Financing the net-zero transition: meeting the $3.5tn challenge

With a new report showing investment in net-zero initiatives needs to triple to reach the globally agreed 2050 targets, where will this funding come from and where will the money be best spent?

Financing The Net Zero Transition

The theme of this year’s Earth Day is ‘invest in our planet’ and the question of financial investment remains crucial if we are to meet the 2050 net-zero target set out in the Paris Agreement. 

Without it, our hopes of limiting climate change are minimal. Finance is how new renewable power facilities, cleaner transport and more efficient infrastructure are funded. It also allows for investment in new technologies like battery factories and carbon capture and storage.

The scale of global investment required was starkly laid out in a recent report from the Energy Transitions Commission (ETC), which claims that the current $1tn (£800bn) per year which is being invested in the net-zero transition needs to more than triple to $3.5tn (£2.3tn) per year, if we are to decarbonise the global economy by 2050.

While the scale of investment required is sizeable – it exceeds the total GDP of the UK ($3.1tn) – it should be seen as an opportunity as well as a challenge, according to Lord Adair Turner, chair of the ETC.

“Having decided to make these net zero commitments and to take climate change seriously, we now face the challenge of matching that ambition with large-scale investment,” he says. “But that also presents an opportunity.”

One of the areas where investment needs ramping up the most is renewable energy. Some 70% of the $3.5tn in required finance should go towards low-carbon power sources, according to ETC’s proposals – $1.3tn to power generation, $900bn to upgrading power networks and $200bn to improved power storage. 

“Clean power is going to underpin the transition across all sectors,” says Hannah Audino, one of the report’s authors. “This will then feed through to industry, buildings and transport, enabling them to decarbonise at faster rates.”

Without sufficient renewable energy capacity, it will be impossible for certain sectors of the economy to become carbon neutral. The electrification of vehicles, heating for our homes and manufacturing processes will inevitably require greater production. Meanwhile, investment in battery and storage capacity will also be important to account for seasonal changes in the output of renewable energy sources.

On a positive note, the relative costs of renewable power generation are much more competitive, when compared to greenhouse gas-producing fossil fuels, than they were only a decade ago.

Since 2010, the average levelized cost of energy (LCOE) – which measures the predicted lifetime costs of a power source divided by its energy production – of solar power has declined by 88%. Onshore and offshore wind power have also seen a significant drop in cost, by 68% and 60% respectively.

As the cost of green energy becomes more competitive with incumbent fossil fuels, and in light of the recent volatility in the oil and gas market, investment in renewables has grown. “The investment in wind and solar has gradually increased and there are huge investments in other areas like battery factories,” Adair says. “But the reality is that it needs to continue to build up.”

Emerging technologies like carbon capture and storage will also play a “vital but limited role” in the net-zero transition, he adds. It is unclear how certain industries, such as cement production, could become completely carbon-neutral without them. But these solutions are yet to see the same reductions in costs.

The role of the private sector in reaching net zero

Closing this $2.5tn financing gap represents a sizeable challenge – and one that the private sector must help meet. “Private companies will drive this investment,” claims Rob Doepel, EY UK&I managing partner for sustainability. “If you look at how much dry powder is awash in the City of London alone, there’s more than enough capital available.”

So if the money and motivation are there, what’s holding back green investment?

According to Adair, the constraint is not the supply of finance, it’s the regulatory process that needs addressing. “There is a danger that where we are talking about first-time deployments, the private sector appetite may not be strong or quick enough to mobilise at the pace required,” he says. “A lot of institutions can invest the required money but they need the correct real-economy policies in place to make it profitable.” These policies include carbon pricing, power market design and planning regulation, which can often stymie large green infrastructure projects.

Doepel agrees. “The challenge is that all capital is looking for a return, so it needs to be allocated for a particular risk profile and return on investment. The programmes that need capital the most are often riskier and aren’t guaranteed to make a good return,” he says. This is where multinational development banks and investment banks can step in to bridge the funding gap.

Climate bonds can also help to encourage investment in bigger and sometimes riskier environmental projects. This type of financing often provides tax incentives to encourage institutional investors to support climate-related projects.

But this is an area where the UK has room for improvement. Research from the Climate Bonds Initiative shows that the UK lags behind neighbours such as France, Germany and Portugal in issuing climate bonds.

But businesses also have a role to play in making their transition plans clearer. “If you look at how much dry powder is awash in the City of London, there’s more than enough capital available,” Doepel explains. “But that money needs to be deployed on actual projects and programmes. That’s where we need the businesses and industries themselves to work out their requirements and provide granular details on how their sectors can decarbonise.”

FTSE transition plans are not up to scratch

The key things that investors care about when financing a new project are a clarity of vision, with interim targets, reducing the downside risk and overcoming supply-side challenges, Audino advises. 

From January 2023, FTSE 100 businesses will be required to lay out their net-zero transition plans as part of the Transition Plan Taskforce’s (TPT) Draft Disclosure Framework. Production of these plans, which have to be “credible, useful, and consistent” should theoretically encourage investment. EY research, however, found that only 5% of blue chip companies have disclosed plans that it would consider to be sufficiently detailed to meet the TPT’s guidance.

Not a week goes by without a new report providing another astronomical number of the capital required

The two components of the Transition Plan Taskforce which need urgent attention are financial planning and sensitivity analysis, according to Doepel. “Most organisations typically plan in three- to five-year cycles. But when looking at the transition to a low carbon way of working you need to be looking over a much longer period,” he says.

This planning has been further complicated by the events of the past 12 months, which have seen energy prices soar and inflation rise. “This has meant that planning windows have shortened as businesses become focused on staying afloat and weathering the economic storm,” Doepel says. “At the same time, we’re asking companies to look 10 to 15 years out, so there’s a real juggling act for organisations to balance short-term expectations of existing shareholders and longer-term responsibilities to wider stakeholders.” 

The focus on the macro level can also be an issue, as ultimately it will be an accumulation of funding for smaller projects that makes the biggest difference in terms of reaching the annual $3.5tn target. “Not a week goes past without a new report providing another astronomical number of the capital that’s required,” Doepel adds. “We need fewer studies at a macro level and more work done at a lower level because that’s when projects emerge that can then leverage the finance available and make an actual impact.”

Despite these many challenges and the scale of financing required, there is optimism that these issues can be overcome. “It is true that we’re running out of time to reduce emissions, so it should provide a strong wake-up call,” Adair says. “But it is all doable with the appropriate commitment.”