Sustainable EU Finance Policy: Mobilise Private Capital for the Green Transformation

Fragmented Capital Markets and a Lack of Financial Literacy Have Hampered the Green Transformation

For the green transformation of the European economy to succeed, huge sums of equity and debt capital will need flow into green projects over the coming years. This is not something that the public sector can do alone; indeed, Europe’s capital markets and banking system will have to play a significant role in financing the green transformation. The financing of innovation through capital market is essential, especially for the transformation of CO2-intensive industries, as the necessary technologies are either not yet available or not available in sufficient quantities.

European capital markets have various weaknesses, however. For one, cross-border financing is minimal, due to market fragmentation. Furthermore, in contrast to the situation in the US, external equity capital in Europe is significantly more expensive than debt capital. As a result, European financing options for startups lag far behind those across the pond. In addition, Europe has much smaller securitisation markets. Institutional investors, who have a crucial role to play in raising the huge sums of private capital needed for the green transformation, often find themselves held back by regulation. Another problem is that private investors in most European countries are less likely to be active in capital markets. There are many reasons for this, including the reduced importance of investment in capital markets for long-term retirement savings. At the same time, a lack of financial literacy – not only generally, but also in the area of sustainable investment – has reduced the capital market participation of private investors.

A single capital market in the EU would help to facilitate access to financial resources. While European policymakers have been working to develop an integrated Capital Markets Union since 2014, progress has been limited. In summer 2024, the EU Rapporteur on the Future of the Single Market, Enrico Letta, proposed developing the as-yet incomplete Capital Markets Union into a Savings and Investment Union. His idea is to make the savings of EU citizens available for investment within the EU via the capital market.

At the same time, the European economy will remain highly dependent on bank financing over the medium term – in part because banks are the most important external source of financing for small and medium-sized enterprises (SMEs). Securitisation is an important instrument for better linking the European banking system to capital markets. But the current market potential for European securitisations is significantly lower than policymakers have estimated, and the originate-to-distribute securitisation model envisaged under the Capital Markets Union, in which banks sell a pool of loans to a separate entity that finances the assets by selling tradable, interest-bearing securities with different risk-return profiles to institutional investors, does not yet seem to be a good fit for the European context.

Recommendations

Strengten Private and Institutional Investors and Create a Favourable Environment for Investment

Strengthen capital market-based pension provision and increase financial literacy

In many countries, the pressure on pay-as-you-go systems has already led to increased investment in capital markets, either directly or by way of pension funds. However, capital market-based pension provision in Germany and other EU countries could be significantly expanded. This would require, on the one hand, a reform of Germany’s Riester pension scheme to make it sustainable and, on the other, the creation of an attractive European range of pension products. With regard to the second objective, the pan-European Pension Product (PEPP) only has one provider thus far. However, various measures, such as the standardisation of EU’s tax policy through upstream taxation, could significantly reduce administrative burdens while incentivising investment.

Financial literacy is an important factor influencing whether people participate in the capital market. In 2022, the EU introduced the “Financial competence framework for adults in the European Union”. Germany should also pursue a national strategy for financial education and contribute at the EU level to the exchange of ideas on best practice and the evidence-based development of education programmes.

Strengthen the role of institutional investors

The activation of institutional investors will likely be decisive for mobilising the huge sums sustainable investment from the private sector required for the green transformation. Yet large institutional investors such as insurance companies, pension funds, and pension plans are subject to heavy regulation. If these investors are to be won over, then regulation at the European and national levels must assure a balanced relationship between returns, liquidity, risk, and sustainability.

Do more to intermesh capital markets and the banking sector

Securitisation can provide a lever for financing green transformation. While large companies obtain direct funding from the capital market, SMEs rely mainly on external loans when they finance green projects. The assets underlying securitisations should have similar properties so that investors can easily understand what they are buying. To this end, country-specific insolvency laws within the EU should be harmonised. And non-reporting SMEs should not incur additional costs for information, as the burden they already bear from the new supply-chain reporting obligations is considerable. Overall, securitisations should be placed on an equal regulatory footing – e.g. terms of documentation obligations and capital requirements – with financial products that carry similar risk.

Attention should be paid to interdependencies between sustainability reporting, the promotion of securitisation, and financial stability. The Green Asset Ratio (GAR) provides an incentive for banks to hold as many green loans as possible on their balance sheets. If banks securitise brown assets, these will be held in less regulated and less transparent parts of the financial system, and could pose a threat to financial stability should climate risks materialise. One option for further incentivising banks to securitise green loans and use the proceeds to finance new green loans would be to include the securitised assets in the calculation of GAR, even when they are no longer held on a bank’s balance sheet.

Create a favourable environment for green investment instead of small-bore regulation
Financial sector regulation that favours sustainable investment is no substitute for effective climate policy in the real economy. For instance, effective CO2 pricing makes non-sustainable investments less profitable, regardless of how they are financed. Carbon pricing can also target the climate effects of production. By contrast, the indirect approach of financial sector policy carries the risk of diminishing the desired outcomes and making them dependant on the requirements and types of external financing. For the optimal integration of the financial sector into the green transformation, the EU should focus less on overly-narrow regulations and more on creating an environment that leverages the potential of capital markets. Measures in this regard could include the financial education of private investors or the creation of a framework for transition financing. It is important here to focus on clear and consistent rules that do not undergo constant revision, as financial market actors require a dependable basis for long-term decision-making.