This article is part of our COP28 series. Learn more about CATF at COP28.
One of the most prominent stories coming out of COP27 in 2022 was the long-sidelined issue of funding for populations that are especially vulnerable to the adverse impacts of climate change, most of whom reside in low- and middle-income countries. The announcement of a “Loss and Damage” fund designed to address those populations was the headline outcome of the negotiations at COP27, for better or for worse.
With COP28 fast approaching, climate finance remains a major focus area — both in terms of building out the detailed arrangements for the Loss and Damage Fund and long-running issues surrounding international climate finance disbursement, some of which has been pledged but never delivered.
This focus, however, while potentially productive, risks losing perspective of the broader challenges of financing global decarbonization. It’s helpful to zoom out ahead of the technical UNFCCC negotiations on these topics and take stock of the facts.
First, we must acknowledge that the capital requirements for the energy transition are extremely large. To achieve net-zero emissions globally by midcentury, we’re likely to need at least $4.5 trillion of annual investment in the energy sector – roughly double the current investment levels, according to the International Energy Agency.1 Furthermore, such estimates do not even include other capital needed for adaptation, extreme weather event damage and disaster relief, or non-energy related development.
Despite such a large-scale challenge, capital is often assumed to be readily available to enable global decarbonization or is simply ignored as part of the challenge. Global net fixed capital formation, the amount of capital invested in new assets, is estimated to be $8 trillion in 2022, or roughly 8% of global Gross Domestic Product.2 That level has been consistent for decades. In 2022, it is estimated that total defense spending was roughly $2.2 trillion. As such, the incremental amount of investment needed to decarbonize the global economy is significant: at least a quarter of all new asset investment or roughly equal to global military spending.
For emerging and developing economies (EMDE), the challenge is more severe. Investment risks such as general country risk, policy uncertainty, governance capacity limits, counterparty payment risks, currency hedging, historical risk bias, and others have historically limited capital flow from wealthy nations into EMDEs. Because of these risks, the cost capital for such economies can be two to three times higher than similar projects located within wealthy countries, which means otherwise profitable projects are unable to move forward. Furthermore, a lack of experienced project development capacity limits the investable project pipeline. IEA estimates that total annual energy investment for EMDEs under a net-zero scenario would need to quadruple to $1 trillion by 2030 and double again to just shy of $2 trillion by 2050.
Remedies to this challenge that are frequently referenced include blended and concessionary finance. However, these solutions often do not consider the potential scale of the challenge and the limits of such solutions. Disbursement from the top six international development banks (IDB) for all investments (not just energy) was $200 billion in 2022 and recipient preferences for IDB disbursement do not rank climate as a top priority, with only $38 billion in climate mitigation financing to low and middle income countries from all MDBs.3 The $0.1 trillion of pledged finance for EMDEs from wealthy nations also remains unfulfilled over 14 years later – with the U.S., Canada, Australia, and the UK primarily responsible for shortfalls in funding.
Last, even if enough capital is available in the right places, capital discipline, a term used to describe processes undertaken by investors to limit investment risks, may also present challenges. Energy transition projects require significant amounts of fully-at-risk development capital to be deployed prior to the involvement of banks. Furthermore, they must overcome system-level chicken-and-egg and path dependence challenges, which can cause investment decision stand-offs and delay important investment opportunities respectively. The lengthy process of designing and de-risking these investments may also present speed limits to how quickly we can go without proactive planning and additional de-risking.
Unfortunately, determining whether enough capital can be supplied at the scale and pace needed remains unassessed. Most models that produce global pathways for decarbonization lack many of the key basic elements of macroeconomic constraints or realistic representations of capital markets. The cost of capital, for example, is often simplified as one global rate that entirely ignores material regional and national differences that can significantly impact energy projects’ affordability and feasibility. Further, most models also assume new mitigation assets are conceived, permitted, financed, built, and commissioned overnight, despite real world experience indicating long development timelines.
Clearly, much work remains to better understand the barriers to global capital availability, regional and national capital flows, and capital discipline and sequencing risks to achieving global decarbonization in a timely manner. Until that occurs, our gap in understanding risks limiting our ability to practical assess whether or how the world can plausibly finance the transition they model at the pace and scale needed.
A full set of scalable solutions can only be developed on a better understanding the challenge. This will require a better assessment of whether or how the overall increase in energy system capital needs can be sourced, how capital can be made more affordable to EMDEs and how policy can accelerate capital deployment timelines. Importantly, all of these solutions need to be evaluated against the global, regional, and national scales of capital needed to transition our energy systems.
COP28 will likely continue to feature a focus on resolving Loss and Damage details and concessionary finance. After the dust settles, however, it will be high time that the ecosystem of researchers, policymakers, and practitioners accept that we face significant gaps in our understanding of global finance barriers that require our collective attention, research, and advocacy. Only together can we tackle such a cross-disciplinary topic. Doing so will surely raise hard questions about the political and social feasibility of the pace of change, burden sharing between affluent countries and EMDEs, and the level of project risk that governments will need to absorb to develop them more quickly. But we suspect the world will be better off for our troubles.
1 These estimates are likely conservative because they generally: (a) exclude development costs to get projects to investment-ready; (b) assume aggressive cost-reduction (learning curves) that continue indefinitely; (c) are too temporally and spatially course to capture the full system integration costs of intermittent renewables; and (d) likely understate future energy demand due to courageous energy productivity assumptions, and weak energy consumption forecasts for low- and middle-income countries.
3 2022 Joint Report on Multilateral Development Bank’s Climate Finance.