According to the International Energy Agency, some $2 trillion will be invested in clean energy technologies in 2024, up from $1.9 trillion in 2023. While this trend is very welcome given the evidence of worsening climate change, more than $1 trillion will still be invested in coal, gas and oil in 2024.
This is a major problem for two reasons. Firstly, any funds going to hydrocarbon investment are not available for green investment. Secondly, it is increasingly likely that hydrocarbon assets will become ‘stranded’ as a result of rapid technical and policy change, with serious consequences for financial stability.
Moreover, with clean energy investment focused on advanced countries and China, these risks will be increasingly concentrated in emerging and low-income economies – although the absolute level of climate transition risk in assets located in advanced countries and China will be substantial as well.
Why has the private sector’s enthusiasm for hydrocarbon investment continued at such a high level – beyond what is needed to exploit fully existing energy assets – despite the evident risks? This is reflected in the vigour with which some major oil companies have resisted shareholder initiatives requiring them to give more weight to climate change in their decision-making.
‘Moral hazard’ and high-risk investments
A plausible explanation and potentially important factor is ‘moral hazard’. In this case investors know the high risk of continuing to invest in hydrocarbon assets, but are attracted by the returns. They assume that governments will either choose to bail them out should the risks crystallize, or be forced to do so because the consequence for the financial system and national economy would be too severe.
Investors have long benefited from special treatment governments have given their energy sectors. But belief in the likelihood of large-scale government bailouts has increased since the COVID-19 pandemic and the energy price shock in Europe that followed Russia’s attack on Ukraine. In both cases advanced country governments provided billions of dollars in aid to cushion the full impact of these shocks on firms.
Investors may also consider that the most likely cause of financial losses will be policy changes – such as new constraints on the use of hydrocarbon fuels in the economy, carbon taxes and the removal of existing subsidies. This, they may believe, will enable them to argue – whether there is any legal basis or not – that their losses are due to government action and so they are owed compensation.
Moral hazard would explain why hydrocarbon investment has continued at such a high level despite the increasing transparency around climate risk in private financial institutions that followed initiatives taken at COP26 in 2021.
The existence of moral hazard is hard to prove definitively and its scale is difficult to quantify. But it has long been a factor driving central bank and financial regulator behaviour.
The full scope of central bank ‘lender of last resort’ policy is purposely ambiguous (known as ‘constructive ambiguity’) to try to limit the distorting effect it could have on the financial institutions that stand to benefit.
Deposit insurance is also limited in scope so that only relatively small retail deposits are protected. An important justification for today’s highly intrusive prudential regulation is to offset the perverse effects resulting from the authorities’ financial safety net on risk-taking behaviour.
Other explanations for the enthusiasm for hydrocarbons
Moral hazard will combine with other factors contributing to continuing large scale hydrocarbon investment.
One possible reason is that investors simply do not believe governments will take the necessary steps to meet the Paris Agreement goals. New coal, oil and gas investments, they may think, will be profitable over their normal life span, notwithstanding the consequences for climate change.
Another possibility is that the returns on hydrocarbon investments are boosted by fossil fuel subsidies. These cost some $7 trillion globally in 2022, of which around $1 trillion were explicit subsidies. Political lobbying helps to keep these subsidies in place as does the complexity of dealing with the socio-economic consequences of the energy transition.
Investors may also recognize the potential in green investment, but lack the information, including default data and modelling capabilities, to identify good projects. Investors tend to focus on familiar investments and investment processes (path dependency), because they feel they know how to manage the risks. Some hydrocarbon funding will also be needed to underpin energy transition in hard to abate sectors.
Project developers may recognize that green investment is a better long-term bet than hydrocarbon-intensive investment, but lack the additional capital to implement a strategy based on this.
The 2022–23 inflation shock and accompanying increase in long-term real interest rates is likely to have exacerbated this. Investors in low-income and emerging economies may also be forced to minimize ‘up front’ capital expenditure due to disproportionately high investment risk premiums.
How authorities should address moral hazard
To address possible moral hazard linked to climate-related transition risks, central banks and finance ministries should first state clearly that financial institutions cannot rely on being bailed out by the authorities if the risks crystallize – including as a result of future government policy measures. The credibility of such statements could be enhanced by legislation.