The big headline at COP28 was delivered on the eve of the conference by the UN’s independent high-level expert group on climate finance.
Their first IHLEG report, published last year, quantified the scale of investment needed in emerging markets and developing countries (EMDCs) outside China to meet the Paris Agreement and hold temperature rises to 1.5% above pre-industrial levels.
It concluded that around $2.4 trillion of investment each year would be needed up to 2030.
The second report, published on November 30 this year, was predictably depressing. We are not even close. Actual investment performance on key climate priorities in EMDCs has stalled.
“While global efforts to tackle climate change are increasing, albeit more slowly than necessary, EMDCs are facing setbacks and obstacles in every critical aspect of the low-carbon transition,” the report states.
Why? Because these countries are too indebted.
“Fiscal deficits that resulted from the response to COVID-19 and the current food and energy crises have left many EMDCs with a legacy of high public debt,” the report points out.
And in the era of high rates, the cost of servicing and rolling over those debts has skyrocketed.
The IHLEG report calls for radical action, including a fivefold increase in concessional finance, a big expansion in the role of multilateral development banks and finding ways to increase international private finance flows to EMDCs for climate action by 15 times from present levels.
Here is the issue not being discussed in Dubai. The same problem is threatening efforts in developed markets too.
On the day before the IHLEG report was published, Olimpia Carradori, Margherita Giuzio, Sujit Kapadia, Dilyara Salakhova and Katia Vozian published a blog on the European Central Bank’s website that comes with a much more specific and radical suggestion to solve the same problem.
The authors highlight their analysis of nearly 4,000 firms in Europe – many of them unlisted, almost all of them heavily dependent on bank finance – that are together responsible for over a quarter of the EU’s greenhouse gas emissions and are thus subject to the EU Emissions Trading System.
This is the cap-and-trade scheme that requires polluting firms to pay for emission allowances. By reducing the number of allowances each year, the EU increases their costs and thus presents firms with a stark choice: either invest in cleaner production, which might be expensive but will also improve your shareholder returns, or pay up for more licences that are a dead expense.
There is a logic to the scheme that boutique investment manager Osmosis Investment Management was one of the very first to spot in the wake of the financial crisis. Well over a decade ago, it began to track the resource efficiency of listed companies by scouring their sustainability reports. Osmosis measured their consumption of energy and water alongside their production of unrecycled waste per unit of revenue.
Companies that invest in more-efficient and thus cleaner production are not just better for the environment. They also provide better financial returns
It found two things that it composed into indices for the cutting-edge institutional investors, mainly Scandinavian pension funds, then obsessing over sustainability.
Companies that invest in more-efficient and thus cleaner production are not just better for the environment. They also provide better financial returns: higher returns on equity, fatter operating margins, but also, intriguingly lower leverage.
That may have been because, by the time their better resource efficiency scores became apparent to Osmosis, companies had passed over the initial peak in investment spending required to clean up their operations and were starting to benefit from stronger earnings.
The ECB blog adds a new slant to this. Yes, borrowing money is the obvious way to finance investment in climate transition for unlisted European companies. But there is a point at which companies that are already highly leveraged struggle to service and paydown their existing debt and are constrained in their ability to borrow more.
These firms may struggle to raise the money needed to invest in low-carbon technologies.
The authors find: “Up to a certain point, firms that are or become more leveraged significantly reduce their emissions in subsequent years. They achieve this without constraining their economic activity: they reduce their carbon footprint through cleaner production.”
But there is a tipping point described as an inverted U curve in the relationship between leverage and investment in green technology.
“When leverage exceeds about 50%, further increases are associated with worse performance in terms of emissions reduction,” they write.
Today, warning signs are flashing over unrated and sub investment grade borrowers in Europe.
Rachel Ward, high yield specialist at Aegon Asset Management, sees increasing divergence coming in 2024, and says that while many high-yield companies will be able to cope with a mild downturn, defaults will rise.
She notes: “Bifurcation is increasing across the market, and we expect the divide to widen in 2024. Weaker companies with lower margins and little room for error are most at risk.”
Banks are also tightening lending standards. So, how can European companies that are already close to debt limits raise the finance to invest in sustainability?
Further improving green bond and loan markets, for example through greater transparency and international standards, might be one way for highly leveraged companies to borrow funds earmarked for green investments, as lenders may be more confident that their finance will increase the profitability and financial stability of borrowers over the medium term.
But the authors have another far more radical suggestion. The entire corporate culture of financing more through debt than through equity is that debt-interest payments are accounted as a pre-tax operating cost, whereas dividends to shareholders are paid out of what is left of their profits after tax.
Availability of climate finance might be boosted through tax changes, they suggest, “such as making the tax advantages of debt financing only applicable to green debt”.
The climate emergency is evident all around us. Addressing it requires far more finance than is now being mobilized. Changing that requires radical action. One of the most radical suggestions appears on the ECB’s website, along with the usual rider that the views expressed are the authors’ and “do not necessarily represent’ the views of the European Central Bank.
