August 21, 2014 – Clean energy finance has gathered speed this year, reports the International Energy Agency (IEA), but it is falling short of what IEA’s “Energy Technology Perspectives 2014” (ETP 2014) calculates is needed to refit the energy sector so that average global temperature does not rise more than two degrees Celsius.

IEA’s flagship technology publication warns that the energy sector will need an extra $44 trillion US in investment by 2050 to decarbonize the energy sector “sufficiently to limit climate change”. The spending outlined for ETP 2014ʼs 2 Degree Scenario will generate more than $115 trillion US in fuel savings and, even at a 10% discount rate, the return in net savings exceeds $5 trillion US.

So why, asks IEA, isn’t there more investment in decarbonizing the energy sector?

The problem for the power sector, ETP 2014 explains, lies with how investors assess the risk and return of decarbonization.

To close on the financing of any project, a developer needs to convince investors of one thing: that they will be able repay the debt and the interest on the debt while also remunerating shareholders for the capital mobilized. For investors, financing low-carbon projects is relatively new territory, fraught with uncertainty.

To assess whether the cash flows of a new project are sufficient to reimburse the investment and capital costs used to finance a project, investors calculate the net present value (NPV). These calculations are based on expected electricity prices and take into account their variation and uncertainty over time, explains IEA. A negative NPV implies the project will not deliver sufficient return and, thus, unlikely to proceed.

But while a positive NPV is a necessary condition for being financed, even this is not sufficient, notes IEA. Investors also appraise projects with other financial ratios, such as the internal rate of return, the payback period or debt coverage ratio under stress conditions to capture other dimensions of financial viability, and to inform investment decisions. Investors need to feel assured that a project with higher perceived risk is going to deliver a higher rate of return.

Low-carbon investments—whether large and financed by sophisticated large utilities or small-scale and financed by households—cannot escape this financing constraint, says IEA. Before deciding to spend $10,000 US for a rooftop solar PV or $5-$10 billion US for a nuclear power plant, investors seek to assess whether they will be able to get their money back and get a return.

Low-carbon projects, like other power plants, face regulatory risks, such as licensing delays and problems of public acceptance, plus the danger of construction delays and cost overruns. Then, once the plant is up and running, private investors face operational risks.

For new technologies, accurate operations and maintenance costs can be known only when operations are underway; some installations of a given technology type can prove to be less reliable and with a lower availability factor than others. For wind and solar power, initial estimates of the quality of the resource can also be a source of risk, and yearly weather variability can affect cash flow, notes IEA. And renewable projects have the added risk of uncertain load factor, resulting from possible curtailment of their output due to grid integration challenges and in the situation of excess generation.

Finally, should a carbon price exist, it lifts wholesale electricity prices, thereby increasing the profitability of non-emitting power plants and providing incentives for their construction… then low-carbon projects must factor in carbon price uncertainty.

Attracting private investment in low-carbon electricity generation requires that governments learn to think like investors, finds IEA’s ETP 2014.

To reassure investors, governments may need to spread related risks and associated costs to taxpayers and consumers, and they need to become more transparent when using such support mechanisms.

To date, low-carbon investments have been driven by support schemes, including feed-in tariffs, output-based subsidies and quota systems. Governments need to assess whether these mechanisms remain relevant or need to be replaced with new options.

ETP 2014 finds that current conditions suggest that it may be necessary to continue supplementing competitive markets to secure the low-carbon investments needed to decarbonize the electricity sector by 2050. ETP 2014 details various options to promote investment return, including direct capital subsidies, individual plant regulation and public procurement, plus feed-in-tariffs, quota systems and carbon pricing.

But the book concludes that no single option should be regarded as the perfect solution. Some are better for the uptake of technologies, but need to be replaced as technology matures, or should any progress be made on implementing carbon prices. Other options fit well for distributed generation that can be installed quickly, while large and long-term low-carbon projects may need long-term commitment by governments.

Governments should carefully apply the best option from their basket of instruments.

Caveats exist for all the options available to supplement markets, ETP 2014 notes. Each can have different implied costs of avoided carbon emissions. Most of the options are technology-specific, yet inefficiencies can arise when governments pick the winners. Promoting too-expensive technologies too early may be unsustainable in the long run and may increase the cost of climate change mitigation. Also, every option can have distortive effects on wholesale electricity markets, again to different degrees.

The key to stimulating investment in decarbonization, ETP 2014 concludes, is to supplement electricity markets while seeking to minimize distortions, and should rely on market mechanism for mature technologies while minimizing costs through timely technology deployment.