Much has been written about the policies required to make clean energy attractive for investors: support mechanisms that are “long, loud and legal”, or that provide “TLC” (transparency, longevity and certainty). However, in many cases, even when supportive policies are in place, results have been mixed, with limited uptake unless risk-adjusted returns are extremely – some would say overly – generous. This White Paper identifies a number of areas in which the regulation of investment itself, rather than policy relating to underlying assets, companies or technologies, may be holding back the flow of investment.
The past decade has seen investment in clean energy grow from less than $50bn per annum to over $250bn per annum. However, for energy-related carbon emissions to peak by 2020 and then decline, this figure will still need to more than double. The water, agriculture and transportation sectors also need to see dramatically increased investment in sustainable versus business-as usual approaches. Yet infrastructure investment only accounts for around 1% of the asset allocation of the average pension fund, and specifically green infrastructure accounts for around 3% of that – a tiny proportion of assets available worldwide for investment.
Regulation of banks, insurance companies and pension funds – even the ownership structures available for different types of assets and the way that public finances are accounted for – can conspire against sustainable investment in three distinct ways. First, by dissuading investors from investing in infrastructure in general, the economy remains dependent on legacy assets which are generally more heavily polluting than current best-of-class conventional technologies. Second, because many clean energy technologies involve heavy up-front investment but low or no running costs, any bias against capital investment is a de facto bias against clean energy. Third, where infrastructure investment does occur, rules governing investment may favour conventional rather than new and sustainable technologies.
The following issues are worthy of attention:
● Upcoming Basel III rules significantly limit the ability of banks to provide long-term, nonrecourse project finance. While this affects the availability of capital for all infrastructure projects, wind and solar projects are particularly vulnerable because they involve high upfront capital costs, offset by lower operating costs. Basel III rules are also driving up the cost of shorter-term construction finance – the provision of which should surely be a core role for the banking sector. Concerns about the ability to secure longer-term follow-on finance are driving banks to be overly restrictive about the number of projects they support.
● Solvency II regulations governing the need for insurance companies to hold capital in supposedly liquid and/or low-risk instruments like public equities and government bonds will reduce their appetite for long-term investments for which there is no public market, even though such investments have well-understood yield characteristics and a well-developed private market.
● Pension funds are important potential investors in clean energy projects, but rules on the matching of assets and liabilities tend to push trustees towards taking a highly conservative approach to asset allocation. In addition, in as the case of the UK at least, rules for calculating
Pension Protection Fund fees can penalise infrastructure investment in general.
● Laws governing the fiduciary duties of pension fund trustees have been interpreted as directing pension funds to adopt a narrow focus on risk-adjusted returns. Because they do not explicitly require trustees to take account of systemic risks such as climate change, or of performance on environmental, social or governance dimensions, investors have tended to avoid such analysis. In particular, no account is generally taken of the risk of write-downs to the value of fossil fuel assets if future action on climate change renders them stranded.
● In many countries, particularly the US and Canada, there are well-developed legal ownership structures to enable private investors and other asset owners to invest in infrastructure while avoiding issues of double taxation. These include real estate investment trusts and master limited partnerships. These structures, however, tend to be limited to certain types of asset – and there is a lag in including new types like renewable energy projects, aggregated distributed generation or energy efficiency portfolios.
● Laws governing the disclosure of risks by publicly quoted companies generally do not require the identification of risks relating to climate, extreme weather, water or environment; yet these can be as material as other types of risks that must be disclosed, such as legal disputes or forthcoming legislation.
● The use of ratings agencies as a means of protecting investors from risks may tend to disadvantage clean infrastructure investment. Rating methodologies focus on near-term quantifiable risks rather than either catastrophic one-of-a-kind events or longer-term systemic risks. The dependence on ratings agencies also acts as a particular barrier to cross-border investment in the developing world, where few countries and even fewer utilities are rated as investment-grade.
● Public sector accounting rules can influence the choice and level of incentive mechanisms available to policy-makers to encourage clean energy deployment. Even when there is a clear intention to support clean energy, the fact that liabilities associated with feed-in tariffs or green certificates may be included in tax or spending totals, even though the cost will in fact be borne by electricity consumers, puts pressure on treasury departments to limit support for clean energy.
● Rules on state aid can also restrict the ability of public sector banks to support new infrastructure technologies. Capital-intensive new technologies such as carbon capture and storage, marine power and second-generation biofuels require support in order to cross the “valley of death” and achieve initial deployment, and national development bank support for this may infringe such rules.
● Finally, on the positive side, the impact of the Dodd-Frank law on the US financial sector has so far proved innocuous – to the relief of those who had feared that tighter regulation could interfere with the markets for Renewable Energy Certificates and carbon offsets. In this White Paper we have defined “investment bias” as a range of factors that might restrict asset allocation to clean technology to a level below what a purely economic analysis of risk and return would dictate. Identifying and eliminating biases could result in significantly increased flows of investment to clean energy and other sectors of sustainable infrastructure. Further work is required to detail potential remedies and quantify the resulting incremental investment flows.