The Chairman of the ECF Supervisory Board gives a dinner speech on Climate Finance in Berlin on 22 April 2015.
The dinner speech is available online via the website of the German Federal Ministry for the Environment, Nature Conservation, Building and Nuclear Safety and further below.
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Introduction
I will take the private sector perspective and – as Chairman of the Board – the perspective of the European Climate Foundation, which is advocating cross-sectoral collaboration and transformational change.
2015 will be a critical year and the G7 summit a highly important step on the road to Paris.
We are familiar with the challenge:
We all know that continuing on a business-as-usual pathway for CO2 emissions will incur extremely risky and irreversible changes to the world’s social and natural systems.
We are likely to see an international climate process delivering a complex outcome due to diverse national contributions. I am optimistic as far as possibilities are concerned but I remain sceptical on the probabilities of a truly satisfactory outcome.
The complexity of the international climate process is symbolic in character: Will, objectives and capacities differ – whether we look at the international climate process, at national debates, at public vs. private sectors. We certainly should come to the conclusion that it is necessary to think in terms of synergies.
Among other things, we are aiming for economic growth, security of energy supply and climate protection. These three goals could be visualised as being bound to each other via a triangular relationship. They are interdependent. Sustainable social and economic wellbeing will not work unless we strive towards all three of them.
This is indeed what the Global Commission on the Economy and Climate emphasises, on which I gladly serve as a member. I am pleased to see that the paradigm of the New Climate Economy Report “Better Growth, Better Climate” has met with a highly positive reception.
In a similar vein, a High-Level-Group involving a number of influential CEOs from various industry sectors and public sector officials was set up by the European Climate Foundation this spring to develop and further European industrial innovation and competitiveness in line with the “2030 package” of a sustainable future. This forum will be looking for a new approach to European industrial policy, rooted in a wider jobs and growth agenda to win competitive advantage from the transition to a new economy.
There is potential for a paradigm shift. These are good news.
As a matter of fact, certain countries and regions are becoming increasingly ambitious. For example, the work on financial reform in China may lead to policies for a green economy and green financial sector being introduced into the next Five Year Plan and placed on the agenda for the next G20. Similarly, the new AIIB could end up leap-frogging the West if it were to have sustainability and low-carbon as a core focus, as is being contemplated.
California Governor Brown’s announcement of 2030 goals for renewables, energy efficiency and reducing fossil fuel consumption in transport is a very commendable continuation of impressive Californian leadership over many decades, showing that growth and emissions can be de-linked. Ontario’s decision to start a carbon market and link to Quebec and California is a significant step, potentially creating a third major carbon market to match China and Europe.
The technology cost of renewable energy is rapidly coming down; a similarly dynamic scenario is emerging as far as climate finance is concerned. Globally, countries are looking to Germany and the EU for best practice, innovative technology and instruments. Germany, as the host of the G7 summit, is at the forefront of the low-carbon transition. Without doubt, we should not make the usual mistake of overestimating the speed of transformational change in the short-term, and underestimating the speed of change in the longer term. We carry responsibility to drive, advocate and channel this transition.
Therefore, the guiding question is not if but how to manage the low-carbon transition.
The G7 has a distinguished history of leadership such as the process that led to the creation of the Financial Stability Board and of the G20. I will suggest some ideas for how you, working with your finance colleagues, could apply this leadership to financing the low-carbon transition.
First, the Problem
Economies today are failing to mobilise sufficient public and private finance for low-carbon investments. This is not due to a shortage of capital in the global economy. It results, in most countries, from a lack of public financing capacity for green infrastructure that efficiently shares risk with private investors, and financial structures that allocate capital inefficiently, with risk, reward and geographic preferences that do not match well with an effective low-carbon transition.
Relative to the transition we need, low-carbon investment levels are too low:
Clean energy investment in 2014 did hit a new high of $310 after 2 years of declines.
However, IEA suggests $1.1 trillion/year is needed in the low-carbon energy sector alone.
And high carbon investment levels are too high:
IEA highlights that $950bn were invested in oil, gas and coal in 2013 – and hence doubled in real terms since 2000.
Although the ratio of fossil fuel to clean energy investment has improved, still ~3x more investment flows into high carbon sources of energy.
No doubt, scaling has to come from private investment and capital flows. A general transition to a low-carbon society is conditional upon a shift to low-carbon finance and “climate-robust” investment portfolios. This, in turn, is fundamentally linked to two important challenges I would like to emphasise:
How to change private sector risk perception: I will highlight intensity and type of perceived and actual risks associated with high and low-carbon investment; and underline the relevance of risk assessments, risk management and predictability of political direction.
How to support action flowing from changing risk perception: Investments undertaken in the coming years determine future pathways. I will outline innovative financing instruments and criteria guiding investment decisions at the micro and macro level.
Risk Perception
Investment is fundamentally a question of risk perception. Investors have long memories around retro-active policy changes. Governments have to do a much better job of providing policy Transparency, Longevity and Certainty (TLC).
Deutsche Bank analysis suggests unsubsidized technologies like solar are already below retail price of electricity in as many as 30 markets. This helps the risk/reward calculation. However some technologies will still require some government support to accelerate their deployment and cost reductions.
High-carbon investments carry the advantage of the established and mature, with the lobbying power that goes with this. However, tides are shifting as the “carbon bubble” narrative takes hold and renewables become more competitive. Investors such the $840bn sovereign wealth fund Norges and many others are recognising that climate change will undermine their returns and that governments will eventually truly get serious about climate action. One pension fund stated: “There is no place to invest in a 4 degree world”. Many are increasing their engagement with fossil fuel companies, shifting or even fully divesting from coal or all fossil fuels.
We see conventional utility business models faltering in Europe and the US, partially due to rapid growth in distributed generation and energy efficiency. Utility shares have underperformed the general market by ~30-40%. The announcement that one of Europe’s largest utilities, E.ON, would split into a “clean company”, keeping the E.ON name, and a “new company”, bundling fossil fuel and nuclear activities, is pathbreaking. The Swedish utility Vattenfall’s intention to divest its lignite operations is another sign of the shifting tides. This may trigger similar moves elsewhere.
Coal is in the news in Germany and beyond, and largely because it is the most vulnerable to carbon bubble risk. We traditionally think of coal as cheap energy, but only because in so much of the world it has not faced a carbon price. As soon as it does, – and needed is a strong, predictable and rising carbon price – the cost curves flip very quickly indeed. We know in Europe that the shift in ETS price that pushes coal off the merit order curve is not large at all – a price of ~€40/tonne is required. A higher carbon price could drive more emission reductions in an economically more efficient manner. Further EU ETS reform is vital, while keeping the overall burden on consumers roughly neutral.
But carbon prices need not be explicit to have profound effects. The plunge in coal consumption in China of late is not a story about explicit carbon pricing. It is a story about implicit carbon prices – air pollution controls, cutbacks in steel production, and financing directives.
As the direction of travel is becoming clearer, governments and regulators are drawing the necessary consequences also as far as finance is concerned, most obviously the Bank of England’s current work on the risk of carbon bubbles in financial firms. I also welcome the very recent French government’s request to the Financial Stability Board to undertake a wide assessment on climate related risks and opportunities. Finance departments and regulators have an opportunity to expand responsible and sustainable capital markets. This should be a broad effort and include measures to encourage institutional investors in shifting the financial sector and real economy to sustainable and profitable outcomes.
The emerging engagement of stock exchanges is encouraging: twelve major exchanges require some environmental and social reporting for at least some of their companies, while seven of these exchanges are requiring reporting for all listed companies. But driving more action will require action by government and regulators, as I will discuss later.
Thorough carbon and sustainability risk assessments will become commonplace if we move towards comprehensive risk disclosure and measurement, and integrated reporting standards to allow fully informed investment decisions.
The outlook is fundamentally positive. Technologies are maturing and being de-risked. Germany is a good example, where the support frameworks for renewable energy are clearly set from the top, with consistent messages and backed by a credible government. As risk perception changes and returns improve, investment will scale.
Action
The G7 should announce its aim for Paris to agree a regular review cycle every five years benchmarked against a 2050, 100% decarbonisation goal. Alongside a global long-term decarbonisation target that is badly needed to provide clarity on the direction of travel, what are the actions governments and regulators should take? I will group proposals under four categories where governments and regulators should lead in stimulating and scaling private sector finance:
Do no harm,
Leading by example,
Setting the rules, and
Expanding new partnerships and instruments.
First, do no harm:
Let me highlight two priorities:
Export credit agencies and coal: OECD governments have the opportunity to end Export Credit Agency financing for coal – a key part of the larger effort to end public financing for fossil fuels and high carbon projects. First movers include the U.S. Export Import Bank and the European Bank for Reconstruction and Development. The European Investment Bank – the biggest multilateral bank worldwide – has specifically set an initial Emission Performance Standard of 550 g CO2/kWh for fossil fuel power plants, which would (for now) only allow financing of the most advanced coal technology if it partially uses biomass or waste heat. A commitment to phase out high carbon financing is important for the Road to Paris.
Subsidies and other incentives: The New Climate Economy Report underlines that phasing out subsidies and other incentives for fossil fuels, agricultural inputs and urban sprawl are priorities. The G7 should work with the G20 to set a firm four-year timeline to end fossil fuel subsidies and re-direct support to other public priorities including green infrastructure investments, energy access and finance for development. This is, of course, familiar territory and a very tall order. It should be approached as part of an economic reform and growth agenda that increasingly incorporates climate into all core economic decision-making processes. Present lower oil and gas prices are clearly a window for policy makers to reduce distorting subsidies to energy consumers and producers, recycling those funds.
Second, leading by example:
A credible finance package is needed for the Road to Paris and the Financing for Development summit. The G7 background report usefully updates the AGF report, which I was involved in before Cancun, and shows that slowly progress is being made towards the $100bn climate finance target. More importantly, it is shifting the debate to the broader question of mobilising all types of private capital for infrastructure and development goals. The New Climate Economy Report found that meeting city, transport, food and telecommunication investments will require $5 trillion in total over the next 15 years, with some additional investments necessary to meet SDG goals.
2015 is an opportunity to create synergies between climate, development and infrastructure. However, a rigid separation between official aid and climate finance would be deeply damaging. The climate finance and sustainable development finance agendas should not try to create new institutions but focus on cooperation between existing institutions: the aid effectiveness agenda.
Expanding responsible ownership: Governments can help expand the number of investors asking tough Environmental, Social and Governance (ESG) and climate change questions of their fund managers and investee companies by expanding and replicating initiatives like the UK and Japan’s Stewardship Codes. However, the massive shift to passive investment and a focus on low-fees poses a challenge to this.
Public sector pension funds should be doing much more to lead by example: G7 countries would work with your many public pension funds and announce that they will deepen their efforts to shift investment mandates and practices towards responsible investment practices of incorporating carbon as well as ESG factors into investment decision making.
Green Bonds: While Green Bonds have so far not led to ‘additional’ investments, it is the start of tapping the debt capital markets at scale and engaging a broader set of bankers and investors. Governments could do more to support that market. However, excessive focus on green standards risks slowing the market, when there are no requirements for transparency for ‘brown’ bonds. I also challenge you: which country can put out the first OECD green government bond?
Third, setting the rules:
Governments have to intensify efforts and take the leadership for creating enabling policy frameworks.
One of the vital elements is carbon pricing.
Carbon pricing: The New Climate Economy report calls for strong, predictable and rising carbon prices. Governments should use a shadow carbon price and carbon discount rate in their decision-making processes. The slow but steady progress that many countries are making towards carbon pricing is encouraging – and the idea of creating a platform for elevating political discussion of carbon pricing would be helpful. One area for focus is to ensure that countries’ domestic carbon markets use the ‘CDM rulebook’ and restore demand for international credits. Ongoing work on far-reaching EU ETS reform is necessary. Generally, policy certainty on future carbon pricing paths is critical.
Implementation of regulation and standards: There are many regulations on companies’ environmental practices but not many for the financial sector. This needs to change. Sustainability needs to be applied through different types of regulation and standards in several areas of the financial sector: annual reporting by companies and investors, due diligence and risk models, institutional investor contracts with asset managers, how asset managers and investors analyse and work with the companies and real estate they invest in, how investors engage with governments and companies in the bond market and how research analysts and credit rating agencies assess sustainability.
I would like to specifically mention the following key areas:
Integrated Reporting: Better information will result in better companies and better growth. Expanding ESG reporting is a vital mechanism to secure access to investors that increasingly need ESG information in their investment process. Integrated Reporting and ESG data disclosure by companies & pension funds is the raw material for longer-term decision-making. The more established an integrated approach is within a company, the more it will also influence the way the company pursues new investment decisions.
EU member states need to implement the Directive on non-financial disclosure – and make it more rigorous. G7 regulators should require reporting using accounting standards being developed by the Integrated Reporting Council and the US focused Sustainability Accounting Standards Board (SASB).
Fiduciary duty: Reform is necessary to expand responsible investment practices. Fiduciary duty exists to ensure that those who manage other people’s money act in the interests of beneficiaries (i.e. pensioners). 10 years ago a ground-breaking report concluded that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions”. A recent UK Law Commission report reinforced these findings.
Now more than 1300 investors with $45 trillion in assets (this is half of the institutional investor market) are signatories to the UN supported Principles for Responsible Investment (PRI). This is significant progress but most investors have yet to fully integrate ESG into their investment process. The PRI will publish a report in September on what is needed to mainstream integration of environmental and social factors in investment decision-making. Governments should support implementation of its recommendations.
Consideration of carbon asset risk in financial institutions: More action is needed to expand consideration of carbon asset risk in financial institutions. It is notable that governments in Brazil, China and Peru have already enacted some environmental regulations for the finance sector. The Brazilian Central Bank said: “Sustainability is a positive asset for financial and monetary stability”.
Financial regulators should work with banks to establish common environmental due diligence standards and jointly examine how future climate and environmental scenarios could be incorporated into financial institutions’ many risk models. Deutsche Bank participates in a project (WRI and UNEP FI) creating the first carbon asset risk guidance for financial institutions. A carrot and stick approach from bank regulators is needed to encourage up-take.
Climate risk analysis: Climate and natural hazard risk needs more analysis. Beyond insurance companies, the finance sector generally does not take adequate account of natural disaster risk in asset valuations, loan books or in real estate. With accelerating natural disaster risk, this is untenable. Until natural hazard risk is appropriately accounted for, financial system risk will accumulate.
One of the initiatives announced at the UNSG Summit in September suggested that financial regulators could require public companies to publish their maximum probable annual losses to natural disasters against their current assets and operations using a ‘1 in 100’ test. The G7 should ask regulators to implement this idea.
And fourth, expanding new partnerships and instruments:
Multi-lateral and National Development Banks remain key partners but there are still too many instances of crowding out private players by competing to finance the few good projects. As the major shareholders in development banks, governments can build on efforts to change their KPIs towards leveraging private investment. More development banks should use tiered risk sharing funds, regulatory enhancements, guarantees and other structures. For new development banks like AIIB, sustainability and low-carbon should be a core mandate. The G7 should work towards placing sustainability and low-carbon as a focus for AIIB.
Climate Lab has been an excellent initiative for focused public-private discussion of concrete financing instruments. Early stage financing and the lack of bankable projects remain an issue for energy efficiency in developed countries and also for low-carbon projects in emerging markets. There is a strong need to expand project development facilities that cooperate with private sector developers. While all of the proposals have merit, we strongly support the ‘Climate Development and Finance Facility’ proposed by the Dutch Development Bank, as it has similarities to our experience in managing the European Energy Efficiency Fund (EEEF). To ensure the success of the Climate Lab, there should be an open but quick public competition for fund managers for the envisaged Facility – a role, which Deutsche Bank is extremely interested in and well positioned for.
Yieldcos and finance structures to reduce cost of capital: A yieldco is a publicly traded company that bundles operating renewable assets to generate predictable cash flows that are distributed to shareholders as dividends. The development of yieldcos first in the US and now in Europe is a game changer for engaging institutional investors and reducing financing costs. There is strong potential for replicating it in emerging markets. A challenge that needs to be addressed is that most renewable assets are owned by small project developers, communities and other organisations – not by large companies. It is time consuming to contact those many asset owners to suggest and negotiate re-financing with a yieldco. Governments should educate owners of operating renewable assets (perhaps by publishing a short guide) and encourage them to consider re-financing through a yieldco or other structures.
An Action Agenda for the G7
The application of these suggestions is complex because it requires collaboration among different sectors of societies, different departments and experts, and close alignment of activity at multiple governance levels. But the G7 has a distinguished history of collaborative financial leadership. Thinking in terms of synergies and acting collectively surely constitutes the basis for sustained economic growth, for energy security and for climate protection.
You as the G7 have a big opportunity to make gains in sustainable growth through a concerted action agenda:
Establishing a long-term decarbonisation goal;
Setting strong, predictable and rising carbon prices, and developing and restoring the international carbon market;
Positioning public pension funds as leaders of responsible investment; and
Driving a broad low-carbon and sustainable financial sector reform agenda.