Financing Decarbonization

Accelerating clean energy transitions around the globe is essential to avoid catastrophic global warming and to achieve universal access to clean and affordable energy. Decarbonization hinges on the rapid transformation to zero-carbon electricity, mainly through the deployment of wind, solar, hydroelectric, geothermal, and other non-carbon primary energy sources. This transformation depends substantially on the terms of finance for zero-carbon energy ¹ .  If finance for decarbonization is ample and at low cost, decarbonization will proceed rapidly – not only because it is desirable for climate change, but also because it is a low-cost, and often the lowest-cost, source of electricity.  If finance for decarbonization is at high cost, the burden of decarbonization is much higher – because fossil-fuel-based power is then typically cheaper and easier to finance. 

Although the need and technological pathways for decarbonization are now relatively well understood, the financing terms for zero-carbon power are not yet supportive of this transition.  In the analysis below, we explain why decarbonization hinges on the financing terms, how financial market regulations can help to tip the balance, and the limits of financial sector initiatives alone to decisively accelerate decarbonization. Clear government policies are vital to guide financial decisions towards decarbonization.  

Zero-carbon electricity and the cost of capital

The transformation globally to zero-carbon electricity is critical to meet global decarbonization targets. This is for five reasons.  First, zero-carbon electricity directly reduces emissions by replacing fossil-fuel-based electricity.  Second, zero-carbon electricity enables zero-carbon electric vehicles.  (If electric vehicles are charged with fossil-fuel-based electricity, the reduction of emissions is small or non-existent).  Third, zero-carbon electricity enables zero-carbon heating and cooking in buildings.  Fourth, zero-carbon electricity can replace fossil-fuels in many industrial applications.  Fifth, zero-carbon electricity can be used to produce green fuels, such as hydrogen, which can then be used to replace fossil-fuels in ocean transport, aviation, steel-making, and other industrial applications.  

The institutional arrangements for generating electricity differ substantially across jurisdictions, involving a range of public and private actors: regulators, public utilities, regulated companies, independent power providers, and others ² . Whether energy systems decarbonize from fossil-fuel based to renewable sources depends on the comparative costs of energy technologies and on public policies.  In cases in which regulators mandate a shift to renewables, public or regulated utilities may decarbonize by passing on higher costs to consumers. In many cases, however, utilities or other regulated power companies are incentivized or even required by regulation to provide electricity at the lowest possible cost to the customer base. In those cases, the transition to zero-carbon energy depends on the comparative costs of zero-carbon energy and fossil-fuel based energy. Decarbonization and the terms of finance are thus intimately connected.    

While the costs of zero-carbon electricity have decreased substantially over the past decade ³ , bringing the levelized cost of zero-carbon energy within reach of fossil-fuel based energy in many locations, fossil-fuel based electricity often remains more affordable. The difference in comparative costs depends importantly on the costs of finance.   

Here’s why:

With most forms of zero-carbon electricity, such as wind and solar power, the cost of production is upfront, in the form of investment outlays for wind turbines, photovoltaic modules, hydroelectric dams, and so forth.  There are no variable fuel costs as with fossil-fuel based power — only annual maintenance and operations expenses.  With fossil-fuel based power, by contrast, the up-front investment costs for building the power plants are typically lower, and much of the expense is pay as you go, as the variable inputs of fossil-fuels (coal, oil, gas) are burned at the power plant.  This obvious difference is illustrated in Figure 1, comparing a 30-year onshore wind power plant versus a 30-year natural-gas combined cycle plant, using illustrative data from the US Energy Information Agency.  

The basic data are the following (see appendix).  To generate 1MWh (10⁶ Wh) of onshore wind power, the capital costs are $514 upfront and $9.91 per year.  To generate the same amount of power using a natural-gas combined cycle plant, the capital costs are $142 upfront and $29.33 per year.  Comparing the two projects, the lower-cost option over 30 years depends on the cost of capital.  If the cost of capital is low, the onshore wind plant is lower cost; if the cost of capital is high, then the gas-fired plant is lower cost.  

This can be verified in two (equivalent) ways.  The first way is to calculate the net present value (NPV) of the total costs of producing 1MWh per year over the 30-year period.  The second is to calculate the levelized cost of electricity (LCOE), which is a transformation of the NPV.  

For purposes of illustration, let us consider a low real (inflation-adjusted) cost of capital, 3% per annum, versus a high cost of capital, 6% per annum.  At the low cost of capital, the NPV of the wind project is $714, and of the gas project is $734.  At the high cost of capital, the NPV of the wind project is $659, compared with $570 for the gas project.  Thus, as was explained intuitively above, the wind project is less expensive than the gas project at a low interest cost, but more expensive at a high interest cost. 

The LCOE is the annualized cost of 1 MWh of power assuming a constant annual outlay over 30 years to finance the upfront investment costs.  To calculate the LCOE we simply multiply the upfront investment cost by an appropriate Capital Recover Factor (CRF), and then add the annual variable costs for fuel plus the annual operating and maintenance costs ⁴ .  For a 30-year project with 3% cost of capital, the CRF is 0.0495; and with a 6% cost of capital, the CRF is 0.0685.  At 3%, the LCOE of a MWh wind power is $35.37, lower than $36.36 for gas.  At 6%, the LCOE of wind power is $45.14, greater than $39.06 for gas.  (See appendix for details.)

These calculations suggest that profit-oriented utilities or other power producers, or those required to produce energy at lowest cost, will be strongly influenced by the cost of capital in their choice of technology.  With a low cost of capital (e.g., a low market interest rate), renewables tend to be the lower cost option; with a high cost of capital, fossil fuels tend to be the lower cost option.   

Three key distortions in market financing of zero-carbon power

Three key cost distortions currently weigh against the adoption of zero-carbon power, and hence against decarbonization more generally.  

The first distortion is the subsidization of fossil fuel use, which may be introduced in a variety of ways, including: price controls and/or public subsidies on the domestic sale of fossil fuels; subsidies for the domestic production of fossil fuels (often through accelerated depreciation allowances for oil and gas production); and favorable tax treatment for the utility that biases the choice towards fossil-fuel-based technologies.   

A second and related distortion that artificially depresses the cost of fossil-fuel based energy relative to renewable energy is the general failure of the marketplace to include the Social Cost of Carbon (SCC) in the calculation of costs. The SCC refers to the environmental damages (mainly anthropogenic climate change and ocean acidification) associated with rising CO2 concentrations in the atmosphere ⁵ . When a utility or power producer burns fossil fuel and emits CO2, the social costs of the CO2 should be included in the annual fuel costs, yet this is rarely the case. 

The United Nations calculated global fossil fuel subsidies, “defined as both explicit monetary subsidies and implicit environmental and social costs that are not reflected in fossil fuel prices,” to be around $5.9 trillion in 2020, or 6.8 per cent of global GDP ⁶ .

The most straightforward means for addressing the above two distortions are to end subsidies for fossil fuel use, both upstream and downstream, and to impose a social cost of carbon in cost calculations, for instance through a direct CO2 tax or through a regulation that obliges the utility to impute a specified SCC as part of its cost calculations in making choices on technology.  

Consider the previous example.  While the wind power plant emits no CO2 in its operations, the gas combined cycle plant emits roughly 0.39 tons of CO2 per MWh of power transmission.  Suppose that the company must pay a tax of $50 per ton of CO2.  That tax adds $19.46 per MWh to the annual costs of the natural gas combined cycle plant. In that case, the LCOE of the gas project will be $55.8 at a capital cost of 3% and $58.5 at a capital cost of 6%, in both cases far higher than the comparable cost of wind power.  Thus, even at high capital costs, the zero-carbon option would be selected. 

The third major distortion is the high cost of capital facing developing countries relative to developed countries.  Sovereign and corporate borrowers from developing countries pay a risk premium of several hundred basis points (several percentage points) compared with the borrowing costs paid by comparable borrowers from the high-income countries ⁷ . (Sovereign ratings act as a ‘country-level ceiling’ for corporate borrowing ¹⁰ . Although not all approaches designated as ‘sustainable investing’ are focused on addressing climate change, a proliferation of climate-aligned initiatives and alliances boast the membership of the largest banks, asset owners and asset managers. Just one such alliance – the Global Finance Alliance for Net Zero (GFANZ), launched at COP26, boasted a total AUM of $130 trillion.  

Yet there are at least four reasons to doubt that sustainable investing will fundamentally shift the basic economics of decarbonization unless governments also adopt basic policies to address the market distortions outlined above. (There are many other reasons to doubt the impact of sustainable investing strategies on improving social and environmental outcomes, but for this analysis, we limit ourselves to those influencing the economics of decarbonization.)   

The first reason for doubt is that for many if not most ‘sustainable’ funds or portfolios, the investment or financing goal remains to maximize returns or the value of the investment portfolio; indeed, many investors in those funds “believe integrating environmental, social and governance (ESG) issues into their investments could lead to greater financial returns or will not affect returns while providing a feel-good sentiment. In other words, ESG investment strategies were not designed to go beyond financial returns.”  ¹¹ The integration of ESG factors in that context merely means that the investor takes into account ESG considerations in forecasting the future trajectory of profits and costs.  When such a “sustainability fund” (or an “ESG fund”) invests in a utility, the investor will still prefer that the utility choose the least-cost options consistent with the utility’s regulatory environment.  In other words, sustainable investing for this category of investors does not mean channeling investment funds to higher cost, less profitable projects.  At best, it means that investors will consider the possibility of future climate regulations or future carbon pricing when making informed investment decisions today.  

The second reason for doubt is that even when some investors are prepared to make investment choices based on ethical principles rather than wealth maximization, other investors will be happy to take up the slack.  Thus, some institutional investors (such as universities, religious groups, and selected pension funds) may divest from fossil-fuel stocks or bonds out of core values, and are even willing to do so at some financial cost. While divestment may meet other goals (including values alignment but also potential signaling to policy makers and others), it is unlikely to influence the cost of capital facing fossil-fuel projects, thereby tilting the investment decisions of utilities (and other energy-related enterprises) towards zero-carbon technologies.  The problem is that other investors, who are investing for wealth maximization rather than values, will be ready to purchase the shares or debt. Some have estimated that at least 86% of shareholders in a company would have to divest in order to impact the cost of capital by at least 1% ¹² . 

The third reason to doubt that sustainable investing will – by itself – influence the fundamental economics underpinning decarbonization is, even for those investors who are proactively investing in clean energy or in public sustainability-linked bonds, most will still not invest in or loan to the poorer countries that lack investment grade credit ratings.  Many investment funds, such as pension and insurance funds, face regulatory limits on investing in sub-investment grade securities (even if the fund wants to invest in such securities for sustainability-related motivations).  Thus, for all of the excitement around GFANZ, there is no evidence to date that much if any of the $130 trillion in AUM will find its way to the poorer half of the world. 

We have little doubt that private capital markets will fund most of the forthcoming investments in decarbonization ¹³ .   Publicly owned utilities, privately owned utilities and independent power producers around the world will have to tap the private capital markets for the enormous investments ahead, amounting to hundreds of billions of dollars per year.  Government revenues, including both taxes and retained earnings of state-owned utilities, will cover part of the decarbonization costs, but only a modest proportion. 

Yet investor strategies, including of sustainability funds or portfolios, will not be sufficient (or indeed even influential) in shifting the market fundamentals that must underpin the massive transformational challenges of decarbonization.  

The most important role will be played by public policies, nationally and internationally, as outlined below.  

Two practical solutions to the financing challenges

We suggest at least two overarching solutions to the market-financing challenge.  The first is to factor in a robust SCC into the consideration of public and private actors, and to end the implicit and explicit subsidization of fossil fuels that is pervasive in economies around the world.  The second is to take practical steps to reduce the risk of self-fulfilling liquidity crises facing the poorer nations, so that those nations too may access private capital on terms close to those paid by the richer nations.  

Incorporating the SCC through quantities and prices, and ending distorting fossil fuel subsidies.  In order to induce investors to choose zero-carbon over fossil-fuel-based technologies, it is important both to lower the cost of capital and to introduce the SCC into production cost calculations.  As mentioned above, the SCC may be introduced in several ways.  Economists tend to prefer the most straightforward method: a tax on CO2 emissions equal to the SCC.  Financial firms tend to prefer an emissions trading system in which the price of the emissions permit equals the SCC.  The trade in emissions permits generates additional business for the financial sector (and typically added administrative costs compared with an upstream tax on fossil fuels).  The third way to introduce the SCC is through regulation that requires utilities to incorporate the SCC in their rate setting and choice of technology.  A fourth way is the most straightforward, and that is to prohibit new investments in fossil-fuel power generation altogether.  In this case, the SCC is introduced implicitly, as a shadow price equal to the incremental cost (if any) incurred by the utility by investing in zero-carbon power compared with fossil-fuel-based power.  Many states in the US, for example, have imposed zero-carbon standards for their utilities as of certain future dates.  In New York, for example, the state regulator has set 2040 as the date for reaching a zero-carbon grid.  It is accomplishing that through a combination of pricing and quantity standards. Introducing a SCC ends implicit subsidization of fossil-fuel power, but ending explicit fossil fuel subsidies (in direct subsidies, tax provisions, price controls, and other means) is also imperative.

Increased development finance for poorer nations.  The poorer countries will be both unwilling and unable to decarbonize unless they have access to much larger flows of financing at far more favorable terms than at present.  The rich countries committed a decade ago to ensure at least $100 billion per year of climate financing for developing countries by the year 2020, of which roughly half was to go towards mitigation (decarbonization) and the other half to adaptation.  In fact, the rich countries fell woefully short of this target, even with a decade of lead-time to fulfill the commitment.  The extent of the shortfall is debated.  The OECD Development Assistance Committee (DAC), effectively overseen by the donor countries, put the 2019 climate financing at $79.6 billion.  By contrast, Oxfam claims that the OECD vastly overcounts the actual financing, placing it a mere $19 – $22.5 billion in 2018.  Either way, the shortfall was significant, and even more alarmingly, the $100 billion target was a small fraction of the overall financing needs of the developing countries.  

We see two major channels for increased funding at the scale of hundreds of billions of dollars per year.  The first is to enhance the creditworthiness, and hence the credit ratings, of the poorer nations.  The second is to increase the flow of development financing supplied by international institutions, most importantly the multilateral development banks (MDBs), including the World Bank and the regional development banks (RDBs).  

The creditworthiness of the developing countries could be enhanced through a better matching of their financing needs and growth prospects with the terms of financing.  We suggest two complementary factors. First, developing countries need long-term loans to give them sufficient time for economic growth to generate the incremental GDP needed to repay the loans.  By extending the maturities of the loans to the poorer countries, their creditworthiness would rise, since there would be little chance of a self-fulfilling credit crisis in the short term.  With long-term lending, it would be prudent for the lenders to increase the magnitude of lending, and prudent for the borrowing countries to take on more debt to finance their infrastructure needs.  Second, we need a review and overhaul of the credit-rating systems. The G20 and the IMF could develop a new credit-rating system that accounts for a country’s growth prospects, long-term debt sustainability, and “a country’s efforts to invest in the SDGs, including in resilience and climate adaptation.” ¹⁴ . If revised ratings incorporated “the positive effects of SDG investment, long-term ratings could also create incentives for such investment and help countries raise long-term capital for that purpose.” ¹⁵

The other main way to increase the flow of decarbonization financing to the developing countries is to increase the loan flows from the MDBs, which are “well placed to fund SDG investments because of shared objectives and long time horizons.” ¹⁶ .Currently, the MDBs lend around $100 billion per year (for all purposes), of which roughly half comes from the World Bank.  Various studies have indicated that even with their current balance sheets, the MDBs could prudently increase their lending by several hundred billion dollars without impairing their balance sheets or risky their high credit rating.  If the balance sheets are augmented with increased paid-in capital, then obviously the scope for increased MDB lending would be even more greatly increased.  

Conclusions

The global challenge of decarbonization is fundamentally a challenge of technological change backed by adequate terms of financing.  The estimates are that trillions of dollars will be needed each year to 2050 to finance the energy transformation by mid-century.  Global saving, currently around $25 trillion per year, is certainly sufficient to finance the decarbonization process.  Yet we’ve seen that the financing falls far short of what is needed.  The costs are too high for many countries, and the market incentives to decarbonize are currently insufficient.  

We identified three main obstacles: the failure to incorporate the SCC in investment decisions; the ongoing subsidization of fossil fuels; and the insufficient flows of financing to the poorer nations.  We argued that these deficiencies will not be solved by sustainable investing, since such approaches are insufficient to change the underlying economics that will enable and accelerate energy system decarbonization.  To accomplish the transformation will require fundamental changes in public policy.  We have highlighted the three most important changes: proper pricing of the social cost of carbon; ending direct fossil-fuel subsidies; and measures to direct increased capital flows to the poorer nations.  

1. IEA (2021), Financing clean energy transitions in emerging and developing economies, IEA, Paris https://www.iea.org/reports/financing-clean-energy-transitions-in-emerging-and-developing-economies
2.  Ibid, p. 65.
3.  International Renewable Energy Agency, Renewable Power Generation Costs in 2020 (Abu Dhabi, 2021). 
4.  In the simple case shown here, with one cost of capital and no tax corrections, the relationship is: LCOE = CRF*INV + VC + O&M, where INV is the upfront investment cost, VC is the variable (fuel) cost, and O&M is the operating and maintenance costs.  CRF is the capital recovery factor.  For a 30-year project with cost of capital r, the CRF = [r/(1+r)]/[1-(1+r)^-30].
5.  See, e.g., The Social Cost of Carbon Initiative, Resources for the Future, for more on the Social Cost of Carbon, https://www.rff.org/topics/scc/social-cost-carbon-initiative/
6. United Nations, Inter-agency Task Force on Financing for Development, Financing for Sustainable Development Report 2022. (New York: United Nations, 2022), available from: https://developmentfinance.un.org/fsdr2022, p. 41.
7.  IEA (2021), Financing clean energy transitions in emerging and developing economies, op.cit., https://www.iea.org/reports/financing-clean-energy-transitions-in-emerging-and-developing-economies, p. 44. (“Economy-wide nominal financing costs in EMDEs range some 700 to 1 500 basis points – up to seven times – above values for the United States and Europe, with higher levels in riskier segments.”)
10. United Nations, Inter-agency Task Force on Financing for Development, Financing for Sustainable Development Report 2022, op.cit.,https://developmentfinance.un.org/fsdr2022, p. 23. ⁸ as well, so they affect both public and corporate borrowing.) The simple fact is this. The credit-rating system systematically punishes poor countries, literally giving poorer nations a lower score simply because of their lower income per capita and their smaller share of the world economy.  

    The situation is summarized in Table 1, where we summarize the credit ratings assigned by Moody’s to 136 sovereign borrowers, classified by their income level according to the World Bank.  None of the 27 low-income countries (LICs) has an investment grade credit rating, and only 3 of the 53 lower-middle income countries (LMICs) do.  By contrast, 10 of the 54 upper-middle-income countries (UMICs) have an investment grade credit rating, and 44 of the 59 high-income countries have an investment grade credit rating.  The global population living in countries with a sub-investment grade rating is 2.9 billion, or 38.6 percent of the world population.  (Note that while only 57 of 193 UN member states has an investment grade, this includes the biggest countries — China, India, and Indonesia — so that 61.4 percent of the world population live in countries with a Moody’s investment grade rating.) 

    The sub-investment grade ratings of all of the LICs and most of the LMICs mean that capital costs in these sub-investment-grade countries are far higher than in the UMICs and HICs.  According to our earlier analysis, the high costs of capital mean that the poorer countries will prefer fossil-fuel projects to renewable energy projects unless the means are found to reduce the capital costs for these countries of investing in zero-carbon power.  

    It might be argued that the high borrowing costs facing the sub-investment grade borrowers is not a market distortion per se, but rather is a reflection of the high risks of lending to borrowers in poorer countries.  We believe that this common belief is not accurate for the following reason.  Poor countries indeed are more vulnerable to defaults than richer countries, but this is mainly because of the pervasiveness of sudden panicked reversals of international capital flows to these countries in response to short-term shocks in the poorer countries.  The sudden drying up of lending to a poor country because of a heightened fear of default is often the cause of a subsequent default, because the poor country is suddenly unable to refinance its debts as they come due, even though such refinancing would be routine for richer countries.  In other words, the poor countries are indeed more prone to default, but as the result of self-fulfilling panics by lenders rather than fundamental economic risks.

    Can ‘sustainable investing’ repair the market failures?

    The massive expansion of interest in “sustainable investing” in recent years reflects, and in turn fuels, the hope that climate-aware investors can shift the market financing from fossil-fuel based projects to zero-carbon based projects.  The growth of sustainable investing is indeed impressive, as shown in Figure 2.  Sustainability-themed funds saw a net inflow of roughly $600 billion in 2021, a 62% increase on the prior year, amounting to more than $2.7trillion in total assets by the end of the year ⁹ Ibid,p. 65-66.

11.  Ibid, p. 66.
12. Berk, Jonathan B. and van Binsbergen, Jules H., “The Impact of Impact Investing,” Stanford University Graduate School of Business Research Paper, Law & Economics Center at George Mason University Scalia Law School Research Paper Series No. 22-008 (August 21, 2021), Available at https://ssrn.com/abstract=3909166. 
13. IEA (2021), Financing clean energy transitions in emerging and developing economies, op.cit., https://www.iea.org/reports/financing-clean-energy-transitions-in-emerging-and-developing-economies, p. 43.
14. UN DESA Policy Brief No. 131: Credit rating agencies and sovereign debt: Four proposals to support achievement of the SDGs, 21 March 2022, https://www.un.org/development/desa/dpad/publication/un-desa-policy-brief-no-131-credit-rating-agencies-and-sovereign-debt-four-proposals-to-support-achievement-of-the-sdgs/. See also Jeffrey D. Sachs, “Time to Overhaul the Global Financial System,” Project Syndicate, December 3, 2021. https://www.project-syndicate.org/commentary/global-financial-system-death-trap-for-developing-countries-by-jeffrey-d-sachs-2021-12
15.  UN DESA Policy Brief No. 131: Credit rating agencies and sovereign debt: Four proposals to support achievement of the SDGs, 21 March 2022, https://www.un.org/development/desa/dpad/publication/un-desa-policy-brief-no-131-credit-rating-agencies-and-sovereign-debt-four-proposals-to-support-achievement-of-the-sdgs/. 
16.  United Nations, Inter-agency Task Force on Financing for Development, Financing for Sustainable Development Report 2022. op.cit., https://developmentfinance.un.org/fsdr2022, p. 18.