6. Financing environmental and energy transitions for regions and cities

Preparing regions and cities for a climate-neutral and circular economy by 2050 requires redirecting and mobilising large amount of investment in sustainable infrastructure and business models. Governments at all levels need to set the right incentives to mobilise finance away from emission-intensive and non-circular projects. While there has been some progress, policies, government revenues and economic interests continue to be intertwined with fossil fuels, emission-intensive and linear activities. Drastic and urgent efforts are needed to redirect investment towards transformative action. Regions and cities play an important role in this context, being responsible for a large share of environmental and climate-related public spending across OECD countries. However, investment pathways are still inconsistent with the aim of climate-neutrality and circularity by 2050 and spending still far below what will be required. Redirecting and mobilising resources across the financial spectrum (including from banks, institutional investors, corporations and capital markets) is therefore essential for the environmental and energy transition. In addition to sufficient financing, the transition requires many new solutions that often go beyond technological innovation and include social innovation, new business models, behavioural changes and new governance approaches.

Regions and cities face several obstacles in mobilising public and private resources for scaling-up environmental and energy transition finance. First, subnational authorities often do not make sufficient use of their ability to mobilise revenues from own budgetary or external (public or private) sources. Another major barrier is the difficulty to give priority to green expenditure when other pressing issues need to be considered, too. The COVID-19 crisis presents such a challenge as addressing the health crisis and providing relief to affected business and workers are the main current priorities. Some subnational jurisdictions also lack the capacities to enhance green budgeting or use innovative financing tools, and/or to engage in arrangements with the private sector. A lack of project pipelines and the insufficient scale of finance provided by some subnational governments are also obstacles. In addition, obstacles and challenges exist concerning national framework conditions. These can range from inadequate regulations to instability in the legal and regulatory frameworks, resulting in uncertainty regarding technological developments. A key question is therefore how to strengthen the capacities of subnational and national governments to better mobilise and scale-up environmental and energy transition finance and related tools.

This chapter discusses the opportunities and challenges for regions and cities to scale-up and deploy transition finance. The chapter focuses mostly on financing to reach climate and energy related SDGS due to the dominant focus on this dimension in the literature. The chapter builds on the OECD-EC seminar series on “Managing environmental and energy transition for regions and cities” and in particular on the seminar entitled “Financing environmental and energy transitions for regions and cities: creating local solutions for global challenges”. The main theoretical frameworks and regional case studies were identified in or inspired by the following publications:

  • Chapter 1 of this publication: “Managing Environmental and Energy Transitions for Regions and Cities: A Place-Based Approach”.

  • Schoenmaker/Schramade (2019), “Financing environmental and energy transitions for regions and cities: creating local solutions for global challenges”, Background paper for an OECD/EC Workshop on 18 October 2019 within the workshop series “Managing environmental and energy transitions for regions and cities”, OECD, Paris.

  • Robert (2019), “Financing Environmental and Energy Transitions in Cities and Regions: Enabling Environments and Other Conditions for Success”, Background paper for an OECD/EC Workshop on 18 October 2019 within the workshop series “Managing environmental and energy transitions for regions and cities”, OECD, Paris.

Emission reductions towards net-zero and the transformation of current energy systems will require supplementary annual investments in the magnitude of around 1 to 1.5% of GDP annually. Table 6.1 includes several estimates, including globally as well as EU-wide and with different time horizons (2030 to 2040). According to recent investment scenarios of the IEA, reaching the energy-related Sustainable Development Goals (SDG 7 on universal access to energy, SDG 3 on reducing air pollution and SDG 13 on tackling climate change) will require net additional annual investment in energy production and use of around USD 600 billion in main economies across the world (IEA, 2019[1]). Several international estimates are roughly similar (Table 6.1). The OECD evaluates that USD 600 billion additional investment in infrastructure investment is required to make planned infrastructure investments climate compatible (OECD, 2017[2]). The IPCC, in its 1.5°C Report, estimates that by 2035, 2.5% of the global GDP will have to be devoted to sustainable energy-related investment every year, of which a bit more than a third constitutes additional net investment needs (IPCC, 2018[3]). The European Commission evaluates the needed increase in annual investment in energy production and use at up to 1.2% of the GDP between 2030 and 2050 to achieve the net-zero greenhouse gas emissions goal for the European Union (between 175 and EUR 290 billion annually on average, depending on the scenario chosen). Investment would gradually increase by 1% of the GDP in 2035 with the increase peaking at 2% around 2040 (European Commission, 2018[4]). By comparison, the estimated annual investments needed to meet the SDGs equates to approximately 4-6% of global economic output, of which roughly a third constitutes additional net investment needs (UNEP, 2018[5]).

Investment is likely to be significantly affected by the COVID-19 crisis, but still need to deliver the green transition. Investment after the COVID-19 crisis is affected by lower levels of demand, higher uncertainty, supply side constraints on investment and worsening financial conditions. At the same time, the European Commission estimates that the investment needs for delivering the green transition and digital transformation are at least EUR 595 bn per year. This amount includes the additional investments needed to reach the EU’s current 2030 climate and environmental policy goals, which are around EUR 470 bn per year, and the European Union’s needs to pursue digital transformation, which amount to EUR 125 bn per year (European Commission, 2020[7]). It is, therefore, important to align current stimulus packages with the objectives of sustainability transitions. Stimulus packages can be designed to orient investment towards sectors and technologies that can accelerate the transition, and improve resilience to future shocks from environmental pressures. Investments in energy-efficiencies are a prominent example that offers many win-win opportunities: energy efficiency projects in construction and manufacturing can create local jobs and reinvigorate local supply chains (IEA, 2020[8]).

Aligning financial flows with zero-emission objectives and circularity is essential to deliver environmental and energy transition. Governments at all levels of government need to set the right incentives to orient finance away from emission intensive and non-circular projects, and orient it towards investments that support a rapid transformation. The world is not on track reaching these objectives. Massive reorientation of investment flows is required. IEA estimates show investment in fossil fuel supplies keep rising under current and announced policy scenarios between the periods 2019-2030 and 2031-2040 (Figure 6.1). Even though the increase is lower in the stated policy scenario, which takes into account planned policies, both current policies and policy plans do not avoid inconsistent investment.

Energy investment is set to fall due to the COVID-19 pandemic. Global energy demand in the first quarter of 2020 (Q1 2020) declined by 3.8%, or 150 million tonnes of oil equivalent (Mt), relative to the first quarter of 2019, reversing all the energy demand growth of 2019. The evolution of energy demand through the remainder of 2020 will depend most notably on the duration, stringency and geographical spread of lockdowns, and the speed of recoveries. Initial IEA evaluations indicate that full-year energy demand could decline by around 6%. Although clean energy investment has been relatively resilient in the downturn, investment levels remain far short of what would be required to put the world on a more sustainable pathway. In the IEA Sustainable Development Scenario (SDS), for example, spending on renewable power would need to double by the late 2020s (IEA, 2020[8]). To achieve the SDS pathway, investments need to be directed from fossil fuels to renewable energies and other low-carbon sources as well as to electricity (Figure 6.1). Additional investment costs are partially offset by lower fuel costs, which are not taken into account. The largest increases in investment are in renewables, and energy efficiency. The latter includes expenses for more efficient buildings, industrial processes and transportation as well as demand-side infrastructures, e.g. for charging electric vehicles (IEA, 2019[1]).

The additional investment needs depend on a range of factors. For example, rapid transformation to a circular economy or behavioural changes can reduce investment needs. Additional unknowns explaining differences in projections are transition paths, the future costs of technologies, life styles and demand patterns. They provide, however, an estimation of the magnitude of additional investments needed to meet energy and environmental transition objectives. The additional investment is net of investment that would be undertaken in the baseline but needs to be avoided in the transition. If such inconsistent investment were not avoided net additional investment would be higher.

Delaying action to a climate-neutral and circular economy results in substantially higher costs. If governments continue to invest in fossil-fuel infrastructure, they risk locking in even higher levels of greenhouse gas emissions for decades to come, and they will enhance the risk of stranded assets (Box 6.1). Such a delay would increase the transition costs and require a more abrupt adjustment at a later stage of action. According to the OECD, in a delayed action scenario where action on climate change accelerates only after 2025, GDP losses are estimated to be 2% on average across the G20 after 10 years, relative to the decisive transition, and would be higher for net fossil fuel exporting countries (OECD, 2017[2]).

Long-term infrastructure planning is key. Failure to invest in the right type of infrastructure in the next decades would either lock the world into an emission-intensive development pathway or enhance the risk of stranded assets. At the same time, current policies tend to foster an incremental approach towards climate policies with some progress on developing and implementing policies towards sustainable infrastructure. Long-term strategies can provide a powerful tool for governments and non-state actors to drive transformational change. They can help create consensus on economic trajectories, provide long-term signals to markets and inform near-term investment decisions. Long-term planning needs to take into account the opportunities and challenges of digital technologies, ranging from enabling technologies (e.g. the Internet of Things) to sector-specific technologies (e.g. electric vehicles) to new business models (e.g. ride sharing) and digital finance systems (e.g. Pay-as-you-go systems). They can make pricing of infrastructure services more efficient, e.g. to enable optimal use of renewables or optimal use of road infrastructure and replace fossil fuel taxes, thereby providing revenue streams and reducing infrastructure cost. The use of long-term scenarios and strategic foresight techniques can help taking into account how socio-economic and technological pathways might shape future infrastructure supply and demand. Back casting techniques can help by working backwards from the objective of climate-neutrality by 2050 to unveil investment decision needs and trade-offs along the road (OECD/The World Bank/UN Environment, 2018[9]). Recognising the pivotal role cities and regions play in advancing climate and circular action and mobilising investment needs, developing long-term infrastructure plans provides an important opportunity to align national, regional, and local action.

Cities and regions are particularly well placed to support environmental and energy transition finance. On average, across the OECD, the largest share of climate-related public spending occurs at the subnational level. Recent estimates show that cities and regions were responsible for 55% of public spending in selected sectors that have a direct implication for climate change over the period 2000-2016. Compared to spending, an even larger share of environment and climate-related public investment occurs at the subnational government level. On average, subnational governments are responsible for 64% of environmental and climate-related infrastructure investment over the period 2000-2016. However, subnational climate-related spending and investments represented on average respectively around 1.3% and 0.4% of GDP over 2000-2016, indicating a need to scale-up transition finance efforts (OECD, 2019[11]).

Encouraging circular economy business models supports the transition. Circular business models are important to finance and scale sustainability transition because they significantly reduce the environmental pressure associated with economic production and consumption and support a more resource efficient economy. This includes efforts to promote more efficient material use, for example through better product design, re-use, and recycling of materials such as steel, aluminium, cement and plastics. Cities and regions can facilitate the emergence of circular business models through circular labs and a flexible regulatory framework under which new business models can be developed and tested. Subnational governments can further promote the supply and demand of circular products and advocate their use through education and information programs among citizens and consumers (see Chapter 3 on the circular economy).

Growing volumes of sustainability transition finance highlight the importance of environmental and energy transitions for the financial sector. The financial sector has expanded the range of environmentally friendly products and services significantly and is beginning to include environmental considerations in its financial decisions. Subnational governments are playing an increasingly important role in financing sustainable investment projects, particularly in the areas of transport, water infrastructure and public buildings. The financial sector is providing products to finance clean energy and electrified transport (CBI, 2019[12]). Sustainable investments in other sectors are increasing more slowly and need to be scaled further.

Investments in clean energy are increasing. Investment in renewable energy has grown significantly in the past decade. Overall, clean energy investment has increased from around USD 60 billion in 2004 to an average of USD 300 billion a year in the past decade (IEA, 2019[13]). Many investors choose to invest more in sectors that support the energy transition, and less in areas that are perceived as risky. In addition, a number of financial investors have signalled restrictions on financing coal assets due to the potential (future) risk of investing in stranded assets (ibid).

However, the still modest share of renewable energies in global energy supply offsets the impressive growth rate. Coal had the largest share of global electricity generation at 37% in 2018, compared to 7% in wind and sun (although it should be noted that when combined with all other carbon-free sources, including hydropower and nuclear power, 36% of low-carbon electricity was accounted for) (IEA, 2019[1]). Low-carbon investment in non-electricity sectors is increasing, but need to be scaled up even more. The transportation sector saw robust growth in low-carbon investments due to falling battery costs and financial incentives. Tax incentives, low operating costs and air pollution and fuel consumption standards have led to continued growth in electric vehicles in particular (IEA, 2019[14]). However, one has to bear in mind that the sale of electric vehicles is still only a fraction of the 87 million cars that were sold worldwide in 2018. Although the proportion of new cars is expected to increase to 30% in 2030 and 57% in 2040, electric vehicles will only make up 9% in 2030 and 30% in 2040 of all passenger cars on the road (Bloomberg, 2019[15]). Progress on road freight, air and shipping is slower. Investment in the buildings sector is also behind (IEA, 2019[16])(see also Chapter 4).

The industrial and land use sector, including agriculture, still has to make significant low-carbon investments. In 2018, only 2% of revenue from green bonds was earmarked for low-carbon projects in the industrial sector and 10% in the land use sector (CBI, 2019[12]). At the same time, heavy industry, heavy goods transport and land use contribute more than 50% to global annual emissions (ETC, 2018[17]). Their emissions are also still expected to increase with current policies while other parts of the economy, such as the electricity and building sectors, are increasingly decarbonising, albeit at too slow a pace.

A large range of actors operates in the sustainable finance arena and performs different functions across the investment chain. Table 6.2 outlines two main categories of actors: Policy makers and public finance actors on the one side, and private finance actors on the other. Policy makers in national, regional and local governments set public policies that establish the frameworks, conditions, and priorities for investments. For example, subnational governments can set sectoral standards to drive investments in a particular direction, or they can establish the necessary legal framework so private low-carbon investments generate revenues. Public subsidies can make projects investable where costs or uncertainty would otherwise be too high, and they can support early-stage R&D for new technologies.

The private sector and the financial system play a key role in supporting transition pathways. However, current financial sector practices are not yet very suitable for financing environmental and energy transitions since the finance structures of private investors (e.g. investment mandates and asset classes) are too often incompatible with the financial needs and capacities of subnational governments. Efforts to align financial flows with climate objectives remain incremental and fail to deliver the radical transformation needed (OECD, 2019[11]). One big challenge for sustainable finance is therefore to better align current public and private actors in transition financing.

Financing environmental and energy transitions in cities and regions will necessarily draw on a diverse array of transition finance actors and revenue sources. Figure 6.2 provides an illustration of main actors and revenue sources to support transition finance. Three core mechanisms to channel transition finance are: i) greening subnational governments’ traditional budgetary resources through earmarking budgets for transition objectives; ii) mobilising transfers from higher levels of government; and iii) and making use of external finance mechanisms and attracting private investors, including through certified green bonds and loans as well as public-private partnerships. Often, subnational governments do not use one tool at the expense of another, but deploy a mix of inter-governmental transfers, own revenues, and external credit to finance environmental and energy transition. External finance only holds a small percentage of cities’ overall investment finance across the European Union. According to the 2017 Investment Survey of the European Investment Bank (EIB), it only represents 18% of municipalities‘ investment finance.1 Overall, municipalities resort mainly to own resources. Yet, many investments are economically viable and thus well suited for external finance (Windisch, 2019[19]). This points to a number of challenges smaller municipalities face in accessing loans, funds and other types of external financing, including limited expertise and administrative challenges.

Many of subnational governments’ sources of revenue can be designed to foster the environmental and energy transition and help finance it. Own-source revenues include taxes levied by subnational governments, user charges and fees, and income from assets, which local and regional governments can use to finance green investments as well as encourage more environmentally sustainable use. Exploiting the potential of taxes set by subnational governments means at least to eliminate any anti-green bias of some local tax provisions. For example, property taxes should support the development of urban cores and transport linkages instead of favouring urban sprawl (OECD, 2019[11]). Fees that can both raise revenue and support environmental and energy transition include congestion charges, parking fees, high occupancy toll lanes, and water and wastewater user fees (Merk et al., 2012[20]). Some subnational governments have also introduced carbon-pricing schemes, although these are more efficiently used at higher government levels. Fees should reflect all costs, including environmental costs. This can improve incentives as well as revenue streams for subnational governments and their public enterprises. These revenues can leverage investment, for example, in infrastructure for more sustainable water use. Using revenues from charges to invest in sustainable infrastructure and protect vulnerable groups upfront also tends to improve citizen support for them (Kallbekken and Aasen, 2010[21]; Baranzini and Carattini, 2017[22]; Kallbekken, Kroll and Cherry, 2011[23]). Property income and land-based financing instruments help local authorities reclaim gains from investments or changes in land regulations, thereby generating revenue that may be used to close some of the funding gaps of environmental and energy transition.

Many subnational governments are able to raise revenue through sources they control, but this varies greatly. In many OECD countries, subnational governments have constitutional rights and/or local government financial laws, which gives them the right to raise taxes. In some other OECD countries, in particular in the United States, voters must approve tax increases for specific purposes, such as infrastructure investment. This requires making a much stronger link between the rates payers must contribute and the benefits they enjoy in return. Where local governments are allowed to alter local taxes as needed, creditworthiness of local municipalities is reinforced. In Sweden, the local government-funding agency Kommuninvest makes use of the high creditworthiness of Swedish municipalities to help them raise capital through the issuance of bonds, which it places in Europe, Japan and other countries.

The international community and national governments have made strong commitments to support environmental and energy transition, but the access they provide to finance it remains limited for cities and regions. Several multilateral banks such as the World Bank, bilateral banks, and global climate funds such as the Green Climate Fund and the Special Climate Change Fund have earmarked funding they provide for the transition. However, most support is channelled through national governments, with limited access for regional and local governments (OECD, 2019[11]). A notable exception is the European Union, which invests directly in regions and cities through the cohesion policy funds.

National governments provide grants/transfers and subsidies. Systematically integrating environmental conditions into general and project-specific grants would allow national governments to nudge regions and cities to support the transition more strongly. Specific grants could also be established to support green projects, and to compensate for potential local costs generated by green policies (OECD, 2019[11]). An example of an intergovernmental transfer dedicated to transition funding is Germany’s National Climate Initiative (Box 6.2).

Private finance can help close funding gaps. Banks and private institutional investors such as pension funds and insurance companies are fundamental actors in supporting environmental and energy transitions, but the private sector provides thus far only a small share of transition finance. Subnational governments face bigger challenges than national governments in accessing private capital due to a lack of creditworthiness and a lack of capacity to access sustainable finance instruments, such as green bonds. In addition, subnational governments are not everywhere allowed to borrow on capital markets. In many unitary countries, bond financing by local governments is not allowed. This is for example the case in Denmark, where subnational governments only issue bonds jointly through KommunKredit. Other countries, such as Greece and Ireland, do not issue subnational bonds. Even when they are allowed to issue bonds, they are not widespread, especially in Europe where loans is the preferred source of external financing. By contrast, in the United States and Canada, bonds represent more than 90% of the subnational government debt stock (OECD/UCLG, 2019[26]). Despite these limitations, green bonds gain prominence in some countries, notably in France, where subnational green finance includes a prominent role for green bonds (Box 6.3).

Public-private partnerships (PPPs) represent an important potential source of external funding. PPPs are a long-term contract between a private party and a government entity for providing a public asset or service, with some of the risk and management responsibility shifted to the private party. Although the average value of PPPs is generally higher at the national level, the number of PPPs is often greatest at subnational level (OECD, 2018[27]). For example, in Germany, subnational PPPs constitute approximately 80% of PPP investment. In France, subnational governments granted 79% of the contrats de partenariat between 2005 and 2011. Subnational PPPs come however not without risks. Challenges emerge in areas such as financing and funding (private borrowing costs might be higher than public ones for example, raising the costs of the PPP project overall) , intergovernmental regulatory coherence, cross-jurisdictional co-ordination, economies of scale and asymmetric information between the contracting parties, which may put local governments at a disadvantage (OECD, 2019[11]). Given the need for large administrative capacity and accountability to deal with these challenges, using PPPs to finance environmental and energy transitions will likely be limited to larger jurisdictions, metropolitan areas or regions with sufficient capacities.

Local and regional authorities face a range of barriers that can hinder the scaling and deployment of transition finance. The below section lists some of the core obstacles as identified through the OECD seminar and further desk research.

  • Lack of awareness about transition finance options: Cities and regions have a wide range of potential tools at their disposal to finance sustainability innovations and related infrastructure, but they are not always aware of all of them. As cities and regions often primarily rely on public funds to finance environmental and energy objectives, there is a particular lack of knowledge about the use of private financing (e.g. green bonds, blended finance). Not being aware of all available financing options makes it difficult to identify and select the best financing instruments to support planned investments in sustainability innovations (Schoenmaker and Schramade, 2019[32]). Dedicated training for cities and regions, such as the Cities Climate Finance Training funded by the Climate-KIC (Institute for Climate Economics, 2019[33]), can help here by informing local authorities about how financial opportunities are can be best used.

  • Insufficient technical knowledge to carry out projects: Insufficient administrative capacity is one of the biggest obstacles to access transition finance at the local level. Even when local and regional authorities have identified the most suitable instruments for transition finance, the associated administrative effort and securing of funding can be challenging. Larger projects in particular require a good understanding of technical knowledge, the preparation of a risk assessment and detailed financial analysis. Not all local and regional authorities have the necessary human resources and skills to undertake such efforts. New skills, such as financial and risk management skills, and technical knowledge on how to measure the sustainability and financial benefits of urban and regional development projects must be acquired. Local and regional authorities can often build on existing knowledge and resources from domains such as urban and infrastructure development, public engagement and communication and develop them further. It is particularly important to avoid silo work in city and regional administrations and to create a regular exchange between the finance department and the environmental and climate department that helps acquiring much-needed skills and expertise (Robert, 2019[18]).

  • Budgetary, regulatory, and political constraints: Fiscal constraints and “mandatory” expenditures can lead to a lack of room for manoeuvre. Increasing administrative capacity for transition financing might require hiring of new personnel or buying outside expertise, which not every local and regional authority can do. Additionally, many budgets at subnational-level require long-term planning and accountability, making experimentation and financing of risky projects difficult. Another issue is that legislation on financing of municipal investments varies across countries. Some subnational governments are legally constrained in taking on debt. Political reluctance can have various reasons, including low public acceptance of transition projects (for example where “more pressing issues” such as fighting unemployment exist), and vested interests profiting from the status quo (Røpke, 2016[34]).

Scaling-up and deploying transition finance means that subnational governments must play a more proactive role than in the past in financing the transition. Because the local context often plays an important role in determining investment needs, local levels play an important complementary role to national governments. However, subnational governments often lack the knowledge and ability to structure transitions in such a way that they can attract private funding. Therefore, although recent trends in climate finance are promising, too few and too small transition projects are currently being carried out, which hinders the timely transition to a climate-neutral and circular economy. This section outlines how building subnational capacities, creating clear signals for investors and facilitating investment as well as deeper financial reform can help scale transition finance.

Subnational authorities face a range of practical challenges due to a lack of capacity and expertise. For example, a recent study on the climate efforts of 13 small and medium-sized cities in the Netherlands showed that even where there were good practices in transition management and finance, there are few exchanges between municipalities. A lack of co-operation and a low level of awareness of existing best practices meant that good initiatives were not repeated in other municipalities, which led to missed opportunities for local measures to support environmental and energy transition (Boehnke et al., 2019[35]). Subnational governments can implement a number of initiatives to overcome practical problems of particularly smaller administrations. This section highlights some examples and suggestions:

  • Valuing co-benefits in cost-benefit analysis: Many environmental and energy transition investments in cities and regions offer significant co-benefits such as better health and job opportunities. For example, in the transportation sector, greenhouse gas emissions and air pollution have a common source that also causes congestion, accidents, and noise. Addressing these problems at the same time will create the potential of large cost reductions, as well as the preservation of ecosystems and health improvements (Rashidi, Stadelmann and Patt, 2017[36]). One way of translating co-benefits into policy evaluation is through monetising the impact of co-benefits on the financial rate of return. For this purpose, cost-benefit analysis should include environmental and social criteria, including shadow carbon pricing, that make environmental costs and benefits part of a broad economic analysis.

  • Enhanced use of tools via templates and protocols: National or international standards can reduce the workload of subnational authorities. By standardising the documentation and assessment of projects contributing to transition, such as energy efficiency projects in buildings, assessing the economic and environmental feasibility of a project becomes easier. The Horizon 2020 funded project Investor Confidence Europe has, for example, developed the Investor Ready Energy Efficiency Certification, which assembles best practices and existing technical standards into a set of Protocols that define a clear roadmap for developing projects, determining savings estimates, and documenting and verifying results (ICP Europe, 2020[37]).

  • Peer-to-peer learning between subnational authorities and smaller cities/communities: Regional peer learning provides a platform to discuss reforms, achievements and challenges on integrating environmental and energy transition finance into national and subnational budgets. It can provide a regular opportunity for government officials to meet face to face and discuss transition finance. Workshops and consultation groups can help smaller cities and communities to exchange and learn from each other. Thematic working groups can be set up to deal with technical details of the market for sustainable finance. Co-operation via regional agencies, associations and NGOs can also help spread good practices and replicate initiatives in a cost and time-efficient manner (Schoenmaker and Schramade, 2019[32]).

  • Overcoming limited expertise through outsourcing of project pre-evaluation to regional experts: Outsourcing the financial evaluation of green projects to external contractors can facilitate access to finance because it reduces the in-house expertise and associated project risks. This is particularly relevant for smaller cities in which the number of bankable projects is limited and where less know-how can be accumulated internally. In the city of Oostende in Belgium, an independent company, fully owned by the city, manages the whole life cycle of green energy project finance (Windisch, 2019[19]).

Cities and regions can deploy several policy instruments to reorient capital flows. Subnational governments can increase returns on investments in sustainability innovations and related infrastructures through well-known policy tools such as financial incentives, regulations and standards to increase returns and reduce risk ratios. Many environmental and energy projects have unattractive risk-return profiles due to technological risks (especially for less mature innovations), commercial risks (especially if sustainability innovations are more costly or have uncertain business models) and long payback times (Schoenmaker and Schramade, 2019[32]).

In order to reduce risks and stimulate investments, policy makers at all levels of government have a mixture of tools at their disposal. These tools can help create markets for sustainability innovations and provide a clear signal of intended development pathways. Selected tools in relation to energy investment are, for example, minimum performance standards for energy efficiency in buildings or purchase subsidies for electricity storage (IEA and IRENA, 2017[38]). However, the rate of return is only high as long as the policy signals are in effect or as long as their effects continue. Sudden shifts in policy priorities may represent an important source of risk that can significantly undermine investor confidence.

Combining investment sources through 'blended finance' mechanisms can also increase financial flows. Blended finance uses relatively small amounts of public funds to mitigate specific investments risks and help rebalance risk-reward profiles of high-impact investment so that they have the potential to become commercially viable over time. This requires deciding the appropriate role for the public sector. For example, public/private co-financing of large solar power projects in mid-income countries was appropriate when the technology was untested, but now such projects can be done privately. Subnational governments need also to balance risk taking and risk avoidance to take on as much risk as needed but not more (Schoenmaker and Schramade, 2019[32]). Providers of concessional finance and institutional investors can help build the capacities of subnational authorities to engage meaningfully in the design and implementation of blended finance deals.

Policy interventions should address barriers that hinder investments by large financial institutions. One key issue for banks and institutional investors is a lack of a transparent project pipeline with high quality and sizeable projects that offer stable investment returns. Energy efficiency investments, for example, are potentially large in numbers but are often small and distributed across numerous households and businesses, implying high transaction costs. Responding to this challenge is likely to involve developing technical and knowledge capacity at the level of subnational governments to help ensure a steady pipeline of good-quality projects (OECD/The World Bank/UN Environment, 2018[9]).

Another useful approach involves standardisation and securitisation, i.e. bundling together small projects or assets (such as green mortgages) into a larger pool so that they can be traded in financial markets. This can be particular attractive for cities and regions, which often struggle to attract private finance because municipal or regional projects with financing needs are often too small in volume to be attractive for private investors and lack suitable aggregation mechanisms. Bonds for example typically need to have a size of USD 200 million to be relevant for institutional investors (CBI, 2019[12]). Inter-municipal co-operation can help upscale projects and co-operation across jurisdictions. Cities and regions can encourage the creation of two types of organisations that stand between small projects and large institutional investors (see Figure 6.3 below):

  • Small Impact Investors: Small impact investors provide funding and advice to companies that deliver sustainable financial and social returns. They often focus on a single city or region and can use their local network and knowledge. An example of such a Fund is the Social Impact Fund Rotterdam. The Fund is part of a local network of actors that help each other to advance the environmental and energy transition.

  • Social Aggregator Funds: Social Aggregator Funds invest in dozens of small impact investors who choose them for their ability to create both financial and social value. Aggregator funds exist for traditional private equity, but aggregate funds with an impact goal are still rare.

Green bonds and sustainability bonds provide another mechanism for increasing large-scale institutional investments. Green bonds are an instrument, to finance green projects that deliver environmental benefits. The green bond market has expanded rapidly rising from global issuance of USD 3.4 billion in 2012 to USD 167 billion in 2018. Sustainability bond issuance in 2018 totalled USD 21 billion; representing 114% growth compared to 2017. Subnational governments are increasingly active in the green bond market, accounting for 13% of green bonds issued in 2016, with budgets earmarked for investment mainly in transport, water infrastructure and public buildings (CBI, 2019[12]).

The growing interest in Green Bonds is representative of an aggregate increase in impact-based investing, or investments with intended social and environmental benefits. These securities are a unique form of ESG (Environmental, Social, and Corporate Governance) investing and face many of the same issues and benefits as the larger impact investing market. These include struggling with defining objective metrics to value the impact achieved and incentivising investors to divert their capital into more sustainable businesses and projects. Social impact investing can reduce investors’ exposure to the risk of investing in stranded assets through a diversification of investments into sustainable assets such as clean energy equities and green bonds.

The green bond market also holds some challenges. First, greenwashing, meaning unsubstantiated claims about a product’s environmental benefits, needs to be avoided. Second, despite its rapid growth, green bonds today account for less than 1 % of the global bond market. One of the reasons for such a low number is that the ongoing flow of investments into fossil fuel exploitation continues to overshadow global investments in renewables (OECD/The World Bank/UN Environment, 2018[9]). While green bonds can reduce investors’ exposure to stranded assets through a diversification of investments into more low-carbon assets such as green bonds, they do not avoid that parallel investments into (still profitable) stranded assets continue. Whether green bonds increase financing flows to “green” projects depends on whether investors are willing to accept a lower return on them. Green bonds may also suffer from multiple certification standards. Broader and more consistent disclosure of risks from investments according to how consistent they are with the environment and energy transition could strengthen investors’ willingness to price the funding they are willing to provide in line with the transition (see below).

A deeper layer of policy reform could address mainstreaming of environmental and energy transition concerns into the financial sector and its regulation. Deeper institutional reform could help overcome structural problems such as short-term oriented returns in the financial sector or a lack of focus on incentives that support sustainability transitions.

Additional measures could seek to reformulate institutional rules and formal expectations of financial actors. Cities and regions can play an important role in advocating for such reforms. Reforms should include strengthening classification systems for sustainable investment. An important first step in this direction has been the political agreement between the European Parliament and the Council on the creation of a taxonomy of sustainable finance from June 2020 (Box 6.4). Based on advice from the Technical Expert Group on Sustainable Finance, a list of sustainable economic activities as well as a standard for green bonds is currently under development.

Strengthening disclosure responsibilities is an important part of redirecting financial flows because it requires companies to inform investors about sustainability performance and related financial risks. Disclosure can help investors, financial intermediaries and governments avoid financing stranded assets. Disclosure could be based on the recommendations of the Task Force on Climate-related Financial Disclosures and the European Union taxonomy. Linking public funding of regional infrastructure or development projects to improved disclosure and its results can also contribute to environmental and climate goals.

Financial supervision is increasingly addressing sustainability considerations. In April 2019, the Network for Greening the Financial System (NGFS) recommended to include climate risks in the monitoring of financial stability. Some countries have already followed these recommendations. Since 2015 - even before the NGFS recommendations were published - Article 173 of the French Energy Transition Act requires institutional investors to report on how they incorporate environmental, social, and governance (ESG) criteria into their investment policies (National Assembly of France, 2015[40]). In April 2019, the Bank of England issued a supervisory statement that calls on the United Kingdom banks and insurers to embed climate risks in corporate governance and risk management and to improve climate-related disclosure (Bank of England, 2019[41]).

Some researchers have suggested changing the mandate of central banks. The narrow focus on price stability and financial stability and regulation could be broadened in OECD countries (Campiglio et al., 2018[42]). In many emerging economies [Brazil, China (People’s Republic of)], central bank mandates are broader and focus on economic development or provide support for strategic sectors. Changes in central bank mandates could, for example, enable green quantitative easing. This could lead to green bond purchases and to investments in financial assets supporting environmental and energy transition projects.

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Note

← 1. Only cities and municipalities with 100 000 inhabitants or less are within scope of the cited report.

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