Leveraging carbon markets to enable private investment
Addressing climate goals cannot be achieved through public resources alone, write Sandhya Srinivasan, senior climate change specialist, Stephanie Rogers, senior financial specialist, and Rachel Mok, climate change specialist, World Bank.
Deep decarbonisation requires structural economic changes and a massive shift in investments. Achieving net zero emissions in the energy sector requires substantial investments in clean energy and an accelerated transition away from fossil fuels. The required annual investments in clean energy are estimated at around $4tn by 2030. These investment needs cannot be met through public resources alone, and there is a need to mobilise private resources. Carbon markets can enable resources from a broader set of participants, including the private sector.
Carbon markets are growing rapidly as many countries and corporations intend to use emission reduction credits toward their climate pledges. Some estimates suggest that carbon markets under the Paris agreement could grow to $300bn per year by 2030 and up to $1tn per year by 2050. Effective leverage of carbon revenues can also allow climate mitigation projects to draw investments from diverse sources. There are two concepts that can potentially address challenges to finance clean energy investments and help enable private sector investment.
First, using a carbon-linked bond to make capital available upfront. Carbon revenues are typically provided after emission reductions or removals have been delivered and verified. However, clean energy projects often have large upfront capital requirements. A carbon-linked bond could help bridge this upfront financing gap by securitising the expected future cashflows from an emission reduction purchase agreement. An ERPA is a forward contract that agrees to pay a fixed price for a specified volume of carbon credits. Securitisation would allow cash flows to be made available to the project upfront, and bond investors would be repaid using future cash flows from the ERPA (Figure 1).
Second, using carbon markets to address exchange rate risks. Local capital alone is often insufficient to address developing countries’ climate investment needs. Furthermore, foreign lending is typically associated with lower interest rates compared to domestic interest rates in emerging markets. However, exchange rate risk – the risk that the local currency depreciates relative to the foreign currency in which an investment is denominated – is a critical barrier to accessing foreign capital particularly since revenues from clean energy investments are in local currency.  While currency hedging could potentially address this risk, it is often too expensive or unavailable for some currencies or longer tenors.
Carbon revenues offer a hard currency cash inflow for clean energy projects that could help mitigate some of this risk. A facility could effectively blend carbon revenues for the underlying projects with other concessional finance to cover the increase in debt service obligation that a local borrower of foreign debt could face due to exchange rate depreciation. Concessional finance drawn by such a facility could take the form of guarantees provided by multilateral and national development agencies as well as paid-in capital provided by international capital providers, such as philanthropies and sovereign funds, to manage exchange depreciation beyond what can be covered using carbon revenues (Figure 2).
Figure 1. Simplified illustration of a carbon-linked bond structure
Source: World Bank
Figure 2. Potential structure of the exchange rate coverage facility
Source: Center on Global Energy Policy