How the transition to net zero is funded will be critical to the success of climate change policy implementation
The question of how the global transition to net zero will be funded is perhaps one of the most important considerations in determining the appetite for and pace of climate change policies and actions. Whether carbon reduction commitments are instigated via public policy or motivated by the private sector, the availability of funding is crucial in order for these commitments to be realised.
The fourth webinar in our "Decarbonisation Week" series considered the role and importance of climate financing, before looking more specifically at the role of finance in decarbonising the built environment and for renewable energy projects in Spain. Emma Harvey, programme director of the Green Finance Institute joined our expert panel.
There are two primary angles to green finance: "greening finance" and "financing green". Greening finance looks at providing information to market participants to allow them to make financial decisions that align with net zero targets. Financing green consists of direct investment, private and public, into decarbonisation projects.
While neither of these are new concepts, they have both been gaining in prominence as a result of increasing investor awareness of environmental, social and governance (ESG) and sustainability in financial markets.
Finance for decarbonisation initiatives
In the UK, public financing initiatives include the Public Sector Decarbonisation Scheme which provides grants for the public sector in order to fund heat decarbonisation and energy efficiency measures. The government has also pledged £210 million of funding over five years to support the development of technologies and infrastructure to reduce carbon emissions from energy intensive industries in its Industrial Decarbonisation Challenge.
In the EU, the EU Innovation Fund has been set up to provide €1.1 billion to fund breakthrough technologies to help to decarbonise energy intensive industries.
On the private finance side, there has been increased interest in sustainability-linked loans which incentivise borrowers to comply with certain ESG key performance indicators in order to reduce their interest rates. Infrastructure banks, which provide a mixture of public and private investment and were established by governments to provide finance in the form seen in private sector (but where it might not be otherwise readily available), have also funded investments into subsidy-free solar and battery storage.
Barriers to take-up
The lack of good quality, readily available data may be a limiting factor in the wider take-up of green finance.
Education around green technology is another issue as a perceived unreliability of the base assets can lead to fears around returns on investment and stranded asset risk. The Green Finance Education Charter has been set up in the UK to tackle this problem. It aims to ensure that principles of green and sustainable finance are included in both academic and professional programmes in order to help the financial sector deal with changes in investment criteria.
Another issue for the industry is that current sustainability reporting regulations are generally not considered robust enough to enforce action to be taken over and above minimum requirements. Investors have recently begun to push back against compliance with voluntary regulation initiatives and a consistent and cohesive approach to regulation is needed in order to counter this issue.
Finance and COP
Last year's COP26 climate conference considered finance priorities in terms of both the public finance required to develop the necessary infrastructure for a climate-resilient economy, and the private finance needed to fund innovation and boost the impact of public investment.
Key developments included more than 20 countries (including the US, UK and Denmark) and financial institutions pledging to halt financing for fossil fuel developments overseas, and diverting $8 billion annually to green energy from 2022.
The Glasgow Financial Alliance for Net Zero (GFANZ) was also established, which now sees 550 financial institutions worth $130 trillion committing to using science-based guidelines to align their assets with net zero by 2050.
The UK announced its aim of being the world's first ever net-zero aligned financial centre, with all investment portfolios to be aligned with the transition by 2050. As part of this, all UK companies will be required to publish detailed net zero transition plans in 2023.
The US and the UK also announced their support of the establishment of the Climate Investment Fund Capital Market Mechanism which aims to raise finance to scale clean energy in developing countries through green bonds.
Over the past year, the global energy crisis has seen many countries turn their immediate focus to ensuring energy security. This has meant that some planned green investment been diverted back to or stayed with fossil fuels. Despite this, Mark Carney (Co-Chair of GFANZ) stated recently that the major finance deliverables set out during COP26 are being met, and that GFANZ is leading the way in this respect. It is clear that private finance will not be able to drive net zero by itself, and needs to be supported by adequate and robust government policies.
One focus for COP27, currently under way, is the continued increase in climate investment and the mobilisation of climate finance in the form of equitable distribution of funds to developing countries. For developed nations who have not yet met their target to provide $100 billion to developing countries, the COP27 forum will aim to hold them to account. There will also be efforts to standardise the definition and understanding of climate finance so that this can be properly measured. (Read more of our COP coverage as the conference continues.)
The built environment
Emma Harvey discussed how retail banking can support the decarbonisation of the built environment, which is responsible for 23% of UK emissions. This is particularly relevant in the domestic space, given the predicted increase in the number of those in fuel poverty as a result of the energy crisis. The government pledge to build 300,000 new homes a year will also mean that new build construction emissions will also increase. The UK Climate Change Committee has estimated that it will take £360 billion to decarbonise UK buildings, of which £250 billion is needed to decarbonise homes. There is a need for private finance to contribute towards these amounts if they are to be realised.
For residential buildings, green mortgages are gaining traction after being recommended by the government's Green Finance Taskforce in 2018. These provide financial support for improvements in energy efficiency for an existing home, or provide finance for those looking to buy an already highly energy efficient property. Following the launch of the first green mortgage in 2006, there are now over 50 products on the UK market with features including lower interest rates, cash back and energy investment reports.
The continued take-up of green mortgages is being restricted by the lack of demand for energy efficiency improvements. There is a role for policy to drive this demand to help these products flourish: one example suggested being the introduction of energy-adjusted stamp duty land tax and the opportunity for rebates for installing energy efficiency measures in homes.
Another form of consumer green finance is local climate bonds. These are issued by local councils to allow residents to invest as little as £5 in green projects in their area and receive a healthy return. Projects include solar photovoltaics, retrofitting local amenities and funding low carbon buses and transport.
In the US, property-linked finance through the Property Assessed Clean Energy Scheme links retrofit financing to the property rather than the owner. This means that the homeowner is only repaying the finance while they occupy the property and benefitting from energy efficiency developments. An incoming homeowner would then take on the responsibility for making any future payments. The scheme has so far mobilised $10 billion towards retrofitting within the US. This type of financing has not yet taken hold in the UK, in part because of the failure of the Green Deal, whose execution has been criticised. The Green Finance Institute is working closely with the market towards testing and developing this concept within the UK.
Ms Harvey predicted that there is likely to be an expansion of green mortgages that focus on energy efficiency improvements, with more innovative products coming to market in the coming years. There is also a need for finance to integrate into energy efficiency "one-stop shops" to provide all the information a homeowner needs to improve their property. This will help to reduce drop-outs that occur when people who are using these resources try to source their own finance to fund home improvements. An increase in place-based investment is also anticipated, which sees financial packages tailored to certain areas to efficiently deliver climate finance into their areas to support decarbonisation of transport and buildings.
Project finance and renewables projects
The panel discussed the availability and practicality of project finance in the Spanish renewable energy market, notably in relation to hydrogen, hybridisation and battery storage.
The financing of green hydrogen in Spain requires tighter levels of financial ratios than regular project finance, which means that only large scale projects are financeable. There are currently only a limited number of hydrogen projects in Spain as it is difficult to find private investors or institutions to cover all the requested leverage. Other issues such as difficulties in finding offtakes to secure the purchase of the hydrogen produced can impact the viability of projects, as well as difficulties in obtaining the necessary water rights given water scarcity in Spain.
Hydrogen is currently being used in various industries in Spain, including transport and industry and the Spanish government is committed to the promotion of green hydrogen for these purposes. Various instruments are being developed to promote private investment into hydrogen. Spain's Recovery and Resilience Plan allocates €1,555 million to the development and promotion of renewable hydrogen. Large scale renewable hydrogen projects are also eligible for the aid programme Proyectos CIEN. Private financing for these projects generally follows the standard project finance structure. As such, there is a need to ensure that all assets are secured, that there is full recourse to shareholders until operation, and there are no cash outs. It is also important to obtain a power purchase agreement to ensure the financier will receive necessary returns as there is otherwise a risk of not finding an offtaker, as hydrogen is an emerging technology that is not fully established in the market.
Green bond principles are requested by private institutions to finance green projects and general corporate proposals. Any project finance complying with green principles can be securitised to obtain specific financing by the private institutions offering such financing. In Spain, public institutions such as the Madrid Autonomous Region are leading the issue of green bonds, though some large private companies (such as Iberdrola and Caixa bank) have also issued green bonds.
Although it is possible to finance hybridisation and energy storage projects, these projects do not use usual project finance structuring. This is because of the particular requirements of Spanish regulation, which means that these projects are funded using leasing structures and asset financing instead. (For more about financing hydrogen projects in Europe, see our Insight).
Osborne Clarke comment
Although considerable progress has been made in the green finance space, private finance will not drive the net zero transition on its own. It needs to be accompanied by policy and regulatory clarity in order to ensure full mobilisation of, and compliance by, private investors.
In terms of funding the decarbonisation of buildings, there is a limit on how far public funding can go, and consumer finance and retail banking will be pivotal in funding this aspect of the transition. Consumer demand for energy efficiency improvements is low, so policy will be needed to create the enabling conditions for green home finance products to flourish.