Landmark energy transition agreement begins to shift sustainable investment landscape in 2024

The 28^th Annual Conference of the Parties (COP28) was intended to set the stage for nations to negotiate climate agreements and help mobilize financial resources under the sponsorship of the United Nations (UN). This year’s event may have been the most controversial yet given its location in the oil-rich United Arab Emirates.

Despite skepticism, the summit concluded with a landmark agreement that calls on nations to transition away from fossil fuels, the primary driver of greenhouse gas emissions. Government ministers from nearly 200 countries approved the deal and emphasized the need for a just, orderly and equitable transition. Leaders also pledged to speed up the development of renewable energy, including nuclear power.

Key challenges remain in translating agreements to economic growth and filling the widening financing gap in developing countries. Throughout COP28, several key themes emerged including: (1) the role of renewables (2) the growth of carbon credit markets and (3) the maturation of climate finance.

The energy transition will require significant capital deployment from investors, particularly given the limitations of sovereign governments and multinational development banks (MDBs) in today’s high interest rate environment. These three themes represent potential risks and opportunities for capital allocators throughout the investment management process.

The role of renewables

To meet ambitious net-zero targets, renewable energy will need to be deployed at a rapid pace. At COP28, 116 countries signed the Global Renewables and Energy Efficiency Pledge, which agrees to triple renewables generation capacity and double energy efficiency by 2030.

This deal complements major policy-driven boosts, namely from the Inflation Reduction Act and the EU Green Deal Industrial Plan. Even without incentives, renewable generation is already cheaper than fossil fuels using the levelized cost of energy, which measures the costs of a power source including initial capital and ongoing operating expenses. In fact, the cost of electricity from utility-scale solar and onshore wind have fallen 85% and 55%, respectively, in the last decade¹.

Exhibit 1: Renewables are the cheapest form of electricity in most nations after years of falling costs²

As of April 2023. Source: Lazard

At least 22 nations, including the U.S., France and Canada, also agreed to triple nuclear power generation by 2050. The pledge aligns with studies from the International Energy Agency (IEA) suggesting that reaching net-zero emissions will require a significant increase in nuclear energy³. Nuclear power’s zero-emission profile and potential role in hard-to-abate sectors make it an attractive alternative to fossil fuels. This stance represents a policy departure compared to previous COPs, where nuclear energy received minimal attention due to cost impediments and perceived safety risks.

The growth of carbon credit markets

Carbon credit markets are vital mechanisms in the global fight against climate change. Businesses use these markets to compensate for emissions by purchasing credits from entities that reduce emissions.

COP28 saw several developments leveraging carbon markets to unlock private capital as a tool for driving decarbonization. The U.S. Department of State presented the core framework of the Energy Transition Accelerator, an innovative platform that will bring together public and private stakeholders using high-integrity carbon credits. Additionally, six of the largest carbon-crediting programs announced a partnership to define common principles for quantifying emissions reductions, signaling a major enhancement in transparency.

The voluntary carbon market remains the most active globally as corporations continue to drive significant demand. Many of the world’s largest firms rely on this market to reach ambitious net zero targets. However, compliance-driven markets will likely become more important as nations scramble to reach net-zero targets. According to the World Bank, more than two-thirds of countries are planning to use carbon markets to meet their contributions to the Paris Agreement⁴. In the past decade alone, government revenues from carbon taxes and emission trading systems have increased nearly 500% as policies have reflected increased ambition⁵.

The maturation of climate finance

In the early hours of COP28, parties agreed to formally establish the Loss & Damage Fund, which aims to provide financial assistance to developing nations most vulnerable to the effects of climate change. The fund will complement humanitarian aid and narrow the gaps that climate finance institutions are unable to fill. The UN estimates a financing gap of around $500 billion annually for climate projects in developing markets over the next decade⁶. Shortly after the decision was finalized, commitments from wealthy nations flowed in, totaling more than $700 million.

While the Loss & Damage Fund will initially be driven by grant-based support, its creation highlights the need for increased financing to developing nations. There is growing recognition that private capital is critical and that attracting it at scale will require market-rate returns. Historically, this has been challenging given the significant risks associated with developing market economies. At a granular level, investors face high upfront costs, lack of liquidity, foreign exchange risk and scarcity of well-planned projects. These risks have been compounded by increasing costs of capital and geopolitical conflicts.

To mitigate this, innovative financial mechanisms have been hypothesized to de-risk investments and attract a broader investor base. COP28 featured new initiatives that blend finance from the private sector with government-funded MDBs. These institutions have begun to provide loss-absorbing accommodations, equity capital or credit enhancements to offer investment vehicles with market-rate returns. By prioritizing equity over debt, development partners avoid adding to the unsustainable debt burdens of developing nations.

A unique example of an ongoing initiative is Project GAIA. This blended finance platform enables institutional investors to deploy capital in developing market climate change adaptation projects, and it has support from multiple public and private sector organizations⁷.

Investor implications

While the impact of the agreements made at COP28 will ultimately depend on implementation, we believe the decarbonization trend will continue to accelerate. For investors, this presents both significant risks and opportunities.

Investors should closely examine a range of hypothetical scenarios that can help quantify the financial impact of the climate transition. This is especially true for holdings in emission-intensive industries, such as energy and materials. These sectors could also face substantially higher costs given the projected increase of compliance-driven carbon credit markets.

We continue to anticipate an “all of the above” energy approach where wind and solar power dominate, but other generation sources, such as nuclear, increase in importance. We see strong valuation support and favorable conditions for clean energy stocks following COP28. Renewable infrastructure stocks look particularly attractive given they tend to have steady demand and provide predictable cash flows based on long-term power contracts. Moving forward, there may be select opportunities for firms with direct exposure to nuclear power generation.

We believe new climate finance initiatives announced at COP28 may lead to further market-rate investment opportunities in developing economies. This would enable investors to further diversify their assets and gain exposure to previously unreachable frontier markets. These investments will help finance climate change adaptation projects in regions that have traditionally been underserved.

 

 

 

 

Sources

1. International Renewable Energy Agency (IRENA), “Renewable Power Generation Costs in 2020,” June 2021

2. Lazard Financial Advisory, “2023 Levelized Cost of Energy+,” April 2023

3. International Energy Agency (IEA), “Nuclear Power and Secure Energy Transitions,” June 2022

4. World Bank, “Countries on the Cusp of Carbon Markets,” May 2022

5. World Bank, “State and Trends of Carbon Pricing 2023,” May 2023

6. Reuters, “COP28 a milestone in terms of ambition, but falls short on finance,” December 2023

7. MUFG EMEA, “GAIA – A Climate-Focused Blended Finance Program,” October 2023