Editing IPCC:AR6/WGIII/Chapter-15 (section)

=== 15.4.1 Definitions of Financing Needs ===

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Financing needs [[#footnote-010|7]] are discussed in various contexts, only one being international climate politics and finance. Also, financing needs are used as an indicator for required system changes (when compared to current flows and asset bases) and an indicator for near- to long-term investment opportunities from the perspective of investors and corporates. Investment needs are widely used as an indicator focusing on initial investments required to realise new infrastructure. It compares relatively well with private sector flows dominated by return-generating investments but lacks comparability and explanatory power regarding the needs in the context of international climate cooperation, where considerations on economic costs play a more substantial role. [[IPCC:Wg3:Chapter:Chapter-12|Chapter 12]] elaborates on global economic cost estimates for various technologies. This indicator includes both costs and benefits of options, of which investment-related costs make up only one component. Both analyses offer complementary insights. There are financing needs not directly related to the realisation of physical infrastructure and which are not covered in both investment and cost estimates. For instance, the needs for building institutional capacity to achieve social and economic goals and to strengthen knowledge, skills, national and international cooperation might not be significant, but an enabling environment for future investments would not be established without satisfying it. Moreover, comprehending financial needs for addressing economic losses due to climate change can hardly be measured in terms of the indicators introduced before.

Understanding the magnitude of the challenge to scale up finance in sectors and regions requires a more comprehensive (and qualitative) assessment of the needs. For finance to become an enabler of the transition, domestic and international public interventions can be needed to ensure enough supply of finance across sectors, regions and stakeholders. The location of financing needs and vicinity to capital matter given home bias ( [[#Fuchs--2017|Fuchs et al. 2017]] ; [[#OECD--2017a|OECD 2017a]] ; [[#Ito--2019|Ito and McCauley 2019]] ) (prioritising own country or regions), transaction costs and risk considerations ( [[#15.2|Section 15.2]] ). Most of the finance is mobilised domestically but the depth of capital markets is substantially greater in developed countries, increasing the challenges to mobilise substantial volumes of additional financing for many developing countries. The same applies to various stakeholders with limited connections into the financial sector. In addition, governments enabling financial market frameworks, guidelines and supportive infrastructure is crucial for inclusive finance for the bottom of the pyramid, especially disadvantaged and economically marginalised segments of society.

The attractiveness of a sector and region for capital markets depends on several factors. Some essential elements are the duration of loan and profile as long-term loans and heavily heterogeneous returns represent challenges in financing mitigation technologies and policies. After the financial crisis and restricted access to long-term debt, capital intensity of technologies and resulting long payback periods of investment opportunities for mitigation technologies have been a crucial challenge ( [[#Bertoldi--2021|Bertoldi et al. 2021]] ). Also, implicit discount rates applied during the investment decision process vary depending on the payback profile, with research mainly covering the difference between the financing of assets generating revenues versus costs ( [[#Jaffe--2004|Jaffe et al. 2004]] ; [[#Schleich--2016|Schleich et al. 2016]] ). In addition, a low correlation between the climate projects and dominating asset classes might provide an opportunity in climate action by satisfying the appetite of institutional investors, which tend to manage portfolios with consideration of the Markowitz modern portfolio theory (optimising return and risk of a portfolio through diversification) ( [[#Marinoni--2011|Marinoni et al. 2011]] ). Transaction cost is a significant barrier to the diffusion and commercialisation of low-carbon technologies and business models and adaptation action. High transaction costs, attributed to various factors, such as complexity and limited standardisation of investments, limited pipelines, complex institutional and administrative procedures, create significant opportunity costs of green investments comparing with other standard investments ( [[#IRENA--2016|IRENA 2016]] ; [[#Nelson--2016|Nelson et al. 2016]] ; [[#Feldman--2018|Feldman et al. 2018]] ). For example, transaction costs are commonly observed in small-scale, dispersed independent renewable energy systems, especially in rural areas, and energy efficiency projects ( [[#Hunecke--2019|Hunecke et al. 2019]] ). A more robust standardisation and alignment of Power Purchase Agreement (PPA) terms with best practices globally has led to a substantially increased interest in capital markets in developing countries ( [[#WBCSD--2016|WBCSD 2016]] ; [[#Schmidt--2019|Schmidt et al. 2019]] ; [[#World%20Bank--2021|]] [[#World%20Bank--2021|World Bank 2021]] ). Notably, PPA significantly increases the probability of more balanced investment and development outcomes and ultimately more sustainable independent power projects in developing countries. Therefore, lowering transaction costs would be essential for creating investor appetite. The role of intermediaries bundling demand for financing has been demonstrated to reduce transaction costs and to reach investors’ critical size. In addition, new innovative approaches, such as fintech and blockchain ( [[#15.6.8|Section 15.6.8]] ), have been discussed for providing new opportunities in the energy sector.

Economic viability of investments – ideally not relying on the pricing of positive externalities – has been a critical driver of momentum in the past. The falling technology costs and the competitiveness of renewable technologies, especially solar PV and wind, have accelerated the deployment of renewable technologies over the past years. Renewable energy technologies are now often competitive, and have even become the cheapest, in many countries, even without financial support ( [[#FS-UNEP%20Centre%20and%20BNEF--2015|FS-UNEP Centre and BNEF 2015]] , 2016, 2017, 2018, 2019; [[#IEA--2020c|IEA 2020c]] ; [[#IRENA--2020a|IRENA 2020a]] ) and without pricing of the avoided carbon emissions. In contrast, the dependency on regulatory interventions and public financial support to create financial viability has provided a source of volatile investor appetite. The annual volume of renewable investment by country is often volatile, reflecting ending and new regulations and policies ( [[#IEA--2019a|IEA 2019a]] ).

For example, the recent Chinese policy direction towards tougher access to and a substantial cut in feed-in-tariffs in 2018 led to a significant drop in renewable investment and new capacity addition in China (FS-UNEP Centre and [[#BNEF--2019|BNEF 2019]] ; [[#Hove--2020|Hove 2020]] ). However, the significant bouncing back of newly installed capacity (72 GW wind power and 47 GW solar power in 2020) shows the strong development of zero-carbon power generation driven by lower cost and policies to support them by energy revolution strategies in China. Investors had proven to be willing to work with transparent support mechanisms, such as with the Clean Development Mechanism (CDM), which stimulated emission reductions and allowed industrialised countries to implement emission-reduction projects in developing countries to meet their emission targets ( [[#Michaelowa--2019|Michaelowa et al. 2019]] ). However, the collapse of carbon markets and prices, especially of the EU Emissions Trading System, led to the continuous decline of Certified Emission Reductions issuances from CDM in the past years ( [[#World%20Bank%20Group--2020|World Bank Group 2020]] ). Also, the dependency on regulatory intervention to ensure fair market access only has proven to burden investor appetite.

A significant share of investment needs in heavily regulated sectors, such as electricity, public transport, and telecom, emphasises the importance of regulatory intervention, such as ownership and market access ( [[#OECD--2017b|OECD 2017b]] ). For instance, energy-system developments require effective and credible commitments and action by policymakers to ensure an efficient capital allocation aligned with climate targets ( [[#Bertram--2021|Bertram et al. 2021]] ).

There is a lot of discussion about the regulated ownership of the private sector (European Commission 2017) and the restructuring of electricity market contributed to low level of investment in baseline electricity capacity and in investment research and innovation. These changes create uncertainty of investment, and barriers to market entry and exit also potentially limit the competition in the market and restrict the entrance of new investment ( [[#Finon--2006|Finon 2006]] ; [[#Joskow--2007|Joskow 2007]] ; [[#Grubb--2018|Grubb and Newbery 2018]] ). This is also the case in developing countries ( [[#Foster--2020|Foster and Rana 2020]] ).

The positive development in the energy sector has benefitted from the evident stand-alone character of renewable energy generation projects. First movers realised these projects with investors and developers acting from conviction ( [[#Steffen--2018|Steffen et al. 2018]] ). Such action is not possible to this extent in energy efficiency with related investment rather representing an add-on component and consequently requiring the support of decision-makers used to business-as-usual projects. Despite the benefits that improvement of energy efficiency has in contributing to curbing energy consumption, mitigating greenhouse gas emissions, and providing multiple co-benefits ( [[#IEA--2014a|IEA 2014a]] ), investment in energy efficiency is a low priority for firms, and the financial environment is not favourable due to lack of awareness of energy efficiency by financial institutions, existing administrative barriers, lack of expertise to develop projects, asymmetric information, and split incentives ( [[#UNEP%20DTU--2017|UNEP DTU 2017]] ; [[#Cattaneo--2019|Cattaneo 2019]] ). While Energy Service Companies’ (ESCO) business models are expected to facilitate the investment in energy efficiency by sharing a portion of financial risk and providing expertise, there has been limited progress made with ESCO business models, and only slightly over 20% of projects used financing through ESCOs ( [[#UNEP%20DTU--2017|UNEP DTU 2017]] ).

The investment needs and existing challenges differ by sector. Each sector has different characteristics along the arguments listed above making the supply of finance by commercial investors an enabling factor or barrier. In the transport sector, transformation towards green mobility would provide significant co-benefits for human health by reducing transport-related air pollution, so the transport sector cannot achieve such transformation in isolation from other sectors. However, a considerable involvement of the public sector in many transportation infrastructure projects is given, and the absence of a standard solution increases transaction costs (including bidding package, estimating, drawing up a contract, administering the contract, corruption, and so on). Financial constraints, including access to adequate finance, pose a significant challenge in the agriculture sector, especially for SMEs and smallholder farmers. The distortion created by government failure and a lack of effective policies create barriers to financing for agriculture. The inability to manage the impact of the agriculture-related risks, such as seasonality, increases uncertainty in financial management. Moreover, inadequate infrastructure, such as electricity and telecommunication, makes it difficult for financial institutions to reach agricultural SMEs and farmers and increases transaction costs ( [[#World%20Bank--2016|World Bank 2016]] ). Low economies of scale, low bargaining power, poor connectivity to markets, and information asymmetry also lead to higher transaction costs ( [[#Pingali--2019|Pingali et al. 2019]] ). In the industrial manufacturing and residential sector, gaining energy efficiency remains one of the critical challenges. Investment in achieving energy efficiency encounters some challenges when it may not necessarily generate direct or indirect benefits, such as increase in production capacity or productivity and improvement in product quality. Also, early-stage, high upfront cost and future, stable revenue stream structure suggest the needs for a better enabling environment, such as a robust financial market, awareness of financial institutions, and regulatory frameworks (e.g., stringent building codes, incentives for ESCOs) ( [[#IEA--2014a|IEA 2014a]] ; [[#Barnsley--2015|Barnsley et al. 2015]] ).

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