As part of the Paris Climate Accord in 2015, over 180 countries agreed to reduce greenhouse gas emissions and limit global temperature increases to below two degrees Celsius. One of the key parts of the Agreement is the objective of ‘making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.’ Five years on and the results are mixed at best. The good news is that over the last 18 months there has been more movement and change than there has been over the last two decades.
One could say that an inflexion point has been made with investors increasingly seeing climate risk as both investment risk and an investment opportunity.
Going forward, a lot needs to be done to mobilise capital to significantly expand investment in low-cost clean energy technologies such as solar and wind, which are needed to achieve carbon-neutrality. But I must admit that I am very positive about the future.
It is easy to criticise the finance industry for financing billions of dollars of new fossil fuel assets that are built every year. The justification has always been that this investment is needed for our economies and that the returns are there to be made. One of the positives of Covid is that it has given the investment community a view of what peak fossil fuel demand will be like. Thanks to weak demand for oil caused by the travel restrictions related to the Covid pandemoniac, oil prices turned negative on April 20, 2020 – meaning that producers had to pay customers to take their oil. A first for oil, but a wake-up call as well!
This event gave investors a view of peak oil, but not peak oil supply as many formally touted but peak demand. The result was that investors rushed for the door on their fossil fuel investments with share prices collapsing across the border. The ExxonMobil share price, for instance, finished 2020 down nearly 40%. In addition, businesses such as BP and Shell made asset impairments totalling $40bn sighting long-term risks around carbon price and oil demand. All three combined generated losses totalling $70bn for 2020.
What we are now seeing is the financial market pulling forward risk as investors seek to avoid ‘stranded assets’ and reallocate funds to greener investments such as the US electrical utility company NextEra, which for a while last year became the biggest energy company in the Western world. Its share price finished 2020 up 20% as investors jumped on the decarbonisation opportunity.
What we are also seeing is that investors across the world are increasingly seeing climate risk as investment risk. There are two aspects to this: the first of which are physical risks, such as storm damage; and the second, climate policy. The latter is a risk particularly for owners of fossil fuel assets or those who are dependent on fossil fuels as an energy source – however, it is also an opportunity as new regulation and legislation drive growth, demand and capital flows into clean energy.
How we produce, use and transport energy is at the heart of the energy transition. The challenge, however, is much greater, requiring structural change in areas as diverse as housing, transport, agriculture, and heavy industry. We require creative thinking, technical solutions, business models, market mechanisms, and financial offerings to achieve net-zero. More importantly, the energy transition also calls for a profound rethinking of how we live and work. We also need to switch the thinking in the finance world from just measuring the risks of climate change to focusing on the opportunities that this transition provides.
The cheapest form of energy has always led to great periods of economic growth and comparative competitive advantage. Think of Britain with its cheap coal during the industrial revolution or Saudi Arabia with its low-cost oil. Today, the most affordable ways to produce electricity are with solar and wind, and as we electrify more and more of society, these technologies will become the bedrock of a 21st century economy. What makes these renewable technologies really interesting is that they have no fuel costs with minimal and highly predictable operating costs. In this new world the way to drive down costs and thus increase competitive advantage is to push down capital costs while at the same time building up the necessary skill set to ramp up and run an energy system based on these technologies.
The good news is that there is no shortage of capital across the world. In fact, the world is flooded with low cost money looking for a home. But this capital is not finding its ways to sectors such as hard to decarbonise ones like cement and countries where it is most needed. Nurturing the financial conditions to enable a rapid deployment of clean energy technologies across the world is one of the defining challenges of this era.
To deliver the global net-zero goal of 2050, the IEA estimates that over $1,500bn of capital will need to be deployed a year, which is a five-fold increase over the current $300bn investment levels. The bulk of this capital, some $1,000bn per year, needs to be invested in emerging and developing economies which have increasing populations and desires for the products and services that those of us in richer countries take for granted.
Mobilising capital on this scale will require a joint effort of both public and private capital, as well as enhanced role for development banks both international and national.
This is a humongous growth opportunity for the whole world, but especially among many developing countries, which are endowed with excellent weather resources and a need for jobs and inward investment to grow their economies. Accelerating the inflows of capital will require far-reaching changes to improve the political and regulatory environment in these countries. The value that this growth opportunity brings is multi-faceted – starting with job creation to access to low cost and clean energy for people and their businesses, and the society and world they are part of. It is also the easiest and lowest cost way to decarbonise our world, as it is much easier and cheaper to integrate sustainable clean energy solutions into growing economies with their new homes, factories, and vehicles than it is to retrofit existing infrastructure.
In practical terms, this increase in investment means replacing the global capital stock of all fossil fuel-powered devices from vehicles to boilers with low and possibly zero carbon alternatives. The size of the required investment is heavily influenced by the cost of capital. The higher the cost, the more expensive the transition will be. In addition, the maturity level and the potential of technological innovation for key technologies such as solar and batteries are critical. This can all be impacted by policy, where poor policy increases risks and lowers capital flows or makes them more expensive, while good policy aligns investor incentives around climate goals as well as reduces risks and thus pulls in lots of low-cost capital.
This low-cost capital is particularly critical for clean energy technologies such as wind, solar and EVs which have higher relative upfront investments costs than fossil fuels but lower lifetime costs. This shift towards a much more capital-intensive energy system is a key difference to the fossil fuel world. This cost of capital issue is particularly critical in emerging and developing economies which currently have financing costs up to sevenfold higher than in Europe and the United States. What this practically means is that the costs of generating electricity with solar in Pakistan are currently higher than Netherlands even though the Pakistani solar system generates 50% more electricity per year!
Transforming the energy system is no easy task and requires a core focus on electrification which is the most important form of energy we have. Without electricity the mass of digital devices that make up our modern lives would not function, and as we saw in the Texas blackouts, heating and water systems did not operate because of the lack of electricity. Almost unbeknown to us, electricity has become indispensable and going forward it will become come more so. As electricity is the most controllable form of energy we have, it plays an incredibly important role in the decarbonisation pathway, as the more controllable the energy is, the less the heat losses are which means they are also cheaper to operate. Boosting investment in clean electricity, grid and other enabling technologies such as batteries will not only drive emissions reductions to meet climate and other environmental goals, but also create local jobs, noting that all these new infrastructures need to be installed, operated and serviced.
This leads us to the final question, which is: ‘What needs to be done to accelerate the path towards carbon-neutrality and ensure access to low cost capital?’ I would suggest three things:
We need to change fiscal incentive structures, price carbon and establish an international platform for best practices in climate.
1. CHANGE FISCAL INCENTIVE STRUCTURES
Across the world, we have put in place tax incentives and subsidy structures that favour fossil fuels over clean energy solutions. These structures are often difficult to change either due to political reasons or due to resistance from conservative tax offices and finance ministries.
One example is in Germany where retail electricity prices are around $35 cents per kWh while natural gas prices are around $9 cents. The former is high because more than 50 percent of those costs are different government taxes and levies, leaving residential customers with no economic incentive to run their heating system on cleaner alternatives instead of fossil fuels. At the same time, it weakens the economic case for buying an EV.
It is thus critical that if we want to decarbonise quickly and effectively, that fiscal tools are aligned with CO2 reduction goals. A suite of fiscal incentives such as tax credits is needed to kick off early-stage markets and to enable related technologies to reach critical mass. This, for instance, is what we are seeing with EVs across many countries. We also need fiscal incentives to drive research & development and investments in sectors where it is difficult or expensive to decarbonize such as heat for buildings. Finally, financial incentives should also be put in place as part of post-Covid green recovery plans.
2. PRICE CARBON
One of the critical questions in economics is how best to price externalities that negatively impact third parties, like residential customers, who are not otherwise involved in the market of a particular product. Fossil fuels are a good example, which are burned and are paid for by a customer. The associated negative cost of CO2 released from burning fossil fuels is unfortunately not paid by the original producer and buyer of those fossil fuels.
One of the critical functions of government is to put in place regulations that counteract these externalities. In the case of automobiles in Europe, for example, one of the major reasons for the push towards electrification is that automobile manufacturers are being fined for not meeting CO2 emission targets. The other way to do this is to price the externality and put a marketplace in and around the levels of emissions allowed.
In the case of carbon there are lots of schemes to do so, the most successful of which is probably the EU-ETS system. This system of carbon pricing is a crucial tool in Europe for aligning market incentives to ensure an effective and efficient use of capital. The reduction, for instance, in UK coal usage in recent years is largely because of this system which has made coal uneconomic for power generation.
The other positive impact of carbon taxes is they provide revenue to governments which can be used to push further decarbonisation or to ensure carbon equality to make sure that the poor in our societies become beneficiaries of decarbonisation. Going forward, we are likely to see a system of border tax adjustments which will ensure that carbon intensive industries do not just move to a location with no carbon taxes.
3. ESTABLISH AN INTERNATIONAL PLATFORM FOR BEST PRACTICES IN CLIMATE
The only way to save our climate is if we all work together. This is why it is critical to share best practices, particularly around regulations and fiscal incentives, but also the ramping up of people skills needed to transform our energy system. In addition, low cost capital, both equity and debt, needs to be made available to enable countries, regions, cities, and communities to deliver on their climate commitments. This new era of cooperation could take the form of institutions such as the Indian-led International Solar Alliance, which could be used as a vehicle for driving low cost capital for this transition.
This Perspective has been written by leaders in their own words prior to us becoming Hitachi Energy.