Many net-zero targets announced may not bear fruit owing to funding shortages
The latest IPCC report paints a rather grim picture. The planet is headed for a catastrophe if we continue the way that we’ve been operating. And this conclusion is based on hard scientific evidence. The truth is that many net-zero targets announced may not bear fruit. As in all projects, time overruns and funding shortages will occur. It is crystal clear that the 1.5 degree Celsius global warming target will be missed. Hence it is imperative that we quickly move towards net-zero targets.
The shift to net-zero requires both a transition in global energy and a significant reduction in greenhouse gases emitted by industries. Both require huge levels of investment. Ideally, governments should come in and pick up the bulk of the financing. However, governments across the world are hampered by budgetary shortfalls and sometimes the lack of political will. This leaves financing in private hands. However, most investments required to shift to net zero are large, complex, and risky. This raises an interesting question of where the money will come from to achieve net-zero goals?
[box type=”info” align=”” class=”” width=””]Venture Capital and Private Equity are generally associated with risky projects. However, they are not in a position to invest hundreds of million dollars in a single project. Large-scale project finance funders may be fine with the tag but wary of the risks involved. These high-risk/high-value projects are known as the valley of death projects – these are extremely hard to fund. There are two possible ways to bring funds into these projects: The first is to reduce the risk of the project. The second is to reduce the amount of financing entailed. [/box]
How can one reduce the risk in these projects? Sponsors can manage the construction and operations risks by being smart while contracting. The major risk is the technology and demand risk. Here governments can come in with guarantees and tax breaks. Insurance companies may also need to gear up to provide adequate cover for these projects. Regulatory risk can also be reduced by the government having clear policy objectives. With risk reduction, funders may develop an appetite for these projects. While the government may not finance the project, it has a critical role to play in risk mitigation.
The second problem is the scale of financing required is much more easily tackled. There are two ways of tackling the problem: First, the project can be broken into smaller parcels (unbundling) and financed independently. Second, if breaking up the project is not possible or easy, then consortiums can be formed where individual players pool in their money for a share in the project. Some of these can be complex both in risk-sharing arrangements and in dispute resolution. Funders pulling out of projects due to deterioration in financial conditions is also not uncommon.
[box type=”note” align=”” class=”” width=””]While these high-value, high-risk projects are problematic, structures for other projects are easily replicable. Project finance works best where risk is low and capital requirement is high. Bank finance comes in where both risk and capital requirement is low. Finally, venture capital works best with high-risk and low-capital requirement projects[/box].
There are other ways to manage finance for the shift to net zero. For example, by bringing in the public sector where public intervention needs are clear. Co-funding by government can also help reduce funding needs. Using carbon prices to project evaluation can sharpen project benefits and spur investments. In such a scenario, subsidies help, provided governments have the money.
There may also be a need to create specialised financial institutions that deal with financing net-zero projects. They can in turn tie up with capital providers at different stages of the project depending on their risk appetite. These financial institution can play a significant role in coordinating various aspects of net-zero financing that most other institutions will find daunting. They can also help prioritise projects that can accelerate the shift to net zero.
The need to shift to net zero is critical. And we cannot wait. What can be done in ten years must be done in five. The development of covid vaccines at an expedited pace is an excellent example of achieving goals before time with finesse. Where there is a will, there is a way, and of course, money!
This article is authored by Professor Utkarsh Majmudar, Member of the Board of Governors, IIM Raipur