World Economic Forum Insurance and Asset Management Council. Joachim Faber. Low Carbon Economy Finance Paper Q4 2011

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1 World Economic Forum Insurance and Asset Management Council Joachim Faber Low Carbon Economy Finance Paper Q Frankfurt / Munich, Oct 2011

2 Introduction The Low Carbon Economy and Finance by the Insurance and Pensions Industry The insurance and pension industry has a vested interest in bringing global warming to a halt. Insurers already know that a not insignificant portion of all industrial insurance claims around the world are caused by natural catastrophes. In particular, property and casualty insurance for both personal and commercial lines will be hurt by increasing weather-related catastrophes, including storms, tides, floods, wind and drought. As the world strives to agree on a response to Climate Change or to answer basic questions like how much CO 2 the atmosphere can absorb before our climate collapses, or what the right price per ton of emissions should be, we must also address the fundamental question of who will finance the migration to a low carbon industrial economy in the developed countries, as well as in the developing world? USD 54.9 trillion is invested globally by insurance companies and pension funds, with a large portion of this invested in fixed income instruments. They are long-term investors because they need to match longterm liabilities with long duration assets and an acceptable risk profile an increasingly challenging task in the current environment of low interest rates and volatile equity markets. With the right framework in place, infrastructure financing of projects for low carbon economy and clean technology can be attractive for long term investors. In the meantime, the insurance industry can also play a less visible, but crucial role for low carbon energy infrastructure projects by providing the necessary insurance cover. Many promising projects are at risk due to the lack of appropriate insurance cover for new technologies (e.g. CCS 1 ), or known technologies in new locations (e.g. offshore wind farms). It is with this in mind that this paper attempts to establish a collection of prerequisites for investments by the insurance and pension industry into the low carbon economy. These investments could come in several forms, including private equity in the equity tranche of a project; debt financing through loans or infrastructure bonds (e.g. so-called Climate Bonds); or investments in or alongside government initiatives, such as the Green Climate Fund as proposed by the UNEP FI submission in August Carbon Capture and Sequestration 2 World Economic Forum Council Insurance and Asset Management 2

3 The Critical Need for Financing the Low Carbon Economy of the Future In order to limit the rise of global temperatures to less than 2 C, a shift to a low carbon economy is necessary. Financing is critical for a number of reasons as follows: - Green Climate Fund (GCF): At the 15 th UN Climate Change Conference in 2009, industrialized countries committed to raise $100 billion per year by 2020 to assist developing countries in addressing climate change. This figure was agreed in the Copenhagen Accord, as drafted by the United States and BASIC countries. - It is commonly acknowledged that this amount cannot be reached without private investment. Accordingly, GCF implementation should be designed to attract private investments that complement public funding. For example, clean tech energy finance represents a promising area of investment opportunity for the industry. - Representing over USD 54 trillion globally, the insurance and pension industry can and indeed should play a major role in providing the private sector funding for such initiatives. - With the world s bond market interest rates falling and equity markets showing extreme volatility that require onerous risk capital allocations, the industry is looking for alternative long-term investments that can deliver a stable return. - The insurance and pension industry should take an active role in shaping the rules of the game that determine the ability to invest in a low carbon future. As fiduciaries invest the funds of their pension holders, insureds and shareholders, the insurance and pension industry should promote policies and rules that will make long-term investments in clean tech and other climate friendly assets commercially sensible and attractive. Global Shift to a Low Carbon Energy System New sources of renewable energy alone are not enough to achieve the shift to a low carbon energy system. It will also be necessary to make wholesale changes in the way that energy is distributed, stored and consumed. Crucially, national and international policy must be clarified and stabilized so that longterm investments will flow into four key areas as follows: 1. Energy Efficiency In a recent report, the McKinsey Global Institute has estimated that USD 170 billion of energy efficient investment opportunities remains untapped, with the potential to produce an IRR of 17% or more. Moreover, if developing countries are able to increase their energy productivity, the growth of their energy demand could be slowed by more than half over the next 12 years, falling from 3.4% to 1.4% annually - ultimately leaving demand some 25% lower in 2020 than it would otherwise be. (McKinsey Global Institute 2008) 2. Smart Grid The grid of the future will have to cope with decentralized, fluctuating supply. It will also be expected to deliver a far more sophisticated range of services to help with demand-side energy management. Only a new and fully digitally-enabled grid architecture will be able to meet these needs, requiring an investment that is estimated by New Energy Finance at 8.6 trillion (including USD 6.8 trillion to repair and replace the existing transmission and distribution network). 3. Energy Storage The need for energy storage is increasing whether to power (hybrid) electric vehicles, to smooth out fluctuations in supply and demand, or to extend appliance functionality. The cost of storing 1 MWh of electricity ranges from USD 50 to 180, depending on the technology used. As power storage prices come World Economic Forum Council Insurance and Asset Management 3

4 down, it can increasingly be used to smooth the supply of power or to bridge the gap between peak and off-peak electricity rates. Improved power storage is also required by ever more advanced mobile appliances and ubiquitous communications. 4. Carbon Capture and Storage (CCS) Although no CCS installations at scale yet, there are already almost 200 projects at varying degrees of completion around the globe. With so many countries including China and the US overwhelmingly dependent on coal for their electricity, and increasing questions about the future of nuclear energy in some countries, CCS needs to form part of the solution if we are to successfully restrict CO 2 concentrations to 450 ppm (parts per million). Emerging Markets the Epicenter of Energy Transformation While emerging markets are the largest source of growth in carbon emissions, they have now also become the epicenter of investments in the manufacturing and deployment of renewable energy. In 2010, global investment in renewable energy jumped by 32% to a record high of USD 211 billion. In particular, this boost stems from wind farm development in China and small-scale solar PV rooftop installations in Europe. - Developing countries have overtaken developed economies for the first time. Financial new investment in the former totaled USD 72 billion, against USD 70 billion in the latter. - China was the world s leading country in terms of financial new investment in renewable energy in 2010 up 28% to USD 48.9 billion. - India gained 25% to USD 3.8 billion. India has continued to roll out new policies intended to spur more domestic clean energy generation and manufacturing capacity. Unveiled in 2009, the country s solar mission plan seeks to add 20 GW of new capacity locally by 2020, with much of the equipment to be sourced locally. - Thailand s renewable investment rose more than fourfold (320%) to USD 700 million. Thailand s Strategic Plan for Renewable Energy Development calls for 20% of total final energy consumption to be supplied by 2020 from renewable sources, which are supported by feed-in-tariffs. - Asian developing countries excluding China and India saw increases averaging 31% to USD 4 billion in total. - Middle East & Africa jumped by 104% to USD 5 billion. - Brazil s financial investments in renewables slipped 5% to USD 6.9 billion. - Mexico took the lead in Latin America (excluding Brazil), where investments, mainly in wind but also in geothermal, grew close to 350%, triggered largely by a government decision to raise renewable energy capacity from 3.3% to over 7.5% by FINANCIAL NEW INVESTMENTS IN RENEWABLE ENERGY: DEVELOPED VS. DEVELOPING COUNTRIES, World Economic Forum Council Insurance and Asset Management 4

5 Source: Bloomberg New Energy Finance 2011 Prerequisites to Unlocking Investments in Energy Transformation and Low Carbon Economic Growth Two key frameworks must be established for the insurance and pension industry to invest at scale. Firstly, an overall macro framework and secondly, a bond framework specifically aimed at unlocking fixed income infrastructure investments: I. Macro Framework 1. A strong and sustained price tag for CO 2 -emissions and an efficient global carbon pricing mechanism are necessary for sending the right economic signals. Existing emission trading schemes today already contribute massively to creating an enabling environment for financing of a low carbon economy and should therefore be expanded. As such, a binding international treaty that includes all major emitters and that sets short-, mid-, and long-term greenhouse gas emission reduction targets is essential. 2. A stable, attractive and competitive risk-return profile of climate investments is a prerequisite to mobilizing private sector capital. This means that the risks of any investment must be assessable and calculable - something that is only possible within a stable regulatory, political and financial framework Increased awareness of the power changes that capital requirements for insurance companies and pension funds (e.g. Solvency II) will likely bring about for investment decisions is required. Smart regulation will be crucial in order to prevent disadvantaging of low carbon investments compared to other (traditional) asset classes, which could jeopardize political goals. 4. The UN Green Climate Fund (GCF) 4 is the lighthouse project of current climate discussions. Therefore integration of private capital into this project will play an important role for low carbon 3 See also: 4 See also: World Economic Forum Council Insurance and Asset Management 5

6 finance. The proposed private sector facility is essential since it will enable the GCF to directly and indirectly finance private sector mitigation and adaptation activities at national, regional and international levels. Operation of the facility will be consistent with a country-driven approach and will promote the participation of private sector actors in developing countries. 5. One potential instrument to leverage such private sector investments in the context of the GCF would be to insure a dedicated amount of concrete investment vehicles in a similar way as the EFSF is likely to ensure government bonds in Europe. 6. Development of e-mobility, as well as low carbon residential and commercial real estate is essential and would help to capture a large part of global emissions. 7. The development and construction of new technologies, including smart grids, advanced energy storage systems and carbon capture and storage (CSS) will play a crucial role in a low carbon economy. 8. Accelerated efforts to reduce emissions from deforestation and forest degradation (REDD and REDDplus) will address one of the major sources of carbon emissions. Further to this, a secondary framework with the following prerequisites is necessary if we are to unlock the funding capacity of the insurance industry for debt financed low carbon investments: II. Bond Framework 1. Given that investments and financing of a low carbon economy must largely be provided by the private sector and taking into consideration that a large part of the portfolios of insurers and pension funds consist of fixed income investments, the mainstreaming of low carbon fixed income instruments that can reach out to traditional bond investors is required. 2. Potential climate bond 5 investors can be attracted by potential yield pick up, additional diversification, positive reputational effects and/or long durations matching long liabilities. 3. The success of this promising asset class is currently being held back by existing barriers such as the relatively high uncertainty regarding risk capital allocations (required by risk models of Solvency II and credit rating agencies), regulatory barriers, lack of knowledge, lack of liquidity and a very small investable universe to date of approximately EUR 16 billion, according to the Climate Bonds Initiative. To give some perspective, this is less than 0.1% of the value of outstanding global bond markets which stood at USD 95 trillion in This investable universe and market liquidity may be increased to attract mainstream investors if governments, municipalities, international institutions (such as development banks) and also potentially corporations sharply increase their low carbon bond issuances. Furthermore, a clear focus 5 Climate bonds are themed, asset-backed or ring-fenced bonds specifically issued to finance climate mitigation and adaptation measures. They are designed to have comparable credit risk and returns as conventional bonds, and therefore represent an important instrument to attract mainstream fixed income investors. Such bonds could also be one possible example of a senior tranche of public private partnerships that combine both public as well as private capital to leverage public financing (Climate Bonds Initiative). World Economic Forum Council Insurance and Asset Management 6

7 on plain vanilla bond structures already known to mainstream investors and debt issuances available in different currencies and with different credit risks and tenors would encourage this expansion. 5. Governments and regulators can support the success of climate bonds with incentives, including reduced tax burdens and risk mitigation measures. Governments or supranational institutions need to provide political risk guarantees for projects in below investment grade countries to overcome existing barriers for private financial investors. 6. A global certification scheme for climate bonds which ensures the linkage to a low carbon economy can also increase transparency and allow for easier integration into the investment processes of institutional investors. 7. International institutions such as the World Bank, the Asian Development Bank, the African Development Bank, the European Investment Bank can play an important role in increasing awareness and building capacity of political decision makers and institutional investors, as well as brokers which can act as catalysts in the capital markets. Close cooperation between public and private market participants is also crucial in order to successfully grow the climate bond market. 8. From an institutional investor s point of view, eligible renewable energy infrastructure projects need to include a long-term (e.g. 20 years) commitment by a high grade rated counterparty or public institution. Potential (retroactive) changes in regulation are a major obstacle inherent to low carbon investments. 9. Risk capital allocation requirements for institutional lenders (insurance companies) must be adjusted in line with the real risk of such financings. Policies and regulations should be aligned to encourage an enabling environment for insurance companies to invest in low carbon assets. Relevant stakeholders mentioned in this chapter should start to grow the climate bond market by working jointly on lighthouse pilot projects. World Economic Forum Council Insurance and Asset Management 7

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