- Sustainable finance is a key ingredient in the energy transition - but there is a large gap between what is available and what is required.
- The market cannot close this gap on its own; policy-makers will also need to play a large role.
- Here are four ways to direct finance where it is most needed within a range of policy contexts.
Sustainable finance plays an essential enabling role in the energy transition and innovation. Meeting a future global increase in energy demand in a sustainable way while reducing emissions from existing infrastructure will require trillion dollars of investment. However, there is currently a gap of many hundreds of billions of dollars between existing investments and what is required.
With the COVID-19 crisis also rippling through the energy sector, a new lens through which to view the energy transition has emerged. Renewable energy sources have strengthened their position in the global electricity mix as a result of changed energy production and consumption patterns during the pandemic. Disrupted global supply chains have strengthened the case for localized, distributed energy solutions that are affordable and reliable. The global stimulus packages that are being devised present a window of opportunity to accelerate the progress towards a more sustainable energy system.
However, the economic downturn might cause the sustainable funding gap to widen, as private sector investments may be deferred and government budgets are strained. In developing countries, governments may not have the financial means for generous stimulus packages, or may even turn to supporting fossil fuel infrastructure. For 2020, the IEA expects the largest drop in global energy investment in history, a fall of 20% compared with last year.
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Now more than ever, it is clear that the magnitude of required capital flows directed towards sustainable energy will not come about solely through the market. A supportive policy and regulatory framework as well as a sustainable finance ecosystem with the appropriate financial tools are required to mobilize capital. In this context, policy-makers and governments, financial institutions, insurers and developers each have a unique and important role to play, and it is essential that they have a clear view on what can be done to unlock more spending on clean energy. While the role of policy cannot be highlighted enough, as stable regulatory framework conditions and supportive policies are key enablers for attracting capital, this topic is being discussed elsewhere.The focus of this article is on four key enabling financial tools that can direct capital toward sustainable activities under vastly different policy realities.
1. Blended finance
Blended finance is a key enabler of accelerating capital flows towards sustainable energy. As the name suggests, it is a combination of commercial funding by investors and concessional funding provided by development partners.
A strategic blend of development finance and philanthropic funds encourages private capital flows to emerging economies, reduces risks and creates a lower blended costs. This helps provide comfort to private investors and addresses their concerns around market and project risks, particularly in developing countries where capital is expensive and funds are limited. Blended finance has mobilized $140 billion in capital towards meeting the Sustainable Development Goals (SDG) in developing countries and almost one-third of the blended finance deals in 2018 were for SDG 7 – Affordable and Clean Energy.
2. Sustainable and green bonds
A sustainable bond is a financial instrument, the proceeds of which are applied exclusively to projects that make a contribution towards sustainability and climate. These bonds typically have a fixed income return and are backed by project assets or by the issuing entities’ balance sheet.
Activity in this sector is growing. By the year 2018, nearly $521 billion in green bonds were initiated by governments and institutions, bringing the total climate bond market to $1.45 trillion.
Green bonds can effectively scale up SDG-aligned infrastructure in developing countries, and commercial financial institutions are increasingly making commitments towards the SDGs as well as their own environmental, social, and corporate governance (ESG) targets. With increased disclosures of ESG by such institutions, they are now emerging as key players for sustainable investments. A huge commitment is already being shown by large investors such as members of Climate Action 100+, an initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change.
3. Guarantee mechanism
Like other infrastructure projects, clean energy projects must be bankable. Guarantees are sometimes required to attract appropriate funding, particularly for technologies and markets that are not yet mature. In many countries, governments and states provide off-take guarantees for real asset projects.
These guarantees are often offered by a third party to hedge the project against default and loss of revenue. Guarantees thus reduce investor and finance risk, which helps to mobilise finance for project development with participation both by investors and lenders.
In countries where a sovereign guarantee is not available, a third-party guarantee mechanism can be beneficial often provided by development financial institutions and multilateral agencies such as the World Bank, the European Bank for Reconstruction and Development, and the African Development Bank.
In the energy transition finance equation, insurance companies can also play a major role by hedging inherent project risks, thus creating an easy path for project finance. They are also essential for rationalising the cost of funds. Large insurance companies have not only committed to the energy transition but have successfully contributed towards project implementation.
Stakeholders must act
Access to affordable and sustainable energy is a must for economic and social growth, and clean energy provides a viable and affordable solution.
To make funding available to energy transition projects, we must address gaps in the ecosystem. Where tools to attract finance are not available, stakeholders can play their part to provide solutions. If policies and regulations are missing, policy-makers should step up. Where disclosures are required, project developers as well as investors need to provide transparency in their domains.
We have a unique opportunity for change. Financial institutions, multilateral agencies, regulators, policy-makers, project developers, technology providers, and other stakeholders can seize this opportunity to speed the transition by creating an ecosystem that supports individual and collective efforts.