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How will we bridge the finance gap to reach net zero?

23 January 2023

Following on from the ICE Policy December 2022 Financing Net Zero panel, Suranjali Tandon discusses how we can address funding gaps internationally to accelerate the transition.

How will we bridge the finance gap to reach net zero?
There remains a visible gap between existing and required finance to get to net zero. Image credit: Shutterstock

There remains a visible gap between existing and required finance to get to net zero.

As of November 2022, 48 countries have either pledged, enacted or introduced a net zero target in policy. Another 48 countries are proposing a net zero plan.

However, the timelines for achieving net zero are not the same across different countries and are dependent on levels of economic development.

The International Energy Agency states that some countries are due to reach net zero well in advance of emerging and developing economies, with emissions falling most rapidly in the power sector.

Emerging markets are estimated to face a transition finance gap of $ 94.8 trillion for net zero by 2060, about half of which is investment in power.

What the net zero transition needs

The transition to net zero would require current global energy investments of $2 trillion per year, or 2.5% of GDP, to scale up to $5 trillion, or 4.5% of GDP.

In terms of composition, the largest size of investments will have to be made in electricity generation, transport, infrastructure and buildings.

If the sums invested need to be scaled up as well as directed to specific sectors, it is critical to understand the kinds of activities that will need financing and the relevant sources.

How to finance net zero

The transition to net zero will entail the re-skilling of labour in impacted sectors, capital investments in green technology and equipment, as well as support to consumers.

There are also a range of financing instruments required.

Products that can finance net zero-aligned activities include:

  • green bonds;
  • ESG based equity investments by funds that in turn nudge companies to disclose their ESG performance;
  • transition bonds;
  • impact bonds;
  • development loans

The expected returns and preference for risks assumed determine which of these are most suitable.

Market for green finance

Until January 2023, a cumulative of US $ 2.16 trillion green, social and sustainable (GSS) bonds were issued around the world by 98 countries.

Energy (483), buildings (475) and transport (220) topped the list of bonds issued.

The market for investments based on environment, social and governance (ESG) indicators (which includes investments in green or sustainable bonds) has also increased substantially.

In 2021, ESG-related assets under management were valued at $18.4 trillion and as per PwC’s survey are expected to yield higher returns.

Large majority investors surveyed were comfortable with paying higher fees for ESG funds, while the existence of pricing advantages is less frequent in the case of green bonds.

Defining the rules around green finance

Even though some information around green finance instruments is available, there is a need for reporting and disclosure standards at a national level that can encourage transparency among companies.

Many countries have already introduced regulations, with some also implementing regulations that check for greenwashing.

Then there are national-level taxonomies that identify activities and sectors that need to phased down or up depending on whether it’s a green or brown taxonomy, respectively, developed by the state or private sector.

These can guide investment opportunities and set pathways to achieving net zero.

Central banks are also starting to nudge the flow of capital to ‘green’ sectors through the capital adequacy norms or credit guidance.

The role of public finance

While it’s possible that private investment will scale up with the regulatory interventions and the world’s largest publicly traded companies (around 2,000) reporting targets to reduce emissions, the social costs would also require financial support.

This would imply higher levels of public funding of infrastructure and utilities.

One strategy to raise public finances is by applying emissions-linked taxes.

These taxes, though targeted, would have to be designed so that lowest income groups are not adversely impacted.

Public development banks: their role in net zero finance

Another key source of finance for projects with social costs and low returns are public development banks.

Globally, there are 450 public development banks with assets amounting to $11.16 trillion and annual investments of $2.23 trillion.

Development banks can provide loans at concessional rates and by agreeing to endure losses in green funding they increase risk-adjusted return for private investors.

Multilateral development banks tend to attract less private finance compared with the total resources they commit and national development banks have experienced success.

The recently established UK infrastructure banks for supporting sustainable heating, or German bank KfW’s success with energy efficient building refurbishing loans, provide templates for financing options for the transition that also takes care of the social costs.

In addition, philanthropies are now co-funding sustainable development goals through impact funds.

The total impact investments in the market are worth $636 billion, which include private and DFI (Development Finance Institution) managed finance.

Way ahead

As countries prepare to transition, there are investments, for example investments in renewable energy, that will make a clear business case.

For green bonds, sustainability linked bonds or loans and ESG-based equity, investments may be forthcoming.

However, along the spectrum of investments, there will be those investments which are more public, because they either consist of high-profile infrastructure, or will be investments to reskill industries and manage the loss of livelihoods.

The contribution of the public sector can be linked to current revenues associated with fossil fuel consumption, including any windfall taxes.

An example of this is the district mineral fund in India that is collected from royalties on mining.

For an inclusive or just energy transition, it’s important that the funding gaps in public goods and social services are suitably mapped with appropriate sources of finance.

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  • Suranjali Tandon, assistant professor at The National Institute of Public Finance and Policy, India