This article is brought to you thanks to the collaboration of The European sting with the World Economic Forum.
Author: Huw van Steenis, Vice President, Oliver Wyman
- COP27 focused on delivering key financial commitments.
- Energy security, improved data and voluntary carbon markets will all feed into the financial strategies for action discussed at COP27.
- Investors and financial institutions need to find the opportunities and manage the risks presented by a complex energy transition and a changing world.
The mood at COP27 was gloomy. The war in Ukraine, the energy crisis, rampant inflation, summer droughts and the sharp increase in the cost of capital for projects weighed on the expectations of investors and business leaders. The underlying concern was that the ambition to limit global warming to 1.5 degrees Celsius was under threat.
Last year, at COP26, finance was in the spotlight with Marc Carney announcing an alliance of 450 banks, investors and other financial institutions’ commitment to Net Zero. This year the story was more about implementation with a few new initiatives, such as the Indonesian program, being announced. I saw three financial themes emerge:
1. Use energy security to drive green policies
Investors and companies tried to disentangle what the war in Ukraine and the energy crisis meant for the green agenda and investment opportunities. The US Inflation Reduction Act (IRA) appears to be a huge accelerator for the shift to cleaner energy. We know the package put $374 billion at stake, but I suspect the consensus could still underestimate the overall potential impact.
The money involved is much higher. According to Kaya Advisory, there are over $1 trillion in tax measures and related lending incentives to support energy security and faster deployment of renewables across all programs. In addition, there is 10-year clarity on the incentives. The United States is quickly becoming one of the most attractive places to develop renewable technologies. Almost every renewable company I’ve encountered is rewriting their medium-term plan — including a more resilient supply chain — to take advantage of this. Private equity and banks are starting to turn heavily towards investment opportunities.
While each country will make different trade-offs between energy security, energy affordability, and environmental considerations, the focus on energy security is accelerating the race for renewables in Europe, Japan, and Australia. (We have seen a fivefold increase in ambition for the European Union in this decade, although Europe was originally hostile to the American IRA.) , the United States is in winning. Europe is way down the shopping list.
Although the race for clean energy is not without obstacles. A wind power veteran told me he expects fewer deals to close this year in Europe than last, as companies haggle over paying too much for the potential domain and have difficulty in obtaining attractive financing. This is far from ideal for Europe. There were tentative signs of EU strategic budgets being used to fill these gaps – or projects in danger of collapsing.
Energy security means that there has been a major reassessment of the need for continued investment in fossil fuels during the transition. “One step back, but two steps forward through energy security,” said a CEO. While climate activists have challenged the banks and investors who still finance fossil fuels, what is not often discussed is that governments are often the first to rely on banks to continue to finance them or even provide guarantees and finance themselves.
2. We need better measures
Rapid decarbonization requires sweeping changes, transforming industries and processes. Do we have the right measures to protect portfolios against transition risk and align with changing opportunities and meet regulatory requirements?
Many investors and financiers worry that the initial metrics and frameworks will struggle to keep pace with the change we need and won’t make the most of all the new data.
For example, the penny fell which finance needs to finance emission reduction, rather than simply having top-down rough nominal targets for lowering funded emissions, which can indirectly push lending or investments into the shadows. “Real world, no paper wallet, lower emissions” was the mantra for many. But many early risk measures can incentivize bad behavior. For example, the EU’s green asset ratio, which divides loans into green or non-green loans, misses the nuance of the transition and may inadvertently discourage the type of financing required.
Another challenge is to develop a set of metrics that can better understand risk or show progress of change, as well as prevent greenwashing. Many have wondered if the UN’s high-level report examining voluntary Net Zero pledges was so difficult that it might have the unintended consequence of stalling the growth of public pledges on corporate climate ambition.
Conversations were lit with what might work. Investors debated climate-sensitive measures that could support the transition and be compatible with the national regulatory frameworks in which their companies operated. In a world where 80% of energy still comes from fossil fuels, helping traditional emitters transition their operations and supply chains is critical. This is why it is crucial to focus on “khaki finance”, or the greening of grey. In this order of ideas, the idea presented by PRC Investments’ Richard Manley to divide a company’s emissions into three: those that are technically and economically feasible now; those that are technically, but not yet economically feasible; and, which is not demolishable.
3. Voluntary carbon markets could explode
At COP27, I also detected a welcome sense of urgency about the need to establish robust, tradable and insurable carbon credits, thereby generating reliable revenue streams that can be re-invested in funding mitigation efforts. and adaptation. A legitimate, credible and efficient market for carbon offsets would be a powerful way to attract more capital to projects that reduce or prevent emissions.
A key part of the conversations focused on how to overcome the limitations of today’s voluntary carbon markets and create a larger market. Credits worth $2 billion traded in 2021 – nearly four times the previous year – with around 500 million credits representing 500 million tonnes of CO2 equivalent changing hands, according to Ecosystem Marketplace.
So far, the buying and selling of these credits has been opaque. Prices are not standardized. Many projects do not keep their promises. Buyers cannot be sure what they are getting is real and sellers cannot be held responsible.
Competing bodies and narratives were on display. The Voluntary Carbon Market Integrity Council and the Voluntary Carbon Markets Integrity Initiative are trying to develop workable standards. Meanwhile, the McKenna report, which was extremely harsh on corporate greenwashing, set a more positive tone on carbon offsets. At COP27, Michael Bloomberg announced the Global Carbon Confidence to help standardize credits.
Besides the philosophical and practical arguments about integrity or carbon credits – and exchange rates – it was striking that interest in carbon credits was much higher this year, especially for hard-to-reduce activities. It will be interesting to see to what extent finance relies on this potential growth. That said, it’s recognized that this will be just a small portion of the $2 trillion in funding aid that emerging markets may need, according to a new report from Lord Nicholas Stern.
What Wasn’t Discussed – The Dog That Didn’t Bark
Finances and business have been much calmer this year when it comes to goals and progress, which some activists attributed to green silence. It also reflects the complexity of the trade-offs companies are trying to negotiate, building datasets, as well as the lingering mistrust between finance and society.
Mark Carney’s alliance has helped integrate climate risk into bank and asset manager boards and into their day-to-day risk management processes, but it’s too easy to forget that no bank had scientific targets for 2030 last year. Today, 53 banks have them, although much work remains to be done.
In summary: the past year has seen a profound shift in the understanding of finance from seizing opportunities while navigating the risks of the energy transition, but much more is being done under the radar.
Conclusion
In 2022, the macro – fueled by huge macro swings and political inflections – has returned with a vengeance. It also means a huge repricing of climate-conscious projects, despite the secular opportunity spurred by energy security policies. The energy crisis of the 1970s had lasting effects. No doubt it will be the same for today. The key is to find the opportunities and manage the risks presented by a complex energy transition and a changing world.