This blog is authored by Olha Krushelnytska, Sustainable Finance Specialist in the Finance, Competitiveness, and Innovation Global Practice at the World Bank Group.

Please note: this blog has been cross-posted on the WBG website.

Ministries of Finance play a critical role in driving progress toward private sector net zero commitments. They have levers of influence that are more effective in bringing about change than companies’ voluntary actions .

Incentivizing the private sector to adopt net zero alignment—a commitment to bring net carbon emissions from their activities as close to zero as possible—is urgent. The financial services industry could have outsized influence in meeting the global climate goal and transforming economies. Yet only a little over 500 private financial institutions, representing around 30 percent of private financial sector assets, have made net zero commitments to date. And with about $469 trillion total assets under management (AUM), private financial institutions are large enough to shape investment decisions and bring significant progress.

Not only do the remaining 70 percent of private financial institutions need to set net zero targets. Existing commitments vary in coverage with respect to the share of AUM covered by commitments, and thus lack the comparability that would make them useful for making decisions. Moreover, the credibility of some existing commitments are questionable, as many of those who have committed have yet to set interim, short-term targets, to ensure implementation.

To improve understanding of the voluntary commitments to date, a recent report by the Coalition of Finance Ministers for Climate Action Supporting Private Sector Net Zero Targets examined voluntary financial sector alliances that coordinate climate commitments.  Most, if not all, private financial institutions that made net zero commitments are members of various net zero alliances, such as Net Zero Banking and Insurance alliances. Mostly have arisen in the last few years, these alliances are a suitable proxies of private sector behavior.

The analysis found gaps in commitment comparability and credibility, suggesting the voluntary alliances, as helpful as they can be, do not have the right tools for setting credible net zero targets. Governments, especially the Ministries of Finance, can play a bigger role in supporting private sector net zero alignments – using soft and regulatory power.  Soft power methods include persuasion and incentives, while regulatory power methods cover law and regulatory enforcement (Figure 1).

Figure 1. Soft and regulatory power levers available to the Ministries of Finance to support private financial institutions net zero commitments 

Adapted from the report Supporting Private Sector Net Zero Targets, Coalition of Finance Ministers for Climate Action, 2022.

The report also examined the actual levers that Ministries of Finance use to promote greener investment in countries who are members to the Coalition of Finance Ministries for Climate Action. These proved to be more effective than incentives within voluntary alliances to date.

For example, in Rwanda, the Ministry of Finance together with the Rwanda Green Fund (FONERWA) applied soft power on the private sector by holding a series of capacity building training sessions and outreach efforts in 2018 and 2020 to promote climate action.  These dialogs culminated in establishment of private sector committees led jointly by FONERWA and the Rwanda Private Sector Federation to discuss options for reaching net zero targets - and laid a strong foundation to boost the credibility of the private financial sector’s involvement in addressing climate change.

In Indonesia, the development of Green Taxonomy 1.0 in 2022 was an exercise in soft power as it brought together various financial service actors into a Sustainable Finance Task Force, which will formulate policy and facilitate capacity building for private financial institutions. Although the green taxonomy is currently used mainly as voluntary guidance, the Ministry of Finance plans to make it a standard in the formation of national initiatives including the decarbonization of state-owned enterprises. It could also be expanded into mandatory disclosures of taxonomy-relevant investment portfolios from the private sector, becoming an exercise in regulatory power.

In Switzerland, the government conducted voluntary assessment of private financial institutions’ climate alignment using the Paris Agreement Capital Transition Assessment (PACTA) methodology in 2017, 2020 and 2022. The program has been well-received by the financial industry but in terms of driving change the results have been mixed, with financial institutions still falling behind their stated climate goals and strategies. These climate assessments may nonetheless be having an impact; more than half the institutions that participated in the 2017 pilot decreased their exposure share with respect to coal power generation and increased their share in renewable power generation, relative to their overall exposure to the power sector. Many stated that they took measures because of their 2017 PACTA results.

Using existing soft and regulatory levers by the Ministries of Finance proves to be effective.

Transition to a net zero future will require increasing government involvement - and understanding of its role is a first important step for supporting private sector commitments and achieving global climate goals.