Two new policy proposals could deliver the stability low carbon investors need
What is the biggest single factor hampering low carbon investment? It boils down to one word: risk.
Obviously, this is true of any investment. Businesses make investment decisions based on their assessment of the scale of the returns they can generate and the pace at which they will be realised, and these assessments are always determined by a forecast of the risks the investment will face.
The problem for the low carbon economy is that, regardless of the compelling macro-economic argument that it is riskier to continue with business as usual than it is to act now to curb greenhouse gas emissions, the risks faced by low carbon investors remain severe.
Firstly, the scale of the capital investments required by low carbon projects are huge, meaning that investors are reluctant to back projects deemed high risk. Secondly, many clean technologies and business models are relatively immature, meaning that there is a significant amount of technical risk attached to many projects. Thirdly, and most importantly, many low carbon investments remain dependent on government policies designed to correct market failure and either put a price on carbon emissions or incentivise investment in low carbon technologies, meaning that there is huge policy risk associated with the majority of green projects.
Green groups are right to accuse investors of often failing properly to price the existential risks associated with climate change and energy insecurity. But when faced with these interconnected capital, technical and policy risks it is easy to understand why it is often difficult to attract the scale of investment the low carbon economy requires.
Mitigating these risks has been the top priority for green policymakers for over a decade, and a vast array of different mechanisms have been deployed to reduce the risk profile for low carbon investments, hence the fact that the global low carbon economy is growing fast while many other sectors are flat-lining.
But the risks still remain too high for many prospective investors, while even effective green policies can have a chilling effect on investor confidence if politicians change them at the wrong time. For example, relatively minor changes to policies, such as the UK government's surprise changes to feed-in tariff incentives or the EU's move to disqualify some carbon credits issued by industrial gas reduction projects, have fuelled investor fears over future policy risk and as a result have had a far more significant impact on green investment levels than many anticipated.
De-risking low carbon investment to a level where it is at least comparable with conventional investments remains the holy grail for green policymakers, and as such it was exciting last week to speak to two leading experts who outlined innovative new proposals that might just help deliver the investment certainty the green economy is crying out for.
The first proposal came from Marcel Brinkman, a partner at consultancy giant McKinsey, who argued that some of the shortcomings of carbon markets could be overcome by mechanisms that bring more stability to the system. While carbon markets in general, and the EU Emissions Trading Scheme (ETS) in particular, have proved more resilient than many of their critics predicted, it is increasingly clear that they contain some significant imperfections.
The problem, according to Brinkman, is that, while cap-and-trade schemes offer an economically efficient means of pricing carbon and driving investment towards the most cost-effective low carbon technologies, they can also undermine green investor confidence by failing to offer stability.
The current outlook for carbon prices in the EU ETS is a case in point, he argues. Experts agree that the price of carbon will rise as Brussels restricts the supply of allowances, but are divided on the pace at which economic recovery will drive up demand and hence prices.
"Above all else, investors want to invest money where they can get stable returns, but carbon markets are an insufficient mechanism for delivering stable returns," he said. "Telling ourselves that the carbon market was a good mechanism for driving investment was always a difficult concept as prices are unstable, as well as not necessarily high enough to justify investment in all forms of renewables."
It is this price instability that is ultimately to blame for the creation of hugely complex low carbon policy frameworks by successive European governments, Brinkman argues.
"The carbon market instability is one of the reasons governments have had to top up carbon pricing with other policies like feed-in tariffs," he explained. "But that creates further policy uncertainty on top of the price uncertainty, which makes it hard to attract investors."
Chancellor George Osborne has attracted criticism from all sides for his decision to impose a 'floor price' on carbon, but for Brinkman it offers a means of introducing some much needed stability into an unstable EU carbon pricing mechanism and should have the desired result of accelerating low carbon investment. If it works, the UK could pioneer a new hybrid carbon tax and cap-and-trade model that combines the efficiency of carbon trading with the stability of carbon taxation. It is a model other EU governments would be advised to keep a close eye on.
And if a carbon floor price can bring much needed stability to the carbon markets, the Green Investment Bank has the potential to bring further stability to low carbon infrastructure projects. That is the hope of Fintan Whelan, co-founder of Mainstream Renewable Power, one of the developers working on the giant Round 3 offshore wind projects, who reckons that the Green Investment Bank could prove more effective as a Green Insurance Bank.
The precise remit of the bank is currently up for grabs, but Whelan is part of a growing band of leading green business figures urging the government to ensure that the bank is allowed to move beyond the confines of a simple investment bank and offer a wide range of innovative financial instruments, many of which would have more to do with insuring projects than directly investing in them.
"The Green Investment Bank could be the vehicle that the government uses to demonstrate that it is serious about low-carbon development," he explained. "The biggest risk for any of these projects is policy risk so, if the Green Investment Bank could go to entrepreneurs and say it will insure them against that policy risk, you could really drive investment and ensure that the government would only change tack with a very good reason to do so."
As we reported yesterday, the bank will have to secure EU state aid approval before it is allowed to do anything more complex than straight project financing. But Whelan's proposal offers the intriguing prospect of an institution that effectively insures the developers of offshore wind farms and other such projects against any unexpected changes to the policy framework in which they operate. Such a move would not completely de-risk projects - they would still face significant technical risks - but it would remove the biggest risk developers face.
The Treasury would probably be reluctant to offer such insurance on the ground that it would then have to cover the liabilities but, if the government is serious when it says the low carbon policy framework will remain stable and will be reviewed only at set times, where is the risk?
Unfortunately, both these proposals remain a long way from getting off the drawing board, but they also demonstrate the kind of thinking that is required if we are to deliver the stability green investors crave.
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