Sectoral policies to channel financing to key climate and clean development needs: Green energy production
Global energy investment flows are dominated by fossil fuels. Energy investments will need to rapidly shift to RE. Coherent and stable long term energy policy is one of the most important ways for the ministry to increase investment in RE. Targets for RE penetration, both near- and long-term, will help provide investor certainty. However, further enabling policies are required to enable these targets to be met, in particular to ensure fossil fuel investments are rapidly wound down. While targets have spread to many markets, other implementing policies have not seen the same growth.[i]
As outlined above, phasing out fossil fuel subsidies and implementing carbon pricing are crucial to improving competitiveness of RE with fossil-based energy production. A RE-based energy system will be markedly different from a fossil-based one, strategic energy policy will facilitate a smooth transition; ensuring adequate energy supply, transmission, distribution and storage.
The energy transition investment gap is also widening. Policymakers will need to focus on enabling capital flows to developing countries, which currently attract 12x less investment per MtCO2e.[ii]
Ramp up renewable energy production
1.5°C-aligned energy systems will require a significant increase in RE investment. To accelerate investment, energy policies will need to provide certainty on risk and return and facilitate the investment process.
Easing permitting processes for renewable energy installations is a low-cost and quick-to-implement policy to accelerate renewable energy investment. Auctions for long-term price contracts provide investors with revenue certainty. While they are one of the most effective policies to boost renewables investment in EM, they are present in only 50% of the markets. [iv] Coordinated long-term auction planning, aligned with permitting processes can ensure speed of deployment and investor confidence.[v]
Auction requirements can also maximise the investment’s impact. Lifecycle emissions requirements can limit the emissions impact of construction and circular economy requirements can reduce demand for materials and ensure the use of recycled materials. However, the possible higher cost of this could be a barrier to auction participation, and such requirements will need to be calibrated to the local context. Requirements such as use of local workforce and local supply chains could enable local support for development, and can ensure a multiplier effect of the investment, kickstarting a local green infrastructure economy. For example, the Turkish largescale renewable energy auctions require the construction of local production facilities.[vi] Local circumstances will need careful evaluation to ensure such requirements do not hinder RE production.
Auctions are, however, often won by larger companies as they are able to make lower bids. [vii] These are mostly previous FF companies which will apply the same economic models of largescale power plants. However, more distributed RE production will better serve the transition. Largescale wind and solar installations impact land use, are viewed negatively by local communities and can lead to grid congestion and imbalance issues. Auctions should include mitigatory measures to enable small scale and distributed productionparticipation. For example,
For innovative and early-stage technologies, feed-in-tariffs (FiTs) can enable economic viability. If properly implemented, they can reduce investment risk more effectively than any other policy and ensure stable returns.[viii] FiTs overcome the price differential between green and high-carbon production and were instrumental to wind and solar scaling – the German FiT is credited with enabling the global solar PV learning curve. However, they are a high cost policy and are increasingly replaced by instruments which also enable competitive pricing – such as contracts for difference or auctioning.[ix] Germany’s FiT was introduced in 2000, funded by a high green energy levy. This increased the RE share in the electricity mix, from 6% in 2000 to 35% in 2020. This model has been replicated in 80 other countries.
The fixed price and guaranteed returns encouraged small scale RE development and led to a boom in energy cooperatives. This ‘citizens as producers’ model enabled a more decentralised and democratic transition than an auction-based system and ensured citizen support for the transition despite high costs. The updated national renewable energy law established a new FiT for rooftop solar installations to encourage increased installations to feed directly into the grid, rather than their development being driven by household consumption.[x] This demonstrates how FiTs can be targeted to nascent technologies and small-scale renewables.[xi]
The German FiT and other RE expansion has been funded by a renewables surcharge on electricity bills. This provides a reliable source of finance for renewables expansion. The surcharge was removed in 2022, to alleviate high energy bills.[xii] This was enabled by increased federal budgetary support for renewables expansion. Surcharges can be used to kickstart RE expansion, then phased outand RE procurement shifted to the federal budget, funded by carbon tax revenues, if the surcharge reduction and tax increase are linked.
In comparison, Spain’s 2007-8 FiT paid solar power producers a very high rate in comparison to electricity prices. It also did not include any step-down mechanism to reduce the subsidy in line with falling technology costs. The FiT was also not funded by consumers, and instead effectively deficit funded. This led the government to suddenly cut FiTs for new wind and solar, and cut the tariff paid to existing producers. This created a boom and bust cycle, particularly harming the solar PV industry. 2708 MW solar PV were installed in 2008, 0 MW in 2009. In addition to damaging the industry, this also hugely damaged investor confidence in RE policy, a critical factor for national RE scaling. FiTs therefore require cost containment measures, to ensure the subsidy stays within budgetary means, avoidance of retroactive policy changes and independent regulation to ensure appropriate levels of support.[xiii]
Carbon contracts for difference (CCfDs) provide low carbon electricity generators with revenue certainty, with the producer paid a subsidy to cover the cost difference with conventional electricity production. Unlike feed in tariffs, CCfDs are auctioned to ensure competitive pricing.
The UK CCfD scheme for low carbon electricity generation establishes a 15-year period of payments based on the difference between the production cost of low-carbon energy and average market energy prices. This provides direct protection to developers from volatile wholesale prices, a critical issue when considering projects with high upfront costs and long lifetimes. Additionally, they protect consumers from paying a premium to suppliers when electricity prices are high. The competitive nature of the programme means the strike price (i.e., the agreed price on the contract for difference) decreases over time; reflecting and incentivising decreasing technology costs. The scheme is funded by a levy on electricity suppliers (the Supplier Obligation), and so provides an additional transition incentive.[xiv]
If technology agnostic, CCfDs’ contribution to scaling innovative technologies may be limited as auctions may be dominated by mature technologies.[xv] For this reason, Germany is already planning pilot CCfDs to promote green hydrogen in the hard-to-abate sectors of steel and chemicals.[xvi]
Long term tax credits could provide income security for RE developers, matching the longevity of RE projects. For example, the US Inflation Reduction Act reinstates and expands existing production and investment tax credits for wind, solar and energy storage with a 10-year time horizon. Previous US tax credits were short term and inconsistent, resulting in high levels of uncertainty. This new tax credit scheme should overcome such issues.[xvii]
Another low-cost policy is the introduction of quotas or renewable energy portfolio standards. This will encourage RE investment from large incumbents, however this might incentivise incremental over transformational change, which can increase the cost of transition.
Quotas could encourage damaging blending practices. Biofuel blending entails blending bioethanol or biodiesel into transport fuels. First generation biofuels are produced from agricultural feedstocks, whereas second generation is from waste. Unless carefully regulated, biofuel production can lead to indirect land use change (ILUC); expansion of agricultural land, impacting biodiversity and carbon sinks. It can also threaten food security by increasing demand for grain, and possibly offering higher returns. The EU has recently reduced its biofuels quotas, citing ILUC concerns. Limits are also set on how much high ILUC-risk biofuels (i.e., first generation) can count towards renewables targets.[xviii] Gas blending entails mixing a certain proportion of low-carbon hydrogen, or other low carbon gas, into the fossil gas supply. This requires infrastructure retrofit at hydrogen volumes over 10%, while the lower energy density of hydrogen means a 5% blend by volume would only displace 1.6% of fossil gas supply.[xix] Combustion of hydrogen for domestic heating or electricity generation results in energy losses of around 30% during the conversion process from electricity to hydrogen.[xx] Hydrogen is better reserved for uses where direct electrification is not possible, such as industrial, high-temperature, processes.[xxi] Quotas could result in the cost of implementation being passed on to consumers, hindering just transition efforts.
Aggregate green distributed renewable energy to enable investment
For many emerging economies, the energy transition will consist of decarbonising local energy production and addressing energy poverty (defined as the lack of access to sustainable modern energy services and products or spending, or as the need to spend 10% of income on fuel[xxii]). This requires investment in distributed renewable energy (DRE), which is considerably less attractive to private investors than large established RE projects. Financial aggregation could help overcome this investment gap, providing capital for DRE and enabling investor portfolio diversification. Establishing an ABS market in EM will help with this. [xxiii]
Standardisation of DRE and mini-grid investments will also increase scalability and facilitate aggregation.
Aggregation may need to be combined with other de-risking mechanisms such as concessional financing, guarantees and subsidies– DFIs will be crucial in enabling development of such a programme. UNDP has set out a Derisking Renewable Energy Investment framework – a set of policy instruments for the public sector to reduce, transfer or compensate for investment risks.[xxiv]
DRE can also enable decarbonisation in countries with high grid penetration, providing flexibility to meet increasing electrification. Net metering (whereby consumers can sell RE back into the grid) is a key policy to drive deployment of small-scale solar, but is available in less than half of markets. [xxv] DRE can pose a challenge to grid operators, due to lack of oversight of ‘behind the meter’ generation, and possible grid congestion from bi-directional power flows. Digitalisation can integrate DRE into the grid, enabling grid operators to monitor and influence their operation, and use them to modulate power loads.
To encourage DRE owners to operate these resources in consideration of grid requirements, incentives are required, for exampleflexible electricity tariff design.[xxvi] As outlined by the German example above, targeted feed in tariffs could also be used to finance DRE development and incentivise small scale RE development for grid feeding-in and not solely personal consumption.
Rapidly phase out fossil fuels
Without rapid fossil fuel phaseout, RE ramp up will not make a significant difference. Over the last ten years, fossil fuel share of the global energy mix has remained consistent. This is despite it being cheaper in over half of the world to build new wind or solar than to continue operating existing coal plants.[xxvii] This can create a barrier to RE investment due to market saturation. The long lifetimes of fossil fuel infrastructure means many plants will need early decommissioning if we are to meet 2030 and 2050 climate targets. According to the IEA, advanced economies need to phase out unabated coal generation by 2030 and the rest of the world by 2040 to achieve 1.5°C targets.[xxviii]
The IEA Net Zero Roadmap warns that there is no room for new development of fossil fuels fields and mines. In addition, other studies estimate that nearly 40% of the emissions related to existing fossil fuels reserves must not be exploited to have a chance to meet the Paris Agreement target.[xxix] The role of policy in achieving a just transition away from fossil fuels is crucial: not only in avoiding the exploitation of new fields, but also in favouring the sustainable decommissioning of existing fields and mines.
While financing the phaseout of fossil fuel assets is expensive, there are significant costs associated with a sudden disorderly transition away from fossil fuels or asset stranding once decarbonisation deadlines materialise. Energy transition mechanisms are financial mechanisms to support an orderly and accelerated fossil fuel phaseout; winding down fossil fuel assets and their obligations, supporting the just transition, and enabling the buildout of renewable energy assets and infrastructure. South Africa’s USD8.5bn Just Energy Transition Partnership Investment Plan is funded by UK, EU, US, France and Germany. However, only 3% of the funds will be delivered as grants, raising concerns over the impact on the country’s debt burden, and whether this offers better terms than raising money on international markets.[xxx]
In EM, development banks and concessional financing may be needed to fund phaseout. Climate Investment Funds launched the Accelerating Coal Transition investment program in 2021 to enable a just transition from coal power to clean energy in emerging economies, starting with South Africa, India, Indonesia, and the Philippines. This will combine concessional financing with technical assistance to de-risk and pilot investments to phase out coal, providing capacity, repurposing or decommissioning coal assets, and creating social protection programs.[xxxi] ADB’s pilot Energy Transition Mechanism uses public and private financing to buy and retire or repurpose coal plants in Indonesia, Philippines and Viet Nam.[xxxii]
US coal phaseout is supported by securitization mechanisms in Wisconsin, Michigan and New Mexico. This refinances the existing customer obligation to pay the utility’s return on equity and debt with a low-interest bond. The utilities can invest in RE and the cost savings invested into just transition programmes.[xxxiii]
Such mechanisms can also be expanded for phaseout of other fossil fuel plants and assets – gas fired power, and distribution infrastructure.
These mechanisms will need careful regulation, to ensure phased-out plants are not replaced by new fossil fuel assets. One way to ensure impact is to require entity-level transition plans from the utilities, aligned with the Climate Bonds Credible Transition Principles.[xxxiv] Plant age eligibility restrictions can also ensure funding is not absorbed by plants already near end of economic life.
Fossil fuel assets can be repurposed for a net zero economy. Fossil-fired power plants’ grid connections can be utilised for RE installations or hydrogen electrolysers, while other plants could be converted to run on renewable energy sources such as waste biomass. For example, Bangladesh’s Mujib Climate Prosperity Plan to convert existing coal and fossil gas plants to become energy hubs, converted to either green hydrogen, waste-to-energy or biomass plants. In 2021, Bangladesh rejected proposals to build 10 new coal-fired power plants.[xxxv]
Governments will also need to transition fossil fuel workforces – to minimise resistance to transition plans, and ensure that transition does not exacerbate inequalities and instead ensures it facilitates economic development. For example, Scotland provided GBP12m for an Oil and Gas Transition Training Fund, re-skilling workers for careers in wind turbine engineering and infrastructure. The US Inflation Reduction Act provides additional incentives for clean energy projects located in energy communities, including coal communities.[xxxvi]
Energy use is not just electricity – electricity accounts for 17% of global energy use. While electricity production is still dominated by fossil fuels, transport and heating and cooling are even more so and are significantly harder to decarbonise. It is vital to address all energy uses.
[i] BloombergNEF, 2021. ClimateScope 2021, https://global-climatescope.org/downloads/climatescope-2021-report.pdf
[ii] BloombergNEF, 2021. ClimateScope 2021, https://global-climatescope.org/downloads/climatescope-2021-report.pdf
[iii] International Energy Agency, 2021. World Energy Investment 2021, IEA, Paris
[iv] BloombergNEF, 2021. ClimateScope 2021, https://global-climatescope.org/downloads/climatescope-2021-report.pdf
[v] Climate Finance Leadership Initiative, 2022. Unlocking Private Climate Finance in Emerging Markets, https://www.gihub.org/resources/publications/unlocking-private-climate-finance-in-emerging-markets/
[viii] Polzin, F., Egli, F., Steffen, B. and Schmidt, T.S., 2019. How do policies mobilize private finance for renewable energy?—A systematic review with an investor perspective, Applied Energy,https://doi.org/10.1016/j.apenergy.2018.11.098.
[xiii] IISD, 2014. A Cautionary Tale: Spain’s solar PV investment bubble, https://www.iisd.org/gsi/sites/default/files/rens_ct_spain.pdf
[xvii] 117th Congress (2021-2022), 2022. Inflation Reduction Act of 2022, H.R.5376, https://www.congress.gov/bill/117th-congress/house-bill/5376
[xix] E3G. 2021, Hydrogen factsheet series, https://www.e3g.org/publications/hydrogen-factsheet-series/
[xxi] Burge, L., 2022. Accelerating the fossil gas transition to net zero, Climate Bonds Initiative, https://www.climatebonds.net/resources/reports/accelerating-fossil-gas-transition-net-zero
[xxii] Madlener, R. 2020, Sustainable energy transition and increasing complexity: Trade-offs, the economics perspective and policy implications, Inequality and Energy,
[xxiii] UNDP and Climate Bonds Initiative, 2022. Linking Global Finance to Small-Scale Clean Energy; Financial Aggregation for Distributed Renewable Energy in Developing Countries, https://www.climatebonds.net/resources/reports/linking-global-finance-small-scale-clean-energy
[xxiv] UNDP, 2018. Derisking Renewable Energy Investment: Off-Grid Electrification. https://www.undp.org/publications/drei-grid-electrification-2018
[xxv] BloombergNEF, 2021. ClimateScope 2021, https://global-climatescope.org/downloads/climatescope-2021-report.pdf
[xxvi] IEA, 2021. Distributed energy resources for net zero: An asset or a hassle to the electricity grid?, IEA, Paris https://www.iea.org/commentaries/distributed-energy-resources-for-net-zero-an-asset-or-a-hassle-to-the-electricity-grid
[xxvii] Bloomberg, 2021. Building New Renewables is Cheaper Than Burning Fossil Fuels
[xxix] Trout, K. et al 2022 Environ. Res. Lett. 17 064010, https://iopscience.iop.org/article/10.1088/1748-9326/ac6228
[xxxi] CIF, 2021. CIF Begins Historic $2.5B Coal Transition Pilot in Four Developing Countries, https://www.climateinvestmentfunds.org/news/cif-begins-historic-25b-coal-transition-pilot-four-developing-countries
[xxxii] ADB, Energy Transition Mechanism, https://www.adb.org/what-we-do/energy-transition-mechanism-etm
[xxxiii] RMI, 2021. Securitization in Action: How US States Are Shaping an Equitable Coal Transition, https://rmi.org/securitization-in-action-how-us-states-are-shaping-an-equitable-coal-transition/
[xxxiv] Climate Bonds Initiative, 2020. Financing Credible Transitions, https://www.climatebonds.net/transition-finance/fin-credible-transitions
[xxxv] REN21, 2022. Renewables 2022: Global Status Report, https://www.ren21.net/reports/global-status-report/
[xxxvi] 117th Cong., 2022. Inflation Reduction Act of 2022, https://www.congress.gov/bill/117th-congress/house-bill/5376/text