Scaling zero-carbon energy finance for 1.5C

Money is high up on the agenda at COP26 with ‘mobilise finance’ as one of the four stated goals. Developing nations are stepping up their calls for advanced economies to make good on their Paris pledge to provide US$100 billion annually for climate mitigation and adaptation. In this post, we explore what needs to be done to scale zero-carbon energy finance for a 1.5°C outcome and why investors now have strong incentives to do so.

Finance required for 1.5°C

The IEA’s World Energy Outlook 2021 estimates in its Net Zero Emissions by 2050 (NZE) scenario that the world will have to quadruple its current investments into clean energy to nearly US$4 trillion annually, to align with a 1.5C outcome. Similarly, the Net Zero Financing Roadmap, released this week by the UNFCCC’s Race to Zero, states that globally, US$32 trillion will need to be deployed this decade to align the world with a 1.5°C trajectory. Of the US$32 trillion, half is expected to be used to decarbonise electricity.

What’s more, global investment must flow into developing nations, which desperately need capital to scale up zero carbon electricity to meet rising demand and avoid carbon lock-in. The IEA estimates that around 70% of the additional spending that’s needed to close the gap between the NZE scenario and the announced pledges scenario (APS) needs to flow into developing nations. These economies require access to international capital markets, but are often overlooked due to their size and risk profile.

Options to attract finance for 1.5°C

Due to the scale of investments required, it is unrealistic for public capital to fill this gap alone. Scaling private finance to support zero-carbon energy investments, particularly to developing economies which need it the most, will require fundamental changes to the current financing landscape. The to-do list includes removing barriers to investment on global low carbon opportunities, a scale up of blended finance, and the emergence of new financial instruments tailored to the specific challenges of the energy transition across each market.

1. Policy enablers and favourable regulation

Investors face a range of financial and non-financial challenges that constrict capital flows into clean energy investments, particularly in developing nations. These constraints may range from guaranteed dispatch of fossil fuel generation, which can reduce the utilisation rates and therefore returns of renewable energy projects, to political and foreign currency risks. Market size can also be an issue: for example, large asset managers, such as BlackRock, cannot invest in small or one-off projects due to the high cost of due diligence.

To unlock large private sector capital flows into these areas, favourable policies aiming at supporting contract design to de-risk these investment opportunities will be welcomed by the investment community. Fiscal and tax incentives, policy roadmaps and high-level signalling may also facilitate investment flows.

2. Blended finance

In areas where it is difficult for private sector players to enter alone, the use of blended finance may offer an alternative channel. Public finance can be used as a de-risking mechanism to leverage private sector financing channels. Public funds may take the form of guarantees, insurance and other risk mitigation instruments, or as direct capital injection to de-risk low carbon investments and unlock private investment. Leveraging private sector funds has multiple benefits for public spending. Crucially, leveraging private finance can free up critical and limited public funds for use in climate adaptation, which is often poorly suited for private capital.

3. Innovative climate financial instruments

To support large capital injections, the use of innovative climate-linked financial instruments may also present opportunities to create a new class of green assets. The rise of “green bonds” into an asset class of its own, is one prime example. From humble beginnings in 2007, the green bond market is set to reach US$1 trillion in 2021. Sustainability-linked bonds are another rising star, with an issuance of $9 billion in 2020, heralded as a way to incentivise better sustainability performance by providing a lower cost of capital if companies meet certain targets. Compared to green bonds, sustainability-linked bonds offer more flexibility on the associated climate target and no restrictions on the use of proceeds. Other examples of innovative financial instruments include climate-aligned funds and green loans.

Public sector players may also play a role in building new financial instruments. For example, the Asian Development Bank (ADB) is piloting the Energy Transition Mechanism (ETM), which aims to use blended finance to retire coal power plants in Southeast Asia, and replace them with renewable energy. This could prove to be a new business model to accelerate fossil fuel retirement in emerging countries.

The time is now

With deteriorating economics of coal and other fossil fuels and the increasing competitiveness of renewables, there are opportunities abound for private actors to invest in the energy transition, while ensuring acceptable financial returns.

Recent analysis by TransitionZero has shown that new investments in wind and solar are now cheaper than new coal in all major regions in 2021. In fact, it is more competitive to build new wind or solar than to operate existing coal plants in many geographies. Our analysis showed this was the case for 22% of global coal plants in 2020 and has shot up to 64% of plants in 2021. Our findings align with a wider body of literature, including analysis for the Net Zero Financing Roadmap, which estimate that by 2030, 80% of low carbon investments will yield higher returns than emissions-intensive competitors.

Investors and policymakers will have to work hand in hand to deliver on the energy transition. The Glasgow Financial Alliance for Net Zero (GFANZ) is the newest addition to the suite of net zero finance initiatives. Under GFANZ, member organisations, with a collective US$70 trillion in assets, will align themselves with an investment portfolio that is consistent with a net-zero by 2050 mandate. We have seen other successful collaborations across relevant stakeholders to produce landmark standards and guidelines, such as Task Force on Climate-Related Financial Disclosures (TCFD) and Sustainable Finance and EU Taxonomy.

Let us carry this optimism beyond COP26, through continued collaboration and cooperation across private and public spheres to ratchet up climate ambition across all sectors.