually align China’s definition for green industries and green finance with international standards will be a big step forward.

Currently, China’s definitions of green loans and green bonds are markedly different from international benchmarks. For example, in the green loan area, China recognises much narrower categories of eligible green projects.

The Green Loan Principles (issued by the Asia Pacific Loan Market Association and the Loan Market Association) adopt a non-exhaustive approach by explicitly recognising several broad categories of green projects with the objective of addressing key areas of environmental concern.

To prevent the risk of greenwashing, the PBOC only recognises green projects in 12 areas. A broader definition could further boost China’s green finance development.

Next, expanding the scope of the carbon trading business by allowing financial institutions to participate in the market. Individual and institutional investors are currently prohibited from trading on the national carbon exchange, the China Carbon Emission Trade Exchange (CCETE).

On top of this, the CCETE allows for a much narrower scope of trading products than the EU Emissions Trading System, which launched carbon financial derivatives, such as carbon emission spot, forward, futures and option products in 2005. These financial derivatives could reduce the volatility of carbon prices, and are thus conducive to the emission cost control of enterprises and enhanced market liquidity, in our view.

We believe financial institutions’ participation in the carbon trading market could facilitate innovation in the carbon finance area and better satisfy companies’ carbon financing demand.

Last but not the least, banks should incorporate more advanced risk modelling and management into their green finance businesses.

China’s banking system does not have a clear responsibility mechanism for environmental accidents and liabilities. As a result, most banks are not conducting comprehensive environmental stress tests.

Even though the PBOC conducted the first round of climate risk stress tests in late 2021, the scope of testing was limited and only 23 large banks participated. There is still a long way to go to develop more advanced modelling, in our view. CAIXIN GLOBAL

The writer is head of Greater China Financials at UBS Investment Bank.