The critical role of cost-of-capital and climate policies in net-zero transitions

• Meeting the goals of the Paris Agreement requires a rapid scaling up of investment in low-carbon energy, yet a significant investment gap exists.
• Mobilizing private sector capital towards low-carbon energy and away from high-carbon energy is critical for closing the investment gap in low-carbon energy.
• See how cost and capital, via interactions with capital raising and climate policies, increases low-carbon energy investment and decreases high-carbon energy investment.

Meeting the goals of the Paris Agreement requires a rapid scaling up of investment in low-carbon energy. The IEA estimates that limiting global temperature rise to 1.5C requires $4 trillion of investment in low-carbon energy annually by 2030, requiring investment to more than triple from current levels.

Yet, while this significant investment gap in low-carbon energy exists, investment in fossil fuel power continues, despite the need for sharp curtailments in development. Mobilizing private sector capital towards low-carbon energy and away from high-carbon energy is critical for closing the investment gap in low-carbon energy.

The theory of change: How the cost of capital impacts investments

The cost of capital is a key lever in accelerating this transition. First, the cost of capital affects the ability of firms and countries to finance the upfront investments required to decarbonize the energy system. Second, capital-intensive renewables are more sensitive to changes in the cost of capital than fossil fuel power.

In this context, using a global asset-level database of power assets to track the development of new assets by publicly listed electric utilities firms between 2012–2021, we examine the relationship between the firm-level cost of debt and debt capital raising with firm-level energy investment and the effect of environmental policy on these relationships.

The evidence: How reducing the cost of capital impacts investments

First, we show that reductions in the cost of debt (and increase in debt capital raised) increase both low-carbon energy investment (LCI) as well as high-carbon energy investment (HCI) globally, but with a stronger relationship for LCI. Further, in OECD regions, this relationship holds only for LCI, a positive result from a climate perspective. However, in non-OECD regions, this relationship holds for only HCI, a negative result from a climate perspective. These results indicate that other factors (e.g., supporting policy) need to be at play — we investigate this next. Further, we find that debt capital raised increases both types of investment globally.

Second, we show that stronger market-based policies (e.g. carbon prices, taxes and portfolio standards) increase firm-level LCI. Furthermore, we find that stronger policies not only strengthen the impact of debt capital raised on LCI but also weaken the corresponding impact on HCI — both are desired results from a climate perspective. This demonstrates how pricing carbon emissions can channel capital away from HCI and towards LCI, as is required for reaching our climate targets.

These findings have several implications. First, they provide evidence that the cost of capital is a driver of LCI, both directly and through its effect on debt capital raising. Second, they also show that a lower cost of capital can drive HCI, especially in non-OECD countries. As a result, our finding that stronger climate policy, such as carbon pricing, can guide capital raised by firms into LCI and away from HCI is particularly important in ensuring that capital markets do not finance carbon lock-in.

In addition, these findings provide empirical evidence that a rising interest rate environment could harm low-carbon energy investment, meaning that additional policy interventions may be required to ensure the cost competitiveness of low-carbon energy.

These findings are also of relevance to financial institutions, namely those representing over $130 trillion in assets committed to aligning with net zero by 2050 and those investing in corporate bonds through primary markets or banks providing loans. Our results show that debt capital raising increases both LCI and HCI. While unsurprising, this demonstrates the importance for financial institutions of ensuring that capital provided to firms in the real economy is invested in accordance with net-zero goals and does not lead to carbon lock-in.

These findings are also of relevance to the debate regarding the efficacy of sustainable finance more broadly. While there is literature showing the impact of climate risks and impacts on the cost of debt, this pricing is yet to be empirically linked to real economy impact.

By showing how changes in the firm-level cost of debt can drive energy investment, we provide evidence of the role of the cost of capital as a transmission mechanism for investor impact in the energy transition. Indeed, there is already divergence occurring in the cost of debt between low- and high-carbon-intensity electric utilities firms in certain regions. While this could help accelerate the transition of lower carbon firms, this could reduce the ability of higher carbon incumbent firms to finance their transitions.