Cross-border investment is crucial to achieving a just transition
In this guest commentary, Ely Sandler and Rob Macquarie describe how a novel use of Article 6 of the Paris Agreement to generate green investment in emerging markets could help raise the unprecedented volumes of capital required to limit global temperature rise – while also supporting an energy transition that is equitable and just.
The world is now beginning to recognise the scale of financing required under the Paris Agreement. The Sharm el-Sheikh Implementation Plan, for one, estimates up to US$6 trillion per year is needed to fund the transformation to a low-carbon economy. The Songwe-Stern Independent High-Level Expert Group on Climate Finance calculates that emerging markets and developing economies alone will require US$1 trillion per year in financing from richer countries by 2030.
Article 6 of the Paris Agreement allows the government or private firms in one country to pay for emissions reductions in another and receive the credit for their own Paris Agreement goals. Negotiations over Article 6 were long and fraught, but implementation is underway. Crucially, while Article 6 has traditionally been thought of as carbon trading, a recent proposal from Harvard University suggests that it should instead be used to generate concessional investment for a green energy system and industry in emerging markets. Based on this novel understanding, Article 6 could become a mechanism to overcome the high cost of capital for projects in the Global South.
The Harvard proposal is now being studied and implemented by the World Bank, as well as by the United Arab Emirates as it prepares to take on the COP28 presidency later this year. While Article 6 is no silver bullet – all efforts must complement far-reaching reforms to the international system – we argue here that the mechanism could tangibly lower the cost of capital for critical clean infrastructure projects crucial to the just transition. First, we set out current proposals for how international partnerships and carbon markets can drive a just energy transition. We then identify drawbacks to these approaches and highlight that lowering the cost of capital for productive, low-carbon investment in developing economies is crucial to achieve equitable green growth. Finally, we outline how adopting a new lens on Article 6 can help to address these shortcomings and complement the wider financing landscape for a just, low-carbon transition.
Existing efforts towards a global just transition
A key part of a just transition is phasing out fossil fuels while building a robust, low-carbon energy system for developing economies. How this task is carried out must also respond to other social and economic inequalities, such as creating equal access to high-quality low-carbon jobs and protecting other aspects of wellbeing, including public services and infrastructure.
The good news is that a range of international pledges and initiatives addressing this challenge have already emerged. The Just Energy Transition Partnerships (JET-Ps) aim to fund the transition away from fossil fuels in key countries while also protecting and expanding energy supply. The first JET-P was agreed between South Africa and a range of donors including the US, UK and EU, who together committed to provide US$8.5 billion in investment over the long-term. Vietnam and Indonesia are now establishing their own JET-P frameworks.
Other proposals aim to leverage the growing market in carbon credits, currently worth roughly US$2 billion, driven in part by corporate net zero targets. Smart policy could harness demand for carbon credits in a way that not only avoids greenwashing, but also supports climate justice. The Energy Transition Accelerator, backed by the US State Department and proposed by US Climate Envoy John Kerry at COP27, aims to “support country-driven energy transition strategies through a high-integrity voluntary carbon market framework”, including expanding energy access, alleviating poverty, and strengthening adaptation in vulnerable countries.
A wider transformation is needed
Despite good intentions, two major problems remain.
First, while financial pledges are important, they must be the start of sustained policy engagement, with a focus on funding actually being delivered. Starting with the original commitment by rich countries at COP15 in Copenhagen to provide $100 billion per year to poorer countries, pledges have often gone unfulfilled. The flagship JET-P in South Africa has been beset by reports of poor transparency and delays in delivery of finance, raising questions over how many countries could benefit from similar deals. The Energy Transition Accelerator remains in the design stage as others like the Voluntary Carbon Market Integrity Initiative and Science Based Targets initiative work to define new norms for a high-integrity voluntary carbon market.
Second, even when the financial taps are turned on, investments often lack a focus on green growth and industrialisation. Example of such initiatives are those that target emission reductions – for example energy efficiency – without increasing an economy’s productive capacity. While these projects are sorely needed, the Global South must also benefit from economic opportunities created by decarbonisation. Transition finance must create new industries and business models in developing economies that can thrive in a net zero world – for example green exports of ammonia, steel and hydrogen – rather than generating fresh sources of dependence on the Global North.
Another potentially problematic dynamic exists in carbon markets. Consider the African Carbon Markets Initiative (ACMI); its roadmap seeks to “build the foundations for a thriving voluntary carbon market ecosystem in Africa by 2030”. Carbon finance must not become an end in itself: emissions credits must help to incubate new economic models that create jobs and catalyse further investment. In other words, rather than thinking of carbon credits as a future “export commodity”, as the ACMI roadmap does, carbon market programmes must enable wider regional and national strategies for sustainable growth and development.
Article 6 can lower the cost of capital
Lowering the cost of capital in emerging markets and developing economies is essential for a just transition. Indeed, the Bridgetown Initiative – launched by Mia Mottley, Prime Minister of Barbados to champion poorer countries’ development and climate finance needs – sees this as central. Green growth requires private investment, and private investment requires that emerging markets can borrow at affordable rates. This is the only way to overcome dependence on carbon credits and donor-based climate finance.
Article 6 of the Paris Agreement can promote this goal. The Harvard proposal cited at the start of this commentary suggests that Article 6 carbon credits should not be thought of as assets sold for revenue. Instead, investors should invest in green projects at concessional rates and would receive credit towards their own targets in proportion to the extent their investment brings down the cost of capital. This will incentivise more investment in efficient emission reductions with strong development benefits. Importantly though, this must be additional to and not a substitute for Paris-aligned policy in the Global North, to avoid displacement of mitigation effort.
How might this work in practice? Take the hypothetical example of a green hydrogen plant in Namibia, a country with a vision to become a ‘green hydrogen superpower’. Investors there currently face operational risk in a new technology, regulatory and political risk, and credit risk from an essentially non-existent market for green hydrogen. Under Article 6.2, which allows a bilateral deal between countries, a national government of a European country could provide cheap debt that lowers overall financing costs. Savings on financing would increase free cash flow, lowering project risk while also increasing funds available to pay commercial investors. This could increase project returns, incentivise greater private interest, and create a virtuous cycle by driving more low-carbon investment. In this case, Namibia would make a ‘corresponding adjustment’, debiting its emissions account with the UNFCCC by the same amount as the financing country credits its own, thereby avoiding double counting.
There are challenges to address. Article 6 has been criticised for allowing countries to withhold information about deals they have negotiated on confidentiality grounds. The methodology proposed in the Harvard paper relies on calculating an intangible cost of capital, so as with all emission reductions, these calculations must be robust and independently verifiable for deals to have integrity. Furthermore, all projects must have strong social safeguards and be accompanied by measures, such as education and training, to ensure justice in implementation. However, given the urgency of raising investment, these challenges need to be confronted and overcome in practice.
Next steps
Policymakers should engage with institutions like the World Bank on innovative financing mechanisms to bring down the cost of capital, including implementation of Article 6. Pilots with the UAE and other countries should be studied carefully, to refine further agreements based on lessons that emerge. Private firms and investors should work with the public sector to encourage policy that can de-risk investment in emerging markets and reinvestment of revenues in new low-carbon industries.
Article 6 must generate high quality investments to set a strong benchmark that the voluntary market can align with. Sovereign investors need to meet a gold standard in their carbon transactions to ensure the private sector follows suit. Civil society must scrutinise the deals that are emerging worldwide. Carbon markets have great potential, but their impact on people must remain a key priority to ensure the capital they raise supports a just transition.
Ely Sandler is an incoming Fellow at the Harvard Kennedy School and Senior Advisor to the World Bank. Rob Macquarie was formerly a policy analyst and research advisor to Professor Nicholas Stern at the Grantham Research Institute, and is now an independent consultant. They would like to thank Josie Murdoch and Leo Mercer, Jeroen Huisman, Abindra Soemali, Agra Suryadwipa, Nicholas Omar, and Katherine Stodulka for helpful discussions and review comments. The views in this commentary are those of the authors and do not necessarily represent those of the Grantham Research Institute.