Catalysing capital (1)

The low-carbon economy will need a major shift in global investment flows, from economic activities which promote emissions growth to those which limit emissions, write David Blood and James Cameron.

[This article first appeared as a paper in the Copenhagen Climate Council Thought Leadership Series. It is reproduced here with permission.]

Capitalism is at a crucial juncture. The sustainability challenges we face – the climate crisis, water scarcity, extreme poverty, shifting demographics – are unprecedented and require an urgent response. Failure to address these challenges will put at risk our ability to create prosperity in the long term. The current state of the global economy compounds these challenges; in fact, the financial crisis has only underscored our conviction that sustainability will be a critical driver of economic and industrial change over the next 25 years.

In the case of the climate crisis, significant capital needs to be mobilized towards low-carbon solutions that span sectors and borders. This mobilization poses a tall yet manageable order as ours is not a problem of capital, but one of capital flow. The global community has the money, the policy insights, and many of the technologies needed to modify our emissions trajectory.

Fundamentally, the challenge ahead is about capital reallocation and timing: how do we steer capital away from high-carbon investments and channel them towards the low-carbon economy? And, above all, how do we mobilize this capital at the pace required to avoid dangerous climate change?

In the face of converging financial and environmental crises, the context for business most certainly has changed. We can capitalise on an opportunity to lay the foundation for a sustainable future, both financially and environmentally. Businesses are seeking new strategies to adapt to a new landscape of risk and opportunity. Governments are facilitating investments in low-carbon infrastructure to boost jobs and economic growth. Unthinkable only a few years ago, today the case for a green recovery of the economy continues to gain traction around the world.

The stimulus package in the United States, for instance, incorporates provisions seeking to deploy capital toward low-carbon assets. The business community is lining up to call for a consistent price signal on carbon to help guide long-term investments. Around the world, governments have already allocated billions in fiscal stimulus to climate-related investments. These commitments are just the first instalment in what could ultimately be a long-term government policy to use low-carbon growth as a key lever for economic recovery.

The financial industry is also adjusting to a new reality. Investors are recalibrating their risk and reward expectations; investment committees, boards of directors and shareholders are adjusting their concept of how to secure sustainable returns. Investors are finding longer-term horizons and investments in tangible low-emissions infrastructure more appealing than in past years.

There has never been a more appropriate time to return to fundamentals. Long-term investment strategies, in particular, will play a pivotal role in the transition to a low-carbon economy. So, how much capital will be needed to avoid dangerous climate change?

A manageable challenge

Investments towards a low-carbon economy must enable reductions in emissions of greenhouse gases sufficient to avert a catastrophic rise in global average temperatures. The investment decisions made in the next 10 years will play a critical role in defining our long-term emissions trajectory as the infrastructure we finance today will lock in technology for decades to come. We need to finance infrastructure that will allow atmospheric concentrations of CO2 equivalents to stabilize at the levels the scientific community deems safe.

Many studies have provided clarity regarding the costs of action (and inaction) to avoid dangerous climate change. While these studies differ in the specifics, their core message is consistent: addressing the climate crisis is technically feasible and the investment required is considerable but manageable.

The Stern Review, commissioned by the British government, estimated that the annual global investment needed to avoid the worst impacts of climate change could be limited to around 1% of global GDP each year if action starts now. By contrast, the report estimated the costs of inaction would be equivalent to losing at least 5% of global GDP each year. While scientific consensus since the Stern report was published has suggested that climate change is occurring faster than was anticipated at that time, the estimates by Stern remain a useful starting point in conceptualising the scale of this challenge.

According to McKinsey & Company, pursuit of the most economically rational emissions abatement opportunities would result in total upfront investment in addition to business-as-usual capital expenditures of €530 billion each year in 2020 and €810 billion each year in 2030. This sum corresponds to 5% to 6% of business-as-usual investments in fixed assets in each respective year. In addition, much of this investment could be recovered through future energy savings, bringing the total investment to €200-350 billion annually by 2030, less than 1% of forecasted global GDP in 2030.

According to the United Nations Framework Convention on Climate Change (UNFCCC), tackling climate change in the next quarter century will require "major changes to patterns of investment and financial flows." The UN study estimated that US$200-210 billion worth of additional investment and financial flows would be necessary to return greenhouse-gas emissions to current levels.

Other studies have estimated the investment needs in specific sectors: the International Energy Agency estimates that additional investments in energy infrastructure equal to 0.6% of global GDP in 2030 are needed to maintain a 450 parts-per-million (ppm) concentration. New Energy Finance and the World Economic Forum estimate that at least US$515 billion needs to be invested annually in clean energy over an extended period to keep carbon emissions from reaching a level deemed unsustainable by scientists."

According to the Eliasch Review on financing global forests, commissioned by the British government, the finance required to halve emissions from the forest sector to 2030 could be around US$17-33 billion per year. In the very short term, 40 forest nations will need roughly US$4 billion to fund capacity building efforts over five years.

These studies provide further insight into why the challenge ahead is manageable. If we are able to capture all costs-savings accruing from abatement measures, many investments could produce net benefits: in many cases, the up-front capital investment could be recovered over time thanks to energy savings. According to McKinsey, approximately 11 of the 38 gigatonnes of abatement opportunity in 2030 could have a net economic benefit by enabling the savings in the future to outweigh their upfront investment.

Another key insight from research to date is that the vast majority of abatement will need to occur in emerging economies. Therefore, a core challenge ahead will be to tackle the barriers to investments in these countries.

Numerous studies have also shed light on the need for prioritising policy tools. Since most global greenhouse-gas emissions are energy-related (power plants, buildings, transport and industry), much of the required capital will have to flow into energy solutions – both towards de-carbonising the supply of energy and reducing demand. These solutions require urgent attention as many of these technologies (such as stricter building codes and fuel efficiency standards) are readily available, yet need public policy support to provide the long-term framework investors require.
New capital and financial flows are also needed to limit the destruction of critical carbon sinks, particularly since land-use changes account for roughly 20% or more of global greenhouse-gas emissions.

Some of the barriers to low-carbon investing are behavioural and sector-specific, such as addressing the agency problems that property owners face to make building efficiency investments. For example, building owners lack the incentives to make the upfront payments to retrofit buildings because the benefits, in the form of energy savings, accrue to tenants and not to them.

In other cases, barriers are institutional: almost all of the investment needed to tackle deforestation will have to be deployed in emerging economies that may lack appropriate institutional infrastructure to make investors feel sufficiently comfortable. Many governments, NGOs, and multilateral agencies, along with private investors, are working proactively to address the needed infrastructure, monitoring, and compliance to ensure national emissions reductions. Globally, the efforts to address deforestation must be scaled dramatically.

NEXT: How can we make the shift?

David Blood is senior partner and co-founder at Generation Investment Management LLP.

James Cameron is vice-chairman and co-founder at Climate Change Capital Ltd.

[This article first appeared as a paper in the Copenhagen Climate Council Thought Leadership Series. It is reproduced here with permission.]

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