1. www.unepfi.org July 2010 The Copenhagen Agreement and Finance Issues- What are the Implications for Business? The Private Sector’s Role in Climate Change
2. Who We Are What We Do UNEP FI develops global standards, guidelines and best practice approaches to sustainability for financial institutions worldwide United Nations Environment Programme Finance Initiative UNEP FI is a unique public-private partnership between UNEP and the global financial sector Over 180 banks, insurers, asset managers and pension funds comprise the partnership with UNEP. July 2010
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8. 4. Special risks in the developing world – special solutions as suggested by UNEP Finance Initiative
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Notas do Editor
UNEP’s objective is to make socio-economic development compatible with a healthy environment. Why? Because the one is not possible without the other: societies need a stable/healthy environment to develop, and a healthy environment needs a developed Zeitgeist and societies that don’t starve! Furthermore, Socio-econimc development needs its fuel – which is delivered by financial institutions and investors with each single investment and credit they provide. That is why UNEP FI exists as a strange animal within the UN system. UNEP FI is not trying to modify the mandate of Financial Institutions as Private Sector Companies in society. We are rather trying to understand the common grounds between developmental/environmental objectives and financial performance, in order to better align the mandate of profit-maximization in the long-term with sustainability issues – Environmental, Social, and Governance – I don’t have to tell you that the sub-prime financial crisis that lead to the recession which we still see today, was caused by social and governance failure of financial institutions. Basic Example : Environmental Credit Risk Assessments, for instance, have positive effects on both the environment and respective banks’ risk exposure and ultimately its profits. That’s our message.
I am supposed to speak about The Copenhagen Implications on financial institutions, but in fact, I am not going to do that; I will rather provide the general context needed to derive implications. My colleagues Alaa and Bolko will then describe the implications in the detail needed. Aim: to sketch a very broad and indicative picture of the space where climate change, private finance and the capital markets, as well international climate change regulation come together. And against this background, to make a careful assessment of what Copenhagen has delivered. Some More detail on some of the issues debated at the negotiations - which are relevant to different types of financial institutions - as well as the implications of the Copenhagen outcome and the Copenhagen accord for financial institutions, will be provided by the subsequent speakers, who are in fact practitioners from real financial institutions. As the level of knowledge and understanding on this specific topic may be quite diverse within the audience, please excuse me, if my contribution becomes too educational.
Very very simply, the world wants the private sector to change ; change meaning more carbon-efficient and less energy-intensive . The reason is that not governments but companies, hence the private sector, emit the overwhelming majority of GHG emissions. The best way of stopping emissions would be to close down all companies, to close down all carbon-intensive production processes in our economies. There are overwhelming reasons though why we don’t really want to do this. So, the question is can the private sector, in a sort of aggregate level change? This graph contrasts changes in GDP with changes in emissions. And we see that the private sector, who is the main producer of GDP in most market-based economies, can change, but that it hasn’t changed in many places. In fact, GDP has grown while emissions decreased, among the 20 largest emitters, only in Germany and in the UK, as well as some post-Soviet countries for obvious reasons. The world expects the private sector to change by conceiving, developing, bringing to market, installing and operating most of the technologies, business models, infrastructure needed to decarbonise the economy and in order to adapt it to the unavoidable impacts of climate change. The reason is very intuitive: here we are talking about markets -- is private sector terrain much more than it is government turf; public entities are predominantly involved in the technology research phase, through universities, other research institutes and technology incubators. The rest of the continuum is driven by market players. It is not only about creating a low-carbon – or green - economy in parallel to the conventional – or brown – economy. It is about transforming the economy into something low-carbon. The above technologies, business models and infrastructure will have to replace the carbon-intensive and vulnerable technologies, business models and infrastructures we have now. Most importantly, however, we know that the private sector is expected to provide the financing needed to enable the shift to a low-carbon and climate-resilient economy. In fact, the UNFCCC tells us that 85% of the investments needed will have to be financed with money from private sector sources, in other words: not from tax payers and not via governments.
Private finance and the capital markets as well as third-party investors step into the picture , because of their unique macroeconomic role: They transform savings into investment They are the owners of large chunks of the economy and can play an influential role in the way companies develop And, they simply provide the money for the investments needed in the development, bringing to market, installation and operation of technologies, business models, infrastructure, you name it. We know that in 2009, for instance, over 70% of all investments into technologies, projects and companies in the clean energy space came not from the companies in the real economy themleves, but from companies in the financial economy, so called third-party sources, in other words from venture capital and private equity firms, project and corporate debt providers as well as through initial public offerings or capital increases via the capital markets. Despite the impressive track record we have seen in the course of the last 5 years in terms of growth in sustainable energy capacity as well as investment flows, the latest figure in 2009 would, on average, have to at least triple (if not quadruple) to meet the financing/investment needs outlined by the International Energy Agency. Some figures: The IEA says that: if dangerous climate change is to be avoided, we need to keep global temperatures from growing beyond 2 degree Celsius ; 450 ppm in the atmosphere; this will require reducing emissions from the energy sector by approximately 10-15 Giga Tonnes of CO2-equivalent per year; which means USD 500 billion additional investment is needed per year in the energy sector, more than 3 times the investment we see to date.
This is what we call the Investment Value Chain along which capital flows. This is helpful in understanding in what investors want and, particularly, why they want it. Most investors – or investment companies - do the investments on behalf of others. The best example is that of probably the largest investors on the planet: institutional investors such as pension funds who do invest money on behalf of current and future pensioners, here the beneficiaries – the relationship between asset-owners, or institutional investors and beneficiaries as well as between asset managers and asset owners is characterized by the very sensible concept of ‘fiduciary duty’. This fiduciary duty consists in doing everything they do exclusively in the interest of the ultimate beneficiaries. Purely and solely their financial interests should determine all behavior of investment professionals. This is what as beneficiary, you would naturally expect them to do anyway. This duty is codified in law. I am sure most people in the room here, including those employed by the UN, are indeed happy that your pensions schemes are also governed by the idea of fiduciary duty. You would be very worried when say, instead, political considerations would begin to drive the investment decisions of your pensions scheme. Fiduciary duty and other factors mean that all investment decisions made by such investors are based purely on the financial interests of beneficiaries; in other words. They are entirely driven by risk-return considerations. That means quite simply that an investor will only undergo and investment with a high level of risk, only if sufficiently-high returns compensate for that, and vice versa.
One can deduct, therefore, that if only insufficient investment has flown into low-carbon and energy-efficient technologies, companies and projects, it is because the risk-return ratio of such investments was not good enough. The thing with low-carbon technologies, projects and companies is that often, by themselves, they cannot compete with conventional technology. That is in fact why we have the problem of climate change and why government action is needed on climate change: reducing emissions often comes at a cost. But things are actually happening: big chunks of investment are flowing into the sustainability space, etc. In 2008 more investment worldwide went into renewable and sustainable energy than into all fossil fuel alternatives taken together. This overview tells you why: innovation, resource economics are making these technologies competitive relative to others. The crucial point here is that such developments can only happen on the back of supportive regulation: government needs to play a crucial role in incentives, subsidies, support, promotion, etc., both at national as well as international level. Once technologies are competitive in terms of their risk-return profile, investors and markets will easily take care of the rest. What is needed from policy is essentially 2 things: Policies and incentives that improve the viability, commercial attractiveness, profitability and hence the risk/return profile of low-carbon alternatives; that alone is seldomly enough though. In addition the markets need Serious policy commitment to tackle climate change in the long term. Why, because many investors have a long term horizon and before investing, or setting up new, say, renewable energy desks or funds they need to be sure that policy support will be there beyond the current legislature. Serious policy commitment should be reliable and measurable, hence best in the form of concrete and legally-binding targets. This creates a clear picture of where the journey is going and what is needed to achieve targets.
World Bank estimates suggest that around USD 475 billion of the total annual investment must occur within developing countries. Around USD 400 billion per annum of investment will be required for mitigation investment. A further USD 75 billion per annum will be required for adaptation investment. Developing countries will be most advantaged if public finance contributions are designed to maximise the leverage of additional private finance. It is estimated that existing contributions to developing world climate-change investment total around USD 9 billion per annum, less than 2 per cent of USD 475 billion. The World Economic Forum (WEF) estimates that the sum of climate-related public sector commitments currently under negotiation, even if delivered to their maximum ambition, totals around USD 110 billion. The shortfall is potentially more than USD 350 billion. Institutional investors and private finance intermediaries could provide much of the capital, if an appropriate risk-reward balance is offered. Institutional investors, such as pension funds, insurance companies and sovereign wealth funds, are in a position to provide some of the required capital. It is estimated that pension funds alone control assets worth more than $12 trillion and that sovereign wealth funds have a further $3.75 trillion under management. However, to stimulate their engagement the expected returns on climate-change mitigation investment need to be commensurate with the perceived level of risk. This is not currently the case. Public Finance Mechanisms (PFMs) — which could deliver between $3 and $15 of private investment for every $1 of public money — are part of the solution. Public money can be used to increase returns or reduce risks, and can be an efficient way of mobilising institutional investor capital. Alongside efforts to reform carbon markets and to create the conditions needed for ‘nationally appropriate mitigation actions’ (NAMAs), PFMs also need to be examined and optimised if they are to facilitate the required scale and speed of private capital injection. One of the issues for discussion at, and subsequent to, the Copenhagen Conference of the Parties is the role of PFMs and the institutional architecture to deliver them. The guiding principles of the Financial Mechanism under the UN Framework Convention on Climate Change should recognise the potential for use of public funds to leverage private finance. The package of public finance mechanisms proposed by UNEP FI is made up of five elements. Country risk cover. Insurance against country risk is already available at the project level from, among others, the Multilateral Investment Guarantee Agency (MIGA) of the World Bank and the US Government’s Overseas Private Investment Corporation (OPIC). Country risk cover could be expanded and explicitly provided to support low-carbon funds. Alternatively, recognising that the specifics of each project may influence the terms of the insurance, ‘in principle’ cover could be provided at the fund level, subject to shorter due diligence on each project. Low-carbon policy risk cover . The same organisation(s) providing country risk cover could also provide low-carbon policy risk cover. Although this is not currently a key role of political risk insurers, the risk of policy change is an important constraint to private sector engagement. This insurance could be restricted to situations where countries renege on legal grandfathering conditions.2 It could also support the development and implementation of Nationally Appropriate Mitigation Actions (NAMAs). Funds to hedge currency risk. Currency funds offering cost-effective hedges for local currencies which would otherwise not be available in the commercial foreign exchange markets could be supported through public finance. The Currency Exchange Fund, supported by the Dutch Ministry for Development Cooperation, is an example. Improving deal flow. Some publicly-funded bodies undertake early-stage project execution for infrastructure projects, such as securing consents and offtake arrangements. Infraco and Infraventures are examples. Building on this experience, vehicles specialising in early-stage lowcarbon projects could be developed. They could be complemented by technical assistance grants for project development. The spending priorities for such technical assistance grants would be determined in conjunction with the host country. Public sector taking subordinated equity positions in funds. The public sector could invest directly in low-carbon funds via subordinated or ‘first-loss’ equity. In this instance, any money made by the fund is directed to private investors first, with the public sector receiving a return on its investment when private sector returns meet a pre-defined threshold. This reduces risk for private investors.
Such targets and policies can be done at the national level. Cap & trade schemes, feed-in tariffs, carbon taxes, standards and codes, tax incentives, loan guarantees…one of the questions is: why do we need an international deal then at all, a deal that is global? When deciding on and committing to GHG emission reduction targets, what is needed is scale. To be able to deal issues around competitiveness needed to increase the ambition of countries in setting targets. The EU makes this very obvious: in the presence of a global deal, the bloc has committed to reduce emissions by 30% by 2030 relative to 1990 levels. In the absence of a deal, and out of competitiveness considerations, the binding target of the EU will amount only to 20%by 2020. In other words: the international dimension enables scale of commitments that will trigger the implementation of policy measures at the national level. 2. To prevent ‘leakage’, meaning that emissions reduction in certain countries could happen at the expense of emissions increases in others. Under the current climate change regime created by the KPl, we have something, but we don’t have enough: we have these two things that we need: 1. We have the targets, at least by most industrialized countries; which were very modest, and from a climate change science perspective, utterly insufficient. 2. We have international mechanisms that help improve the risk-return profiles of low-carbon projects, particularly but not exclusively in developing countries, through the mechanisms of Joint Implementation and the CDM. These have so far only been able to direct investment into the low-hanging fruit; a small range of countries, particularly in China, and a range of, at times controversial technologies. Commentators agree that the CDM and JI, as currently designed and with the current demand generated through emissions reduction targets, will not by enough to leverage the scale of private finance needed. 3. But do we have long-term certainty?
