Funding the Net-Zero Carbon Economy
Where's the Financing?
Global leaders are working hard to develop and implement plans for transitioning the global economy to a net-zero carbon emissions environment by the year 2050, or at least some of them are. This will not be an easy task. The engineering challenges are varied and complex, the ultimate solution may depend on technological advances far into the future and the geo-political issues often seem insurmountable. The transition to a net-zero carbon environment will also require a huge amount of sustained capital investment over several decades, but no one yet knows how much money will be required or how the money will be spent. By some estimates, the amount of required capital investment could be as large as $4 trillion annually. Other estimates are lower at $1-2 trillion. Global GDP is currently around $100 trillion, so we are talking about a very significant capital investment sustained over a long period of time. How will this be financed?
Students who have taken my corporate finance course will be familiar with two handy abbreviations used in the banking world: WTF and NFW. In my class, but not always on Wall Street, WTF stands for Where’s the Financing? and NFW stands for Not Financially Workable. A good banker avoids taking on NFW projects but for more viable projects can always tell you WTF, for a fee of course. So how should we think about the financing challenges associated with the transition to a green economy? NFW, end of discussion? Or might this be doable, in which case we need to ask: WTF?
Greg Ip, chief economics commentator of the WSJ, seems to think even $4tn a year is doable and can be financed without too much difficulty. In an article published a few days ago, “Why Financing the Transition to Net Zero Isn’t That Hard”, Mr. IP explains his reasoning: “The world needs $4 trillion a year to transition to a carbon-free economy. Sound like a lot? It’s not. Every year, the global financial system channels trillions of dollars from people who have capital to people who need it without breaking a sweat. Doing the same to achieve net zero carbon emissions by 2050 is well within its means. It just needs something to invest in.”
These views are also shared by Bank of America CEO Brian Moynihan, quoted by Mr. Ip, who believes that most of the money will have to come from the private sector. “Government doesn’t have the money, it has to come from the private sector”, says Mr. Moynihan. “The role of government is to create revenue streams or demand signals or even mandates that open up the markets so that the money comes in.” “It’s not that much money”, he says. “If there’s a revenue stream, then the funding is infinite.”
Before we all breathe a big sigh of relief and move on to other matters, let’s take a minute to consider these views. Are Messrs. Ip and Moynihan correct? Is the amount of financing needed to fund the transition to net zero really no big deal? Can all of it be raised by the private sector? Is the amount of funding available for these projects really “infinite”?
No of course not. Ip and Moynihan are making a rhetorical point—that funding is not the main challenge associated with the transition to a green economy—and I agree with them. But we should not get carried away by this sort of Wall Street hyperbole. Bankers like to talk big, especially when pitching for new business or talking to the press, but they can turn decidedly conservative if not cowardly when they are required to put up the money. With all due respect to Mr. Moynihan, capital investment projects get funded based on investors’ expectations of future profits and free cash flow, not just revenues, and for risky projects the required investor return (cost of capital) can be quite substantial. It may be that government needs to absorb some significant portion of the project risk to facilitate private funding, particularly in the early days. And finally, let’s be clear about capital market capacity. The only source of money which is “infinite” is that provided by central banks, which I do not think is what Mr. Moynihan had in mind.
What about Mr. Ip’s statement that “every year, the global financial system channels trillions of dollars from people who have capital to people who need it without breaking a sweat.” This is true, but we should not confuse the size of the capital markets or the volume of secondary market securities trading with the amount of money raised in the primary markets to fund new projects. Most of the money raised each year in the capital markets goes to finance governments, not private industry, and certainly not to fund speculative new age energy projects. The market capitalization of the global capital markets today is around $250tn, but close to half of this consists of outstanding sovereign (government) bonds When Mr. Moynihan says “governments don’t have the money [to fund the green transition]”, he is right. Governments have to borrow to fund their daily operations as well as their longer-term capital projects, making up any shortfall in tax revenue (plus refinancing needs) with the proceeds of debt issuance. One fiscal consequence of covid has been to increase substantially the size of government deficits and debts, to levels that only a few years ago would have been considered unthinkable. And I might add, this has only been made possible by extraordinary, and very controversial, central bank support programs.
But what about the equity markets? Can they be counted on to fund promising new green projects? Yes, of course they can, but the amount of equity funding may not be as large as Ip and Moynihan suggest, and it is certainly not “infinite”. Global equity markets currently have a market capitalization of around $125bn. But this is a bit of an artificial number, determined by the current elevated level of share prices, which are volatile and have doubled or tripled in recent years due in large part to the hyper-accommodative monetary policy of the major central banks in response to the financial crisis and more recently the covid pandemic. And “market cap” is not the same thing as “available funding” or “money raised”. Global secondary market trading volumes (the trading of outstanding equity securities) is estimated at $150tn annually, but primary public market equity issuance (new money raised from the sale of newly issued equity securities) is much lower at $1tn or so, perhaps $1.5tn if we include private equity and venture capital funding. Including debt financing (bond issuance), the total amount of new money raised each year is closer to $30tn globally, but most of this consists of sovereign (not corporate) debt issuance.
In thinking about the amount of equity capital potentially available to fund the transition to a green economy, we should also consider the amount of capital investment which is currently being financed with internal corporate cash flows, some of which can and will be redirected to green investment. (This is already happening of course, and the amounts are growing rapidly.) Annual gross capital investment runs at around 20% of GDP in the US, around the same level in Western Europe and substantially higher in some of the large developing economies. (China is at 40%.) Global GDP is currently around $100 trillion (and growing) so every 1% of GDP redirected to green investment equates to $1+ trillion of incremental funding. Incorporating these funds flows into our financing analysis reduces the scale of the external funding challenge considerably.
So where do I come out on all of this? While we do have some big financing challenges ahead of us as we transition to a greener economy, it seems to me that they should not be insurmountable. As noted, financing is far from the biggest unresolved issue associated with the transition to a net zero carbon environment. But while funding may not be our primary challenge, it will not be a slam dunk either. Funding the green revolution will not be like issuing T-bills when the Fed is buying, as was the case during covid and before that during the last financial crisis.
Because of the complex and speculative nature of many of the carbon-transition projects to be funded, it will be critical that governments across the world get their act together and do so soon. Funding from corporations and the capital markets will be available, in size, but only if and when the global regulatory, tax and political environment is accommodating, transparent and stable. And because much of the required capital investment will take place outside of the developed economies—by some estimates as much as 70% of the total—this will require an unprecedented level of sustained geo-political coordination and cooperation, which has been sorely lacking of late. Some promising things seem to be happening at COP26, but many informed and objective observers remain critical of the progress to date and it hasn’t gone unnoticed that China didn’t even bother to show up.
Under the circumstances, I think it is fair to say that we have a long way to go and time is not on our side. If and when we do get our act together, the money will be there. But it might be costly and it won’t be infinite.
Links:
Why Financing the Transition to a Net-Zero Carbon Economy isn’t that Hard. WSJ, 4.11.21