Financing the low carbon economy

Inclusive Economy25 Apr 2013Evert-jan Quak

Many trillions of US dollars are needed quickly to finance the investments for a low carbon economy. Where to find the capital and investors, what keeps them away from investing in more sustainable initiatives. Ingrid Holmes (E3G) spoke about that and much more in Amsterdam.

Earlier this week Ingrid Holmes (Programme Leader Low Carbon Finance at Third Generation Environmentalism, E3G) spoke in Amsterdam in the SID (Society for International Development) lecture series ‘The Private Sector in Development: Towards a Sustainable Future’. Her lecture was about how the financial system should change to serve the low carbon economy. Holmes told a convincing story about the inability of the current financial system to acquire enough capital to pay the investment needed for the transition to a low carbon economy, and the current political inability to change this situation. She focused on the challenges in Europe without underestimating the challenges for emerging and developing countries, which have less capacity and far less cash for the transition.

The International Energy Agency (IEA) estimates that around $140 trillion are required just to transform the energy system to meet the 2050 climate and energy security goals. The problem is that this capital is needed in the short term ‘all in one go’, but that the payback time is over a long period. Finding financial support for the investments is a big challenge, because of the high upfront capital costs for low carbon assets, although the operating costs are lower compared to high carbon assets. The task is to find an awful lot of cash and quickly, and that goes against the logic of the short-termism of the financial markets: investments should be paid back in the short term and require low upfront costs.

According to Holmes this challenge is far beyond the reach of the public purse alone. Governments invested in the past in big infrastructure projects (e.g. train networks and sewage systems) in the public interest. But now, with austerity ruling over Western economies and the idea still alive that government interference in markets is suspicious, private sector investments on a much larger scale will be essential to deliver the required capital for the low carbon economy.

The required new financing and business models will, according to Holmes, be too innovative and therefore generate more risk – ‘something the finance sector, and perhaps society in general, is keen to avoid at the moment’. So, this means that new capital pools and financing frameworks must be found and developed, at a time when risk avoidance is high.

For the answer Holmes looks to governments, who need to ‘create adequate returns to incentivize private sector investment in the low carbon sector to compensate for higher costs’. This is the idea of creating ‘long, loud and legal’ ‘investment grade policy frameworks’.

Holmes’ message is that, to support the low carbon transition, the current ad hoc approach needs to be reformed and rationalized so it can deliver in a more synchronized and strategic way. The best way this can be done is with (old fashioned) state-backed development and infrastructure banks. In the past they have tended to be formed at times of key development change, where the market could not deliver the scale of finance needed. Now the transition to a low carbon economy is a key development challenge, some new state-backed banks are investing in decarbonizing. In the UK the Green Infrastructure Bank started in 2008, Australia has a Clean Investment Finance Corporation, directly modelled on the GIB and funded by revenues from carbon trading, the French Government is setting up BPE to assist with financing low carbon infrastructure, and in the Netherlands there has been a long-term discussion about setting up a Green Investment Corporation.

The Public Private Partnership (PPP) approach that is behind most of these initiatives enables the private sector to do what it does best – engage in developing, financing and operating infrastructure projects. The key issue is how governments can effectively maintain a balance between the public interest and fair returns for private investors. Holmes: ‘I’d argue that public banking professionals can do a better job at this than government officials simply because they have financial expertise. And if they can, we have a partnership that will enable institutional investors to access the offered low-risk investment opportunities and stable income streams they crave while government gains to leverage limited public funds to close the financing gap.’

In particular, governments should take the lead in the transition. However, and this is my perception on the issue as a participant in the debate, the urgent need for a transition to a low carbon economy cannot be based on the narrow perception of combating climate change, as this will not convince most policy-makers. If we want governments to develop institutional responses that match the scale of the challenges ahead, other arguments and opportunities for the long term must be highlighted. For example, how reducing public health costs, increasing employment rates, and recovering from low economic growth, can be achieved with smart investments.

However, as Holmes states in her lecture, the regulatory environment that will control investment in low carbon assets are not heading in the direction of making a capital influx in the low carbon economy easier. Solvency II, the new solvency regime for all EU insurers and reinsurers, for example, was implemented in 2012. ‘This new system would demand high capital adequacy from investments in long-term low risk bonds, which is likely to deter investment in infrastructure bonds in particular.’

Holmes’ message is clear: there is an obvious need to ensure coherence between financial regulation and low-carbon objectives: a new and sustained dialogue about cross-sectoral regulatory coordination. ‘The EU’s green paper on long-term investment is a start’ she said, ‘but this should be augmented by requiring institutions like the European Banking Association, EIOPA, and the European Central Bank to be charged with assessing the interactions between financial markets and climate change policy objectives’.