June 22, 2024

Lets Be Clear On What Finance Can And Can’t Do

For all the talk of sustainability being put on the back burner whilst other issues (inflation, rates, AI, geopolitics etc) take centre stage, the energy transition and how the world makes good on the commitments made at the UN’s COP28 summit have continued to be central to the conversation in Davos this week. But that conversation has moved on since the World Economic Forum annual meetings of just a few years ago.

Much of the technology and innovation needed to facilitate the energy transition is now already here – think renewables, electric vehicles, battery storage and energy efficiency – and others are following closely behind, with strides made in carbon capture, green hydrogen and ammonia, for instance. Private markets are pivoting to the investment opportunities these developments are creating, despite challenging capital markets conditions, interest rates and higher inflation in the last year. Nevertheless, more financial outlay at scale is still needed to advance these technologies at pace to meet the world’s climate goals.

But, whilst some may have been guilty of giving the impression that finance can “drive” and “deliver” the transition at earlier Davos gatherings, this has given way to a more candid assessment: capital is just one piece of the puzzle to unlocking deeper decarbonization, and we need more clarity on what finance can and cannot do.

Financial providers like banks (I work at one) have a deeply vested role in supporting the transition by both facilitating and providing the necessary capital, as the potential commercial opportunities from the Green Industrial Revolution for our clients and our institutions are substantial. Estimates such as those by the International Energy Agency suggest more than $4T of annual global investment will be needed for the energy transition, with the potential to fundamentally transform the energy system at a level we have not seen since the first Industrial Revolution. Providing financial services to businesses poised to capitalize on this, at the intersection of opportunity and necessity, can be profitable while also spurring innovation, reinvigorating manufacturing and supply chains, and creating a wealth of employment opportunities for society.

Like all sectors, we also need to reduce our own environmental impacts, and financing companies driving the transition is an important component of this.

Whilst finance itself is a vital, and indeed many investors and capital providers are already generating strong returns from the more mature transition technologies, it may be tempting to think of the flow of capital as simply “flipping a switch”. However, there are two major reasons why this isn’t the case.

Enabling government policy is essential

To achieve a successful and orderly transition that creates economic growth, preserves energy security and mitigates the global impacts of climate change, supportive government policy is absolutely instrumental. To transform the energy mix, boost new industrial activity, and build sustainable infrastructure at speed and scale, governments need to lead by setting necessary enabling regulatory frameworks and policy incentives to transform regional and local economies, reskill global workforces, unblock permitting to develop the backlog of necessary infrastructure, and so on.

With the right incentives and investment opportunities, capital will flow into the necessary technologies. In the U.S., as an example, the Inflation Reduction Act (IRA) has been instrumental in improving the economics of many technologies. Existing public policy support and the Green Deal Industrial Plan, with its relaxation of state aid rules to allow similar support to businesses across the EU, is having a similar impact in Europe.

If well-implemented, industrial strategy and hard policy interventions like carbon prices, subsidies and market-based incentives can be game-changers. Moreover, they may be necessary to make the transition economically viable for businesses across the whole economy and ensure coordinated progress.

Public guarantees and instruments can also play a key role in drawing in private capital, giving investors the certainty they need to put money behind long-term, capital intensive projects. Enhanced risk sharing through public-private partnerships, with governments ready and willing to provide the initial support needed for new technologies to scale will make a real difference too.

The bottom line is that without the necessary public policy interventions, insufficient capital will flow into the required transformative technologies and industrial activities.

Green projects must deliver a good rate of return

Next, financial institutions have an obligation to generate sustainable returns and to serve the communities they operate in. Many banks look to capture the significant opportunities that exist to work with companies choosing to pursue their own low-carbon objectives as a business decision, whilst at the same time ensuring that they appropriately manage the emergent risk that such activity will bring.

A huge capital allocation to a new energy source without an established customer base could mean a long lead time before an investment returns capital – if it does at all. Another example – despite massive sustainable infrastructure gaps across the emerging world, projects often struggle to secure lending due to inadequate project preparation or sovereign and currency risk.

As the hedge fund manager Ray Dalio said at COP28, private capital can only realistically get involved in financing climate solutions if the returns make sense – “you have to make it profitable.”

On this, pools of capital around the world are increasingly focused on sustainable outcomes, seeking to marry impact and stellar returns. And with help from governments on risk sharing for green energy infrastructure, innovative financial structures are taking shape, like Alterra, the UAE’s $30B climate investment fund announced at COP28, with backing from BlackRock, Brookfield and TPG.

Only with unprecedented collaboration from actors across public and private sectors can we remove decarbonization blockers – creating the real economy conditions that will actually enable finance to support and ultimately accelerate the transition.

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