Securing macro-economic gains from decarbonisation investment: the finance dimension and an Italian case study

02 February 2018 | Dr. Michael GrubbDr. Nadia Ameli

Two years since the negotiation of the Paris Agreement, the global community faces significant challenges in mobilizing the investment required to meet the goals established.

There is no shortage of capital available globally – the financial sector encompasses more than EUR 100 trillion of assets globally – but several factors inhibit the expansion of private finance in low-carbon investment. Yet there are potential macro-economic gains from doing so.

In the GREEN-WIN project we have investigated the conditions which might attract such levels of finance, and whether and how this could lead to net economic gains on timescales to make this politically attractive.

We seek to investigate i) what affects the scale of finance and the demand for low-carbon investment; ii) what actions could help to channel capital towards low-carbon investment; iii) why the cost of capital varies widely between different countries and sectors and iv) the macroeconomics of low carbon finance and innovation based on an Italian case study.

Factors affecting the scale of finance and the demand for low-carbon investment, and related policy options were explored through interviews. The macroeconomic implications of low carbon finance and innovation were based on modelling assessment through extension of the GEM-E3 model, as detailed in Green-WIN deliverables and elsewhere.

The transition to a low carbon economy is a capital-intensive process requiring large scale finance combined with suitable low-carbon investment projects. The relative attractiveness of different energy investments may be substantially affected by the cost of capital, depending upon the relative capital intensity, construction times, perceived risks and expected operating lifetimes of the asset.  The higher the cost of capital, the more up-front investment costs will weigh, making the cost of capital itself one key component of the levelised cost of electricity (LCOE) generation.

The Weighted Average Cost of Capital (WACC) in the ‘green and renewables’ sector varies widely across countries reflecting perceived risks and barriers of investing in a given sector and country. For instance, it ranges from 3.4% (in Germany) to 8% or more in Greece and many emerging markets. Italy is closely comparable to the US (5%).

Factors affecting the scale of finance operate at both general and sector levels, on both the supply (financial structures) and demand side (energy technologies and policies) of investment decisions. They include perceived country risk, the policy framework, investors’ experience and performance track record in the sector, and analytical approaches to assess climate risks and opportunities. Supply-side factors include limitations of appropriate investment instruments, project size and the lack of high quality estimations and standard reporting to allow appropriate and sufficient due diligence.

To effectively encourage investment for the low-carbon economy and increase their attractiveness, policies focusing on markets and pricing and on investors’ behaviour and their short-term view, would be beneficial. Moreover, the transition to a low-carbon economy needs to be supported by strategic public long-term capital in key phases of the investment channel. Development finance institutions may play a significant role by deploying de-risking instruments and pooling projects together to allow investors to invest at scale.

Finally, this policy brief summarises a case study of the macroeconomics of low carbon transition taking account of innovation and finance dimensions, using the extended (GEM-E3-WIN) model to assess the implications decarbonising the Italian energy system. This assumes that clear and credible policies deliver a cost of finance close to the German rate, along with intra and cross-sectoral spillover of knowledge associated with R&D in clean technology.

The results suggest that the transition yields one to two decades of increased investment which helps to lift the Italian economy, increasing both imports and exports, which then decline as the transition matures; the Italian economy is then significantly less dependent on energy imports (17 % reduction of energy imports from reference over the 2020-2050 period), and becomes a supplier and exporter of clean energy products (like electric vehicles) which helps to pay back the loans on the investment, leaving the Italian economy in the long run at least as well off as in the base case.

The modelling work suggest that the low carbon transition (Italy reduces overall GHG emissions by ~60% in 2050 from reference levels) does offer macroeconomic opportunities over the coming decade, if Italian industry can maintain a stake in the relevant sectors (like electric vehicles) and if there is a supportive and consistent investment environment to attract low-cost capital financing of low carbon assets.