The public sector can't finance net zero alone. Here's how it can scale climate investment

COP27 has kept the momentum behind the 2015 Paris Agreement’s 1.5° Celsius target going, with the renewed push from the United States and European Union to strengthen countries’ commitments to phase out fossil fuels. While the conference stopped short of agreeing to a final text that commits to phasing out the use of fossil fuels, the Sharm El-Sheikh Implementation Plan made clear that investments of at least $4 trillion to $6 trillion a year are required for the global economy to reach net zero. That would be on top of the $4 trillion a year needed to expand renewable energy. That would represent a significant increase, given that the International Energy Agency estimates only $1.4 trillion was invested in clean energy projects in 2022 (including $472 billion in renewable power).

The amount of government funding to support innovative climate solutions and low-carbon fuels has been increasing over the past few years:

However, different forms of public sector financing have different levels of effectiveness when it comes to mobilizing capital on the scale needed. While direct subsidies can support nascent markets for green products, they may also have unintended consequences, potentially distorting competition across jurisdictions or preventing different climate technologies from competing on a level playing field.

To avoid those unintended consequences, here are three ways the public sector can provide targeted support that addresses specific market failures and builds capacity for large-scale public-private collaboration.

The fundamental science behind many climate solutions has existed for decades and been proven at various scales. However, the lack of deep commercial markets for green solutions today and the disproportionate premiums on those solutions compared with high-emission alternatives result in uncertainty around their long-term revenue outlook and too much risk for most investors. This in turn means that financing is either not available for commercial-scale projects or interest rates required to compensate investors for the risk make them economically unattractive.

Long-tenor CfDs have emerged as an important way for governments to reduce revenue risk: These contracts of 12 to 15 years essentially work by having one party pay the difference between a pre-agreed strike price and a reference price. The reference price is typically the market price for a “high carbon” alternative, such as electricity generated from natural gas, while the strike price is set at a sufficiently high level to compensate producers for the green premium that they face today. CfDs have been successfully deployed at scale:

CfDs provide the necessary long-term price stability needed to attract private investment. Compared with approaches that provide a fixed amount of subsidy to producers, CfDs avoid “over-compensating” producers when market prices rise, as seen in the payments some renewable energy generators in the United Kingdom had to make to the LCCC when electricity prices rose above their strike price.

Targeted specifically at reducing revenue risk, CfDs can attract a wide pool of investors to invest in the climate solutions that they would otherwise shun, making more projects economically viable.

Blended finance has often been brought up as an approach to crowd in the financing needed for high-risk projects that are based on innovative climate technologies. This structuring approach allows governments to address the high real or perceived risks involved in these projects, and the relatively poor returns on those risks compared with other available investments. By seeking both public and private investment on projects, governments can achieve a multiplier effect on their own investment, while private investors gain access to opportunities at a suitable risk-return profile.

A pair of examples can be seen in the EU:

Multilateral development banks (MDBs) can structure financing instruments to target specific project risks. For example, MDBs can tie loan repayments to the successful construction and operation of a project and write off repayments if the project fails, transferring a significant portion of a project’s completion risk to the MDB. That then creates an investment opportunity that matches investors’ risk-return appetite. Under InnovFin, the EIB used an innovative financing structure backed by EC funds to support a first-of-a-kind plant in Belgium that would convert the waste and byproducts from steel-making into ethanol.

While instruments like InvestEU and InnovFin can go a long way to de-risk climate technologies at different levels of maturity, they are not available at the scale needed to meet our near-term goals for decarbonizing the industrial and mobility sectors. More needs to be done to replicate these instruments, and adapt them to target-specific risks as the relevant technologies and market players mature.

H2 Green Steel is a large-scale project in Sweden that promises to produce low-carbon steel. Its recent successful funding rounds show the importance of coordinating a complex set of stakeholders. By sharing project risks among public sector, equity and strategic investors, the project secured the large amount of debt financing required. This investment group included more than 10 strategic investors that had agreements to either provide critical technology or purchase the low-carbon steel that would be produced by the project. At least six public sector agencies and four commercial banks provided loans, guarantees, and equity financing.

To help scale up these types of projects, blended-finance platforms built on a common framework can reduce coordination and transaction costs and allow various sets of public and private sector investors to collaborate in a structured manner. Several of these platforms exist today, with varying scopes:

While how and where to use these platforms to address the wide range of challenges facing hard-to-abate business sectors is unclear, the critical role the public sector can play mobilizing capital to bolster climate technologies has been well-proven.

As governments, policy-makers, and the private sector gather in Davos, discussions on the financing of climate solutions will no doubt include what more needs to be done to scale up investments. They should remember the importance of public and private cooperation and seek to design more financing instruments that capitalize on it.