THE PLACE OF THE CAPITAL MARKETS IN ADDRESSING CLIMATE CHANGE ISSUES
INTRODUCTION
There is an abundance of literature on the increasing negative effects of climate change. The empirical evidence is simply overwhelming and unless you are Donald Trump, there is absolutely no reason to undermine the issue of Climate Change. Global warming is occurring beyond any reasonable doubt and the reasons are not unknown. They include increased presence of greenhouse gases (GHG) in the atmosphere such as carbon dioxide (CO2), methane and nitrous oxide. Atmospheric concentration of these gases has increased markedly as a result of human activities since the beginning of the industrial revolution and now far exceeds pre-industrial levels.
The effects of climate change are at a point where we can no longer exhibit a carefree attitude. A foremost author on climate change, Lord Nicholas Stern, former Chief Economist of the World Bank, predicts that climate change may reduce global economic output by up to 3%, and displace as many as 200 million people in the 21st century. A report released by Trucost (“Carbon Counts USA”, www.trucost.com) states that a failure to cut GHG emissions could lead to up to a 20% reduction in GDP. Unarguably, the consequence of climate change will not only be felt by the environment, but also the entire human population and their activities – and it is only a matter of time before climate change significantly starts to affect investments, transactions, and all form of human endeavours.
This is what makes it expedient that all opportunities be explored towards reducing the emissions of greenhouse gases and solving the problem of climate change. In this piece, the writer looks towards the capital markets as an underutilized sector which, if well harnessed, can be leveraged to tackle the causes and effects of climate change.
MITIGATION AND ADAPTATION: INTERTWINED APPROACHES
Although there have been several arguments and theses that the world was going to self-destruct, climate change still did not start out as a problem on its own. It is a resultant effect of the unmitigated actions of human beings. Consequently, the greatest way to battle this problem is equally through human endeavours – it is by policies, valuations, investments, and conscious efforts that climate change will be tackled. These efforts of humans towards solving climate change have been categorized into two folds: mitigation and adaptation
MITIGATION
The understanding behind the proponents of mitigation is that if climate change is resulting from the actions of humans, then steps can be taken to predominantly prevent the further occurrence of such. Mitigation therefore involves the reduction of the flow of greenhouse gases into the atmosphere. This is done by either reducing the sources of these gases (for instance, the burning of fossil fuels for electricity or transport) or alternatively by enhancing “sinks” which accumulate and store these gases (for instance, oceans and forests). From the 2014 report on Mitigation of Climate Change from the United Nations Panel on Climate Change, the goal of mitigation is to stabilize greenhouse gas levels in a time frame sufficient to allow ecosystems to adapt naturally to climate change, ensure that food production is not threatened and to enable economic development to proceed in a sustainable manner. In essence, mitigation is aimed at reducing the human interference with the climate system.
To achieve mitigation, we would have to, among other things, look into: decarbonisation of electricity generation, replacement of current coal-fired power plants with modern, efficient natural gas combined cycle power plants or combined heat and power plants, new infrastructure and urban redevelopment investments and design, afforestation, sustainable forest management and reduction of deforestation. Clearly, mitigation is preventive; an approach which preaches nipping the causes of climate change in the bud right from the outset. However, given the complex nature of climate change, is this approach viable enough to work on its own?
ADAPTATION
Stemming from a clear understanding of the realities and nature of climate change, the adaptive approach argues that encouraging policies and investments to help populations, ecosystems and economies adapt is as critical as it gets. The need for this is not far from proper reasoning. At best, the causes of climate change may be reduced, but not totally prevented. More so, in times past, several steps to mitigate have not only proved futile, but have also been derailed from.
Moreover, the complex and uncertain nature of climate change makes it extremely difficult to anticipate the overall consequences. There is little or inadequate consensus on the magnitude of global warming. It is why Nobel Laureate, Paul Krugman, argues thus: “When it comes to climate change, uncertainty strengthens, not weakens” All these conveniently indicate the compelling importance of adapting to a consequence which, to a reasonable extent, is imminent.
Flowing from the above, it becomes clear that these two approaches are inextricably intertwined. To purposefully combat climate change, finances and investments have to be directed into strengthening these approaches. This will make it possible to tie the loose ends in fighting climate change. This reality creates the growing need to convince investors to see reasons behind investing in climate conscious projects. The financial opportunity that abounds in the capital markets is just about enough to fill the financial gap in climate change projects. However, for investors whose primary business is profit, what are the necessaries to be considered? This begs the need to look into the challenges of integrating climate change into the capital markets.
CLIMATE CHANGE IN THE CAPITAL MARKETS: THE CHALLENGES
Before analysing the place of capital markets in the problem of climate change, there is a need to observe the challenges that come with the integration of climate change in the capital markets
MISALIGNMENT OF TIME FRAMES
Arguably the greatest challenge, the obtainable misalignment of time frames is a factor preventing financial and corporate actors from divesting funds to climate change projects. This is because the lasting nature of the effects of climate change creates a wide gap between expected financial returns and the available timeline. Investors are generally motivated by the structure of their incentives, time frames of their compensation, and the life span of their profession. Due to the fact that the implications of climate change last for years and centuries, a high discrepancy is created as the motivation for investors is often to maximize their short term returns. This gap therefore makes investment in climate change often times financially unwise for investors.
CLIMATE RISK
Closely linked with the first challenge, climate risk entails investment risks that result from the years of unmitigated climate change. This has increased the level of uncertainties which potentially abound with climate change so much that investors may not realize how severe this may be. In addition, the nature of this risk is systemic, thereby making it cut across various sectors. Consequently, the risk includes physical risk, litigation risk, regulatory risks, and competition risks, among others.
CLIMATE CHANGE POLICY
Another factor which poses a challenge to investors is the absence of strong policy action as it pertains to climate change is policies. Ordinarily, investments in such an area as climate change are financially risky and unsafe for business. As such, it will take the presence of strong, sustainable and data-driven policies to motivate investors to release their money for such purposes. However, this is not the case yet. Economists have demonstrated that the laws of the market are not efficient in dealing with negative externalities, such as pollution and CO2 emissions. To this end, policies have to be made to close the widening gap between making social impacts and investment returns. Such policies are easily formidable instruments to solve, or at least mitigate, the problem of time frame misalignments.
THE PLACE OF THE CAPITAL MARKETS
Firstly, it is important to understand that the capital market is the financial market. In clearer terms, this is where the money resides, where the money revolves, and where the money goes out from. This is why investment is the epicentre of the discourse of the capital markets in relation to climate change. When it is said that capital market has a place in the literature of climate change, think about investments and financial injections. That is where the nexus lies. However, the problem is that the funds are often wrongfully directed. According to CPI in their “Global Landscape of Climate Finance 2014” report, the greatest current concern is that global financial flows are going in the wrong direction: a total of $331 billion was deployed in climate-related finance during 2013, down from $359 billion in 2012. Yet, the International Energy Agency (IEA) estimates that an annual average of $1.1 trillion in additional low-carbon investments is required between 2011 and 2050 in the energy sector alone to keep temperature rise below the required 2°C. This narrative then leaves us with two questions: how do we direct global funds? In what other ways can the market come in?
LOOKING TOWARDS CLEAN ENERGY
If we must combat climate change, and we must, then the first and most significant place that must receive sustainable investments is the clean and renewable energy sector. The world still largely lives on fossil fuels, with renewable energy comprising a meagre 20% of the world energy supply. This emphasizes immense opportunity opened up for exploration in the journey towards the embrace of clean energy. If this is not taken as a matter of utmost importance, the world is at a risk of more complications. According to the International Energy Agency, till 2035, there is a global need for a consistent cumulative $52 million investment in low carbon energy, if the world must steer clear of dangerous climate change implications. Thus, investors have to be made to see the need to invest in these long term projects. The most viable way to incentivize them is by incentivizing de-carbonization.
One key policy that has spurred the increase in the supply and use of renewable energy is tax incentive. It is no co-incidence that a relatively significant embrace of clean energy has been noticed across different countries. For instance, in a publication titled Global Landscape of Climate Finance; China, USA, and India have witnessed increased commitments to energy efficiency. This increment and use did not sprout out of outright volition. For instance, in 2005, the US developed a 30% tax incentive for investments in solar energy and, just a year after, this incentive occasioned a $66 billion investment in solar energy in the US. This goes to strengthen the argument that when you de-incentivize carbon and incentivize clean energy, investors would be financially motivated to invest in clean energy, thereby – knowingly or unknowingly – socially cultivating a climate responsible attitude.
CARBON PRICING AND TAXING
Closely associated with the above approach is carbon pricing and taxing, which is a measure that can be used to force the hands of investors into making climate considerate investments. Increasing the cost of fossil fuels for consumers will gradually but surely cause them to seek alternative means of energy. Here is where carbon pricing and taxing come in as instruments to make this happen. The first approach is an emission trading system where the total amount of emissions expected from a country or region is capped at a particular amount, and overshooting this will attract significant payments. Consequently, companies are allocated the permit to pollute within this range, while making conscious steps to transit to clean energy.
The second approach is carbon tax. That is, emitters are charged very high taxes based on their respective amount of pollution. The aim of this approach is that when the taxes become unbearable – and yet the companies cannot leave because of the obtainable large potential market – they will become deliberate and intentional about polluting less and transiting to renewable energy.
In the long run, these approaches are invariably targeted at investors who finance projects based on fossil fuel: that when there are several tax encumbrances and limitations abounding with pollution stemming from fossil fuels, the direction of investment will be revisited and changed for the better.
ISSUANCE OF GREEN BONDS
Green bonds are one of the modern investment instruments to finance climate change projects. They are a perfect medium for striking the balance between making social impacts and not losing your money. In very simple terms, here is how it works; a bond issuer will raise a fixed amount of capital, repaying the capital (principal) and accrued interest (coupon) over a set period of time. The issuer will need to generate sufficient cash flows to repay interest and capital. In form, there is no exact difference between these green bonds and conventional bonds. The only unique feature they possess is the specification that the proceeds be invested in projects that generate environmental benefits. This makes green bonds a pliable way to contribute towards climate financing and establish public-private partnership towards increasing green investments.
In 2008, the World Bank became the first to issue a green bond and since then they have issued over 3.5 billion worth of green bonds towards accelerating climate related projects. Given the nature of these bonds, it is necessary for investors to not only invest their money, but also their trust in the bonds that they will perform as expected. Issuance of green bonds should adhere to the international guidelines released by the International Capital Market Association (ICMA) for green bonds, named the “Green Bond Principles” (GBP). A continued high success rate of green bonds in climate financing will gradually and consistently motivate investors.
OPPORTUNITIES FOR EMISSIONS ABATEMENT
Scholars have argued that given the reality of the use of fossil fuels, steps have to be in place for the abatement of emissions so as to stabilize and ensure that greenhouse emissions necessarily remain within the advised 2°C. Studies by McKinsey & Co have split the CO2 abatement opportunities into two categories: those which create economic value for each tonne of CO2 avoided and those which incur an economic cost for the same outcome. The former category – which is the one that has recorded impacts over the years – involves incentivizing sustainable and climate responsible technologies such as LED lightings and improving building insulations. For instance, there has been a high success in the US regarding this, catalysed by tax credits. However, on the overall scale and elsewhere, there is an inadequate financing for these projects. As such, the range of opportunities in the abatement of emissions provides avenues for climate investments.
CONCLUSION
There is a persuasive argument behind the use of fossil fuels, that the so called sources of clean energy are not enough to measure up with the rate at which fossil fuels are easily made available. This is an argument which stems from “what is”. That is, based on the reality and the absence of enough finance behind renewable energy, it cannot conveniently replace fossil fuels yet. However, if we look towards possibility, renewable energy can gradually but surely replace fossil fuels on a large scale, given there is an abundance of investments therein. The commercial marketplace is currently volatile and unmotivated towards climate financing due to the obtainable uncertainties and complexities. This reality spells out the need for policymakers to advance clear and financially sustainable pathways for investors to tread towards climate financing. The narratives on the negative effects of climate change are far overwhelming, but the narratives on solving the problem are still far underground. To that, the capital market has a thing or two to say.
Author: Habeeb Asudemade
INSTITUTION: UNIVERSITY OF IBADAN
BIO: Habeeb is a vast writer and a versatile penultimate law student with demonstrated interests in Law, Leadership, Policy-making, and Community Service. He is a 2019 Nigeria Higher Education Foundation (NHEF) scholar with a flair for corporate law.
