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Decarbonising the economy is one of the key challenges of the twenty-first century. Due to the limited carbon-reduction potential of incumbent transport and energy technologies,  a major shift in the way we produce and consume energy is needed to avert potentially disastrous climate change.

This transition will only be possible through substantial upfront investment. It is unrealistic that these considerable sums will come only from the public sector. Pure public finance would imply a nationalisation of the energy sector; and public budgets are already over-stretched, even in times of relative stability.

Private investment is crucial for the success of the post-carbon transition. However, private actors are reluctant to engage heavily in 'green projects' that are markedly different from their usual lines of business. Green projects, such as carbon-free power plants, new transmission lines, refuelling infrastructure for clean cars, and investments in energy efficiency, are typically characterised by very long pay-back times and often low returns. Therefore, these investments would only be attractive if their risks were sufficiently low.

However, at present green projects are often more risky than conventional projects for various reasons: (1) The cash-flow of many green projects is critically dependent on the hard-to-predict future carbon price. The carbon market is not yet well-established. There are no clear accounting rules for carbon credits and no good models for hedging corresponding risks. (2) Currently, low-carbon projects rely primarily on government intervention schemes (subsidies, feed-in tariffs, obligations, emissions allowance trading, etc.) which provide neither a stable nor a long-term price signal for investors. (3) Moreover, the payoffs of green projects are subject to various levels of political, technical and regulatory uncertainty. Recent regulatory shifts in European renewables support schemes are telling examples of the political volatility of public support. For example, Spain and other countries cut its feed-in tariff for existing and new solar installations because of the financial crisis. This resulted in a wave of bankruptcies of solar companies and the loss of confidence of investors in corresponding schemes throughout Europe. Regulatory downside risk is not matched by a corresponding regulatory upside chance. The reason is that regulatory changes are typically targeted at creating 'additionality' and thus only compensate for investments induced by the new regulation, but ignore already existing green projects. (4) Furthermore, the regulatory framework for new infrastructure assets (eg hydrogen refuelling stations) and new appliances (eg technical standards for fuel cell electric vehicles) remain unclear. These regulatory risks are further exacerbated by the often long-term and capital-intensive nature of green investments.

Political, technical and regulatory uncertainty is a significant impediment to private finance. Uncertainty, in contrast to risk, cannot be properly quantified or managed. Consequently, the absence of a robust regulatory environment and a credible and sufficient carbon-price signal translates into higher costs of capital for green projects. Private investors face a risk of stranded cost which is difficult to manage. This results in the inability of green projects to attract long-term debt and equity finance, while public funding is insufficient to cover all the gaps in investment.

A potential solution to the financing issues faced by green projects is being explored in the UK. The UK Green Investment Bank has been proposed as a publicly-driven intermediary structure. The core tasks of this institution will be to address the market failures faced by green projects, and to attract private investment by managing the inherent risks of low-carbon projects. The novel aspect of this proposal is a shift from current public support policies that simply provide higher subsidies, to a public-support system that reduces private investment risks. The UK Green Investment Bank (GIB) will start its operations in 2012, backed by an initial capitalisation of £3 billion.

The GIB will help to lower investment risk in three key ways. First, it will pool and restructure currently dispersed government grants for funding emerging green technologies. Second, it will be responsible for issuing green bonds. In the set-up phase, green projects are financed by equity. At the end of this phase, when the projects start to generate positive cash-flows, the GIB will buy up these green projects. This allows equity investors with an appetite for high-risk investments to sell their mature projects in order to generate funds for starting new green projects. The GIB can later issue green bonds to refinance its activities based on a broad portfolio of cash-flow generating green projects, and possibly ensuring high ratings through additional state guarantees. That is, ultimately, the GIB allows institutional investors, with an appetite for low-risk investments, to finance low-carbon projects. Third, the GIB will unlock project finance through:

(.1)     Equity co-investments at the early stages of low-carbon projects.
(.2)     The purchase and securitisation of green project finance loans (or pooling of the loans provided by the commercial banks for green projects). In this way, risks can be mitigated and lending for these kinds of projects increased.
(.3)     Long-term carbon-price underwriting or the provision of guarantees on a stable long-term (or floor) price for the investors.
(.4)     Providing the insurance products for mitigation of the inherent risks related to a non-sustainable regulatory framework and possible market failures (eg offering to buy completed renewables assets, extreme events insurance or contingent loans facilities).

Even though, it is too early to evaluate the success of the UK GIB, the idea of establishing a special financial institution that will be responsible for managing the particular risks of low-carbon projects is well worth exploring. Such an institution might play a major role in attracting the long-term private capital needed for funding commercial green investments critical to the success of any post-carbon transition. Furthermore, a public financial institution that has widespread exposure to green investment projects through its portfolio, could be an important signal to other market participants that the public sector is committed to supporting the low-carbon transition. This signal reduces the perceived risk of abrupt support-policy changes, and might make it easier to finance green projects through commercial banks. Thus, the establishment of public instruments that serve to create credibility and to lower investment risk for private actors, and not merely to subsidise, may prove essential to the success of a post-carbon transition.