Governments can provide more incentives to boost private sector green investments, say Morgan Stanley’s Imtiaz Ahmad and Climate Bonds Chair Sean Kidney in “A Climate Change Fix” in Trading Carbon magazine.

The United Nations Framework Convention on Climate Change (UNFCCC) is currently negotiating the establishment of a $100 billion a year by 2020 Green Climate Fund (GCF) – in fact the. In addition, some countries have their own funds, such as the UK’s announced International Climate Fund (ICF) amounting to £2.9 billion in funding over the next four years.

There’s been a lot of discussion about how to best use those funds. Much of that discussion has been ill-informed. Here we propose a path forward.

The International Energy Agency has estimated that $10.5 trillion in additional investment beyond “business-as-usual” (BAU) – i.e. redirecting capital to low-carbon technologies from conventional – is needed globally in the energy sector over 2010–2030 to be consistent with +2 Celsius climate target.

The challenge is acute in emerging and developing countries. Here, the capital-heavy nature of required investments, such as for renewable energy, when combined with the perceived “novelty” of such technologies, means higher financing costs. As a result, investment capital has been largely flowing into traditional business areas and power sources, including oil and coal.

To be able to shift away from BAU it is necessary to effect a wholescale change in power generation investments in emerging and developing countries to low-carbon options.

This is all the more imperative given that the power generation sector accounts for the majority of greenhouse gas emissions – something that Annex I (developed countries) sponsors must not lose sight of in terms of where and how they wish to allocate their funding support.

The clean technology and renewable energy sectors will require some degree of regulatory support if BAU behaviour is to be adjusted.

For the GCF, many developing countries are arguing for a simple disbursement fund, where grant applications will be received and paid out. On the other hand, some developed country governments and their national development banks argue that the simplest option will be for them to invest equity or loan capital (the later on a minority basis). The basis for this argument is that this signalling will lead the private sector to magically follow with the balance of the investment capital.

Both proposals are deeply flawed.

The first has two problems. First, given the scale of the investment required, $100 billion in grant funding will go quickly. Second, the opportunity to use the funds to attract additional private capital will be lost. It will be compounded by the reality that most sponsoring countries now see themselves as cash poor, and direct transfers to the GCF are likely to be a fraction of $100 billion.

The second proposal is driven by the correct idea that scarce – Annex I/sponsoring country – public sector funds will be most efficiently deployed if they attract private funding. But the actual proposal fails to appreciate that a more nuanced approach will be needed to address risk and return issues for investors.

The larger part of private sector capital is in the hands of institutional investors. If private sector finance is to be deployed – assuming governments wish to avoid mandating investment participation – the risk profiles of target investments need to match the appetites of investors.

There are two ways in which this can happen. One, regulatory and government support for mitigation and adaptation investments. The key step is to ensure regulatory support that can be implemented in the form of Nationally Appropriate Mitigation Actions (NAMAs) in developing countries that create a domestic framework within the host country for robust and transparent regulations to support or even mandate the development of clean energy infrastructure.

Two, credit enhancement. The GCF, and national funds, such as the UK’s ICF, should be put to this use.

GCF funds could be used as a guarantee pool to lower the risk of investment for private sector finance, thus attracting money at lower rates and decreasing the lifetime costs of projects. For example, cutting interest rates for a 20-year, $1 billion project by 5 percent can save as much as the whole project cost.

There are many shades of credit enhancement; the trick is to selectively tackle the risks that are going to lead to the greatest improvement in credit rating.

A collection of effective guarantee mechanisms hold out the promise of mobilising large slabs of private sector funding that will enable leveraging of capital market investor financing.

We should not just look at full guarantees, but also at partial guarantees

  • the first 20 percent of losses, for example
  • and selective guarantees (for policy or construction risk) and partial guarantees of that selective risk.

Currency risk is a big issue and one whereby sponsoring countries could work with insurers to design low-cost solutions suitable for institutional investors making the large-scale investments needed.

The availability of guarantees should be limited to investments in assets that comply with a global decarbonisation framework. We need consistent rules about whether retrofitting coal-fired power stations are eligible or not, and those rules should be drawn in the context of steep international emission reduction targets.

The political risk insurance offering from the Multilateral Investment Guarantee Agency, a member of the World Bank group, should be heavily promoted and expanded.

Guarantees could be provided at project and sectoral levels. For example, a country could seek credit enhancements for a range of public and private investments for low emission transport development.

The liability or obligation of sponsoring governments will be limited to the financial payment that they will make.

We need pilot schemes to prove the concept and refine solutions. This should be the priority for this year and for the Durban UNFCCC climate change conference in December.

Non-Annex I (developing) countries that need new sources of energy supply, with their investment decisions constrained by the high cost of finance for alternatives, are continuing to lock in long-term investments in traditional fossil fuel-based energy. The more this happens the tougher it becomes to affect a shift to a low-carbon economy from BAU.

We have an opportunity with the GCF to change the game; that opportunity is the real agenda for Durban.

 

Imtiaz Ahmad is a lecturer at the London Business School and former executive director and head of carbon trading at US bank Morgan Stanley in London. Sean Kidney is CEO and co-founder of the Climate Bonds Initiative in London.