Which tools can we use to help shift capital allocation patterns to clean industries? David Blood and James Cameron conclude their two-part assessment of the low-carbon recovery.
[This article first appeared as a paper in the Copenhagen Climate Council Thought Leadership Series. It is reproduced here with permission.]
Dealing with systemic climatic risks will require systemic shifts in capital allocation. Given the technologies we currently have and the need to act swiftly, what tools will enable this shift in allocation patterns? Because risk-reward expectations drive investors to deploy capital toward some assets but not others, we need to lower the risk associated with low-carbon solutions to make them attractive to investors. Investors must recognise that carbon assets, not just sub-prime mortgages, are toxic.
We need new approaches to manage systemic risks that build upon three core principles:
• Long-term perspective
• Good governance and transparency
Solid adherence to these principles over time will need to coexist with adaptive flexibility in the implementation of the ideas suggested below.
Principle one: long-term perspective
Most investors and governments face limited incentives to use the long-term as their compass for decision-making. Investment performance is judged and rewarded based on quarterly results while governments can be defeated if they are deemed not to have delivered within a short time horizon. Encouragingly, there is a growing movement against short-termism; the current financial crisis is a dramatic example of what can happen when it goes unchecked.
To deploy capital at the scale required, investors will need policy signals that are long, loud and legal: long-term oriented, clearly defined, and written into law. Establishing de-carbonisation mandates along a pre-defined and long-term horizon is the most critical enabler of low-carbon investing. With such mandates in place, policy uncertainty will no longer erode the returns and valuation of these assets. Governments need to implement a regulatory framework that will provide a solid foundation for investors.
In the absence of long-term credible policy signals including a price on carbon, low-carbon investments will fail to reach the scale needed. The global market for carbon credits – dominated by the EU Emission Trading Scheme (EU-ETS) and Clean Development Mechanism markets – has grown steadily in size in recent years to a value of US$110 billion in 2008. Although this market has succeeded in establishing a market-driven price for carbon, this price signal has proven insufficient to catalyse low-carbon investment on the scale that policymakers expected and investors require.
The uncertainty about the post-2012 climate regime has created volatile price signals that have failed to guide long-term investment decisions. The price signal from the EU-ETS, for example, has not resulted in fundamental changes to the energy footprint of participating European utilities. In the future, the market is expected to provide reliable guidance to the private sector as it grows to include new parts of the world – the United States, China, India, and Brazil in particular – and larger parts of the global economy such as aviation and forestry. In the meantime, we need a broader set of catalysts to unlock investments in low-carbon solutions at the scale and pace required.
Because the de-carbonisation of infrastructure is at the centre of the climate crisis, new financial products and strategies are needed to encourage pension funds and retail investors to invest in climate solutions. Governments could help develop funding schemes modelled upon the "war bond" philosophy – using savings bonds to help fund a collective effort against a common adversary. For example, "climate bonds" could be state-backed debt instruments with ring-fenced proceeds going directly into green infrastructure projects. Products like these could raise money from retail investors and pension funds and would guarantee that the proceeds go to climate solutions.
The need for modern grid infrastructure in the United States and EU illustrates where private capital must be mobilised alongside government infrastructure spending. New "smart grid" infrastructure could cost up to $400 billion over 10 years in the US alone. Government expenditure and green stimulus will likely help mobilise private investment through the multiplier effects that government expenditures have on the wider economy.
In addition to new products, momentum is building to create a specialised facility geared toward long-term investments in low-carbon infrastructure, offering loan guarantees, lines of credit, equity investments and insurance. This idea is gaining support in the US, where the 2009 federal stimulus package included billions to support loan guarantees for renewable energy and electrical transmission technologies.
Finally, at the household level, many of the investments in energy efficiency for buildings involve investment decisions by millions of homeowners, creating a need for new financing strategies for individuals. In particular, large-scale deployment of "green mortgages" could provide household loans to help finance the additional upfront capital required to enhance the energy efficiency of a house, enabling homeowners to pay over time with the energy savings that accrue in the years which follow.
Principle two: good governance and transparency
The implementation of measures to price externalities, such as CO2 emissions, requires strong institutions. The specialised agencies at the core of the global economy – including the World Trade Organization, International Monetary Fund, and World Bank – arose from the efforts of governments in the post-World War II era to develop the institutional architecture required to facilitate global trade, financial stability and economic development.
Today, the joint financial and climate crises underscore the need for a similar multinational effort to revise and update this institutional architecture. The global economy has indeed entered a post-Bretton Woods era, and we must now reform our international institutions for trade, finance and development – first envisioned over 60 years ago – in order to address today's financial and environmental challenges and respond to the linkages between these two spheres.
Climate governance at the global level calls for new institutional arrangements. Several global mechanisms have been proposed ranging from a global carbon fund to a global trust for ecosystems and forestry. These proposals have different emphases but share a philosophy: long-term orientation, multilateralism and protection of the "global commons."
Good governance and transparency are mutually reinforcing. We will need to increase non-financial disclosures to further shift capital allocation away from carbon-intensive assets. Greater disclosure of climate risks will allow investors to uncover hidden climate risks and opportunities in their portfolios. Possible ways to mandate stricter listing requirements of climate-risk disclosure among public companies as well as requirements for better disclosure, both qualitative and quantitative, of climate risks in annual financial reports also merit further exploration.
A concerted effort to gauge and manage carbon data around the world needs to complement a global institutional anchor for climate finance. Carbon analysis should no longer rely on data collected for other purposes (e.g. fossil fuel consumption or transport data). Just as labour and financial flows are carefully and officially tracked around the world, carbon also needs its own centralised and international data management facility.
We need reliable emissions data that is as timely and relevant as the data investors already receive on GDP, non-farm payrolls, consumer price indexes, industrial production and house prices.
To catalyse and scale up capital toward low-carbon solutions, a global fund could be created with the sole purpose of financing projects that protect the global commons. Such a facility would operate along the logic of a federal reserve, ensuring that we have enough liquidity to invest in carbon reduction – and that the economy does not deviate from a safe emissions trajectory. Funding would come from governments, and the agency would operate as a multilateral body. It would set rules and facilitate financial emission-reduction transactions, and could also provide "rescue packages" in critical situations.
Because forests are in particular danger and a key element of any solution, a global fund could provide financing to governments that seek to avoid deforestation. Forestry trusts or ecosystem endowments could be put in place that would allow host governments to sell forests to the global carbon fund in exchange for certain guarantees, and the fund could be a means of delivering foreign aid in exchange for the preservation of important carbon sinks.
The Catalyst Project, which aims to rapidly accelerate the world's response to climate change, has explored the creation of a "bank" to help boost the Clean Development Mechanism (CDM) under the Kyoto Protocol. Such a global system would require developed countries to buy credits at their market (marginal) cost from the "carbon bank," which would then use the proceeds to buy credits in developing countries at a price close to the incurred (average) costs. The carbon bank would use the proceeds from any difference between sale and purchase prices to enhance and fund domestic mitigation and/or adaptation efforts in developing countries, in a way similar to the current CDM levy.
Principle three: cooperation
In the coming years, we are unlikely to make progress in tackling climatic and financial risks without a significant increase in collaboration. The concurrent financial and environmental crises will likely demand a level of cooperation not seen since the Second World War. Given the existential threat we face, cooperation will be akin to self-preservation. The natural world offers examples of animals choosing to cooperate as a mechanism to survive. Communities of species that exhibit collaborative behaviour tend to outperform communities where competition is the only option.
In the past 20 years, we may have put too much emphasis on the benefits of competition and paid insufficient attention to the long-term benefits of cooperation; in the face of current problems, we need both. Competition enables the very innovation in technologies, products, and services that are critical for the transition to a low-carbon future, but it must be complemented by a collaborative philosophy.
For example, collaboration is necessary for the development of financing strategies that scale up the retrofitting of buildings. According to McKinsey & Company, many of these upfront investments could pay for themselves in about 10 years by delivering equivalent energy savings. The main obstacle to these investments being made, however, is a combination of the initial upfront payment, agent, and principal problems, and inertia.
To resolve these issues, some foundations and non-profits are working together with banks to offer solutions, including strategies that allow the owner of a building to implement a retrofit without disbursing the initial capital expenditure. Instead, the owner retains 100% of the energy cost savings from their projects. These savings can be used to repay loans used to finance home improvements or can be kept by the owner, depending on the scheme. Major multi-stakeholder collaborative efforts are also needed to implement strategies to de-carbonise at the city-level, which calls for joint efforts to define long-term planning directives that guide appropriate investments towards cleaner infrastructure.
Governments will also have to radically bolster the way they cooperate to ensure consistency and foster progress. Among those requiring coordination, few projects will demand more collaboration to successfully deploy capital than those tackling deforestation. Since land-use-related abatement opportunities are mostly in emerging economies, the challenge must command the engagement of those governments with the foreign reserves, sovereign wealth, and economic strength to offer assistance.
Many of the ecosystem services that forests provide are crucial for maintaining life and livelihoods: roughly 1.6 billion people depend on them for their welfare and income. To build trust, countries with the capacity to help will need to not only honour their own commitments to reduce emissions, but collaborate with those receiving assistance to achieve climate goals. A new platform for cooperation will require the use of performance-based criteria to build confidence that the projects are delivering expected reductions. Norway's collaborative approach with Brazil to combat deforestation illustrates this approach.
Cooperation is also critical because systemic changes in our geopolitical landscape are underway. We are moving toward a multi-polar context in which large emerging economies command a stronger voice in global affairs. In this new context, we need to creatively move beyond sterile technology-transfer prescriptions that fail to account for new realities. The breakdown of the world into "developed" and "developing" categories is quickly losing currency. A dynamic wealth creation process is occurring in large emerging economies and cooperation will be needed to continue building trust with these countries.
Much of this collaboration can be channelled toward creating stronger institutions in the emerging world that will allow more investment to flow into low-carbon infrastructure. Many of these countries will require new and larger infrastructure in the coming years and their technological choices will lock the world into a particular emissions trajectory in the future.
Finally, a successful approach to addressing the climate crisis will require innovation and collaboration to address other fundamental challenges facing our society, such as energy security, water scarcity, demographic changes, extreme poverty and disease. These challenges are deeply interrelated and will require joint action on many fronts to manage complexity and encourage synergetic solutions, such as infrastructure projects that incorporate climate change and water-related considerations, while simultaneously creating employment and economic prosperity.
David Blood is senior partner and co-founder at Generation Investment Management LLP
James Cameron is vice-chairman and co-founder at Climate Change Capital Ltd.
[This article first appeared as a paper in the Copenhagen Climate Council Thought Leadership Series. It is reproduced here with permission.]
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