This blog is the third in a three-part series on sustainable finance metrics that better evaluate corporate climate risk, opportunity, and impact, and make metrics more relevant to financial decision-making. The first two blogs analyze the value of CapEx and energy transition ratios as key transition metrics.
At the heart of it, financing brings the future into the present. When a lender or investor provides financial capital now for revenue generated later, it allows the creation of something that would not yet be able to happen otherwise. This is why financing is so powerful. Nowhere is this more true than in the deployment of climate solutions: it takes finance’s greatest power — drawing the future nearer — and uses it to hasten the creation of a net-zero economy.
In this third installment of a blog series on sustainable finance metrics, I focus on the value of climate solutions investing and the special role that banks have in doing it. This post draws on a recent paper I co-authored with Dean Granoff and Elina Rolfe for the Global Impact Investing Network (GIIN), titled Climate Solutions Investing in Review: An Analysis of Key Issues and Recommendations for an Investment Framework. While that paper was developed to inform GIIN’s eventual framework for asset owners, the analysis has significant implications for banking as well. This blog summarizes some of the key elements of that framework, and applies them to the context of banking. Throughout, for simplicity’s sake, I use the terms “investment” and “financing” in their broadest sense, comprising all different means for allocating financial capital.
Banks are particularly important because they are often in the business of allocating new capital. Whereas much of sustainable finance has centered on the role of institutional investors managing already-allocated capital associated with the greenhouse gas (GHG) emissions of already-issued securities — through portfolio decarbonization, stewardship, or risk-weighting — banks often operate at the point of capital creation. They lend and underwrite, and, critically, they do so in ways that shape the real economy before emissions ever materialize. In this way, they directly influence where the material economy is poured, not polished. It is through the primary market – and particularly the power it has pre-investment – that finance becomes a central actor in creating a net-zero economy.
Why is climate solutions financing important?
Creating the net-zero economy – whether by mid-century or otherwise – is a necessity. This is an important starting point that frames what sustainable finance should achieve. Reaching net zero requires replacing most high-carbon goods, services, and infrastructure with low- or zero-carbon substitutes. This process occurs when new capital is directed toward developing, deploying, and enabling those substitutes at scale. In other words, transition finance only becomes transformative of the real economy when it provides capital that enables businesses to deploy climate solutions to substitute for the high-carbon economy. Without climate solutions investment, sustainable finance would imply that many economic demands should simply go unaddressed. Where climate solutions address economic demands, on the other hand, they generate corporate income and create opportunities for investors and companies to further allocate capital toward climate solutions and recognize a return.
Climate solutions investing is thereby the most direct sustainable finance mechanism by which to create the net-zero economy. The Glasgow Financial Alliance for Net Zero (GFANZ) offered a useful taxonomy of transition finance strategies that helps contextualize the special role of financing climate solutions. GFANZ defines “transition finance” as enabling four things:
- managed phaseout of high-emitting assets;
- alignment of companies and their business models with net zero;
- already-aligned companies to deliver on their commitments and plans; and
- climate solutions and their creation, deployment, and scaling.
Each of these plays a role, but finance is not equally powerful in each case. Of all these strategies, climate solutions investing is unique in its ability to align the return-seeking function of investment with a company’s central function of generating revenue. Whatever a company’s business, the core of it is to generate revenue by creating value for its consumers through the sale of its products, which are necessary to generate returns and growth for its investors.
In contrast, the first three categories often focus on financial institutions managing financial assets – and associated emissions – from companies to which they are already exposed. This often means they are exerting influence only at the margins — tweaking portfolio weights, cajoling management, or divesting. Financial institutions’ efforts are sometimes even in tension with the core revenue-generating business of the investee, so they must create value by managing risks that are often dispersed and challenging to internalize. In contrast, climate solution investing is explicitly centered on allocating capital to create an economy of goods and services delivered with net-zero emissions.
That is why in our paper we argue that climate solutions investing should be seen not merely as a fourth category of transition finance, but the most important one, where financial institutions have their greatest influence. Of all the ways investors may shape the real economy to achieve net zero, they may be at their greatest influence when providing new capital to companies to produce climate solutions.
That makes climate solutions investing uniquely capable of driving real-economy transformation.
To understand climate solution financing, it is helpful to start by defining terms. In our paper, we define “climate solutions technology” as a product or process that does one of three things: (1) substitutes GHG-emitting technologies, (2) enables that substitution, or (3) removes GHGs from the atmosphere. The ability to solve a climate problem depends in part on the nature of the technology, and in part on the nature of the market context in which it is being deployed.
A “climate solutions investment” is a financing activity that enables the deployment of climate solutions technologies. This distinction is key since investing entails inherent uncertainty about the relationship between the financial activity and outcomes in the real economy. Navigating that uncertainty is crucial for financing to enable the development, deployment, and scaling of climate solutions technologies.
First, the nature of the financing can introduce uncertainty. A purchase of secondary equity in a company with a clean energy business unit does not directly enable any new deployment — it just shifts ownership. A loan to that same company for the purpose of building new production capacity would. The investor’s position in the capital stack, the type of asset or company being financed, and the financial instrument used — all affect the financial activity’s real-economy relevance to the deployment of climate solutions technologies. Said differently, climate solutions investment is not only about what is being financed, but how and through what financial relationship.
It’s also essential to consider the nature of the financed entity. At its core, financing climate solution technology is about financing that enables a low-carbon product to scale and capture market share. This is typically achieved by supporting a company to bring that product to market. Sometimes, though, it also means financing consumers of the technology to acquire and deploy it.
The details of the financed entity matters, since financiers never actually finance climate solutions technologies directly: financing of climate solutions technologies is intermediated by a company (even project financing relies on a special-purpose company). In our paper, therefore, we encourage investors to consider the nature of the company receiving financing, distinguishing between:
- pure-play climate solutions companies;
- multi-product firms; and
- companies that use climate solutions internally.
The form of the company, along with the nature of the financing, affects the financier’s certainty about the degree to which the financing actually enables the creation, deployment, or scaling of a climate solutions technology. When financing a pure-play company, only producing climate solutions technologies, the link between financing, the deployment of the technology, and the emissions outcome is direct and strong. In contrast, when financing a multi-product firm, ring-fencing of proceeds or analyzing capital expenditure plans may be necessary to be certain that the financing enables the climate solution technology.
Finally, whether the financing is enabling a company to produce or consume a climate solution is a critical distinction. The impacts of financing are often more confined when it enables a company to deploy a climate solution technology internally. Really, this is enabling the consumption of another company’s climate solution technology. Financing the consumer of a climate solution product can be valuable, but its value depends on how much it enables the product, rather than its role in the deploying company’s business.” It’s great, for example, when an oil and gas company deploys renewables to power its facilities, but the impact of that deployment depends less on how it changes the company’s business (likely little), and more on whether the deployment materially accelerates the technologies market deployment.
In each case, the nature of the technology, market, financing, and company all bear on whether and to what degree a financier is financing a climate solution.
Why Banks Are Essential to Scaling Climate Solutions
If climate solutions investing is the most powerful form of transition finance, then banks are among its most powerful agents.
Banks operate at the front lines of the real economy – they provide loans, structure project finance, and underwrite bonds. These activities deliver primary investment that businesses use to expand, build infrastructure, and scale technologies. Whereas much of financial activity consists of trading in secondary markets, which provides exposure to climate solutions — the core of a bank’s activities directs primary capital for the growth of their investees.
This role is especially important at the stage where climate solutions technologies move from early innovation to scaled deployment. Once a technology is proven and commercially viable, climate solutions technologies need financing in the form of working capital, equipment financing, and long-term debt. Clean energy infrastructure, grid upgrades, electrified transport, industrial decarbonization — these are capital-intensive sectors where debt becomes the primary vehicle for scaling.
In addition to providing critical primary capital for growth, banking is especially well-equipped to structure financing in ways that direct proceeds to enable deployment of climate solutions technologies. Instruments like green project finance, sustainability-linked loans with meaningful performance criteria, or bonds earmarked for net-zero-aligned CapEx all offer avenues for creating more certainty that climate solutions are being supported through mainstream lending.
Financing Climate Solutions from A Bank’s Eye View
Applying a climate solution financing lens to banking can both help banks navigate the uncertainty of climate solution financing and leverage a bank’s unique role in capital formation.
Effective financing of climate solutions requires somewhat different tools than conventional corporate GHG footprinting, labeling, and rating— instead evaluating the underlying technology, the type of company, the use of capital, and the market context. Such analysis reduces uncertainty about whether, and to what degree, financing enables those solutions.
Navigating such uncertainty entails asking some foundational questions, including:
Does this financing enable the development, production, or deployment of a technology that avoids or removes greenhouse gas emissions?
What kind of technology is being enabled — a “substitute”, an “enabler”, or a “removal”? How mature is it, and how material is its potential contribution to a net-zero pathway if the business’s objectives are realized?
Is the financing providing “primary capital” — new money into the company — or merely trading existing risk?
What is the borrower’s business model and capital plan, and what is the role of the climate solution technology in that plan? Is it transformative as the company shifts its revenue model, or does it reinforce a high-carbon legacy business?
Banks often look for quantitative metrics to help inform decision-making. In our paper, we focus on the value of expected emissions reduction (EER) – effectively forward-looking avoided emissions analysis – as one such metric, providing insight about the potential impact of financing a climate solution. We also point to “carbon yield” metrics as an even stronger tool, calculating the per-dollar expected emissions reductions of a particular transaction, allowing financiers to assess the “efficiency” of their financing in enabling a climate solution. To be clear, EER (and carbon yield, relying on EER) is a terrible means of emissions accounting and attribution: it requires developing speculative projections, and then comparing those projections to an equally speculative counterfactual base case. Still, not all financial analysis must be accounting — revenue projections are central to conventional finance, despite being speculative – and EER helps companies and financial institutions have foresight about expected outcomes if the financing activities lead to the expected outcomes.
We focus on EER, a forward-looking metric, in particular because financiers have their greatest power over the company they are financing before capital is allocated, when they can set expectations, negotiate terms, define performance, and shape strategic direction. Recently, colleagues at The Sabin Center for Climate Change Law and the Columbia Center for Sustainable Investing and I hosted an industry-centered workshop on bank-client engagement on climate issues. Origination emerged as a key opportunity for meaningful engagement for managing transition risk, finding opportunity, and creating impact. Before a loan is made or a bond is placed, banks have the ability to interrogate capital plans, set eligibility criteria, structure covenants, and help design their financial products.
These considerations can be embedded in pre-financing operations, such as credit allocation frameworks and deal assessment processes, and inform decision-making at the point of structuring or underwriting a deal.
When seeking to enable climate solutions, banks will also inevitably come to realize that opportunities to finance climate solutions in the public markets are limited, and they will have to look to private markets as well. (In our paper, we encourage institutional investors to increase climate solution exposure in alternatives.) Banks will thus need to explore new business lines and develop new financial products. Companies will also have climate solutions financing needs–e.g., capital for early-stage technologies that are still too early and too risky to finance–which most banks will not be well-equipped to support.
In seeking to identify and enable climate solutions financing opportunities, though, banks can influence how and which firms grow, which projects proceed, and which technologies can achieve scale. A climate solutions lens equips banks to look forward, at what financial capital can create, shifting from from assessing exposure to enabling action, and from tracking what has been, to using their capital to build the net-zero economy next.
Ilmi Granoff
Ilmi Granoff is a managing partner at the strategic advisory firm Climate Technology Group and a non-resident senior fellow at the Sabin Center for Climate Change Law. He is also a senior advisor at the Natural Resources Defense Council, the senior independent director on the board of Tracker Group (Carbon Tracker and Planet Tracker), and a member of the Advisory Board of InfluenceMap.
Great Job Ilmi Granoff & the Team @ Climate Law Blog Source link for sharing this story.
