The transition teething process often means two steps forward and one step backwards
Many OIC markets in Asia face a range of challenges when increasing the installation of additional renewable energy capacity, often driven by challenges in financing. In some markets, the electricity infrastructure is the limiting factor; in others it is lack of appetite from banks for long-term finance in the absence of developed capital markets. Some markets’ regulatory policies are not transparent and lack enough certainty for investors, while in others credit ratings at the sovereign level, high levels of indebtedness, or low credit ratings of power-purchasing entities can play a driving role.
Some countries like Malaysia have received plaudits for their policies, while in others multilateral efforts are underway to provide targeted support, including a $2 billion World Bank program for Europe and Central Asia that aims to mobilize $6 billion of private investment. The initiatives are particularly important in creating the electricity infrastructure to support other efforts to promote electric vehicle adoption in developing countries, to ‘leapfrog’ further growth of internal combustion vehicles.
The pace of change has sped up dramatically, with a slew of new regulations and sustainable finance frameworks in the GCC and elsewhere. The ASEAN Transition Board (ATB) has expanded its third version of the Taxonomy for Sustainable Finance across the region to add in technical screening criteria for the transportation & storage and construction & real estate sectors. The ATB’s taxonomy offers a way to link together national taxonomies that have been issued with substantive differences across ASEAN member countries.
Indonesia has received criticism after adapting the sustainable finance taxonomy to give an amber label for new captive coal power plants that reduce GHG emissions and are scheduled to shut by mid-century. This contradicts analysis from the International Energy Agency on Net Zero 2050 that said new coal and unabated coal power after 2040 is incompatible with global Net Zero by 2050. At the same time, coal phase-out financing was provided a green label to address the apparent contradiction between many financial institutions’ pledges to stop financing coal and the need — especially in Asia — to accelerate the retirement of many recently commissioned coal power plants.
The development of frameworks and supporting policies to guide more finance towards the green transition (both into green projects and to enable energy transition in line with global Net Zero 2050) is a positive, but there remains uncertainty about which policies will be effective and which will be counterproductive. In addition to the policy uncertainty, there is also substantial doubt about whether the financial system as a whole — comprised of regulators, management and staff at financial institutions, investors, capital markets (domestic and international) and ratings agencies — is able to row in the same direction at the same time.
One recent example of the pitfalls that lie close to the surface under the structures being built to transform the financial and non-financial corporate sectors was when the Science Based Targets Initiative (SBTi) outlined a proposed change to its net zero targets that would allow companies to use carbon credits to abate Scope 3 emissions, which quickly sparked a significant backlash.
At issue is where to draw the line about responsibility for emissions within a value chain. One argument in favor of allowing offsets for Scope 3 emissions is that they are generally outside of a company’s control, and the requirement for offsets retains a financial incentive to do more than disclose Scope 3 emissions. The mechanism of carbon credits provides a way to direct finance towards projects that could reduce global emissions.
The challenge — which ties into the process of experimentation in the way financial systems are being adapted — is that although companies don’t usually have operational control of their Scope 3 emissions, it could still influence their behavior in sub-optimal ways.
One example would be an industrial company that relies on purchased inputs that are high emissions, such as nickel that is smelted in a factory powered by a captive coal power plant. A company that relies on this source of nickel as an input could choose to source it from smelters that are powered by hydropower rather than coal, but this would have a quite narrow cost differential where the lower emissions source makes short-term financial sense. In either case, this company would be in a more advantageous position than a more integrated industrial company that owns more of its value chain including intermediate manufacturing and the ore smelting.
In this example, the integrated company would not only face the choice of location of smelters to use (which would be substantially more costly to change than if it purchased inputs from another company). It would also face questions from short-term minded investors about whether instead of investing in decarbonizing its upstream operations to reduce its Scope 1 and 2 emissions, it should just divest that supplier and switch to purchasing offsets to meet its emissions targets.
Through this process, rather than investing in decarbonization, it may be easier to arbitrage between the requirements it faces from stakeholder pressure for net zero targets in its home market, which may be more muted in markets where the supplier is located. In addition to affecting the industrial company, this type of activity would impact the company’s investors and the investment bankers advising on the divestment transaction.
On paper, the emissions impact is neutral or slightly positive (moving emissions from Scope 1 and 2 to Scope 3 and purchasing carbon credits). However, in effect, the transaction would reduce the likelihood and speed of decarbonization of the activity. It would also muddy the interpretation of the financed and advised emissions claimed by various financial institutions, resulting in more questions than answers.
This is just a hypothetical impact of a proposed change to the wider corporate and financial ecosystem around making the transition towards global Net Zero by 2050. However, it is indicative of how the challenges buried in the details expand every time there is a new framework with a different wrinkle in how different scenarios are managed. The transition will be challenging, and there will be many differences in how it happens in practice in different parts of the world.
From the perspective of changing the way that the financial sector engages in the process, there will need to be significant capacity built to be able to manage the nuances from different requirements in a way that remains true to the overarching objectives of global Net Zero by 2050 and not diverted by the practice that sometime takes over of cleverly arbitraging differences in regulations, guidance or market norms for short-term benefit at the expense of the long-term goal.
Get the latest insights about responsible finance in OIC markets & Islamic finance from the RFI Foundation, C.I.C. Subscribe to RFI’s free email newsletter today!
