Climate Finance 101

Climate finance refers to funding drawn from public and private sources to support climate mitigation and adaptation measures. Climate finance can come from, and support, initiatives from the global to community level.

While there are many forms of climate finance, this explainer will focus specifically on financial markets and the role that investors can play in developing a clean energy future. Investors are increasingly interested in how they can navigate the complex landscape of risks and opportunities created by climate change and the energy transition. By choosing to invest in some projects or divest from others, investors can shape the speed and breadth of climate mitigation measures. (For example, by choosing to invest in a new offshore wind company and not in a new coal-fired power plant.)

The International Energy Agency predicts that it will take approximately $4 trillion in annual investments by 2030 to reach global net-zero emissions by 2050. Reaching this goal will require more than tripling today’s annual investments and indicates a needed shift in the flow of capital to climate-related activities. Filling this financial gap crucially depends on investor beliefs, information, and the policy environment.

This explainer will dive into investor motivations and actions, challenges to climate-focused financial investments, and policy options.

Investor Motivations

Across the board, investors prioritize returns—money made on investments over time. While other factors (such as an overarching mission statement) may influence a decision to invest or divest in a venture, an investor will tend to make most decisions based on how it will affect the bottom line. As discussed at length in our Climate Financial Risk 101 explainer, the financial market stands to suffer from the physical and transitional risks brought on by the climate crisis. On the flip side of the coin, there are many opportunities for investors to adjust more easily to climate change by investing early and “getting in on the ground floor” for game-changing technologies and institutions. For instance, an extensive body of research has shown that companies’ financial performance is positively linked to their environmental, social, and governance (ESG) record. Managing climate-related risks and rewards is a dominant motivation for investors to engage in climate finance.

Investors’ decisions also hinge on the climate policy landscape. Policies that support low-carbon technologies and the energy transition increase the financial return of related activities and can motivate investors to also direct funds toward them. Investment decisions are also made in consideration of future returns: if investors believe that a climate policy could strengthen or be scrapped in the future, their investment decisions may also reflect those beliefs. We discuss how uncertainty over climate policy can affect green investments in more detail below.

Notably, there are two major types of investors that have similar, but slightly different, motivations to engage with climate risk. Institutional investors are organizations that invest money on behalf of other people; they hold the most power over financial markets. Institutional investors have increasingly recognized that it is their fiduciary duty—their legal duty to act in their beneficiaries’ interests—to incorporate climate considerations into their investment strategies both to manage the physical and transitional risks posed by climate change and to harness the favorable returns associated with good ESG performance.

Retail investors are individuals using their own money to make investments. Like institutional investors, their primary motivation is a positive return. But retail investors also invest in companies and ventures that support their values, including concerns for sustainability, as shown in a 2020 survey from Morning Consult. The actions of retail investors can “snowball” and apply pressure on the broader financial institution to change institutional investor actions.

Investor Actions

As described above, climate change can pose significant financial risks to investments. The first step investors can take to address this problem is to quantify climate risks. A recent survey of institutional investors found that 38 percent of the respondents have analyzed their portfolio firms’ carbon footprints and 35 percent of them examined the risk of the portfolio firms’ assets becoming stranded.

Investors can also hedge against these risks. A hedge is an investment that can act as insurance against events that will lower a portfolio’s return. In the context of climate change, enacting a carbon price will lower investment returns from fossil fuel companies. To hedge against this risk, investors need to also invest in assets or financial instruments that will yield higher returns when such an event occurs. Recent studies have proposed innovative strategies to construct hedging portfolios based on assets’ carbon footprints or their responses to climate risk news.

Investors also increasingly take actions beyond standard risk management when making portfolio decisions. Many of these decisions to adjust portfolios in response to climate risk raise the cost of capital for polluting companies and facilitate the flow of capital toward decarbonizing activities. For example, investing based on ESG, climate-related, or other sustainability metrics has accelerated in recent years, with US assets under sustainable investing increasing from $12 trillion in 2018 to $17.2 trillion in just two years. Similarly, green bonds, though still a small share of the market, have seen a rapid expansion in the past decade. Many investors are starting to divest from fossil fuel industries, with around 1,500 institutions representing $40 trillion in assets making divestment commitments in 2021. Some “activist” investment groups have also worked to push companies toward more environmentally conscious investing. However, this is largely concentrated among the public and nonprofit sectors and is relatively rare among private investors.

Investors can also engage directly with companies to change their production and management practices to be more compatible with the energy transition. Surveys show that over 80 percent of institutional investors intervene in general corporate governance of companies in their portfolios and a similar fraction engage with management on climate issues. These actions include holding discussions with management, submitting and voting on shareholder proposals to push for climate risk disclosure and decarbonization plans, and forming climate-focused networks with other institutional investors such as the Glasgow Financial Alliance for Net Zero (GFANZ), Climate Action 100+, and the Paris Aligned Investment Initiative for more effective engagement.

Despite a growing trend toward sustainable investing, many institutional investors continue to invest in profitable fossil fuel companies. Public/peer pressure, policies that give a clear indication of the government’s position on climate action, and more research about climate financial risk could motivate institutional investors to turn from the status quo.

No investor has a crystal ball to see exactly what the future will hold—but a stable investment environment and adequate information can help an investor more accurately predict the risks and rewards of an investment. As the climate changes, investors will need both factors if they are to step away from business-as-usual, carbon-intensive investments.

Uncertain Policy Environment

Climate and energy policies—such as taxes and regulations on carbon emissions or subsidies on green technologies—can significantly increase the return of green investments. Therefore, clarity in the policy environment is crucial for climate finance. In a 2021 survey, financial professionals overwhelmingly rank the risk of regulatory uncertainty as the most important climate-related risk, illustrating the importance of a predictable policy environment for investors and companies to make sound decisions. As a result, investors must make assumptions about future policies, which tends to increase risk. Indeed, research has shown that climate policy uncertainty reduces green asset prices relative to polluting ones. Analyses by the International Energy Agency and others also suggest that policy uncertainty slows investment in low-carbon technologies.

While financial regulators cannot make climate policies, they may provide guidance on or mandate risk assessments for investors and companies, which includes analyzing outcomes under different policy scenarios.

The Information Gap

When making green investments, investors need information to assess a company’s ability to deal with physical and transitional risks of climate change compared to its competitors. Key information might include a firm’s emissions reductions plan or energy transition plan.

However, such information can be limited: currently, there are no uniform standards for climate disclosure required by the US government. In March 2022, the US Securities and Exchange Commission (SEC) proposed a climate disclosure rule that would require publicly traded companies to disclose information like their greenhouse gas footprints, their plans (if any) to reduce emissions, and how they assess/manage climate-related risks. You can read expert perspectives on the proposed rule in this special series for Resources. As of publication, the SEC’s rule is not in effect and companies are not specifically required to disclose climate-related financial information.

The lack of disclosure standards has also led to concerns about greenwashing, which occurs when a company makes its products or processes sound more environmentally conscious than they are. For example, a firm may claim to be “green” due to their recycling program or rooftop solar panels when in fact it still emits more emissions than its peers. As consumers increasingly look to buy products that are “environmentally friendly,” companies have begun to capitalize on this demand even if they do not meet expectations in reality.

Over 1,200 companies and counting have net-zero emissions pledges—but getting a sense of which companies are serious about these pledges, and which ones may be treating them as a marketing or investor management tactic, can make it difficult for investors to decide which ones are best equipped to deal with future climate risk.

One proposed approach to greenwashing is a green taxonomy to provide incentives and guidance for firms to decarbonize. For example, the European Union’s “taxonomy for sustainable activities” (which went into effect in 2020) classifies which investments are considered sustainable and which ones are not, using a variety of metrics that include a firm’s efforts in climate change mitigation, pollution prevention, waste prevention, and ecosystem protection. Such a metric can create clear signals for investors, but the effectiveness will depend on whether the metric accurately identifies truly sustainable investments across firms. The US SEC is also considering rules that would require publicly traded companies to be more transparent about their ESG commitments.

Given the growing emphasis on transparency and well-founded emissions reductions efforts, private sector actors, such as the Science Based Targets initiative (SBTi), are also working to validate and offer guidance to companies that are setting emissions reductions goals.

Carbon Offsets

Carbon offsets are a popular approach companies use to fulfill net-zero pledges. Carbon offsets are credits companies get by funding external activities that reduce or remove carbon emissions, such as reforestation. For companies, offsets can offer a straightforward way to achieve their climate pledges alongside reducing emissions from their own production process, which can require complex or costly changes in management practices, technologies, and facilities. Historically, carbon offsets have fallen short of delivering the degree of reductions claimed, prompting legitimate concerns over the widespread use of this approach. In many cases, the credits do not lead to additional abatement, but either have temporary effects or are claimed by providers who will engage in the offsetting activities anyway.

A direct policy action to address this issue is to strengthen regulatory oversight of the voluntary carbon market. The voluntary carbon market, which allows emitters to purchase “credits” that represent emissions reductions elsewhere, remains poorly regulated. Some stakeholders have suggested that financial regulators can set up standards to help investors evaluate companies’ net-zero plans, including their dependence on carbon offsets vs. in-house abatement and the environmental integrity of offsets adopted. One example of a proposed standard is the SBTi Corporate Net-Zero Standard.

Investors, who are primarily motivated by financial returns, have also become increasingly interested in shifting capital to green activities, both as climate financial risks become more salient and as stakeholder demand has shifted to promote more environmentally conscious investments. While investments now may be based on expectation surrounding future policies to encourage clean energy and discourage fossil energy (especially in the United States), continued uncertainty and/or lack of policy progress creates the greatest barrier to progress and ultimately could unravel private-sector efforts. Meanwhile, financial regulators and other organizations can help investors by promoting market transparency to show whether firms are truly making strides to reduce emissions and increase sustainability.

The authors would like to thank RFF scholars Billy Pizer and Marc Hafstead for their invaluable contributions to this explainer.