We need to decarbonize industry. Here's how to finance it

The 2015 Paris Agreement recognizes that keeping the increase in global average temperature below 2°C from pre-industrial levels would significantly reduce the impact of climate change. In order to achieve this, it will be essential to decarbonize industry. Direct industrial processes contribute 5.2% of global greenhouse gas emissions, while energy use in industries contributes about 24.2%. This is set to rise further with rapid industrialization and the use of emission-intensive processes, particularly in developing countries.

There are many ways of reducing emissions in industry. For example, some state-of-the-art industrial technologies can absorb carbon dioxide through 'carbon scrubbing'. Industries can introduce circular economy principles in production and supply chain, and use sustainable alternative fuels. Some estimates indicate that replacing existing assets or processes in heavy industries could reduce carbon emissions by 10-20% without any significant adverse impact on financial returns.

However, it is currently very difficult for businesses to adopt low carbon and energy-efficient technologies, due to a lack of suitable financing. There are huge costs involved in constructing new project facilities and buying specialized equipment, especially for heavy industries like chemical, steel and cement. Businesses do not plan to replace these kind of assets frequently, and upgrading them or replacing them requires substantial investment. It can also be difficult to salvage equipment once it has been decommissioned.

In order to change their assets and systems, project owners need to see financial benefits There are currently few market-tested mechanisms to price industrial carbon emissions, which means that there is little incentive for businesses to shut down higher carbon-emitting legacy production plants, machinery, and processes, or to replace them with capital-intensive, low carbon-intensive technologies.

Debt financers, particularly banks, do not consider energy-efficient industrial equipment as an attractive lending proposition. There is a lack of credible historical data on the energy efficiency of new equipment and a perceived risk of the equipment failing to yield adequate financial savings. Once any new equipment is integrated with the project facility, it is also difficult for the lender to separate and ring-fence the asset in order to use it as collateral on the loan. If the borrower defaults, the debt financer might be left with a stranded asset that is not easy to liquidate in the secondary marketplace.

Often, businesses that wish to adopt new technology to reduce emissions are left with Hobson's choice: either issue fresh equity or raise debt from capital markets. The former leads to a lower return on equity in the near term. The latter is not efficient either, as debt providers demand a higher coupon rate and stringent covenants to make sure that proceeds are used for their intended purpose.

If we want industry to decarbonize, we need to make debt capital available at a cost that does not discourage lenders or lower the business's return on equity. This could be done with public-funded unsecured subordinated debt financing. This is a debt that takes second place to other debts when it comes to claims on assets.

It would provide reassurance to debt financers, and to sweeten the deal for the creditor, the subordinated debt could be offered as a payment-in-kind note, deferring regular principal and interest payments until the financial benefits of the new technology have been realized. The tenor of the subordinated debt could also be longer than those of existing debts, offering extra security to existing debt financers.

This would help the borrower to develop an improved credit profile, discouraging existing debt financers from imposing stringent covenants on their debt. Furthermore, as the business is not required to issue fresh equity to raise funds, the new debt would not affect the return for existing capital providers. The business can mobilize additional resources at a relatively low cost, without reducing the equity holdings of existing shareholders. Lastly, during the repayment period, the borrower would be eligible to claim a tax deduction on the interest paid on subordinated debt.

The source of public finance for this subordinated debt financing could be a line of credit from multilateral development banks, international financing mechanisms like Green Climate Fund, public financial institutions, governments, or green bonds issued by the borrower to one of these institutions.

It would be possible to identify standardized plants, equipment, and processes that reduce carbon emissions substantially and offer financial benefits, rather than backing a variety of technologies across industrial sectors. The initial identification of standardized technologies would help to reduce the costs of researching and assessing the environmental and financial benefits of new technologies.

At the COP26 Summit in Glasgow, several countries committed to achieving net-zero carbon emissions by mid-century. Increased uptake of low-carbon equipment in the industrial sector will play an important role in the rapid decarbonization course.