The continuing large flows of private finance to hydrocarbon-
intensive investment reflect economic distortions created by subsidies and moral hazard, among other factors. Urgent measures are needed to remove these distortions; such a reform would also increase the demand for green investment projects and climate finance.
Alongside steps to increase the supply of climate finance, it is also critical to increase the demand for it. According to the IEA, some $2 trillion will have been invested in clean energy technologies in 2024, but more than $1 trillion will still have been invested in coal, gas and oil in the same period.
There are many well-developed approaches for incentivizing and facilitating private green investment, including through direct subsidies, regulation, carbon taxation, carbon border adjustment measures, and the development of compulsory and voluntary carbon markets. However, this section focuses on another key approach, which is to reduce the demand for hydrocarbon-intensive investment.
The continued scale of hydrocarbon-intensive investment – whether in the form of consumers buying petrol or diesel cars, or major corporations investing in new oil and gas resources – is very surprising, even if viewed in purely financial terms from the perspective of a typical investor. There is a widening appreciation across much of society that decarbonization is ultimately unavoidable given the enormous human and economic costs of rising temperatures. This realization – combined with the speed of technological change and the threat of radical policy shifts (whether driven by governments or the courts) in the context of popular reaction to extreme weather events – means that the risks inherent in investing in fossil fuels and other carbon-intensive sectors are rapidly increasing.
The continuing flow of funds to carbon-intensive projects is important in frustrating or slowing overall net zero transition efforts.
At the same time, the continuing flow of funds to carbon-intensive projects is also important in frustrating or slowing overall net zero transition efforts. Firstly, such investments not only maintain the level of greenhouse gas emissions in the near term, but also lock in future hydrocarbon use and related emissions. Once made, the initial investment becomes a sunk cost. The related plant and equipment will only be displaced if regulation mandates it or if running costs are permanently undercut by the combined capital and running costs associated with building a new non-hydrocarbon plant.
Secondly, any funds going to hydrocarbon investment are not available for carbon-free and low-carbon investment. This is particularly critical at a time when the terms for private finance have tightened sharply following the global inflation shock.
Finally, it is increasingly likely that hydrocarbon assets will become ‘stranded’ as a result of rapid technological and policy change, with serious consequences for financial stability. These risks are likely to be increasingly concentrated in EMDEs, where the demand for fossil fuel and other carbon-intensive investments remains strongest.
Why are high levels of hydrocarbon-intensive investment continuing?
There are good practical reasons for some continued investment in hydrocarbons and other carbon-intensive sectors. These include: the need to maintain output in hard-to-abate industrial sectors, pending the development of new, economically viable, low-carbon technologies; the need to invest in some existing oil and gas fields in order to extract the remaining output during the energy transition; and the need to provide access to energy in areas where the costs of renewables are still prohibitively high.
But the current scale of hydrocarbon-intensive investment goes well beyond what might be explained by these factors alone. Continued investor enthusiasm appears to be driven by a mix of the following interrelated factors and underlying assumptions:
- Investor short-termism. The prospect of high short-term returns from the development of oil and gas fields is still attractive to shareholders in oil and gas companies. But these high returns will only be delivered if the assets have conventional lifespans (40 years for power systems). A sharply accelerated move to net zero would lead to the assets being forcibly retired much earlier, significantly undermining these calculations. Similarly, 80 per cent of the cars which consumers buy globally are still conventional petrol or diesel vehicles. This reflects the lower initial cost of such vehicles, but does not take into account the much lower running costs for electric cars over their 10–15-year lifespan, or the possibility that the use of existing hydrocarbon-based cars becomes sharply restricted.
- Regulatory and infrastructure bottlenecks. Investors and consumers are concerned about regulatory obstacles and infrastructure bottlenecks, such as delays to grid connections for new renewable energy investments, or a lack of public charging infrastructure for electric vehicles in urban areas.
- ‘Path dependency’. Investors may choose fossil fuels and other carbon-intensive assets because such assets are familiar, and because investors feel they know how to manage the risks associated with them.
- Hydrocarbon subsidies. In some countries, the returns on hydrocarbon investments are artificially inflated by fossil fuel subsidies. In 2022, the global cost of such subsidies was $7 trillion, of which around $1 trillion consisted of explicit subsidies. Political lobbying helps to keep these subsidies in place, as does policy inertia that reflects the complexity and political sensitivity of managing the socio-economic consequences of the energy transition.
- Financing constraints in EMDEs. Investors in EMDEs may identify attractive high-return green investment projects but be unable to finance the initial capital expenditure due to high country risk premiums or even a complete lack of availability of finance. The 2022–23 inflation shock, and the accompanying increase in long-term real interest rates worldwide, has exacerbated this situation.
- Technology optimism. Some investors may assume that technology solutions – such as much cheaper carbon capture and storage (CCS), direct air capture (DAC), or geo-engineering and solar radiation management (SRM) – will result in current hydrocarbon-intensive investments becoming consistent with preventing catastrophic climate change and hence viable over the long term.
- Lack of credibility in climate commitments. Given the history of missed targets and failed promises, and despite the implications for global warming, investors may simply not believe that governments will take the necessary steps to meet the Paris Agreement goals. Investors may assume, for example, that aggressive timetables to decarbonize road transport in Europe and the US will be abandoned in the face of pressure from industry and labour.
- Moral hazard. In this case, investors know the high risk of continuing to invest in hydrocarbon assets and recognize that high short-term returns may not continue. However, investors may assume that governments will either choose to bail them out should the risks crystallize, or be forced to do so because the consequences for the financial system and national economy would be too severe.
Investors have long benefited from the special treatment that governments have accorded to the energy sector. But investors’ belief in the likelihood of large-scale government bailouts has probably increased since the COVID-19 pandemic and the energy price shock in Europe that followed Russia’s 2022 attack on Ukraine. In both cases, governments in advanced economies provided billions of dollars in aid to cushion private firms and consumers from the full impact of these shocks.
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 for it or not – that their losses are due to government action and that they are consequently owed compensation.
Moral hazard could also explain why hydrocarbon investment has continued at such a high level, despite the increasing transparency around climate risk in private financial institutions that followed the launch of climate alignment initiatives at COP26 in 2021. The existence of moral hazard is hard to prove definitively, and its scale is difficult to quantify.
How can hydrocarbon-intensive investment be deterred?
Responses to some of the factors listed above are already developing. For example:
- A few major oil and gas companies are well aware of the disconnect between what their shareholders want – in terms of reaping short-term high returns from oil and gas investment – and the very uncertain long-term prospects for the underlying investments. In response, these companies are hedging their investment strategies between hydrocarbon assets and green assets, and may look for ways to educate their existing investors and/or attract new investors with longer-term perspectives.
- Regulation and planning obstacles to green investment may prove short-lived as the authorities in some countries step up investment to address power bottlenecks and prioritize regulatory reforms. Private investments in long-term hydrocarbon-intensive assets that have been substituted for green investment in the meantime could then prove to be costly mistakes.
- Path dependency in favour of hydrocarbon-intensive assets (and against green investment) should be declining as the regulatory and technology risks around such assets increase rapidly.
- An increasing number of governments (e.g. in India and Africa) are reducing hydrocarbon energy subsidies despite the risk of political fallout.
- The likelihood of green measures being rolled back in some countries may decline in the face of growing loss and damage costs arising from extreme weather events (although it is also possible that the growing incidence of loss and damage will see some funds being diverted from mitigation to adaptation and dealing with loss and damage). The prospect of intense competition from China across the full range of low-carbon technologies may also act as a disincentive to continuing hydrocarbon-intensive investment, as delaying adjustment to new technologies will become even riskier for other countries in terms of global competitiveness. A further possible deterrent is the growing role of independent courts in forcing governments to keep to their legal commitments on greenhouse gas reduction.
- The World Bank and other MDBs are seeking to improve private sector appetite for emerging-market risk (including green investment) by publishing their own historical project default data.
Step 4: Addressing moral hazard
In addition to the steps outlined in Chapter 3, a further important step that finance ministries and central banks should take is to address decisively the risk of moral hazard distorting investment decisions. This is not only important in its own right, but will also help reinforce a number of the positive trends and incentives described above by forcing the private sector to look at alternatives to hydrocarbon-intensive investment.
No additional finance or complex regulation is required. Instead central banks, financial regulators and finance ministries should simply state as clearly as possible that financial institutions, industrial companies and resource companies cannot rely on being bailed out by the authorities if hydrocarbon-intensive assets are made redundant by technological and regulatory developments – including as a result of future government policy measures. The credibility of such a statement could be enhanced by legislation.
To reinforce the effect of this statement, the authorities should also introduce climate-specific measures in financial regulation. There is a menu of potential options, including: mandatory climate risk disclosure policies for financial institutions (in countries where such policies do not already exist); additional, climate-related, capital adequacy weightings; and conceivably an absolute cap on the amount of climate risk any one institution is allowed to take on in relation to its total assets.
It could be argued that the existing prudential regime already covers risks arising from climate change, and that additional climate-specific requirements would overcomplicate the regulatory system. However, in a world where modelling of the economic and financial aspects of climate risk is widely seen as unfit for purpose, an element of ‘bootstrapping’ to protect the financial system while measurement and modelling techniques are improved can be justified.
