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27 January 2023, by Ely Sandler
Ely Sandler is co-author of the recent Harvard Kennedy School white paper, Financing the Energy Transition through Cross-Border Investment
When the United Arab Emirates assumes the COP28 presidency this November, one goal is paramount: mobilizing private investment. To keep the Paris Agreement 2° warming targets on track, the UN estimates that between $4 to $6 trillion of investment in low-carbon infrastructure will be needed every year. This would require annual spending greater than the total of Joe Biden’s Inflation Reduction Act.
The scale of money needed to fund the energy transition is what makes private investment so critical. The world cannot reach $6 trillion of climate investment annually by adding up individual government pledges: there is simply not enough money in public sector coffers. Instead, the capital must come from the private sector, with banks, investors and private firms financing the lion’s share.
Private investment will be particularly crucial in the Global South, which now accounts for nearly two thirds of annual carbon emissions. While scrutiny has rightly focused largely on advanced economies’ decarbonization, unless rich nations also catalyze sustainable development in places like India, Indonesia and Nigeria, global emissions will balloon.
So, how can the UAE’s COP28 presidency mobilize the trillions of dollars necessary to fund investment in the developing world? One strategy is to lower the cost of capital for projects that reduce emissions. This key measure, cost of capital, represents the return paid to investors in a project. The higher a project’s perceived risk, the higher the cost of capital needed to attract investment. This goes for any project, be it renewable energy, energy efficiency or electric transport. If we can lower the cost of capital for carbon mitigation in emerging markets, more projects will be able to afford to raise investment, resulting in more clean infrastructure and lower emissions.
The good news is that the UAE presidency will inherit a host of international initiatives with the potential to lower the cost of capital where it is needed. Take one example, the US-led Energy Transition Accelerator that John Kerry announced last year, and expanded this January in Abu Dhabi. This aims to channel billions of dollars towards shifting emerging markets’ electricity supply off hydrocarbons like coal. By cutting the emissions of the power sector, renewable energy producers will earn carbon credits that they then sell to private firms, creating a new revenue source. Higher revenues for renewable energy projects equals more profits for their investors. Higher profits create a more attractive investment with reduced risk, resulting in a lower cost of capital and more investment in clean energy.
Another star of COP27 was Prime Minister Mia Mottley of Barbados, whose Bridgetown Initiative would reform institutions like the IMF and World Bank. The proposals would facilitate lending to projects in the developing world at concessional rates. This would lower emerging markets’ cost of capital through the principle known as blended finance. Here, cheap loans from the IMF and World Bank “blend” with private investment, pushing down the project’s overall cost of capital.
These initiatives are a start, but from 2019 to 2021 there were only $14 billion of blended finance deals, and the picture was even bleaker in 2022. The problem is that amid precipitous debt burdens and rising interest rates, investments in developing countries are riskier than ever. Global policy must therefore go beyond sweetening private investment in green projects. The “carrot” of lowering the cost of capital for carbon mitigation must be paired with the “stick” of raising that cost for carbon-intensive investments.
As discussed, cost of capital is a measure of risk, and in today’s world a crucial financial risk is the energy transition. Because investments are long-term, investors must ask: will there be a buyer for fossil fuel-based power or high-carbon industrial products in 2050 and beyond? If not, such investments will become riskier, pushing their cost of capital higher.
To raise the risk of investing in pollutive industries, and make green investments comparatively more attractive, global policymakers must therefore convince the private sector that the world is serious about decarbonization. Long-term pledges made at international fora like COP28 change how the market sees the risk profile of their investments. A pledge to phase-out fossil fuels is not just about the action governments themselves take, it’s a signal to the private sector that long term investment in pollutive industries is risky.
We have reason to be optimistic that the UAE can deliver on these goals at COP28, with several initiatives already starting to gather pace. As one example, in January the UAE hosted a roundtable with Masdar, the Emirati state renewable energy company, to build on a recent policy white paper from the Harvard Kennedy School. The Harvard proposal suggests that a crucial part of the Paris Agreement - Article 6 - can be leveraged to lower the cost of capital for green projects in the developing world, thereby facilitating private sector investment. This roundtable, attended by leaders from both the private and public sectors, is just one of many discussions within Abu Dhabi Sustainability Week, which marks the kickoff of the UAE’s outreach ahead of its presidency. Such efforts have potential, and provide essential tools for private sector mobilization. The cost of failure, however, would be high. Not just for capital, but for the energy transition itself.
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