An Investment Climate for Climate Investment
Professor Sam Fankhauser is Co-Director of the Grantham Research Institute on Climate Change and Deputy Director of the Centre for Climate Change Economics and Policy, both at the London School of Economics.
If Europe is to create the highly integrated economic space its leaders aspire to, massive new investment in energy, transport and communications will be required. Making the European economy emissions-free at the same time will create further capital requirements.
Measured over their economic life, low-carbon solutions like renewable energy are still more expensive than conventional technology. Many of them also have a different financing profile, with high investment costs (for example for a wind farm or an electric car fleet) followed by low operating costs. That is, more capital is needed upfront.
Yet, climate finance is not primarily about extra money. Europe does not just need more investment, but also different investment. Existing capital flows need to be redirected from high-carbon to low-carbon, sustainable uses.
The process needs to start now. Infrastructure is long-lived, and making the wrong investment choices today risks locking in high-carbon structures that will be costly to reverse later. Record-low interest rates are another reason to accelerate the pace of investment. Governments may be hampered by high levels of public debt, but in the private sector there is substantial liquidity.
So what is holding back low-carbon investment in Europe? Three factors stand out. The first one is project economics, that is, the (real or perceived) risk-return profile of low-carbon projects compared with alternative investment options. The second factor is financing barriers, that is, regulatory and behavioural features in the financial sector that prevent capital from flowing in a low-carbon direction.
Underpinning these two factors is a third, overarching issue: the political economy context. The concern here is about Europe’s low-carbon investment climate, and whether it provides enough confidence to investors in terms of policy stability and on-going political support for low-carbon growth.
The project economics of low-carbon technologies have improved considerably over recent years. The levelised costs of solar PV have fallen by over fifty percent over the last five years, and those of wind by around 15 per cent. Both technologies are approaching the point where they can compete with fossil fuels on a level playing field. However, the playing field is not always level and there are important clean tech solutions, such as off-shore wind and low-carbon heat, where cost parity is still some way off. The economics of low carbon investment therefore still depend on the right policy support: A strong carbon price, the absence of fossil fuel subsidies and adequate research, development and deployment (R&D) support.
The regulatory coverage on climate change is increasing, not just in Europe but worldwide. The number of climate change laws and policies globally is doubling every four to five years, and has now passed the 800 mark. Over 75 per cent of global greenhouse gas emissions are subject to economy-wide emissions targets. This means that action by the European Union is increasingly less likely to raise competitiveness concerns. Europe is moving in tandem with the rest of the world.
That leaves financing barriers. While good clean-tech projects can generally secure funding, the terms are often not as attractive as for conventional investments and the suite of available financial instruments is more limited. Structured products, for example, where solar PV installations or low-emission car loans are bundled and securitized are as yet underdeveloped.
There are several reasons for this. A factor that is often mentioned is financial regulation. Technologies like renewables, which have high upfront costs and require long-term financing, are disadvantaged under the new Basel III and Solvency II rules. While this is clearly the case, the remedy is less obvious. The risks associated with high levels of long-term debt are real, and it seems unwise therefore to exempt particular project types from prudential regulation.
The solutions to other financing barriers are less controversial, including, crucially, those related to the novelty of low-carbon technologies. Financial institutions are inherently conservative. They are cautions about exposure to unknown products and untested project structures. This is evident even in green-finance success stories, such as climate bonds. The green bond market is booming, with a record US$ 36 billion issued in 2014. However, practically all of these issues were structured in a way that protects investors from actual “green risk”.
There is an important role here for Europe’s international financial institutions, in particular the European Investment Bank and (for new member states) the European Bank for Reconstruction and Development. There are also national institutions such as Germany’s KfW and the UK’s Green Investment Bank.
They are uniquely placed, indeed often designed, to work alongside the private sector to share real risks, overcome perceived ones and introduce the market to novel products. To be effective, they need to offer the full range of financial instruments– debt, equity, guarantees and mezzanine products – and be willing to intervene at any stage in the project cycle, including the difficult early development stage.
However, even public financial institutions will baulk if the underlying project economics are wrong. By far the most important thing European policy makers can do to promote low-carbon investment, therefore, is to create a business environment that provides policy consistency, long-term certainty and a clear political commitment to decarbonisation as an EU objective.
EU leaders made a start in this direction last autumn when they agreed a new 40 percent emission reduction target for 2030. As before, the new carbon target is complemented by parallel objectives for renewable energy and energy efficiency. There are also plans to reform the ailing EU Emissions Trading Scheme, although they will take a long time to kick in. EU leaders have also yet to decide how the emission reduction burden will be shared among member states.
The decisiveness and pace of these reforms will be important. Investors have learnt the hard way that the low-carbon policy environment is rarely stable. Across the European Union we find examples of policies that are inconsistently implemented or incoherent in their objectives. Rules can change suddenly and sometimes retroactively. Changes to feed-in tariffs for renewables in Spain are a classic example.
Much more will therefore be required to offer investors the “long, loud and legal” policy signal they are looking for. But providing that signal is crucial. On the back of it, with some support from international financial institutions, capital will start to flow.