Occasional Studies Volume 19 – 2 Financing the transition: seizing opportunities for a green recovery Financing the transition: seizing opportunities for a green recovery ©2021 De Nederlandsche Bank n.v. Authors Justin Dijk, Jan Willem van den End, Rianne Luijendijk, Guido Schotten and Sophie Steins Bisschop The Occasional Studies series aims to disseminate thinking on policy and analytical issues in areas relevant to De Nederlandsche Bank. Views expressed are those of the individual authors and do not necessarily reflect official positions of De Nederlandsche Bank. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or disclosed in any form by any means, electronic, mechanical, photocopy, recording or otherwise, without the prior written permission of De Nederlandsche Bank. De Nederlandsche Bank N.V. P.O. Box 98 1000 AB Amsterdam Internet: www.dnb.nl Email: [email protected] Financing the transition: seizing opportunities for a green recovery DNB Occasional Study Authors: Justin Dijk, Jan Willem van den End, Rianne Luijendijk, Guido Schotten and Sophie Steins Bisschop1 1 Acknowledgements Thanks to Emily Bell, René Bierdrager, Melle Bijlsma, Taras Bogouslavskii, Dirk Broeders, Guus Brouwer, Jeannette Capel, Malou Dirks, Willem Evers, Gerard Eijsink, Wim Goes, Jessica Havlinova, Vincent Jungen, Mark Mink, Pieter Moore, Eva Nielsen, Christiaan Pattipeilohy, Rene Rollingswier, Nikki Rupert, David Rijsbergen, Niek Verhoeven, Coen ter Wal and Sandra Wesseling. We also thank various representatives of the PBL Netherlands Environmental Assessment Agency, the Ministries of Finance and of Economic Affairs and Climate, Triodos, PGGM, Invest-NL, the Sustainable Finance Lab and Erasmus University Rotterdam for their participation in an expert session to comment on the previous version of this study. Any errors that remain are our sole responsibility. Content 1 Introduction 7 1.1 Background 7 1.2 Impediments to the financing of the transition 8 1.3 Policy options 9 2 Investment task and financing sources 10 2.1 Investment task 10 2.2 Financing sources 13 3 Business case for climate investment 16 3.1 Reasons for limited business case for climate investment 16 3.2 Potential to improve the business case 21 3.3 Opportunities for more government involvement 23 3.4 Obstacles to greater government involvement 27 4 Supply of finance for sustainable businesses 30 4.1 Supply of private finance for climate investment 30 4.2 Representation of sustainable businesses in current financing flows 32 4.3 Options for scaling up private financing of sustainable businesses 38 5 Sustainability incentives for carbon-intensive businesses 42 5.1 Incentives through capital markets 42 5.2 Incentives within the financial sector 50 5.3 Central bank incentives 56 6 Summary of policy proposals 59 6.1 Improving business case for climate investment 61 6.2 Reducing the mismatch between the risk profile of climate investment and financing 64 6.3 Strengthening market incentives to increase the sustainability of established businesses 66 7 Literature 69 1 Introduction 1.1 Background 7 Over five years ago the world’s leaders signed the Paris Climate Agreement. That set a clear limit for global warming, namely a maximum of 2°C or preferably 1.5°C. Many countries translated the Paris objectives into specific greenhouse gas reduction targets enshrined in climate laws. The EU aims to be climate-neutral in 2050, with an intermediate target of a reduction of at least 55% of CO2 in 2030 compared to 1990. This is a more ambitious target than the Netherlands has set at national level in the Climate Act (-49%). Despite these clear, ambitious climate targets, the current efforts are still insufficient. The latest estimate by PBL Netherlands Environmental Assess- ment Agency shows that the Netherlands’ adopted and intended policy will deliver a -34% reduction in CO2 in 2030 compared to 1990. The current efforts are insufficient to reach the climate objectives (Study Group on the Fulfilment of the Climate Objectives, 2021). In addition, the faster the transition, the greater is the likelihood of abrupt adjustments. A sudden transition can be harmful to the economy and the financial sector (DNB, 2018). This risk will increase if the agreed targets for limiting global warming are not achieved. It is therefore of vital importance that the new coalition government substantially strengthens climate policy in the Netherlands. In order to limit the financial risks and promote sustainable economic development, DNB is calling for an acceleration and scaling up of climate investment. This is investment that contributes to the achievement of the climate targets. Current investment in the climate transition is inadequate, despite the large volume of finance potentially available. The bulk of the climate investment will have to be made by private parties. The financial incentives for such investment are often insufficient, however. For example, the estimated volume of annual climate investment in 2019 totalled around EUR 580 billion worldwide, while in the energy sector alone it is estimated that between EUR 1,600 and 3,800 billion will be required annually to 8 achieve the 1.5°C target (CPI, 2019 and IPCC, 2018). This study identifies the underlying impediments to the scaling up of climate investment, with a focus on the financing side. Policy options will also be presented to tackle the impediments and promote a green recovery from the COVID-19 crisis. 1.2 Impediments to the financing of the transition There are various reasons for the inadequate level of climate investment. The main reason is that the business case for carbon-intensive projects is often much more attractive than the business case for sustainable alternatives (impediment 1). This is principally because greenhouse gas emissions are often underpriced. The business case is also heavily dependent on (current or future) government policy, which is subject to significant uncertainty. This inhibits the necessary climate investment and improve- ments to the sustainability of the economy. That is reflected in a lagging share of sustainable finance in the overall financing flows. Furthermore, the energy transition requires investment in new, often unproven technologies and sustainable businesses that have only recently been established. This creates additional uncertainty for financiers with regard to the business case, leading to a mismatch between the risk profile of required climate investment and the risk preferences of private financiers (impediment 2). In addition to investment in relatively young sustainable businesses, more investment is also required to reduce carbon emissions of established businesses. As yet they have insufficient market incentives to make the transformation (impediment 3). This is due in part to inadequate carbon pricing but also due to a lack of binding standards and transparency on climate risks. 1.3 Policy options 9 Kick-starting climate investment requires a combination of pricing, support and regulation. Adequate pricing of carbon emissions through higher carbon taxes and the phasing out of fossil fuel subsidies is crucial to improve the business case (Chapter 3). In addition to taxes on polluting economic activities, support is required from innovative, sustainable business and techniques. In sectors affected by coordination problems between investors and financiers, the government must play a stronger coordinating and supporting role. The success of the energy transition for many sectors depends on successful technological innovations, but the businesses behind this type of innovation are often not market-ready. It is important that governments do more to promote innovative investment and its financing, through subsidies, co-financing and guarantees. This requires consistent and reliable government policy, so that private investors have sufficient certainty to provide the necessary finance on a long-term-basis. Another precondition is that these efforts must not jeopardise the stability of public finances. Regulators can boost the private financing of innovations by promoting the market for equity finance and financial innovations (Chapter 4). Finally, established businesses must be given incentives to reduce carbon emissions. That requires not only market incentives but also reporting requirements, including on climate matters, and binding supervisory and risk standards. Until better data are available, current indicators used to measure sustainability can already provide some insight (Chapter 5). In the review of the monetary strategy the ECB and national central banks such as DNB consider how climate risks can be incorporated in monetary policy. The policy options are discussed in greater detail in Chapter 6. 2 Investment task and financing sources 10 Climate investment needs to be scaled up to achieve the climate targets. This investment is financed by different parties (public and private) and in different forms (debt, equity). The type of investment, coupled with the risk-return profile, is crucial in determining the source and type of financing. Given the size and variety of the investment task, the energy transition theoretically requires all sources of financing. 2.1 Investment task The energy transition requires large-scale investment in energy services and increased investment in reducing carbon emissions of manufacturing, transport, agriculture and buildings. Most investment is related to energy consumption, such as the generation of sustainable energy,