13 February 2012 | Linton Nightingale
Carbon, Climate Change, Energy, Finance/insurance

 

Remco Fischer: Programme Manager, UNEP Finance Initiative

Investment in clean energy systems will have to more than triple current levels in order to revolutionise our energy supply and put us on the path of climate sustainability. As the overwhelming majority of the investment required will have to come from private sector sources, we need a parallel revolution in the way the world’s financial markets allocate capital to energy systems, to favour lower carbon intensity and higher energy efficiency projects.
 

The climate finance gap

Approximately US$500 billion is required annually as incremental investment until 2030 to reduce the carbon-intensity of energy systems, improve their efficiency and limit GHG concentrations to a maximum of 450 parts per million (ppm), the target governments have set themselves under the Copenhagen Accord. To put this figure into perspective, 2009 saw, after a number of years with unprecedented, double-digit growth rates in sustainable energy investment, a total of US$162 billion going into sustainable energy companies, technologies and projects; a seven-fold increase over 2002.

Given global energy demand forecasts, much of this investment will have to flow into the developing and emerging world, where according to the World Bank, climate change mitigation investment needs are estimated to be around US$400 billion per annum, including in the broader energy sector. Of the 2.5 per cent of global energy demand growth per year forecasted to 2030, 93 per cent is bound to take place in the swiftly growing economies of Latin America, Africa and Asia, where local middle classes continue to emerge and strive for western consumption lifestyles while the 1.5 billion people currently without electricity find their way to the grid.

Achieving the complex task of solving the world’s energy problem while reducing GHG emissions at magnitudes sufficient to stabilise the climate will require what the International Energy Agency (IEA) has termed a true revolution in the way mankind sources, transforms and consumes energy. The wide body of analysis available on the financing of climate change mitigation points towards two facts of utmost importance to the way in which societies respond to climate change:

• 85 per cent of the total investment needed for climate change mitigation across sectors and regions will have to come from private sector sources.

• Over 70 per cent of total investment in sustainable energy to date has been financed by third-party entities, meaning external investors and lenders which include financial services sector, the capital markets and thirdparty investors such as venture capitalists (see Figure 1).

The availability of sufficient, appropriate financial resources at the needed scale and in the right place will be key. As the overwhelming majority of these resources will only be available from private as well as third-party sources, it becomes clear that not only a revolution in the energy sector is needed. A parallel revolution is needed in the way the world’s financial markets allocate capital to energy-supply and demand: bankers, investors, financial analysts, and fund managers will have to be at the heart of the revolutionary transition of energy systems towards lower carbon-intensity and higher energy-efficiency.

Increasing private financial flows at the needed scale will require financial practitioners of all types to shift perceptions regarding the attractiveness of sustainable energy technologies, projects and companies, and it is unlikely that a shift of this size will come entirely from philanthropic and corporate social responsibility (CSR) motivations. The financial services sector is a heterogeneous group of institutions, mindsets and procedures. But fundamental changes in the way capital is reallocated to technologies, companies and projects – at the scale required – will have to be triggered by one of two variables that essentially drive mainstream financial decision-making, namely risk and return.

Financial return and risk are not stand-alone categories however: lenders and investors want to make a return proportional to the level of risk they undertake. Sustainable energy investment will hence become more likely and frequent if perceived levels of risk are reduced for a given level of return, or returns are increased for any given level of risk. The growth throughout the last decade of sustainable energy investment has been triggered record has only been witnessed in a limited number of jurisdictions and technology types and, despite rampant growth in investment flows, absolute figures remain insufficient compared to what is needed. The ultimate question is what forces and/or external drivers will trigger the shifts needed in the way the finance sector views the sustainable energy space through its risk and return lens? And what barriers stand in the way?

Enabling the finance revolution

Enabling the finance revolution for a low-carbon energy future is, in principle, simple and it is already happening around the world, albeit at a modest scale. The risk-return profile of sustainable energy relative to carbon-intensive energy is even improving, slowly but steadily, without any explicit government support, due to a number of ‘naturally’ occurring developments

• Resource economics: increasing fossil fuel demand and the resulting supply constraints, will lead to ongoing price increases in the medium to long term. The price of oil in 2009, for instance, was US$59.21 per barrel and is predicted to be US$135.22 per barrel in 2035, an increase of 125 per cent. The price of natural gas was US$3.33 per 1,000 cubic feet in 2009 and is predicted to be US$8.06 in 2035, an increase of 142 per cent.

• Innovation economics: ongoing technological innovation is making sustainable energy technologies competitive with and commercially superior to conventional technologies. The average price for photovoltaic modules, for instance, excluding installation and other systemic costs, has fallen from levels of roughly US$100 per Watt of installed capacity in 1975 to US$4 per Watt in 2006. In the US, the price for electricity from wind has dropped from US$0.30 per kWh to US$0.05 per kWh.

• Green consumerism as a macro market trend: sustainability is considered by many commentators to be one of the most fundamental macro-trends in consumer markets, with green products and services traded at a premium: technology developers, project developers, power generators, grid operators and utilities with green credentials will increasingly be able to capitalise on this macro-trend to reap above-average prices. In Germany, for instance, more than one million households purchased around 2.8 terawatt-hours (TWh) of greenpower in 2007 and more than 60,000 commercial customers purchased another 1.3 TWh. Estimates for 2008 show household purchases more than doubled 2007 levels, at 6.6 TWh.

Unfortunately these trends are still too weak to drive and accelerate the scale-up of low carbon investment towards the US$500 billion needed. Only policymakers, regulators and the international climate change regime can enable the finance revolution. Such approaches can include:

• A price on carbon driving the internalisation of the environmental costs of GHG emissions: by forcing the internalisation of environmental costs, a meaningful carbon price creates a level playing field between sustainable and conventional energy options. Under a cap and trade system or an international crediting mechanism, a price on carbon can open new revenue streams for sustainable energy projects. At present, operative emissions trading schemes can be found only in the EU-27, a few states in the US and New South Wales in Australia, while carbon tax schemes are found only in two US states, eight European countries and two Canadian states.

• Loan guarantees and other public finance mechanisms improve the economics of a financial transaction itself rather than of the underlying investment asset. A loan guarantee, for instance, considerably reduces counterparty risk for any given level of return (interest) without influencing the underlying profile and viability of the actual project. An example is the Currency Exchange Fund (TCX) that hedges local currency risks with swap products for those investing in developing countries. There exists no similar fund aimed at reducing risks explicitly in the sustainable energy space.

• Tax incentives will decrease the overall tax burden of developing or deploying sustainable energy technologies. A decreased tax burden will lead to higher profits and increased investment returns but in 2005 only 37 countries had implemented tax-based incentives for sustainable energy options.

• Renewable energy production incentives and feed-in tariffs can considerably enhance the risk-return profile of sustainable energy projects:

(i) Providing a price premium for renewable energy compensates for the cost disadvantages of clean energy sources, enhancing the profits of projects and returns on investment

(ii) Feed-in tariffs as well as production incentives are mostly offered at a predetermined height and over a predetermined number of years and provide medium to long-term certainty on prices and revenues. Market risk is therefore entirely mitigated while prices for conventional energy remain volatile.

There are many approaches that legislators and regulators can follow in unlocking markets and private finance for decarbonising energy systems, including phasing out the massive flows of fossil fuel subsidies and decoupling the profitability of power generators and utilities from electricity volumes sold. Policy transparency, longevity and certainty

The actual types of policy design and instruments appear to be of only secondary importance from an investor’s perspective: according to Mark Fulton, managing director of Climate Investment Research at Deutsche Bank and co-chair of UNEP Finance Initiative’s Climate Change Working Group, it is crucial that policies are in place, but they are not much use unless investors and financial intermediaries can fully rely on them in the medium to long term.

Of primary importance for investors and lenders is that policy frameworks and instruments are governed by the principles of transparency, longevity and certainty (TLC). Only if these principles are featured in government action on carbon emissions, renewable energy and energy efficiency, will investors deploy capital. Investors need transparency in policies to create understanding and a level-playing field. Longevity means policy has to match the timeframe of the investment and stay the course. Certainty refers to knowing that incentives are financeable and can be trusted in the financial return calculation and are likely to be maintained over the course of the investment. In economic terms, TLC should result in a lower cost of capital for projects while still delivering a fair and market-related return to capital.
 

Who is winning the global race for clean energy investment?

This year has been a tough one for the global climate agenda. Policy pessimism after Copenhagen has been compounded by (largely unfounded) doubts over climate science along with governments backtracking on commitments in key countries. But, according to Nick Robins, Head of the HSBC Climate Change Centre of Excellence and Co- Chair of UNEP FI’s Climate Change Working Group, “through the fog of the carbon war, a new climate economy is emerging and the global race for attracting investment for a clean and innovative energy economy continues, driven as much by resource scarcity and industrial innovation as by the raw realities of global warming.”

New research by HSBC shows that the future size of the ‘climate economy’ – which encompasses products and services related to the generation and distribution of lowcarbon power as well as energy efficiency improvements in buildings, industry and transport – is likely to double in size from US$740 billion in 2009 to between US$1.5 and US$2.7 trillion in 2020. It also shows that the fastest growth is likely to occur in emerging markets, notably China and India, with the low-carbon energy market in both countries offering average yearly growth rates of 14 per cent. This delivers an important shuffling of the pack in terms of market share. The EU remains the largest market but its share falls from 33 to 28 per cent by 2020. China grows from 17 to 24 per cent, pushing the US into third place. India also rises and becomes the fourth largest market, with Japan falling to fifth. Clearly, these growth rates are strongly influenced by the underlying economic dynamism in Asia – but they also reflect the growing strength of policy frameworks in these countries with regards to transparency, longevity and certainty. The analysis suggests that just two regions – the EU and China – already make up half the global market and this proportion is projected to grow further by 2020.

Looking around the world, there are many examples of countries embodying the principles of TLC in their climate and energy policies and achieving capital deployment. Germany has established a feed-in tariff (FiT) regime that supports the EU mandated goal of 20 per cent renewable energy as a share of electricity by 2020. Germany’s FiT system embodies TLC for investors: not only does it provide standardised, transparent contracts with up to 20 years of longevity, with guaranteed payment streams; it also ensures the ‘right pricing’ for electricity consumers, through a tariff digression over time to match all reductions in technology costs, with an end target of grid parity with fossil fuels. The results speak for themselves: the creation of 300,000 jobs; renewable energy at a 13 per cent share of electricity and rising; a rapid fall in solar Photovoltaic costs leading to lower tariffs on the digression schedule with a forecast of grid parity by 2013.

First Published: december 2010

Image: Creative Commons / flickr / Buildingresults

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