TODAY’S STUDY: THE AFFORDABILITY OF THE NEW ENERGY TRANSITION

Moving to a Low Carbon Economy: The Financial Impact of the Low-Carbon Transition

October 2014 (Climate Policy Initiative)

Executive Summary

A major concern regarding a transition to a low-carbon economy is the impact that it could have on the global financial system. Would the scale of investment required consume financial resources and crowd out investments elsewhere in the economy? Would the impact that the transition would have on the value of existing investments — that is, the assets it would strand — reduce the capacity of investors and governments to invest?

This paper assesses the impact of a potential transition, looking not just at the investment required and the impact of a transition on the value of existing assets, but also looking more broadly at other factors that could affect the financial capacity of the global financial system, including operating expenses, risk, and the lifespan of investments. A savings in operating costs, for instance, could provide investors additional cash that could then be invested back into the economy. Lower risk frees up reserves and enables investment in further growth. And longer asset life means that investments need not be replaced as often, freeing cash for investment that would otherwise be needed for asset replacement.

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When all of these factors are taken together, we find that transitioning to a low-carbon electricity system could actually increase the capacity of the global financial system by as much as $1.8 trillion between 2015 and 2035. Transitioning from oil to low-carbon transport could also result in a positive impact on the financial system over the same period, with an estimated impact ranging from a negative impact of $2.5 trillion to a net benefit of $3.5 trillion, depending on policy choices. Increasing the capacity of the system to invest creates opportunities for growth and lower costs that could reverberate across the economy.

These overall benefit estimates capture the following dynamics in a move from business-as-usual to a 2-degree pathway.

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Electricity (Figure 1)

• Low-carbon energy infrastructure is less expensive to operate, primarily because of avoided operating costs associated with extracting and transporting coal and gas. We estimate that operating savings would be significant, totaling $4.6 trillion.

• The global electricity industry (including fuel extraction, generation, and transmission and distribution) would see more capital investment under a low-carbon pathway, because low-carbon energy tends to be more capital-intensive than fossil fuel energy. Low-carbon investments tend to have slightly longer lives, somewhat offsetting the higher investment levels. Taken together we estimate that total depreciation and amortization (D&A) (the amount of the investment capital actually used up over a given time frame) would increase by $1.1 trillion between 2015 and 2035 — the net impact of a $2.8 trillion increase in low-carbon capital (D&A) and a $1.7 trillion decrease in fossil fuel D&A.

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• Financing costs, which reflect both the level of investment and the riskiness of those investments, would increase by $0.6 trillion. Many low-carbon electricity investments carry lower inherent risk than some of the fossil fuel investments they replace and would particularly see lower costs of capital if the institutional and financial systems are fine-tuned to low-carbon investments rather than fossil fuel investments. However, total financing costs would still increase because of the larger quantity of capital investment under the 2-degree pathway. Globally, existing fossil fuel assets that would otherwise be employed in electricity generation (including coal, oil, gas and power plants) would lose an estimated $1.1 trillion in value during the low-carbon transition.

• The net impact of transition is an increase in available investment capacity of $1.8 trillion.

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Transport (Figure 2)

• Operating expenses would decrease by $2.8 trillion.

• Total depreciation and amortization of capital would increase by $3 trillion between 2015 and 2035 — the net impact of a $6 trillion increase in investment in low-carbon vehicles and mass transit and a $3 trillion decrease in investment in fossil fuel transport (including the extraction, refining, and movement of oil for transport, as well as investment in fossil fuel powertrain vehicles).

• Financing costs would increase by $0.5 trillion. The impact of the low-carbon transition on the value of existing assets would depend on the policy pathways chosen. We estimate that the impact could range from a $1.8 trillion net loss in asset value to a $4.2 trillion net benefit.

• The net impact of the transition ranges from a $2.5 trillion reduction to a $3.5 trillion increase in capacity, depending on policy impact on asset values.

Decisions by policymakers, regulators, and institutional and other investors have a major influence on the financial impact of the low-carbon transition. Our analysis suggests the following priorities to maximize the financial benefit of the low-carbon transition:

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Power

• In developed countries, create and expand financing vehicles that can efficiently channel low-cost institutional investment into low-carbon energy infrastructure.

• In both developed and developing countries, consider restructuring the electricity industry, market design, and regulation to clarify the infrastructure characteristics of the low-carbon assets and appropriately allocate risks between investors, consumers and governments.

• More broadly, policy measures such as pricing carbon, eliminating fossil fuel subsidies, and supporting the development of new low-carbon technologies also change the risk/reward equation in a positive direction for low-carbon infrastructure.

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Transport

• To reduce the use of oil in transport, focus on policies that reduce demand for oil, rather than policies that restrict supply. A combination of taxes and innovation appears to be the most promising policy approach…

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Conclusions and policy implications

Policymakers at all levels should consider the full financial picture when evaluating the potential gains or losses from transitioning to a low-carbon system. We find that in the transition from fossil fuels to renewable electricity, the savings from avoided fossil fuel investment and operating costs would more than offset the increased capital investment and stranded assets, leading to a net financial benefit of up to $1.8 trillion from 2015-2035. For the transition from oil to low-carbon transport, the net impact will depend on policy choices that affect asset stranding. Policy choices that reduce demand for oil with a combination of taxes and innovation could lead to a financial benefit of over $3 trillion for the low-carbon transition in transport. Both of these figures would grow significantly if health and environmental benefits of reducing emissions were taken into account.

Decisions by policymakers, regulators, and institutional and other investors (discussed in Box 3) have a major influence on the financial impact of the low-carbon transition. In both cases, given the scale of investment needed, reducing the cost of capital is critical.

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