2 Climate Finance
2.1 Institutional Dynamics
Baer
Financial markets not only have an important role to play in steering financial capital to support the net-zero transition but also are increasingly vulnerable to climate-related financial risk that may be a source of financial instability. In this context, Frank Elderson, chair of the Network for Greening the Financial System, in a speech of 2018 meaningfully titled ‘Let’s dance’
, highlighted the elevated responsibility of central banks to act on climate change.
Analysing the institutional relations between political authorities (governments) and delegated authorities (central banks and financial regulators), as well as their mandates and degree of freedom for intervention across jurisdictions, the authors of this paper argue that central banks cannot and should not ‘dance alone’, as only coordinated efforts between these institutions will be sufficient to mitigate climate risks – put simply, it takes two to dance.
Supporting the analysis and to better explain the heterogeneity in institutional behaviours in the field of climate-related financial policies, the authors propose a framework to distinguish: i) the motives for policy implementation – either the desire to tackle climate change by directly influencing the allocation of financial capital (promotional) or the desire to ensure the stability of the financial system in the face of climate-related challenges (prudential); ii) the relevant policy instruments to achieve these objectives (informational, incentive and coercive); and iii) the type of implementing authority (political or delegated).
Applying this framework, the authors demonstrate how sustainable financial interventions in certain jurisdictions – most notably, the EU – rely solely on informational policies to achieve both promotional and prudential objectives; this is in contrast to emerging economies. The authors term this restricted usage of climate-related financial policies for promotional purposes in Europe a ‘promotional gap’ and explain this through two main institutional dimensions: the low strength of public control on private financial markets; and the high degree of independence of delegated authorities. This leads to an institutional deadlock in which only measures fitting with both political and delegated authorities’ objectives can be implemented.
Relying on a game-theoretic framework, the authors then argue that the current institutional setting is unstable and discuss three potential evolutions: a drift towards a green financial technocracy; a re-politicisation of delegated authorities; or a move towards fiscal-monetary coordination.
Murau
Monetary architecture and the Green Transition
The political challenge of converting cautious monetary institutions, with their enormous power, into deliberate instruments of ecological transformation, is beginning to receive serious study.
How to finance the Green Transition toward net-zero carbon emissions remains an open question. The literature either operates within a market-failure paradigm that calls for carbon taxes or cap-and-trade to help markets correct themselves, or via war finance analogies that offer a “triad” of state intervention possibilities: taxation, treasury borrowing, and central bank money creation. These frameworks often lack a thorough conceptualization of endogenous credit money creation and disregard the systemic and procedural dimensions of financing the Green Transition. We propose “Monetary Architecture” as a more comprehensive framework that perceives the monetary and financial system as a constantly evolving and historically specific hierarchical web of interlocking balance sheets. Using the United States as a case study, we stress the importance of a systemic financing dimension that uses all available elasticity space in the monetary architecture while considering a division of labor between firefighting balance sheets such as central banks or treasuries and workhorse balance sheets such as off-balance-sheet fiscal agencies or shadow banks. Procedurally, public workhorses should provide an initial balance sheet expansion and crowd in the rest of the monetary architecture, notably shadow banks, for long-term funding. Firefighters should prevent systemic instability and manage a possible final contraction. Murau (2023) Monetary architecture and the Green Transition (pdf)
Tooze
Text has variaous links to transition articles:
2.2 Assistance to Developing Countries
Climate Finance assistance to developing countries is NOT on track. Oxfam Report 2020 (News issue)
2.3 Asset Managers’ Scoreboard
We surveyed 29 major asset managers, mostly based in Europe and among the biggest institutions in terms of assets under management. We analyzed their investment practices regarding climate change, using coal as the most straightforward benchmark on climate. The first edition of this scorecard focuses on coal, as one of the easiest asset classes financial institutions can begin to act on and as the sector that requires the most urgent exit.
Key information on our sample of 29 asset managers:
• They represent a total of €34 trillion in assets under management;
• Overall, ‘passively’ managed assets represent approximately 48% of this amount;
• Each participant represents at least €300 billion in assets under management and 24 participants are headquartered in Europe.
Main findings:
• Less than half of the asset managers assessed have a public policy to phase out coal. Vanguard, PIMCO and Schroders are among the big asset managers that have still not adopted such a policy.
• Moreover, because these policies often allow for many exceptions, overall, only 25% of all the assets managed within our sample were covered by a coal exclusion criterion. For example, while they have adopted a coal policy, BlackRock, Legal & General Investment Management and UBS AM’s coal policies apply to less than 40 % of their assets.
• Even when a coal policy does apply, the criteria used to exclude companies are rarely robust. Only 20% of the asset managers exclude companies that still have coal expansion plans. As a result, of €23 trillion of assets covered by long term climate commitments, only €3.4 trillion exclude companies with coal expansion plans.
• Even worse, whilst being signatories of the Net Zero Asset Managers Initiative, six asset managers have still not adopted any public policy to restrict investments in coal, including Vanguard, DWS and Allianz GI.
• ‘Passively’ managed investments are increasingly a recipe for climate chaos: although they represent more than 45% of the assets handled by the 29 asset managers, they are hardly covered by coal-related criteria. Hence, passive asset managers’ exposure to coal remains very high. Among the biggest ‘passive’ managers in our sample, less than 3% of their passively managed investments is currently covered by a coal exclusion criterion.
• Half of the asset managers are publicly requesting or recommending companies they invest in align with Paris Agreement objectives. However, none systematically define time-bound requests or apply sanctions in case of absence of short-term progress. As a result, combined with weak exclusion policies, most asset managers are not acting to protect their clients from stranded assets.
2.4 Accounting Standards
2.4.1 Double Materiality
The concept of double materiality brings environmental impacts into the focus of standard-setting in accounting. Different reasons for adopting this concept might lead to widely varying interpretations, yet the fitness of the financial system to facilitate a net-zero economy depends on how it is conceived.
Lack of data – lack of decisions
No matter where on the spectrum any one institution sits, they all voice one similar complaint: there is a lack of granular, high-quality, useful data. Without that data, financial actors often feel unable to make climate-related decisions, even if they wanted to. This has prompted both debates and actions by financial supervisors and regulators in terms of adapting disclosure requirements to plug the data gap. The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) is the most global and prominent example. More recently, the International Financial Reporting Standards Foundation (IFRS), which sets accounting standards for approximately 120 nations, announced it was throwing its weight behind the task of bringing sustainability into financial disclosure. In this context of sustainability-related financial disclosure, a new concept has emerged: double materiality. What is double materiality?
Double materiality is an extension of the key accounting concept of materiality of financial information. Information on a company is material and should therefore be disclosed if “a reasonable person would consider it [the information] important”, according to the US Securities and Exchange Commission
. Thanks to the work by the TCFD, it is now widely accepted within financial markets that climate-related impacts on a company can be material and therefore require disclosure.
The concept of double materiality takes this notion one step further: it is not just climate-related impacts on the company that can be material but also impacts of a company on the climate – or any other dimension of sustainability, for that matter (often subsumed under the environmental, social and governance, or ESG, label).
This notion of materiality is already embedded in the EU’s new sustainable finance disclosure regime for financial firms and corporates. Additionally, Mark Carney, former Chair of the FSB, is now, as UN Special Envoy for Climate Action and Finance, pushing for worldwide mandatory climate disclosure ahead of the COP26 climate summit, elevating the concept of double materiality to a matter of global concern.
Accounting standards are not neutral, but they systematically affect capital allocation and market dynamics. Decades of global standard harmonisation have veiled the fact that accounting practices are simply social conventions and not exact or objective measures. In 1993, for instance, the German car manufacturer Daimler disclosed 615 million Deutsche Mark in net profits under German accounting rules but a loss of 1.84 billion Deutsche Mark under US rules. Accounting rules can therefore substantially alter the perception of a company in the eyes of financial markets and incentivise certain management practices (e.g. distributing profits to shareholders) over others (e.g. reinvesting profits). They might even exacerbate financial crises; fair value accounting, for instance, has been criticised for having pro-cyclical effects during the 2008 financial crisis. Thus, far from being neutral, accounting standards shape capital allocation dynamics. Their implications for facilitating or preventing climate-aligned investment therefore deserve close attention.
2.5 Tax-credit transfer
St. John
From tax equity to transferability: A sea change in how clean energy is financed
Why can’t today’s tax-equity markets handle the coming wave of clean energy tax credits initiated by the Inflation Reduction Act? Simply put, the traditional way of doing things is just too complicated and expensive to meet the scale and scope of investments coming, Moon said.
Moon and his co-founder at Reunion Infrastructure, Billy Lee, both come from the tax-equity investment world, starting together at solar development pioneer SunEdison and then working separately at large banks and private equity firms. “We’ve pitched tax equity [deals] to corporates for 15 years — and they very rarely do it,” Moon said. “It’s very complex.”
At the core of that complexity is the long-standing rule that allowed only the project owner to claim tax credits associated with the project. The government structured the rules that way to ensure that the benefits of the tax credits would go to an entity with a vested interest in ensuring the project was actually built and operated properly.
But it also complicated the process of using tax credits to build clean energy projects. Project developers and deep-pocketed tax-equity investors used complex transaction structures, such as partnership flips and sale-leasebacks, to make the investor the owner of the project for as long as it would take for them to be eligible to claim the tax credit. After that, they would “flip” ownership back to the developer for the remainder of the project’s lifespan.
These labyrinthine partnerships can take millions of dollars in legal and administrative costs to put together, and because of their inherent complexity, there is little opportunity to streamline or standardize based on past efforts and make future deals simpler or cheaper, Moon said. They also force investors into the position of owning a clean energy project for years at a time, exposing them to risks that very few companies are willing to take on.
That’s why the pool of tax-equity investors is as small as it is, LevelTen’s Worrall said. “Over 50 percent of it is JPMorgan and Bank of America,” with about 40 other institutions rounding out the market, he said. And because these deals are so complex and risky, these investors have little appetite or capacity to expand how much new business they can take on — “they’re investing regularly, and they’re full.”
These conditions have led to a “huge supply-demand imbalance for tax equity,” Moon said. “Projects that could previously get tax equity are in the last six months struggling — there just isn’t enough. And if you don’t get tax equity, you can’t build a project.”
Another problem with the status quo is that tax-equity investors tend to only target deals of $100 million and up. That has forced developers of smaller-scale projects like community solar to sell to project aggregators that bundle numerous smaller projects together into high-dollar portfolios valuable enough to attract the interest of banks.
The IRA’s new transferability option upends this landscape entirely, Moon said. “Now there’s an option for those developers to build the projects and sell the credits themselves.”
Would-be buyers of tax credits also have a much simpler road ahead under the new transferability option, Worrall said. “There’s no longer a partnership investment with a ton of due diligence upfront and a ton of maintenance over the lifetime of the investment. You’re talking about a simple transfer: corporate tax credits for cash.” These deals also have much simpler accounting requirements, he added.
While tax-credit transferability opens the door to smaller developers and inexperienced corporate investors, it could also be an option for those already active in the existing tax-equity markets, Moon added. “Large and very experienced developers are talking about how this will be part of the portfolio. All the banks and tax-equity investors are looking at how to integrate transferability,” with financiers including Bank of America reporting deals in progress.
We need to move from a world where there are 40 or 50 credible” financial institutions investing in the market and processing about $20 billion in traditional tax-equity deals per year, to one capable of processing about “$85 billion in credits per year by 2031.
One way to make the new tax-credit transfer deals more appealing to skittish corporate buyers is by reducing their risk exposure as much as possible. “The key to that is the buyer protections” that dealmakers must structure to protect companies from the risks they take on when they purchase large amounts of tax credits.
Right now, the biggest risk lies in what’s called “recapture,” Ullman said, referring to the Internal Revenue Service’s right to reclaim the tax credits from failed, sold or otherwise ineligible clean energy projects. Many clean-energy tax credits, including those for solar power projects, are pegged to the value of investment into a project in the year it begins operating.
If that project ends up going bankrupt and shutting down, or is destroyed by extreme weather, or is sold to another party, or otherwise fails to meet the rules that allowed it to claim the tax credit in the first place? If that worst-case scenario occurs, the IRS can claw back the value of those tax credits.
The good news is that there are already established ways to mitigate this risk. “Recapture insurance and qualification insurance is a mature market — all the big carriers and brokers carry that insurance, Insurers are all quite excited by the market opportunity.
St. John (2023) New tax-credit transfer rules could unlock $1T in cleantech investment