Private Capital and Climate Change: Rethinking Climate Financing Pathways

Aaswash Mahanta

Abstract

The Post-war world order has thrived under the ambit of individualism and private capital, driven primarily by the motive of profit maximization, well-supplemented by unlimited access to fossil fuels. The world order, however, is rapidly changing, bringing in new challenges and risks that state capacity alone cannot tackle. Here comes the role of private capital to not just provide scalable solutions to these externality problems, but also to create new financing opportunities in the climate sector, thus helping us transition to net zero goals by 2050. 

Introduction

The urgency to transition to a net-zero emission economy by the middle of this century is perhaps the most important discourse in recent times. The IPCC in its first report in 1990 called for the need for “global cooperation”.

And till today, five Assessment Reports have been published. The sixth assessment report is in its process and the synthesis report would come out at a critical moment in our lives, coming out before 2030 when the world must take some critical decisions to limit global warming within the 1.5° cap. A failure to meet such targets would mean that we may have an upper limit of around 4° C to 5° C in the future. And to achieve the 1.5° cap, emissions need to decrease by 43% by 2030. 

To put the emission records into context, our earth is already 1.1° C above pre-industrial levels, which has mostly affected around 1 Billion people, mostly from the Global South who account for less than 1% of emissions. There are 3 Billion people, mostly from the Global South that currently reside in areas that are highly vulnerable to climate change. The World Economic Forum in its Global Risks Report 2023 identified the top ten risks for the world in the coming years, and unsurprisingly, climate and environment-related risks comprise 5 of them. They are climate action failure, extreme weather, biodiversity loss, human environmental damage, and natural resource crisis. 

Promoting climate adaptation and mitigation, building climate-resilient infrastructure, reducing emissions, and alleviating climate-induced poverty require large financing opportunities and the development of sophisticated regulatory instruments, be it through Prescriptive Regulations (Command and Control Mechanisms) or the Market-Based Incentives (through the establishment of carbon markets).

We need around US$ Six Trillion of climate finance annually by 2030 to avoid the worst impacts of climate change. The World Bank reports that we need to mobilize around US$ 90 Trillion in the climate space by 2030 to make ends meet. Although we cannot fully internalize all the social benefits of tackling climate change, estimates suggest that it could be anywhere around US $ 26 Trillion by 2030 compared to business-as-usual. 

Identifying Climate Risks

Climate change brings to the forefront numerous investment risks for private players, owing to the risky climate-sensitive investments and adaptation mechanisms set up worldwide. Several assets today are overpriced simply because they have not attuned themselves to the dynamics of climate risk and sustainability.

The IEA estimates under its most climate-ambitious scenario (net-zero emissions) that oil demand will drop to around 24 million barrels per day and demand for natural gas to 1,750 billion cubic meters by 2050, compared to today’s demand of 100 million barrels per day and 4,100 billion cubic meters respectively. Given these dynamics and issues of depreciating natural capital, companies need to adopt sustainable mechanisms that do not hamper the abilities of future generations.

Meanwhile, financial institutions, for instance,  do not just emit carbon through their offices but also by financing fossil fuel companies that emit large amounts of GHGs. These are mere instances in which climate-related risks arise in the market. Different forms of risk might also include: 

  1. Political Risks: owing to unstable governance frameworks and frequently changing policy and regulatory regimes.  
  2. Capital Risks: owing to the unavailability of sufficient liquid assets to tackle climate change
  3. Legal Risks: owing to weak legal, monitoring & regulatory frameworks to internalize and assess climate risks in businesses
  4. Credit Risks: owing to the risk of defaults and bankruptcy while investing in climate projects
  5. Miscellaneous risks include technological & operational risks in adopting climate infrastructures

In this case, well-designed and innovative financial instruments and solutions pose a significant opportunity through which the risk-return profiles of such climate investments can be assessed and balanced out. Such new innovative financing mechanisms today are known as Blended Finance.

Here comes the role of Multilateral Development Banks (MDBs), which are well-positioned to leverage global capital flows toward climate investments, especially in low-income and developing countries that suffer most from the risks of climate change. The rationale is that public resources are not enough to meet countries’ climate adaptation needs, and hence, private-sector investments are critical to close these funding gaps (UNEP, 2018). So the role of the market can be best leveraged in the following two ways: 

  1. Blended finance & innovative capital in climate change mitigation & climate adaptation
  2. Regulatory Instruments to tackle climate change through the Design and Implementation of a carbon market 

Firstly, the fight against climate change has two aspects: mitigation and adaptation. Because mitigation is financially more viable and lucrative for the private sector (since it gives higher returns to investors), the majority of the private capital today has been flowing into mitigation efforts. But this has inadvertently created significant funding gaps for poor nations and vulnerable populations who immediately need climate-resilient and adaptation infrastructure. Worldwide, an annual estimate of US $ 300 Billion is required to fund the cost of climate adaptation. The COP26 Glasgow Summit committed to doubling the 2019 adaptation fund by 2025, which is less likely to operationalize given the major demand downturn caused by Covid-19.

The Global Commission on Adaptation estimated that investing US$ 1.8 trillion from 2020 to 2030 could generate around US$ 7.1 trillion in total net benefits in five critical areas – early warning systems, climate-resilient infrastructure, improved dryland agriculture crop production, global mangrove protection, and more resilient water resources.

Secondly, emission abatement can be achieved through the creation of stable regulatory instruments. The most widely used environmental regulatory instruments today are undoubtedly the Command and Control Mechanisms (C&C) and the Market-Based Incentive Mechanism (MBIs). The rationale behind the regulation is based on the idea that markets are imperfect, that market failures are bound to rise, and that negative externalities continue to aggravate climate change today. 

Prescriptive regulations involve an environmental regulator such as the government who stipulates the action that a firm must take to control pollution or facilitate environmental protection. It involves the set up of a pollution-regulating technology standard or a piece of equipment, and a performance-based standard that stipulates the maximum emissions per unit output by any firm.

For instance, the Clean Air Act of the US stipulated that all cars should have a PCV valve on all engines (technology standard) along with a cap on the carbon monoxide emissions per mile driven (performance standard). However, the major problem with such regulations is that they are overly centralized and suffer from informational asymmetry: inspection costs for regulatory agencies are way too high and firms have an inherent incentive to distort information. 

Market and Capital-Based Incentives

On the other hand, Market-Based Incentives today have gained popularity mostly because of their ability to provide cost-effective emission abatement solutions. It rewards firms for doing what is in the public interest: abate emissions to tackle climate change. It includes a Pigouvian fee which is charged per unit of pollution emitted, where the fee is equal to the marginal damage caused by such pollution.

It also includes the design of a carbon market where emission offsets can be bought and sold as tradable permits in the free market. The major carbon trading mechanisms to date are the Emissions Trading System of the EU, the Clean Development Mechanism developed under the Kyoto Protocol, and New Zealand’s Emissions Trading Scheme.

India has already pivoted towards the implementation of a carbon market, setting up a National Steering Committee to be managed by the Ministry of Power and the Ministry of Environment Forest and Climate Change (MoEFCC) which would help India reach its Nationally Determined Contributions by 2030.

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However, carbon markets are complicated, and the total emission abatement in absolute terms is still unclear. Linking carbon markets around the world is still a major challenge, as there is not much consensus as to how regulated entities in one jurisdiction such as that of Europe would trade with entities in India for instance. Amidst such uncertainty, the only thing we truly know is that carbon markets work: carbon markets reduce emissions and because of such capacity, it has the potential to drive investment decisions of the future. 

This provides us the case for Blended Finance, an opportunity where we can all have a common sustainable growth trajectory, one that is perhaps the only path for us to tread to avoid total climate collapse. Hence, acknowledging the urgency, we need to rethink our discourse on private capital, and create a sustainable pathway with the following objectives in mind:  

  • To truly leverage private catalytic funding 
  • To create collaborative pathways with donors, climate philanthropists, governments, financial institutions, and other stakeholders
  • To create transparent disclosure of climate-related risk data, and take up initiatives to de-risk Climate FDI. 
  • To create stable regulatory frameworks to facilitate private investments in the climate adaptation sector, and
  • To experiment, detect, develop, and scale up new financial instruments that can aid Climate & Impact Investing mechanisms for the future. 

Conclusion

Since time immemorial, our growth story has vastly relied on fossil fuels, on a devastating trade-off of our environment, indigenous peoples, and our climate, all for a dream of a faster-growing economy. As for the economy, it has historically lacked a level-playing field, which inadvertently incentivized those at the top of the social and income hierarchy, disenfranchising minorities, and low-income individuals.

Given this context, we cannot wait for the invisible hand to take care of our development problems today. But we now know that private finance posits enormous opportunities in addressing climate change. Hence, maybe the most crucial decision we have to make today is to seriously rethink our outlook toward the future of this planet.

References

The Global Risks Report (2023).

https://www3.weforum.org/docs/WEF_Global_Risks_Report_2023.pdf

State of climate action (2022) – Researchgate.

https://www.researchgate.net/publication/364746856_State_of_Climate_Action_2022

United Nations, Finance and Justice, UN Website

https://www.un.org/en/climatechange/raising-ambition/climate-finance

Emanuele Campiglio et al (2022): Climate-related risks in financial assets, Journal of Economic Surveys

https://onlinelibrary.wiley.com/doi/10.1111/joes.12525

IEA (2021), Net Zero by 2050, IEA, Paris

https://www.iea.org/reports/net-zero-by-2050

Adaptation Gap Report 2020. (2021). In United Nations eBooks

https://doi.org/10.18356/9789280738346

 For more on the basics of the Equimarginal Principle, refer to Kolstad: https://www.researchgate.net/publication/227466982_Environmental_Economics_International_Edition

Acknowledgment: The author would like to thank Tripta Behera and Aishwarya Dutta for their comments and suggestions to improve the article. 

About the Author: Aaswash is a Visiting Researcher at IMPRI and is a BA Economics (H) graduate from Shaheed Bhagat Singh College, University of Delhi.

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