Bridging the Climate Financing Gap

12. September 2019

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To keep the global temperature rise below the two-degrees Celsius target set out by the Paris Agreement, large cuts in global greenhouse gas emissions (GHG) will be necessary. This can only be achieved with tremendous investment in renewable energy and carbon reduction technologies.[i] In a context of serious constraints on public budgets, what can be done to steer private sector funds toward these crucial investments?

The Clean Development Mechanism (CDM), one of the three flexible mechanisms implemented by the Kyoto Protocol, wasseen by many as a trailblazer. It is a practical scheme that can help countries meet their national emissionsreduction targets, contribute to achieving theSustainable DevelopmentGoals (SDGs),and incentivize private investment in the clean energy revolution. As the international community examines a new sustainable development mechanism under Article 6.4 of the Paris Agreement, policymakers should build upon its past successes to renew and boost the CDM.

The right idea: a good mechanism faced with systemic challenges 

The climate action funding gap is especially pressing for developing countries confronted with both growing energy needs and poverty reduction priorities.[ii] Recognizing this, the Kyoto Protocol implemented the CDM to specifically incentivize the creation of climate change mitigation projects in countries with limited resources. Through the CDM, such projects earn one Certified EmissionReduction (CER) credit for each metric ton of COreduced or avoided through the project. CERs can then be traded and sold to help developed countries meet their emissions reduction targets at a lower cost and with greater flexibility. For example, companies regulated under the EU EmissionsTrading Scheme (EU ETS)— currently the world’s largest cap-and-trade market — are allowed to use CDM CERs.[iii]

A recent United Nations report noted that the CDM has reduced two billion metric tons of carbon dioxide from the atmosphere. It has meanwhile sparked investments of close to USD 304 billion in a wide range of projects in wind, biomass and solar energy production, landfill and waste management, and afforestation and reforestation.[iv]

Despite these successes, the mechanism faces major challenges. Recurring weak demand in carbon credits, as cap-and-trade markets are met with widespread opposition and struggle to increase carbon pricing, is only one such obstacle.[v] Policymakers should also refocus the CDM on foreign direct investment (FDI), the category of financial flow most likely to maximize sustainable development co-benefits in the host economy.

Expand demand for CERs with highercarbon pricing

Since demand for carbon credits is key to incentivizing companies to invest in CDM projects, the CDM cannot work without strong emission trading systems (ETS). If the carbon price is high, investors will search for the most cost-effective ways to meet their GHG reduction obligations and invest where it is cheapest globally.

To expand demand in CDM CERs, several policies can be implemented under Article 6 of the Paris Agreement. First, the credibility of existing ETS, such as the EU ETS, must be reinforced by acting on price volatility and transparency. Second, technical support should be provided internationally to accelerate the creation of new national and regional ETS. Those of China and South Korea, for example, could be more quickly finalized and deployed with technical assistance. Third, commitments to the creation of national carbon tax regimes allowing payments in CERs should be operated, as recently done in Colombia. Most importantly, other multilateral forums to create global carbon offsetting systems in specific sectors should be incorporated, such as the International Civil Aviation Organization’s Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA).

Refocus on FDI incentives

As carbon-efficient know-howis primarily held by firms in developed countries, a critical challenge of combating climate change is to foster channels to disseminate knowledge of clean technologies to developing countries so they can “leap frog” the more heavily polluting phases of development. Contrary to other forms of investment, FDI operations enablethe export of these technologies and best practices through the establishment of a foreign affiliate, a joint venture,or the takeover of shares in another company.[vi]

The Clean Development Mechanism includes three forms of transactions models, and so far the FDI model has seen only limited use.[vii] This is mainly due toa lack of incentives, the complexity and length of the approval process,and insufficient promotion by home and host countries.[viii]  Policymakers at the international and national levels should reform and simplify the approval process for CDM projects. By accelerating review by the CDM Executive Board, and setting up more Designated National Authorities, waiting times could be significantly reduced.

Similarly, the World Association of Investment Promotion Agencies (IPA) should step up its communication plan on CDM investment opportunities and provide better information and support to investors throughout the process. Finally, home countries—from which firms conducting FDI originate—could promote CDM FDI through specific incentives, such as tax breaks, loans,and insurance directed to this category of projects.

Asdonor nations have yet to meet the USD 100 billion annual fund pledged at the Paris Climate Conference,[ix] and money does not simply grow on trees, a modernized Clean Development Mechanism seems to be the next best solution to attract the private investment much needed to solve the climate crisis.

This article won the second prize of our 2019 Essay Writing Competition on Combating Climate Change.

References

Picture by Zainal Azrin Mohamad Saari

[i]International Energy Agency (IEA)and International Renewable Energy Agency (IRENA), “Perspectives for the Energy Transition : Investment Needs for a Low-Carbon Energy System,” March2017.

[ii]Stephen S. Golub, Céline Kauffmann and Philip Yeres, “Defining and Measuring Green FDI: An Exploratory Review of Existing Work and Evidence,”OECD Working Papers on International Investment, 2011/02, OECD Publishing, 2011.

[iii]UNFCCC report, “Achievements of the Clean Development Mechanism – HarnessingIncentive for Climate Action,”United Nations Climate Change, 2018.

[iv]Ibid.

[v]Luke Sherman, “To Succeed, Cap-and-trade Must Be Revamped,”Policy Corner, July 14, 2018.

[vi]Karl P. Sauvant, “Reservoirs of the Future,”in What’s Next? Strategic Views on Foreign Direct Investment, ed.  Samuel Passow and Magnus Runnbeck(Stockholm: ISA, 2005), 90-97.

[vii]Anne Arquit Niederberger and Raymond Saner, “Exploring the relationship between FDI flows and CDM potential,”Transnational Corporations14,no. 1 (April 2005).

[viii]Jane Elis and Sami Kamel, “Overcoming Barriers To Clean Development Mechanism Projects,” OECD report, Paris: OECD and IEA, 2007.

[ix]Tracy Carty and Armelle Le Comte, “Climate Finance Shadow Report 2018 – Assessing progress towards the $100 billion commitment,”Oxford, UK: OXFAM,May 2018.

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