Energy & Environment

Europe must complete its low carbon transition

Nick Mabey / Dec 2011

Photo: Wikimedia Commons

With Europe's most visible economic project in crisis there is an understandable lack of confidence among politicians delivering on other ambitious objectives. But it is also still true that without a common purpose Europe as a political project will fail. There is another economic arena where a renewed sense of common purpose is urgently needed to preserve European prosperity and security: completing the economic architecture needed to underpin the shift to a low carbon European economy.

But while European leaders understand climate change as an environmental challenge, they have yet to fully absorb the economic reforms needed to deliver a low carbon economy. Among economic policy makers tackling climate change is still often seen as either peripheral or actually damaging to economic growth. There is an on-going battle inside every EU member state between finance and environment ministries over the pace of low carbon action.

This attitude is out of date and does not reflect the real economic risks in European markets. The shift to a low carbon economy is now a major economic factor shaping real investment decisions across all major sectors of the economy. Unless economic policy makers understand this, and help build the necessary regulatory architecture to underpin the low carbon transition, Europe will face significant short term risks to its energy and economic security.

Moving to a low carbon economy involves replacing decades of future payments for fossil fuels with up-front investment in low carbon technologies. Europe will need at least €2.5 trillion of low carbon investment just to meet its 2020 targets. This produces an immediate “pulse” of additional investment in sectors such as electric power and requires a doubling of normal investment rates.

Europe needs this increase of investment into new and risky sectors at the same time as it is managing the consequences of the financial crisis. The regulatory response to the financial crisis is also itself slowing flows of infrastructure finance.

Some European politicians have suggested managing these risks by freezing climate change policy. But in fact the consequences of such an approach would raise long term political risk and would be economically disastrous. Rolling back Europe’s climate commitments would actually decrease the rate of investment and growth in these sectors.

The impact of the low carbon transition on investment risk is largely independent of immediate climate policies.No logical investor is going to risk billions of euros by building an unabated coal power plant in Europe in the hope that it will avoid serious carbon constraints on its earnings over the next 40 years. It is not credible that Europe can rollback its carbon or renewable energy targets in the short term as this would involve too much unpicking of European law. Even a failure of the international climate negotiations would not remove commercial investment risks. Countries would continue to move towards a lower carbon future, even if this is slower than needed. China, Korea, Mexico, Australia, Indonesia, Chile and South Africa along with many US states are making significant low carbon investments. These efforts are driven by multiple motivations and will not evaporate overnight.

Governments cannot unilaterally revoke the science of climate change or the investment risks an active climate policy unavoidably brings. Political risk cannot be magically removed from energy markets when they must deliver the public goods of sustainability and security. Europe must take the harder path of actively risk managing the process of decarbonisation based on the reality of how markets, politics and technology choices interact.

But neither is the reverse true. Just because investors are not willing to bet against Europe moving to a low carbon economy does not mean they are yet ready to bet on it by investing the billions of Euros needed. In most of Europe climate change policy is not clear enough to deliver an adequate balance of risk and reward to investors. Europe has yet to construct a sustainable economic architecture capable of delivering the low carbon transition.

Outside heavily incentivised areas, many private investors are looking to delay investment. They are hedging their bets by moving more strongly into short term options like gas power stations, because this minimises their long term capital exposure to climate policy risk. Some companies are even deciding to move large parts of their investments portfolios to countries outside Europe like Turkey where economic growth is higher, future demand more certain and political risks are perceived to be lower.

Europe cannot afford to end up with a half-decarbonised system that fails to deliver the investment needed to keep the lights on in the later part of this decade. This dilemma is most starkly seen in Poland where these risks mean that energy security is unlikely to be secured through private investment in new coal power stations (currently without carbon capture and storage). Poland will need to instead reform its domestic policies to drive investment in energy efficiency, renewables and interconnectors in order to maintain supply as its ageing infrastructure begins to fail.

But climate change advocates should find no satisfaction in this. If a country like Poland does experience serious energy security problems many will doubtless point the blame at green policies. It would be hugely damaging if the low carbon transition was blamed for blackouts.

So it is in the interest of actors on all sides to see an immediate response to these real investment risks. This economic logic has already been recognised by policymakers in the UK and Germany. They are beginning a far-reaching process of policy strengthening, market reform and financial innovation to address these challenges, though often in the face of serious resistance from finance ministries.

This task of regulatory reform and market (re-)creation is extremely daunting. It is not surprising that many want to try and remove the complications of decarbonisation by promoting an alternative scenario where Europe can follow a path dominated by gas power for the next two decades. This would delay fundamental choices on technologies and market reform, but an over-reliance of gas power exposes Europe to short term price volatility and energy security risks, while failing to deliver a robust pathway to a decarbonised economy.

To deliver the low carbon economy European governments will need to take more risk out of private markets through regulation and direct financial interventions. This de-risking must be carefully designed, targeted and will often be temporary. It needs to tackle existing oligopolies by strengthening the competitive and market incentives needed to promote new entrants.

Risk needs to be actively managed across four areas: politics; finance; technical capacity and market opportunities.

Politically, investors need to have increased confidence in the enduring trajectory of European climate and energy policy. This could be done by increasing the European 2020 carbon reduction target to 30%, or by increasing incentives from trading the emission system (ETS) through a set-aside of ETS permits.

Investors need to believe in climate targets that are politically sustainable during a time of falling real incomes. The best way to achieve this is by reducing consumer bills through a massive increase in residential energy efficiency investment, using the German model of blending low interest rate loans and targeted subsidies funded from ETS auction revenues.

Financially, power sector investors need to see greater certainty from reformed electricity markets which are moved away from commodity market structures and onto systems of long term contracts. Reducing price risk will allow a greater diversity of companies to enter the market for both centralised and distributed power investment.

National public banks such as KfW Bankengruppe in Germany and in the UK the new Green Investment Bank should prioritise support to sectors like offshore wind and low cost finance for residential energy efficiency. Alongside the European Investment Bank national banks could help grow the European market for green infrastructure bonds, which would allow these sectors to tap into the €18 trillion in assets held by global pension funds.

Technically, there is a need to strengthen European electricity infrastructure so that the large amounts of renewable energy resources on the periphery of the continent can be reliably connected to major demand centres. European leaders should spend as much diplomatic energy on ensuring electricity inside Europe and the neighbourhood as they have on Nabucco.

To maintain investment in renewable energy beyond 2015 suppliers will need to have greater visibility of demand into the 2020’s. Otherwise they will build supply chains and factories elsewhere. Greater certainty can be delivered by setting goals for renewable energy to 2030 alongside a clear timeline for decarbonising national power sectors.

The need for direct financial intervention raises the importance of resistance to the low carbon agenda among European economic policy makers. Currently, many finance ministries are resisting innovative financial instruments, such as national efficiency financing and European project bonds, on the grounds of fiscal discipline. They argue that launching new financial instruments will undermine restrictions on public debt brought in after the crisis, and damage market confidence in fiscal consolidation. However, these instruments put financial risk onto energy consumers not taxpayers. In all European countries people are more likely to pay their electricity bills than their taxes, so these mechanisms should be financially sustainable and low risk.

The fate of the low carbon economy has largely shifted from the hands of environmental policy makers to economic decision makers. The stakes are high and failing to take tough decisions will result in serious economic end energy security problems. We cannot afford the comfortable delusion that investment would flow if only we could remove the uncomfortable implications of climate change. We have to deliver prosperity and security while solving both the climate and financial crises. Member states are beginning to lead the way in developing the necessary regulatory and financial solutions. We now require concerted and cooperative action to implement these reforms across Europe.


Nick Mabey

Nick Mabey

December 2011

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