Policy Memo: Recommendations for COP 24 /Reducing Risks in the Financial Transactions and Internalizing Carbon Pricing in the Valuation of the Firms
This policy memo is written for the Environmental Finance: Scaling Up Clean Energy Course during the Fall 2018 Semester at Columbia University, School of International and Public Affairs (SIPA). The subject of this paper is giving recommendations to the 24th Conference of the Parties to the United Nations Framework Convention on Climate Change (COP 24) in order to better utilize and mobilize financial instruments for renewable energy and Green House Gas reductions.
Executive Summary
On the way to the 24th Conference of Parties (COP 24) to the United Nations Framework Convention on Climate Change (UNFCCC), there is still a huge investment gap to combat climate change. The annual investments required to limit the increase in global temperature to 2°C above pre-industrial levels require a $1,000 billion-dollar annual new investment which is three times more than the investment made in 2017. The public sector cannot close this investment gap due to its high indebtedness. Then, the only way to solve this problem is to mobilize private capital through public sector guarantees and insurances.
Subject
The subject of this paper is giving recommendations to the 24th Conference of the Parties to the United Nations Framework Convention on Climate Change (COP 24) in order to better utilize and mobilize financial instruments for renewable energy and Green House Gas reductions. The COP 24 will be held on December 3, 2018, in Katowice, Poland.
Situation
Global warming is a scientific and human-made fact. One of the first attempts to combat climate change was the adaptation of the 1992 United Nations Framework Convention on Climate Change (referred to as the UNFCCC or the Convention), which later was followed by the 1997 Kyoto Protocol and 2015 Paris Agreement.
The main reason for the temperature rise is the burning of fossil fuels which increased enormously after the industrial revolution. Paradoxically, the era started with the industrial revolution has also changed the quality of human life enormously. Therefore, decreasing the Green House Gas (GHG) emissions were considered to be a dilemma in front of the development projects. However, thanks to the technical and financial innovations, renewable energy is much cheaper which makes the development and reduction in GHGs simultaneously possible. For this reason, these two targets were first inserted in the Millennium Development Goals and later into the Sustainable Development Goals of the United Nations. However, there is still a need for financing this change e.g. the adaptation and mitigation of climate change. Mitigation is as important as adaptation. Because even all humanity stops emitting CO2 today, the global temperature rise will be around 1.75° Celsius by the end of 2100[1] due to the cumulation of CO2 in the atmosphere that has been emitted already. Thanks to this scientific fact, the two conclusions can be derived. The first one is the cumulative concentration of CO2 in the thin atmosphere is important. Second is the CO2 emissions have global impacts. Therefore, the market adaptations to climate change should be global in nature such as the global carbon market.
These two issues were first addressed in Kyoto in 1997. Kyoto Protocol brought the binding emission reduction commitments for developed country Parties. This meant the space to pollute was limited, and what is scarce essentially commanded a price. GHGs—most prevalently CO2—became a new commodity. It also established flexible market mechanisms, which are based on the trade of emissions permits. Therefore, parties could meet their carbon abatement targets through three market-based mechanisms which ideally encourage the abatement where it is less costly. In short, as long as carbon abatement is ensured, it does not matter where.[2]
However, the nationally binding targets of Kyoto did not function very well and during the 21st Conference of Parties (COP 21) to the UNFCC, a new protocol is signed, the Paris Agreement. The Paris Agreement brought forward the nationally determined contributions (NDCs) in reduction of carbons. This includes requirements that all Parties report regularly on their emissions and on their implementation efforts.
Now while we are heading to the COP 24 to be held in December 2018 in Poland, there have been essential problems in front of the government to solve.
Complications and Predicate (What should be done)?
The annual investments required to limit the increase in global temperature to 2°C above pre-industrial levels[3] require a $1,000 billion-dollar annual new investment. It is three times more than the new investment made globally in 2017 which was $334 billion. Besides, while ninety-one percent of this new investment ($306 billion) came from OECD and BRICS countries; the remaining nine percent was made by the developing countries. In order to catch up with this investment gap, the developing countries should invest nineteen times more and OECD and BRICS should invest two times more than their current annual investment.[4] This is a big challenge in front of governments. The public sector cannot close this investment gap by itself due to its high indebtedness. According to the World Bank, the world indebtedness reached 100%, with $73 trillion of debt on $73 trillion of GDP in 2015.[5] Moreover, the investment needed in the developing world is much riskier than the one in the OECD and BRICS countries. The private sector seeks higher return rates in those countries and it is becoming more challenging for governments to attract private investment. In short, finding a new investment to combat climate change is not an easy task. Yet, it is doable. The task, then, is how to canalize the private sector to the mitigation and adaptation of climate change and make them invest in clean energy while reducing their risks.
In 2017, the total global investment in renewable energy was $461.4 billion. While around $127.9 billions of it was asset and company mergers, acquisitions, refinancing, buy-outs, etc., the remaining part ($334 billion) was the new investment in technology, research and development, roll-out phase of new build asset finance (AF) in the middle finishing with total secondary market and so on. The new investment was in 2017 only 7% short of 2015’s record investment of $360 billion. Among all types of renewable energy (solar, wind, energy-smart technologies, bioenergy, etc.), so, the new investment in solar has been the highest since 2011. In 2017 globally, $161 billion dollars was pledged to solar; whereas, $107 billion to the wind and $49 billion to energy-smart technologies. Dollar investment via asset finance and small-scale solar projects has been affected by sharp reductions in PV costs. 2011 is also the year when Europe left its pioneering position to China in new investments to renewable energy. In 2017, while China (Asia Pacific region but mostly China) made $187 billion new investment; Europe $69 billion and American continent mainly the USA dedicated a new $78 billion in renewable energy.[6]
In short, the public sector does not have enough resources to combat climate change. Yet, the private sector investment in clean energy is not enough to catch the 2°C target.
How do we know that there are enough resources in the private sector?
Today the global capital stock (which is composed of public debt, securitized and non- securitized loans, public equity, cash and cash equivalents, real estate, and private companies) is $512 Trillion.[7] This numbers and composition show us the ways in which individuals, companies and governments can store value; how capital moves around the world and between multiple asset classes and how capital market transactions involve a transfer of capital from one group to another in order to achieve economic activity and generate a return for investors.
The debt markets represent the single largest source of capital for private companies and governments. Both the public and private debt markets have a nineteen percent share of global capital stock. Both make thirty-eight percent of the global capital stock. The debt markets had a value of approximately $194 Trillion in 2017. The debt providers seek stability and consistent returns and consistent interest payments plus principal. They do not share in company earnings and they have lower risk tolerance than equity. Moreover, the outstanding global bond market in 2017 was approximately $100 US trillion. The three biggest bond markets in 2017 (outstanding) were the U.S. with $39.3 trillion, EU with $28.8 Trillion and Japan with $12.7 trillion. The bond market in China is trying to expand. However, due to the non-transparent government control mechanism, China is the fourth biggest market after Japan with $11.8 trillion. In general, the bond market is much larger than the stock (equity) market in the world. For example, Japan’s bond market was two hundred percent of its annual GDP in 2017. Yet, bond prices can be volatile.[8]
The difference between the debt and equity markets would be seen better if we look at the new issuances in debt and equity markets. While the new (bond) issuances in the debt market were on average $12 Trillion annually; the issuances in the equity market on average was around $1 trillion dollars annually between 2006 and 2016. Basically, the debt market is twelve times more than the equity market globally. However, the equity markets are also an important source of capital and liquidity for companies and investors alike. The private and public equity was around $167 Trillion in 2017. The equity investors seek higher returns and share of earnings and they have higher risk tolerance than the debt providers. As a result, they demand a higher yield for their increased risk. The equity shares of public companies are traded on exchanges around the world; whereas, the private companies are not listed and make up a significant portion of all businesses worldwide. Specialized investors and asset managers, such as Private Equity and Venture Capital companies, focus on private company investments.[9] Therefore, the increase in equity investment would a source to mitigate climate change.
Thirdly, the real estate market has a value of approximately $110 Trillion and by itself, it was the third biggest component of the global capital stock in 2017. The real estate seeks capital appreciation and income stream (rental). It could yield high returns. However, there are barriers to investing include a lack of transparency, low liquidity, and undeveloped capital markets in the world. The real estate market is useful for diversification and as a hedge against inflation, but many see it as a high-risk play, particularly in developing countries.[10]
Lastly, cash and cash equivalents correspond to eight percent of the global capital stock and have a value of approximately $41 Trillion. Cash and cash equivalents refer to the line item on the balance sheet that reports the value of a company's assets that are cash or can be converted into cash immediately. These include bank accounts, marketable securities, commercial paper, Treasury bills and short-term government bonds with a maturity date of three months or less (readily be converted into cash) Bank deposits are divided into two sub-categories i.e. M1 and M2.[11] This capital stock composition tells us why we need blended finance.
To sum up, due to high indebtedness in the public sector and much higher resources in the private sector, the only possible way to combat climate change and achieve the SDGs is to mobilize the private sector investments by reducing their risks through public sector guarantees and encouraging blended finance.
Recommendations
1. A tax on financial transactions (also known as Tobin tax)
The Tobin tax is not something new. The Nobel laureate American economist James Tobin proposed a tax on foreign-exchange transactions to discourage speculative activity[12] in the 1970s after the collapse of the Bretton Wood system. This model is started to be discussed again especially in Europe after the 2008 financial crisis.
My first suggestion is levying a tax (it can be very small depending on the nature of the financial transaction from 0.01% to 0.1%) on any financial transactions but specifically on the asset-backed security transactions in order to avoid a new financial crisis similar to the one in 2008. The Tobin tax would be a mechanism to check how many times asset-backed security (a debt) capitalized without enough guarantees in the background. At this point, if there is a need for further guarantees or insurance, the government agencies would supplement them which would reduce the default risk for private investors. Therefore, the Tobin tax on financial transactions together with government guarantees would reduce the risk and increase transparency.
Similarly, a Tobin tax would be imposed on the financial transactions of companies whose activities result in GHG emissions. Any security (bond or stock) issued in the fossil fuel market (especially the petrochemicals), non-renewable power generation (coal, natural gas, oil, etc.), transportation sector (the ones that are using fossil fuels with internal combustion engine), textile industry, etc. will be subject to the Tobin tax. Then, this funding would be transferred either to specific renewable energy projects or to the Green Climate Fund or they would be used as collateral for renewable energy projects.
However, in order for this system to work, it should be globally applicable. The Tobin tax examples in Europe where it was implemented unilaterally did not work because firms relocated their businesses to a place where there is no such kind of transaction cost. Therefore, in this proposal, any country that is a part of the Paris Agreement has to impose a Tobin tax on financial transactions related to GHG emissions.
2. Carbon Market (Emissions Permit Trading System)
The carbon tax and permits work similarly. Yet, with the permit system, we can know the exact amount of emissions. The emission permit system sets the quantity emitted. The carbon tax sets the price, but the quantity emitted would vary.
Moreover, while some pollutants are global like CO2 (the global concentration of CO2 matter, not its local emission); some of the pollutants need local, geographical (surely trans-border) regulations such as particles or NOx. Because some industries in specific locations would have more severe impacts in terms of local pollution and health damages.
Therefore, our goal should be minimizing both abatement costs and health damages. In order to achieve this, economist Meredith Fowlie suggests that there should be trading ratios for permits that are inversely proportional to the transfer coefficient – transfer of pollution to different areas. [13] In this way, we can treat the emission permits like currency. My recommendation is to establish a global exchange rate mechanism for permit trading. And, this exchange rate should be internalized in the valuation of firms.
For example, let’s consider a coal power plant in Beijing, China which emits both CO2 and NOX. Besides, it has damages to public health because of its proximity to the city center. Let’s say this firm’s permit trading ratio 24:1 which means it needs 24 permits in order to continue to operate with its current level of emissions. Let’s consider a similar coal power plant in mid-West USA but because of the coal type and its distance to the city center, its permit trading ratio is 12:1. Then, in public trading, the Chinese power plant will be twice less valuable than the American one. Whereas, a wind farm will be 24 times more valuable than the Chinese coal power plant and 12 times more valuable than the American coal power plant. This system, therefore, will make renewable energy companies more valuable in public trading and will internalize the negative externality of emissions. I believe that the only way to make all private companies invest in renewable energy is by decreasing their public trading value in accordance with their carbon and other pollutant emissions. This suggestion, of course, assumes the financialization of all markets which I believe would reduce the price of highly valued commodities such as carbon abatement.
3. Blended Finance
The Milken Institute asserts the need for public sector guarantees to unlock the blended finance i.e. mobilize different private sector capital.[14] It is true that with the government guarantees in the least developed countries and in lower-income countries, we can decrease the risk which would attract new capital to locate these remote areas. However, how the governments will find the resources to ensure these guarantees is another question. As I mentioned above, I believe that the tax on financial transactions would be a source for further public guarantees in the renewable energy sector.
The public sector guarantees would be the production tax credits or the investment tax credits which change the risk profile of the projects. As a result, the financial institutions will find investing in these projects attractive due to its decreased risk.
* This paper is written for the Environmental Finance: Scaling Up Clean Energy Course during Fall 2018 Semester in Columbia University, School of International and Public Affairs (SIPA)
[1] IPCC, https://www.ipcc.ch
[2] UNFCC https://bigpicture.unfccc.int/#content-the-paris-agreemen
[3] The Paris Agreement target.
[4] International Energy Agency (IEA); Coalition for Environmentally Responsible Economics (CERES), Bloomberg New Energy Finance (BNEF)
[5] Columbia University, SIPA, U6238 Environmental Finance: Scaling Up Clean Energy Course Notes, Class #3
[6] Class notes 2; Abraham Louw (January 16, 2018) “Clean Energy Investment Trends, 2017: 2017, challenging the highs of 2015” Bloomberg New Energy Finance)
[7] Gadzinski et. al..The Global Capital Stock: A proxy for the Unobservable Global Market Portfolio (2016) UNEP, The Value of Everything (2015)
[8] Class #3 Notes idem: SIFMA and BIS
[9] Class 3 Notes idem; Gadzinski et. al. “The Global Capital Stock: A proxy for the Unobservable Global Market Portfolio” (2016) UNEP, “The Value of Everything” (2015) Market Data as of August 14, 2018 and Private Equity, Private Holding Companies, Venture Capital
[10] Class #3 Notes; idem
[11] Class #3 Notes; idem
[12] The Economist article June 30, 2011 “The EU's Budget: Stuck on Tobin again” Retrieved from https://www.economist.com/free-exchange/2011/06/30/stuck-on-tobin-again
[13] Fowlie, Meredith. 2010. “Emissions Trading, Electricity Restructuring, and Investment in Pollution Abatement.” American Economic Review, 100(3): 837-69.
[14] Chris Lee, Aron Betru, and Paul Horrocks (April 2018) “Guaranteeing the Goals: Adapting Public Sector Guarantees to Unlock Blended Financing for the U.N. Sustainable Development Goals” Milken Institute