Climate laws and green finance the value of legal commitment

Most economies have introduced climate-related laws and policies to meet the Paris Agreement’s climate change mitigation targets. This paper focuses on climate framework laws (hereafter “climate laws”), a type of climate-related legislation establishing legally binding commitments or institutional arrangements to reduce greenhouse gas emissions. Climate laws codify national mitigation commitments. Many set quantitative emission reduction targets, such as net-zero emission targets or interim targets. Others define broader climate objectives, define responsibilities across government bodies, or mandate monitoring and reporting. By doing so, climate laws strengthen stakeholder engagement, signal credible
government commitment, and create accountability mechanisms. More broadly, climate laws provide the legal basis for the formulation and execution of mitigation policies and offer firms and citizens legal recourse against inaction or reversal (Dubash et al. 2013; Iacobuta et al. 2018; Scotford and Minas 2018).

By making climate commitments legally binding, climate laws anchor expectations about the transition to a decarbonized economy. As expectations shift, financial markets reassess the attractiveness of different assets in light of anticipated climate policies. That is, climate laws can improve the expected risk return profile of climate-aligned investment by raising their relative expected returns, lowering their volatility, or both. On the supply side, this should encourage firms to align their operations with climate goals, potentially leading to an increased issuance of green assets and securities. On the demand side, a better risk return profile of sustainable investments should result in higher demand for green assets and securities. However, despite the rising importance of climate laws, evidence on their effects remains scant.
This paper is the first to investigate empirically how climate laws affect sustainable investment,
as captured by environmental, social, and governance (ESG) mutual fund holdings. We use economy-level mutual fund holdings data sourced from Emerging Portfolio Fund Research (EPFR) and match it with a newly compiled dataset on climate laws. Employing a state-of-the-art difference-in-differences (DiD) design, we estimate the effects of adopting a climate law on the share of ESG fund holdings over total fund holdings, with economies without a climate law forming a control group.

We find evidence that the adoption of a climate law catalyzes sustainable investment by significantly increasing the share of ESG funds’ holdings over all mutual funds’ holdings. The effect is almost entirely driven by climate laws that set net-zero emission reduction targets (i.e., net-zero laws). In economies adopting such laws, the share of ESG fund assets rises by about 5 percentage points within 5 years of the climate law’s adoption, relative to the control group. In contrast, climate laws that just set interim quantitative targets (i.e., emission reduction targets before mid-century) or establish institutional arrangements have smaller and statistically insignificant effects. These findings are robust to various modifications of the baseline regression.

The absence of pre-treatment effects supports the assumptions of parallel trends and no anticipation effects. The estimated effect of climate laws on ESG holdings is not only statistically significant but also
economically large. A simple back-of-the-envelope calculation suggests that, for the average economy in our sample, the adoption of a net-zero law may have mobilized additional green finance equivalent to about 1.8% of gross domestic product (GDP) within 5 years from adoption through mutual fund portfolios alone. In extensions, we find that the effectiveness of climate laws depends critically on the economies’ institutional capacity.

source:
https://www.adb.org/publications/climate-laws-green-finance